What a difference seven years makes. No one had a problem with Japan having super low interest rates and stoking a global carry trade, nor with the US running overly loose monetary policy that led to a real estate bubble that spread its impact beyond our borders via the creation of toxic mortgage product sold far and wide.
But one difference this time is now the dollar, rather than the yen, looks like the best funding currency, and the dollar is a deeper market, so the scale of potential damage is much greater. Second is that a lot of countries are running loose money policies, but they are at least making some credible noises re tightening (whether they follow through is another matter, of course). The US, by contrast, has made clear that it is keeping things easy-peasey for the foreseeable future. And the US (starting with the Greenspan era) has signaled any hawkish moves well in advance, so the odds that the Fed will have a sudden change of heart are just about zero.
Now, to play devil’s advocate, one could argue that the loose money policy is warranted. There is tons of slack in the economy, unemployment is high and rising, capacity utilization stinks. Surely raising rates now would be the worst move possible, right?
The authorities are completely responsible for the messes on two different fronts that intersect to create monetary policy dilemma. Going below 2% for Fed funds was a huge error (well maybe you could justify 1% as a very short term expedient), but the Fed is now painted in a corner. But second, and the much bigger issue, is that (as everyone can see) all this cheap money is not going into the real economy. A few very high quality borrowers are getting good rates; everyone else finds credit scarce and costly. So spreads are higher than before, and even absolute rates are often higher expect in markets like mortgages where the Fed has intervened.
Now some readers will correctly say that overly loose lending is what created the problem, and we need to undo that, but they are conflating two issues. Tightening up on WHO gets credit and HOW MUCH they get is separate from pricing. If this was mere improved standards, you’d expect to see more discrimination within various types of borrowers. But instead, across entire swathes of borrowers, particularly consumers and small businesses, banks have simply turned off the spigot. This has little to do with a return to prudent practices. In fact, it illustrates a real cancer: that across consumers and many small business owners, old-fashioned multi-variable decision-making (which included some verification of income) has been replaced by heavily or entirely FICO based systems. Those systems failed utterly. But they were cheap to operate, banks have no intention of reverting to earlier, more costly approaches. So we have a credit assessment process that is broken, but no one wants to admit it.
So if all this loose money isn’t getting to the real economy, there should be no reason not to raise rates, right? Wrong. This little procedure is again, entirely about the banks, screw the real economy and everyone in it. First, low rates (and now a steep yield curve) are an ideal setting for banks to make money. Greenspan pulled the same trick in the wake of the S&L crisis, and it enabled banks to rebuild their very wobbly balance sheets comparatively quickly (I’m amazed at the revisionist history about the early 1990s banking woes, which also involved pretty serious damage from dud LBO loans, and left the US banking system seriously undercapitalized). This plus high spreads makes ofr a very attractive environment for any new business.
But the second reason for keeping rates low is explicitly to keep asset prices aloft. The bubble is an explicit goal of policy. Remember, early in the crisis, they was talk of the markets being irrationally depressed. Funny how it is only prices that are seen as inconveniently low, and not ones that are insanely high, that are criticized.
But to cite Richard Nixon parodists: Let us make one thing perfectly clear. These monetary shenanigans are in no small measure the result of the utter failure of nerve late last year and early this year, to take sick institutions and resolve them. In many cases might not have entailed the bogeyman of nationalization (as in protracted government ownership), but throwing out the old top management and board, and forced debt to equity conversions. Cleaning up the banks was never treated seriously as an option, when the track record clearly shows that that is the fastest, least-cost way to deal with a financial crisis.
Of course, the powers that be really only want bubble restoration in those asset classes to which banks and capital markets firms are heavily exposed. A bubble in gold goes them no good, and a bubble in other commodities is downright counterproductive. And that was the logic behind the Fed’s proliferating programs: to drive liquidity to the markets it deemed worthwhile. We can see how well that worked.
Now even though China is correct in accusing the US of stoking a global carry trade, they are not exactly free of blame either. China’s past and continued currency pegs helped enable US reckless borrowing.
And despite the many complaints of readers yesterday on a post on government deficits, let me point out one ugly fact. The main argument was “we need to cut our debt levels.” Guess what, sports fans. That will not, cannot happen across the economy unless we run trade (more accurately, current account) surpluses. Do you think this has a snowball’s chance in hell of happening if China keeps its currency pegged at favorable rates to the dollar? So China’s fulminating, even if narrowly correct, serves to distract attention from its own culpability in this mess.
And low dollar interest rates pose a particular problem for China. Its dollar purchases had been, and may still be, running at levels so high as to make it impossible to sterilize the purchases. The net effect is that they wind up importing our loose money policy to the degree that they cannot fully sterilize the dollar purchases they make to suppress the value of their currency. Some recent reports (admittedly anecdotal) suggest inflation in China is running at 15%, which is the upper limits of what the population will tolerate. So the Fed’s policy is of even more immediate interest to China.
Some snippets from the news. First the Financial Times, which highlights that there is more than a bit of the pot calling the kettle black here:
The US Federal Reserve is fuelling “speculative investments” and endangering global recovery through loose monetary policy, a senior Chinese official warned…
Liu Mingkang, China’s chief banking regulator, said that the combination of a weak dollar and low interest rates had encouraged a “huge carry trade” that was having a “massive impact on global asset prices”….
Before these latest comments, however, Beijing had generally been most critical of US fiscal policy, urging Washington to spend less.
But speaking at a conference in Beijing, Mr Liu said the Fed’s policy of maintaining low interest rates together with the weak dollar posed a threat to the global economic recovery.
“[It] is boosting speculative investment in stock and property markets and will pose new, real and insurmountable risks to the global recovery and particularly to the recovery in emerging markets,” said Mr Liu…
However, Mr Liu’s criticism of the Fed comes as China’s own monetary policy is attracting growing scrutiny at home and abroad. Critics say the massive expansion in bank loans this year could cause asset price bubbles and inflation.
Qin Xiao, chairman of China Merchants Bank, last month said China “urgently” needed to tighten monetary policy to avoid stock and property market bubbles.
On Monday, Dominique Strauss-Kahn, the head of the International Monetary Fund, said a stronger Chinese renminbi was part of the reforms that Beijing needed to implement in order to increase domestic consumption and help ease global imbalances.
The Wall Street Journal argues that higher rates in China may not curb speculation:
China hasn’t raised its benchmark interest rates since late 2007, although policy debate has been shifting in Beijing as the recovery in the domestic economy consolidates and as the People’s Bank of China tries to manage the flood of liquidity and credit underpinning the recovery.
A key concern about any Chinese rate hike is that it may prompt more speculative inflows into the recovering domestic economy. And because of the way the yuan pretty much tracks the U.S. dollar despite the local unit being referenced to a basket of currencies, increased capital flows into China adds further to the liquidity in the domestic money markets.
China continues to state that its own exchange rate policy reform will be done for its own needs and done in its own time.
And a separate Journal story:
Chinese leaders previously expressed nervousness that the U.S. may be ready to sacrifice China’s economic interests to haul itself out of the worst recession since World War II. China is the largest creditor to the U.S. It frets that huge U.S. budget deficits will weaken the dollar and slash the value of China’s massive foreign-currency holdings, which hit $2.273 trillion at the end of September, the latest figure available.
Beijing’s suspicions of U.S. intentions have been exacerbated by trade quarrels under the Obama administration.
These intensified in September, when U.S. decided to hit Chinese tire exporters with tariffs. The U.S. has since targeted Chinese steel pipes with tariffs, a decision that China denounced as “abusive protectionism.”
The U.S. is now moving ahead with investigations into the alleged “dumping,” or selling at below-market prices, of coated paper from China and Indonesia, and of certain phosphate salts from China. China has started its own investigation into imports of some U.S. cars.
Yves here. I have zero sympathy for the Chinese officialdom on this issue. The government bought Treasuries as a result of an explicit, concerted strategy to pursue mercantilist aims to help their manufacturers at the expense of ours. This was not an “investment”; this was a by-product of currency manipulation. Now the US bears a lot of blame for not taking that practice on a long time ago. But we need to quit indulging this crap. Buying foreign assets at a time when you are keeping your currency low by design is almost certain to produce foreign exchange losses. So the US is to blame for the inevitable result of Chinese currency manipulation? I don’t think so.
Update 4:00 AM: Paul Krugman has taken up the currency peg theme tonight:
Despite huge trade surpluses and the desire of many investors to buy into this fast-growing economy — forces that should have strengthened the renminbi, China’s currency — Chinese authorities have kept that currency persistently weak. They’ve done this mainly by trading renminbi for dollars, which they have accumulated in vast quantities.
And in recent months China has carried out what amounts to a beggar-thy-neighbor devaluation, keeping the yuan-dollar exchange rate fixed even as the dollar has fallen sharply against other major currencies. This has given Chinese exporters a growing competitive advantage over their rivals, especially producers in other developing countries.
What makes China’s currency policy especially problematic is the depressed state of the world economy. Cheap money and fiscal stimulus seem to have averted a second Great Depression. But policy makers haven’t been able to generate enough spending, public or private, to make progress against mass unemployment. And China’s weak-currency policy exacerbates the problem, in effect siphoning much-needed demand away from the rest of the world into the pockets of artificially competitive Chinese exporters.
But why do I say that this problem is about to get much worse? Because for the past year the true scale of the China problem has been masked by temporary factors. Looking forward, we can expect to see both China’s trade surplus and America’s trade deficit surge.
Yves here. “trade deficit surge” = “bigger US debts”. These two issues are inextricably linked. Back to Krugman:
That, at any rate, is the argument made in a new paper by Richard Baldwin and Daria Taglioni of the Graduate Institute, Geneva. As they note, trade imbalances, both China’s surplus and America’s deficit, have recently been much smaller than they were a few years ago. But, they argue, “these global imbalance improvements are mostly illusory — the transitory side effect of the greatest trade collapse the world has ever seen.”
Indeed, the 2008-9 plunge in world trade was one for the record books. What it mainly reflected was the fact that modern trade is dominated by sales of durable manufactured goods — and in the face of severe financial crisis and its attendant uncertainty, both consumers and corporations postponed purchases of anything that wasn’t needed immediately. How did this reduce the U.S. trade deficit? Imports of goods like automobiles collapsed; so did some U.S. exports; but because we came into the crisis importing much more than we exported, the net effect was a smaller trade gap.
But with the financial crisis abating, this process is going into reverse. Last week’s U.S. trade report showed a sharp increase in the trade deficit between August and September. And there will be many more reports along those lines.
So picture this: month after month of headlines juxtaposing soaring U.S. trade deficits and Chinese trade surpluses with the suffering of unemployed American workers. If I were the Chinese government, I’d be really worried about that prospect.
Unfortunately, the Chinese don’t seem to get it: rather than face up to the need to change their currency policy, they’ve taken to lecturing the United States, telling us to raise interest rates and curb fiscal deficits — that is, to make our unemployment problem even worse.
And I’m not sure the Obama administration gets it, either. The administration’s statements on Chinese currency policy seem pro forma, lacking any sense of urgency.
That needs to change. I don’t begrudge Mr. Obama the banquets and the photo ops; they’re part of his job. But behind the scenes he better be warning the Chinese that they’re playing a dangerous game.
Update 4:30 AM: Sheesh, Ambrose Evans-Pritchard is on the same page as Paul Krugman, namely that China’s policies are global economic menace number one:
By holding the yuan to 6.83 to the dollar to boost exports, Beijing is dumping its unemployment abroad – “stealing American jobs”, says Nobel laureate Paul Krugman. As long as China does it, other tigers must do it too.
Western capitalists are complicit, of course. They rent cheap workers and cheap plant in Guangdong, then lobby Capitol Hill to prevent Congress doing anything about it. This is labour arbitrage.
At some point, American workers will rebel. US unemployment is already 17.5pc under the broad “U6” gauge followed by Barack Obama. Realty Track said that 332,000 properties were foreclosed in October alone. More Americans have lost their homes this year than during the entire decade of the Great Depression. A backlog of 7m homes is awaiting likely seizure by lenders. If you are not paying attention to this political time-bomb, perhaps you should….
It is fashionable to talk of America as the supplicant. That misreads the strategic balance. Washington can bring China to its knees at any time by shutting markets. There is no symmetry here. Any move by Beijing to liquidate its holdings of US Treasuries could be neutralized – in extremis – by capital controls. Well-armed sovereign states can do whatever they want.
If provoked, the US has the economic depth to retreat into near autarky (with NAFTA) and retool its industries behind tariff walls – as Britain did in the 1930s under Imperial Preference. In such circumstances, China would collapse. Mao statues would be toppled by street riots.
I was going to write that I anticipate capital controls before this is over, but neglected to make that my coda, and now I see Evans-Pritchard has come to the same conclusion. It doesn’t have to be as draconian as what he suggests, but it is the inevitable end game if China refuses to relent.