Extreme Measures: Currency/Trade Tensions Rising, Will Action Follow?

After the in retrospect not that terrible first acute phase of the financial crisis, August-September 2007, this blog began taking note of Extreme Measures. These were proposals by respectable people for dealing with the burgeoning mess that were usually very creative and had zero chance of happening. The fact that so many normally sound people (in the British sense, of being conservative and well reasoned) would find it necessary to be thinking way outside the box was a sign that they recognized the severity of the situation.

We seem to be getting back to Extreme Measures territory, with the trigger this time the unresolved problem that is politely described as global imbalances. Depending on what your vantage is, you might characterize it as “overspending, overborrowing deficit countries” like the US, Spain, England, Ireland and their compatriots, or you might focus on export powerhouses, in particular China (but also Germany) who take mercantilist stances relative to their trade partners. While their behavior certainly sounds virtuous, any behavior carried too far can and often does lead to undesirable outcomes. In the case of China, it has accumulated the biggest foreign exchange reserves in relationship to GDP of any country in the last 100 years, possibly ever. Its nearest competitors? The US on the eve of the Great Depression, and Japan at the peak of its bubble.

Put it more simply, a country that runs persistent, large trade surpluses drains employment from its current account deficit incurring trade partners. No one minded very much when global growth rates were decently positive. But now that the world economy has taken a big hit and has yet to regain former level of employment, the refusal or perhaps inability of China and other large exporters to change course is putting stress on the international currency and trade architecture.

It is pretty much a certainty that despite Congressional pressure, Timothy Geithner will not certify China as a currency manipulator in a semi-annual report due tomorrow. With unemployment stuck at 10%, and broader measures of joblessness at roughly 17%, this will not be a well received stand down. But expect the Treasury to make pointed statements to appease the calls for blood that fall short of using the currency manipulator designation. Per the Financial Times:

Data released on Thursday by the commerce department showed the deficit in goods and services widening 8.7 per cent to $46.3bn. That was the second highest gap of the year, exceeding economists’ expectations. The rise was driven by US businesses stocking up on consumer goods and cars at the end of summer.

Of course, the reason that the US does not need to resort to this cudgel, in theory, is that it appears to be on the verge of embarking with a new experiment in quantitative easing. As we noted before, QE resulted in only a 17 basis point reduction of Treasuries; a mountain of purchases produced perilous little in the way of results. But the Pavlovian conditioning of market participants is sending “risk on” trades on an impressive upward trajectory.

The belief in some circles is that the US is deliberately exporting inflation (via its monetary easing) to improve the terms of trade. If China holds a dollar peg but inflation increases, its goods will become less competitive (nominal price increases with a fixed exchange rate translate into real price increases).

But US easing is a blunt tool, and the Fed quite honestly has never designed its policies with the trade sector as the prime object of its concern. My impression is its rationale is straightforward: growth is too low, and if your only tool is a hammer, every problem looks like a nail. The central bank is using, most would say overusing, the only remedy it has at hand. It isn’t so much that the Fed is out to tank the dollar as it has hit the point where it is willing to let the dollar be collateral damage if that is what it takes to kick growth into a higher gear (it seems not to occur to the Fed that it might get the collateral damage without achieving its goal).

While another round of QE looks to be an Extreme Measure in a world awash in liquidity, it is no where near as radical as an idea proposed by Michael Pettis. He starts out by stressing that the Chinese trade surplus is not a US issue being fanned by an opportunistic Congress; plenty of other countries are unhappy too:

The problems is that the numbers actually do not work. China and Germany need to grow their surpluses to maintain growth. In fact China has to choose between an unhealthy overreliance on the trade surplus and an even unhealthier over-reliance on investment, as I mentioned in a comment in Bloomberg yesterday. Japan cannot allow its trade surplus to decline because with no demand growth this can only come about as a contraction in production.

On the other hand European deficits are collapsing as a consequence of the financial crisis. And the US cannot tolerate a rapid increase in its deficits. How does this math work? Surpluses and deficits, after all, must balance to zero.

So what is his solutIon?

Well I guess one way to get this balance (here comes my modest proposal) would be for China to engineer a New Deal in America, which we could call Xin Fa’an (“new deal” in Chinese)….. Beijing needs the US to continue running a rising trade deficit in order to absorb Chinese overcapacity while China slowly rebalances its economy towards domestic demand, which will take many years….

….the US can run a rising trade deficit is for a surge in investment. With a slowing world economy it is unlikely that private investment will rise, but as Joseph Stiglitz pointed out recently in a debate during the IMF/World bank meetings in October last week, the US is paradoxically in a very good position to increase investment because it has very poor infrastructure for its levels of development. The US has tons of room for a major expansion in infrastructure and, unlike in China, almost any infrastructure spending is likely to be value creating.

One way for this to happen is for the US government to fund and engineer the infrastructure spending directly. The resulting increase in the US trade deficit would of course be financed by Chinese lending to the US government as it is forced to accumulate USG bonds. But aside from the fact that there is too much pork-barrel politicking involved in US government spending, it will result in a rapid rise in the US fiscal deficit.

Would that matter? No, because this is exactly the kind of fiscal spending that is sustainable. US wealth creation would exceed the rise in debt and so the US is in the aggregate better off. But of course the politics of a rise in the US fiscal deficit are pretty sticky.

So why not have China do it directly? Let China engage in a massive rebuilding of US infrastructure – it can build airports, highways, damns, and railways – which would raise investment levels enough keep the US trade deficit high in a way that benefits the US and China.

One way for this to happen is for the US government to fund and engineer the infrastructure spending directly. The resulting increase in the US trade deficit would of course be financed by Chinese lending to the US government as it is forced to accumulate USG bonds. But aside from the fact that there is too much pork-barrel politicking involved in US government spending, it will result in a rapid rise in the US fiscal deficit.

In fact, a lot of infrastructure is now packaged and sold as investments (think the Sydney airport). And as the article suggests, the Chinese participation could be ad bond investors, which would give them a pickup in yield over Treasuries without the obvious appearance of control.

This is a clever idea, but is a non-starter politically, even if the Chinese were relegated to a passive role.

But the fact that someone as astute as Pettis can come up only with a far-out solution is stark testimony to how intractable the global imbalance problem is. We may indeed wind up breaking the current system as the only way out.

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  1. Richard Kline

    Heyyy, I even like Pettis’ uptake on Stiglitz’s observation. I suspect China would love to recycle its dollar debt for something paying better than treasuries, if backed with a similar government guarantee. Development bonds. Constructive symbiosis (to coin a phrase). O’ course most here wouldn’t _take_ their money . . . . But still.

    1. Steve Williams

      What, if after being freed from export-man’s yoke, import-man’s government were taken over by a corrupt, self-serving oligarchy, a la Zimbabwe? Oh, wait–never mind.

  2. Kevin de Bruxelles

    What Pettis’ “modest proposal” is really suggesting, once you strip it down to its core, is that reserve-rich export-man countries like China launch a kind of neo-colonial “mission civilisatrice” for the economically backwards import-man nations of the world such as the US.

    And I think it could work! But we must modify his modest proposal to make it even more “modest”.

    The original colonialism was based on the idea of advanced industrializing countries going into the back waters of the world and investing in infrastructure, and then trying to “civilize” the natives by imposing new cultural norms on them which allowed these natives to extract resources, and finally exporting the native’s raw materials back to the home country. This system only worked because the investment in infrastructure was socialized (for the glory of the Empire) while the profits where privatized into special chartered companies who were granted monopolies by autocratic powers.

    Marx was actually quite supportive of colonialism (later qualified that only if led by a proletariat government) and since at least in theory the Chinese Politburo would seem to meet this criteria, it seems the China should have no ideological qualms about taking on the export-man’s burden.

    But they would have to re-conceptualize colonialism a bit. Sure, the standard colonial model could still would work to some extent (forcing the natives to gather natural resources for shipment back to the home country) but the problem is that only a small percentage of the American population has much of a memory of, or is in any physical condition to do, any hard work. That would take a huge amount of cultural and physical reprogramming to get the import-man natives even half as productive as your average export-man. And in the end, just as European agricultural techniques often failed in tropic colonies, so to trying to impose the Chinese work ethic in modern America may also prove futile as well. So a much more modern updated version of Colonialism would need to be conceptualized. Nowadays America’s best natural resource is plentiful aggregate demand, based the gluttonous consumption by many of its natives, but due to the incompetence of its banker class, the supply lines of consumables are being blocked from reaching import-man end-users by such silly notions as repaying debts! So the infrastructure the Chinese neo-imperialists could build would have to use the latest technology to bridge these debt swamps the natives have not been able to master in order to get these vital consumables into the hands of import-man. So it seems quite reasonable that the Chinese would want to come to America and build the trains networks, the road systems, the airports, etc, to keep their products moving effectively to their end users in various import-man settlements.

    As for political problems, that’s easy. The Chinese could do what the original colonizers always did, co-opt the local elite by promising to allow them to maintain their elevated status in return for their faithful execution of the colonizer’s policies. In other words the Chinese just have to go out and find a faithful roi nègre among the local native elite. And this local elite would still be allowed to maintain their barbaric customs, including their various spectacles and diversions, and even some of their native dress habits could be kept, the ones the natives are so accustomed to. And at the same time, who knows, maybe even some of the superior export-man ways would rub off by osmosis onto import-man?

    But there are pitfalls in Colonialism that the Chinese would have to guard against. The most obvious is the danger of “going native”. Might not the Chinese viceroys and others imperial officers start to ape the no-work, all-play ways of the very natives they are charged with civilizing? Maybe the Chinese would even start tapping into some of the pacifying consumer goods stash in the pipeline before it got to the natives. Why shouldn’t they start “using” some of these goodies, they are a long way from home and they could stop any time they want, right?

    And what if the natives start to get uppity and the radicals among them start to organize? Some natives might even try to claim that import-man is the equal of export-man. Other native factions may believe that they have made the transformation by learning the ways of export-man and so it is time for them to run the show. Maybe these groups would even get brave enough to start spray painting revolutionary slogans on the walls of the new infrastructure about throwing off the Chinese jackboot and whatnot?

    And in the worst case the whole system could even collapse. Maybe in the end the import-man would manage to organize himself and when combined with the inevitable softening of the Chinese overlords, the Americans may actually manage to regain their independence again. But the question will be, are they really ready to stand on their own in an export-man’s world? What if they are not, what if all that infrastructure, all the new roads, airports, the high-speed train networks started to fall into disrepair after independence? What if in the end, import-man had been unable to imbibe enough of the export-man’s culture to understand why these assets are so important and after several years of import-man independence, the few trains still working would only manage to run at low speed, the roads were slowly reverting back to their natural state, and the airports were falling into disrepair? Would export-man, after organizing a few benefit concerts, in the end just stare down from afar and shake his head at the mess import-man had made of his former paradise?

    1. Externality

      “Maybe in the end the import-man would manage to organize himself and when combined with the inevitable softening of the Chinese overlords, the Americans may actually manage to regain their independence again.”

      How long until Chinese citizens begin to attack their culture out of post-colonial guilt, wail endlessly about “Asian privilege,” and insist that China needs a non-Chinese president to atone for its “deep cultural guilt?”

      What is really sad is that many of the cultural traits that made China prosperous (saving money, buying gold, strong families, respect for authority and community) were found in pre-1965 America. Various interest groups found them inconvenient, and did their best to undermine them.

      The Federal Reserve (and its UK counterpart) has, for example, consistently encouraged consumption over savings by maintaining negative real interest rates. The BOE admitted that was deliberately trying to devalue savings so that people would spend, not save. http://www.guardian.co.uk/business/2010/sep/28/spend-save-economy-bank-england-chief http://www.telegraph.co.uk/finance/personalfinance/savings/8028884/Savers-told-to-stop-moaning-and-start-spending.html
      Westerners who buy gold continue to be derided by the media. China, OTOH, encourages its citizens to save money and to buy gold and silver. http://seekingalpha.com/article/159962-china-urges-citizens-to-buy-gold-and-silver Chinese-Americans are often surprised to meet White Americans who share save money and/or buy precious metals.

      While the concept of “family values” has been consistently by the Christian right used to attack LGBTs like me, I can see how non-Western cultures benefit from family cohesion. The same is true of the way that China avoids identity politics, requiring for example that only Mandarin be used on state radio, state television, and in government offices. http://www.radioaustralia.net.au/connectasia/stories/201008/s2971923.htm http://worldblog.msnbc.msn.com/_news/2010/07/27/4763183-protesters-say-no-to-mandarin Compare how America governments are forced to translate documents and texts into more and more languages.

      1. alex

        “China avoids identity politics, requiring for example that only Mandarin be used on state radio, state television, and in government offices.”

        Is that avoiding identity politics, or fueling the fire? China also has interesting methods for dealing with “unpleasant news”.

  3. agog

    It won’t happen because the Chinese govt. is aware of the looming peak oil crisis, even if the US govt. (excepting the military) isn’t.

  4. KN

    So, Pettis’s idea is to spend money on public infrastructure, right? Build schools, dams, or bridges, right? Which is what Japan has done over the past 20 years. And what happened? Japan grew by mere 0.8% annually on average for that period. For 20 years up to 1990, Japan grew by 4% per annum. 4% for the first 20 years v.s. 0.8% for the next 20 years. Can you believe that?

    The logic behind public infrastructure spending is that while the government is spending, private investment hopefully comes back to life. Japan’s experience, however, tells us that private sector doesn’t increase investment as expected, and worse still, overall productivity declines as marginal productivity in public spending dramatically worsens. It’s a bureaucrat’s job, isn’t it?

    The only difference is that Japan financed it on their own, while the US would finance it with China’s money. But money is money. No big difference.

    Pettis admits in the comment section of the same article that it “was partly presented as a joke that illustrates just how deep the problems are.” Well, the problems are too deep-seated that everybody’s idea looks like converging to what Japan has had.

    1. Anonymous Jones

      What bizarre notions of logic and causality you have. You are seriously proposing that the evidence shows that investing in infrastructure diminishes growth? Sometimes I just can’t believe how twisted up on knots people can make themselves. Let’s see where private investment ends up after the bridges collapse and the roads are impassable. Think about *that* causality for a moment…

  5. Siggy

    The developing tensions are rooted in purchasing power differentials. For the US, it could be a very big blessing for the dollar to cease being a reserve currency.

    Apart from our need for oil, we have a greater capacity for autarky than any other nation I know of. If ever there was a point in time to reflect on the potential benefit of being able to not have to import anything, now is the time for such ruminations.

    Trouble is, it’s not only oil and goods that we’ve been importing, it’s the repatriation of consumption dollars that come back to us by way of foreign buying of our treasury and private debt instruments. We’ve been borrowing from the world for so long we have forgotten who it is that we owe and are beholden to for our liquidity needs.

    China has a population 1.3 Billion, we have a population of .3 Billion. China needs a much bigger economy and they don’t have it. That’s a tinder box that could blown up in our face. They have little to nothing to lose. In that they are liable to be very irrational.

    1. alex

      “For the US, it could be a very big blessing for the dollar to cease being a reserve currency.”

      Hear, hear!

      The supposed “exorbitant privilege” of being the world’s reserve currency has long since become a golden noose. When China, etc. threaten to stop using the USD as the world reserve currency, my reaction is that we should get so lucky.

  6. Robert Dudek

    Instead of QE2, why not, as Steve Keen suggests, raise the wages of workers so as to boost domestic demand. This would be the best way to avoid the deflation trap and soak up all that unemployment (via job guarantees at a minimum livable wage). With increased employment, tax revenues would go up and the budget deficit would probably narrow.

    With demand picking up, private business would gain confidence and begin hiring again. It would also begin to move the Gini coefficient in the right direction.

    But of course, for some unknown reason, this is politically unpalatable. The powers that be prefer to stoke asset-price inflation which disproportionately benefits the rich, clinging on to the absurd belief in trickle-down economics.

    1. alex

      Do you have a link to where Keen suggested that? Conceptually it’s a nice idea, but I have no idea how the details would work.

  7. alex

    The problem with Pettis’ idea of borrowing ever more money for building infrastructure is that loans need to be paid back. Unless of course the creditor decides otherwise. If China likes Pettis’ idea then they can start by burning $1T of the treasuries they hold. Then we can reasonably put off currency negotiations for a few years while we build golden bridges using Chinese money. Frankly it’s not as though China has over $2T in USD assets as a form of investment anyway. It’s all just to support their mercantilism. This way they could just be more upfront and admit that their government will paying anything to keep Chinese exporters humming along.

    1. David Stinson

      Under the economic law of gravity, loans need to be paid back. But when economics defies gravity, they don’t. Check out this post by Pettis on why China can’t simply recall its loans. http://webcache.googleusercontent.com/search?q=cache:_RRnJHQ_TS0J:mpettis.com/2010/07/the-capital-tsunami-is-a-bigger-threat-than-the-nuclear-option/+site:mpettis.com&cd=1&hl=en&ct=clnk&gl=us (cached version, as the website presently seems to have been hacked by Cialis.) Basically, all their money is going to end up in US bonds somehow. Alternatively, they can invest it into US stocks – which would then take their money and put it into US bonds. Or, the could invest it in the bonds of other countries, like Japan – which would then take the money and invest it in US bonds. The only other option would be to invest it in themselves, which would be a nuclear option on China, not the US. In short, the market distortions that led to this point are not going to go away in a flash.

  8. lark

    One of the main intellectual ideas underlying our current set of problems is that globalized distribution (of risk, in financial products, of supply chains, in manufacturing) allows for more efficient use of resources and capital.

    This proposal is an example.

    I think we need to be skeptical of this idea. The cost in complexity – political / social as well as organizational – can easily overwhelm the benefits. Cascades of errors, misunderstanding, failures in accountability and or communication – we have seen all these.

    Globalization has made this crisis more globalized – how is that a help?

    We need to reduce the mindless embrace of globalizing everything. It is politically a non-starter to have heavy Chinese investment in American infrastructure. And for good reason!

    Get real, people. Look at what the Chinese just did with rare earth elements. You want to invite that kind of behavior into our domestic economy? It’s nuts, frankly. This is one of those examples of economists being disconnected from the real world.

  9. TC

    I quite agree with your closing conclusion.

    However, characterizing “global imbalances” as “overspending, overborrowing deficit countries” is deceptive, because truth is these imbalances were created by a private sector unwilling to do such due diligence as would properly price risk. The solution to these imbalances (accumulated over many decades) begins with bankruptcy reorganization, and then fans out to restore a climate in which sound, profitable investment, much as Mr. Pettis suggests, can be made (INVESTMENT, not bald faced, roll the dice, hope I am not the greatest fool, speculation).

    I also quite agree with the conclusion made by many that, the Fed is attempting to export inflation. This has been the game for decades. QE is but the final manifestation — the last gasp — of an arrangement that MUST overlook systemically encouraged criminality, so that those who facilitate mispriced risk feeding global inflation might continue. The hope, of course, is that yesterday’s boo boos might be overwhelmed in a hyperinflationary deluge of even more mispriced risk. Trouble is they’re running out of viable paper alternatives into which this deluge might flow. Confidence has been shot. There’s no “risk on.” Rather there is only distribution into weak hands (among which are several grossly overleveraged, white shoe firms — get over it), while the wall of money goes into “things” whose price rise continuance assures the global economy soon will collapse in a Weimar Germany-like, hyperinflationary death spiral.

    I disagree that, QE is the “only remedy” the Fed has at hand. We could insist on a Fed chairman who appears before Congress and implores representatives to use their constitutional power to craft bankruptcy laws suitable for this moment. He or she could instruct that body on how Alexander Hamilton took a bankrupt confederation of states and planted the seed for what was to become the greatest nation on earth, this via creation of a national bank issuing credit for projects serving the nation’s economic posterity. Instead, we get a man who adores that fascist Hjalmar Schacht. BERNANKE MUST GO.

    Pettis’ solution is a non-starter from the financial end of things, though. Yet, as I indicated above, his objective — infrastructure — is spot on. The financing of great infrastructure projects must be facilitated by a publicly-owned corporation run through the U.S. Treasury — a national bank — whose dealings are directed by Congress. These are, after all, investments, not budgetary expenses. Therefore, they are to be promoted and protected as best as possible, a task for which a national bank is well-suited.

    China, indeed, already grasps the concept of a Hamiltonian credit system. You see this in their agreement with Russia to finance development of the resources of Siberia. Basically, they are taking the revenue stream produced by their hoard of U.S. Treasuries and leveraging these in capital-intensive investment whose capacity to secure repayment of principal and a fair profit is more greatly assured (this relative to what is the case were their Treasury holdings left to the devices of that nut case Bernanke).

    I will say it again: BERNANKE (and any like-minded policy maker) MUST GO.

  10. RebelEconomist

    I believe Michael Pettis’s post is tongue in cheek, but the US should itself have been using the interest rate subsidy provided by Chinese intervention for public sector investment all along, as I have argued here many times.

    I even suggested some specific projects once: http://www.nakedcapitalism.com/2010/02/should-germany-quit-the-eu-rather-than-rescue-greece.html#comment-82923

    And explained the arguments in more detail in my own blog:

    But Americans reject such mass public sector intervention outside of major wars. It would be ironic if the coming shake-up proved to be that serious anyway.

  11. Ed

    Kevin de Bruxelles,

    Brilliant post. But I think the transoceanic colonial model of the 15th through 20th centuries is not really applicable.

    The world had a population of a billion people, same as China today, when Napoleon was alive and now its six billion, projected to grow to nine billion before levelling off. European and American style colonialism is too difficult to implement, the West doesn’t have the share of world population it did in the nineteenth century. Colonialism of Europea and American by some country like China is pointless, they already have more than enough workers to exploit.

  12. David Stinson

    I think the easiest option here would just be to take our national debt, and split it up into two sections: American deficit, and Chinese surplus. It would be an accounting measure, and on its own right would have no influence on the economy. But it would certainly shift the discussion in useful ways.

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