Since I am endeavoring to spend some time with my family, forgive me for dispatching this New York Times story, “Dollar Shift: Chinese Pockets Filled as Americans’ Emptied.”
The article buys, hook, line and sinker, then- Fed-governor Ben Bernanke’s depiction of so-called global imbalances (the US borrowing from abroad to fund overconsumption; Japan, China, Taiwan, and the Gulf States running significant, persistent trade surpluses and oversaving). Bernanke chose to position the problem as a “savings glut” which had the convenient effect of placing responsibility for the problem overseas, particularly on the Chinese, who kept the renminbi cheap via a hard peg to the dollar. Key bits:
In March 2005, a low-key Princeton economist who had become a Federal Reserve governor coined a novel theory to explain the growing tendency of Americans to borrow from foreigners, particularly the Chinese, to finance their heavy spending.
The problem, he said, was not that Americans spend too much, but that foreigners save too much. The Chinese have piled up so much excess savings that they lend money to the United States at low rates, underwriting American consumption.
This colossal credit cycle could not last forever, he [Ben Bernanke] said. But in a global economy, the transfer of Chinese money to America was a market phenomenon that would take years, even a decade, to work itself out. For now, he said, “we probably have little choice except to be patient.”….
Yves here. As far as I am concerned, this was rationalization of a clearly unstable and unsustainable pattern. But rather than try to find a way out, or at least keep it from becoming more pronounced, Bernanke recommended doing nothing. And it was NOT a market phenomenon, but the result (on the surface, at least) of China pegging the RMB at an artificially low level. Did we explore the possibility of WTO sanctions for the currency manipulation as an illegal trade subsidy? Apparently the US was acutely aware of this as a possibility, and took great care not to give private parties any grounds for using the RMB as the basis for a WTO action. This comes late in the article:
At the last minute [in 2006], however, Mr. Bernanke deleted a reference to the exchange rate being an “effective subsidy” for Chinese exports, out of fear that it could be used as a pretext for a trade lawsuit against China.
So we knew we had the nuclear option in our hands, and there was no will to use it. One has to wonder if there were any threats made in private. My gut says no, given the history here.
Back to the piece:
China, some economists say, lulled American consumers, and their leaders, into complacency about their spendthrift ways.
The problem with this characterization is it make the US a passive party and a victim in a paradigm that we embraced. And let us not forget it takes two to tango. If China ran a savings glut, the rest of the world in aggregate had to consume (overspend and borrow enough) to take up the slack. But it most certainly did not fall upon the US to put up its hand and do it virtually solo (the EU runs a slight trade surplus).
Funny, some (many?) Chinese bureaucrats say that the US conned China into taking worthless paper (US Treasuries) in return for valuable Chinese products. Two can also play the blame game.
And the New York Times buys hook, line, and sinker into the “gee, we really had no choice” party line:
To be sure, there were few ready remedies. Some critics argue that the United States could have pushed Beijing harder to abandon its policy of keeping the value of its currency weak — a policy that made its exports less expensive and helped turn it into the world’s leading manufacturing power. If China had allowed its currency to float according to market demand in the past decade, its export growth probably would have moderated. And it would not have acquired the same vast hoard of dollars to invest abroad.
Others say the Federal Reserve and the Treasury Department should have seen the Chinese lending for what it was: a giant stimulus to the American economy, not unlike interest rate cuts by the Fed. These critics say the Fed under Alan Greenspan contributed to the creation of the housing bubble by leaving interest rates too low for too long, even as Chinese investment further stoked an easy-money economy. The Fed should have cut interest rates less in the middle of this decade, they say, and started raising them sooner, to help reduce speculation in real estate.
The story also conveniently makes the global imbalances problem sound as if it is all about the US and China (and by implication, of relatively recent origin) when in fact it has long been in the making but the vital indicators moved into the danger zone in the post 2002 era (US trade deficits rising to unprecedented levels as a % of GDP, savings plunging to zero) and were ignored.
In fairness, the Times piece later suggests that the Greenspan Fed was far too sanguine, that the Chinese were highly resistant to pressure regarding revaluing their currency, while the Japanese went along with the 1985 Plaza accord which called for a stronger yen (I remember when it was 250 to the dollar).
While we admittedly have more leverage over Japan than China, the flip side is the Chinese wanted badly to win on this issue and we caved. I sincerely doubt we tried very hard, since as the story clearly indicates, the officialdom rationalized global imbalances as a “market phenomenon” when it was anything but.
The article points out that we used cheap Chinese funding poorly:
But Americans did not use the lower-cost money afforded by Chinese investment to build a 21st-century equivalent of the railroads. Instead, the government engaged in a costly war in Iraq, and consumers used loose credit to buy sport utility vehicles and larger homes. Banks and investors, eagerly seeking higher interest rates in this easy-money environment, created risky new securities like collateralized debt obligations.
Let us turn to economist Thomas Palley for an alternative point of view as to where the problem originated, which in turn suggests other courses of action. Note that the material from Palley comes from 2007 and early in 2008, yet the Times gave no consideration to his or other dissenting-from-orthodox views.
Palley starts with the observation that our recent expansion was unbalanced. He sees the big problems as record trade deficits (the result of an overvalued dollar), and (related but somewhat separate) the erosion of manufacturing.
The emphasis on the role of manufacturing is interesting and credible. When you consider the lead times, inflexibility, and transportation costs of manufacturing in Asia (remember, even goods like furniture, which involve round-trip shipping, are often made in China) one has to wonder how we screwed up, particularly when I hear from clothing designers that the reject rate on Chinese garments is typically 50%.
One would think there would be a role for at least for highly-flexible, high quality manufacturing that took advantage of geographic proximity, ability to do small runs at competitive prices, and high reliability. It would never be as large as China’s output, but it would cream the high end of the market (and with them, presumably high margins) and also keep core skills at home. And the US is still competitive in highly capital intensive and highly demanding manufacturing, such as coated paper (unlike newsprint, coated paper production is very difficult to keep running at the near-constant output level that its huge capital base requires).
Part of the problem, as we have discussed earlier, is that we have taken a naive stance in trade negotiations. We seem seduced by the idea of open markets, when in fact what we have is a system of managed trade. And our trading partners, who for the most part are keen to preserve employment, protect certain key industries, and have trade surpluses, seem to have achieved better outcomes than we have.
A 2007 Wall Street Journal article, “Is Productivity Growth Back In Grips of Baumol’s Disease?” supports Palley’s hypothesis about the value of manufacturing:
In the 1960s, Mr. Baumol, now at New York University, and William G. Bowen, an economist who later became president of Princeton University, argued that because productivity growth in labor-intensive service industries lags behind that in manufacturing, productivity growth in service-oriented economies tends to sag.
Their famous example was a classical string quartet — there are always four players in a quartet and it always takes about the same amount of time to perform a set piece of music. You can’t get any more music out of the same number of musicians over that same period of time. Broadening that to other types of services, the implication is that rich countries such as the U.S. that tend to veer toward services would face higher prices as wages and costs rise….
Sectors where productivity is high and average labor cost low “are those things that can be automated and mass-produced,” Mr. Baumol, now in his mid-80s and still teaching, said in an interview. “And things where labor-saving is below average are things that need personal care — these are health care, education, police protection, live stage performance… and restaurants.”
U.S. job growth has been concentrated in those latter sectors. More than half of the 1.6 million jobs added in the private sector in the past year have been in food services, health care and social services. Food services alone account for more than 20% of all new jobs this year, including government….
Population aging will shift more of the U.S. economy toward one-on-one services. The Labor Department estimates that between 2004 and 2014, seven of the 10 fastest-growing occupations will be in health care, and health-care employment will double the national average. Employment in leisure and hospitality will also outpace the average, though not by as much
Palley argues that the Fed, despite having given lip service to global imbalances, is in fact operating from and supporting a flawed paradigm.
The U.S. economy has been in expansion mode since November 2001. Though of reasonable duration, the expansion has been persistently fragile and unbalanced. That is now coming home to roost in the form of the sub-prime mortgage crisis and the bursting house price bubble.
As part of the fallout, the Federal Reserve is being criticized for keeping interest rates too low for too long, thereby promoting credit and housing market excess. However, the reality is low rates were needed to sustain the expansion. Instead, the root problem is a distorted expansion caused by record trade deficits and manufacturing’s failure to fully participate in the expansion.
If the Fed deserves criticism it is for endorsing the policy paradigm that has made for this pattern. That paradigm rests on disregard of manufacturing and neglect of the adverse real consequences of trade deficits.
By almost every measure the current expansion has been fragile and shallow compared to previous business cycles. Beginning with an extended period of jobless recovery, private sector job growth has been below par through most of the expansion. Though the headline unemployment rate has fallen significantly, the percentage of the working age population that is employed remains far below its previous peak. Meanwhile, inflation-adjusted wages have barely changed despite rising productivity.
This gloomy picture justified the Fed keeping interest rates low. However, it begs the question of why the economic weakness despite historically low interest rates, massive tax cuts in 2001 and huge increases in military and security spending triggered by 9/11 and the Iraq war?
The answer is the over-valued dollar and the trade deficit, which more than doubled between 2001 and 2006 to $838 billion, equaling 6.5 percent of GDP. Increased imports have shifted spending away from domestic manufacturers, which explains manufacturing’s weak participation in the expansion. Some firms have closed permanently, while others have grown less than they would have otherwise. Additionally, many have reduced investment owing to weak demand or have moved their investment to China and elsewhere. These effects have then multiplied through the economy, with lost manufacturing jobs and reduced investment causing lost incomes that have further weakened job creation.
The evidence is clear. Manufacturing has lost 1.8 million jobs during the expansion, which is unprecedented. Before 1980 manufacturing employment hit new peaks every expansion. Since 1980 it has trended down, but it at least recovered somewhat during expansions. This business cycle it has fallen during the expansion. The business investment numbers tell a similar dismal story, with spending being much weaker than in previous cycles.
These conditions compelled the Fed to keep interest rates low to maintain the expansion. That policy worked, but by stimulating loose credit and a house price bubble that triggered a construction boom. Thus, residential investment never fell during the recession and has been stronger than normal during the expansion. Construction, which accounted for 5 percent of total employment, has provided over twelve percent of job growth. Meanwhile, higher house prices have fuelled a borrowing boom that has enabled consumption spending to grow despite stagnant wages. This explains both increased imports and job growth in the service sector.
The overall picture is one of a distorted expansion in which manufacturing continued shriveling while imports and services expanded. This pattern was carried by an unsustainable house price bubble and rising consumer debt burdens, and that contradiction has surfaced with the implosion of the sub-prime mortgage market and deflation of the house price bubble.
The Fed is now trying to assuage markets to keep credit flowing, and it will likely soon lower interest rates. On one level that is the right response and it may even work again – though it does increasingly seem like sticking fingers in the dyke to prevent the flood. However, the deeper problem is the policy paradigm behind the distorted expansion, which is where the Fed is at fault and where it deserves criticism.
The ideological and partisan Alan Greenspan wholeheartedly endorsed corporate globalization and promoted the White House and Treasury’s unbalanced expansion policies. The Fed’s professional economics staff also seems to have dismissed domestic manufacturing’s significance and endorsed corporate globalization in the name of free trade. Consequently, the Fed has tacitly supported the underlying policy paradigm that has given rise to America’s distorted expansion. Despite talk about reducing global financial imbalances, the Bernanke Fed still seems locked in to this paradigm and that is where constructive criticism should now be directed.
And Palley gave a broader view of the fundamental problem in an early 2008 post:
The last twenty-five years have witnessed a boom in the reputation of central bankers. This boom is based on an account of recent economic history that reflects the views of the winners….
That said, there are other less celebratory accounts of the Great Moderation [the post 1980 smoothing of business cycles] that view it as a transitional phenomenon, and one that has also come at a high cost. One reason for the changed business cycle is retreat from policy commitment to full employment. The great Polish economist Michal Kalecki observed that full employment would likely cause inflation because job security would prompt workers to demand higher wages. That is what happened in the 1960s and 1970s. However, rather than solving this political problem, economic policy retreated from full employment and assisted in the evisceration of unions. That lowered inflation, but it came at the high cost of two decades of wage stagnation and a rupturing of the link between wage and productivity growth.
Disinflation also lowered interest rates, particularly during downturns. This contributed to successive waves of mortgage refinancing and also reduced cash outflows on new mortgages. That improved household finances and supported consumer spending, thereby keeping recessions short and shallow.
With regard to lengthened economic expansions, the great moderation has been driven by asset price inflation and financial innovation, which have financed consumer spending. Higher asset prices have provided collateral to borrow against, while financial innovation has increased the volume and ease of access to credit. Together, that created a dynamic in which rising asset prices have supported increased debt-financed spending, thereby making for longer expansions. This dynamic is exemplified by the housing bubble of the last eight years.
The important implication is that the Great Moderation is the result of a retreat from full employment combined with the transitional factors of disinflation, asset price inflation, and increased consumer borrowing. Those factors now appear exhausted. Further disinflation will produce disruptive deflation. Asset prices (particularly real estate) seem above levels warranted by fundamentals, making for the danger of asset price deflation. And many consumers have exhausted their access to credit and now pose significant default risks.
Given this, the Great Moderation could easily come to a grinding halt. Though high inflation is unlikely to return, recessions are likely to deepen and linger. If that happens the reputations of central bankers will sully, and the real foundation and hidden costs of the Great Moderation may surface. That could prompt a re-writing of history that restores demands for a return to true full employment with diminished income inequality. How we tell history really does matter.