china

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China Frenzy

Just a quick note: you will have noticed that the Chinese raised their interest rates today. They are trying to fend off inflation and a potentially nasty real estate bubble. How I wish we had done the same thing back in 2004/2005. This action will slow their domestic economy, and thus drain some of the global economy’s demand as well. My feeling is that the are trying to get their shot in before Bernanke goes ahead with his next round of easing which I expect right after the upcoming Fed meetings on November 2nd. The Chinese move will mute the Fed’s action somewhat, and make it a little more difficult to inflate the world economy. It is a classic example of two economies working in different directions and possibly offsetting each other. The Chinese would not have been forced into this move had they allowed their currency to float up from its currently rigged state. They want to keep their currency as weak as possible in order to boost exports. That can only reduce our ability to get our economy going and hurts our already abysmal job creation prospects. Meanwhile we want to weaken the dollar vis their currency to inhibit their trade and boost our own. As long as the two economies remain uncoordinated we should expect more of this head butting contest. Hopefully we take a much harder line and ignore all the Chinese protestations about the inflationary consequences of further stimulus: they want contract their demand to avoid overheating, and for the US to help out by going into contraction mode as well. Since we are already depressed that is not a viable option for us. The conflict is growing.

Watch for this to get more heated.

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Currency Wars: The Chinese View

Let’s be fair: the Chinese have a point.

They can rightly claim that the US is trying to inflate the world economy by flooding it with dollars, and that the flood is about to reach tsunami proportions if the Federal Reserve Board goes ahead with its long awaited second round of “quantitative easing”, or QE2 as it has become known as colloquially.The problem is that we face two separate yet intertwined requirements in order to get the global economy back onto solid ground.

First we need those countries running trade surpluses to switch to a policy based more on domestic demand in order to absorb the excess savings that they are throwing off. Those excess savings are a result of their focus on production and export rather than on consumption. During the last decade this wave of excess savings sloshed around the world economy and was absorbed only by the creation of asset price bubbles in the importing countries like the US and the UK. The world suffers from a lack of aggregate demand, and while the US, UK, and others cut their debt levels they cannot be relied upon to provide that demand. Someone else must. That would be China, Japan, and Germany principally.

Second we need the importing countries to go in the opposite direction and reduce imports by switching either to lower consumption levels permanently, or by increasing their production and export of goods and services. The US plays the pivotal role in this switch since it is the world’s largest economy and has the world’s largest imbalances.In broad terms what we need to do is to ditch the Reagan illusion and reduce debt while at the same time increasing our focus on basic economic activity in areas such as infrastructure and production. We need to make or build actual stuff rather than play at bankers all the time. It turns out we weren’t very good at banking anyway, but that’ another story.

The problem is that this switch is not easy. We are still deeply mired in a period of debt reduction. That means that the US private sector – households and businesses – is retrenching rather than expanding. This opens the door for a perilous disinflation or, even worse, deflation. We should all expect the Fed to react strongly to any news that the pace of inflation has dropped too low. My own view is that we could do with a solid bout of inflation in order to relieve the stress on debtors and thus make the adjustment to a lower debt regime more comfortable.

Just to make things difficult the likely course of monetary policy is that the Fed will try to lower long term interest rates through QE2, maybe starting this month, but at the same time signal its desire to allow inflation to creep up. In normal circumstances these two movements would be going in opposite directions. Rising inflation should be priced into interest rates by an increase in the “inflation premium” they include. Rates would thus rise, especially at the longer end of the yield curve. But: aggressive QE2 actions would flood the economy with even more liquidity and drive rates down, especially if the Fed announces its intention to keep rates low for an extended period. My bet is that the Fed is looking to get the long term bond yield down to 2.0% and keep it there. If it succeeds there is precious little room for an inflation premium. Do the math: if we expect inflation to edge above the top of the Fed’s target range, which the Fed would dearly love to see happen, then the presumed inflation premium would be bid up to reflect that expectation. Deduct that premium – let’s say it’s 3.0% – from the newly reduced long term rate of 2.0% and we disclose a negative inflation adjusted rate of 1.0%. Lenders would be paying you to borrow, instead of the other way round.

If that doesn’t encourage borrowing I don’t know what will. Which, of course, is the entire reason for QE2.

And this is where the Chinese come in.

QE2 is a massive purchase operation by the Fed. It will enter the money markets and buy up securities. The cash it uses for the purchases will flood the coffers of those selling and, more than likely, they will be tempted to buy new securities or other assets rather than hold onto the cash. As they search for new places to invest they will naturally look for higher returns than those offered in the US, especially as the whole point of QE2 is to lower those returns. So some of the cash, indeed a good percentage, will find its way into foreign markets. Their are two types of such markets: those with high rates of return due to their fast growth – these are typically emerging economies like China, Brazil, and India – and those with lower rates of growth, but less perceptible internal imbalances like Switzerland. This inflow of American sourced cash will tend to drive up asset prices and, or, drive up the exchange rates of those countries. In effect the US is trying to inflate the global rather than face deflation domestically. This is a disruptive policy and flies in the face of what is sensible for those nations affected.

So a battle royal could erupt.

The Chinese would dearly like the US to go through depression as it strips away the Reagan illusion. The US would dearly like the Chinese to accelerate demand rather than stifle it by focusing on exports.

The Chinese have a point. We are forcing the consequences of our thirty years of stupidity on the world rather than taking the medicine we have so often foisted on weaker countries abroad. Thinking back through the Reagan illusion we can identify plenty of occasions when the US forced countries to go through enormous, and often rapid, adjustments. Those adjustments were painful, austere, and deflationary. Exactly what we are now seeking to avoid.

Unfair?

Absolutely.

Likely?

Absolutely.

The US has a great advantage in that the dollar is still, although maybe not for much longer, the world’s currency. The Chinese and others have to be mindful that if they resist their options are limited. The main one being to offset the flood of dollars by buying them up and stashing them in their central bank reserves. That would reduce the impact on their currencies, but would imply a huge run up in dollar based debts that they own. And the ownership of all those dollars gives them a stake in the success of the Fed’s attempted inflation.

So they are damned if they do, and damned if they don’t.

As a result: look for a very tense round of negotiations during November leading up to the Group of 20 meetings in South Korea. If those meetings fail to outline a more cooperative way out of the current global imbalance, the likelihood of a round of hostile policy moves, including tariffs, competitive devaluations, and even capital flow restrictions shoots up.

There is a whiff of war in the air. Currency and trade war.

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Jobs; Trade; Banks … Ho Hum And Bun Fights

This is getting dull. Really dull. The economy refuses to shift gears. Wall Street twitters on about nothing in particular. Central Bankers are even more confused and surly than usual. Businesses are sitting on piles of cash and complaining that no one cares about them. Banks are in a snit over being asked to play nicely. Consumers have all but disappeared. Government policy makers wring their hands and smile at the same time. The dark clouds of currency wars have rolled into view. And we go nowhere fast.

Welcome to the crisis part 2.

Oh: the very slightly good news is that new claims for unemployment assistance fell again last week. Whoopee. The drop was by 11,000 all the way to 445,000, which, in normal times, would be viewed as hopelessly inadequate, or a mere blip not worth mentioning, but was the reason that Wall Street roared briefly to life this morning. We exist – I won’t dignify our current state by using the word “live” – in such diminished times that even the most modest step in the right direction can be viewed as a triumph of the first order. Our era has so perverted our language that we no longer can use the word “modest” without feeling slightly apologetic. Personally I blame corporate America for its incessant hyperbole that has undermined the value of words that used to mean something.Modest used to mean, well, modest. Now it means a mix of useless and wimpy. Thus when we run into a putrid performance we have and reach for a proper descriptor we are apt to bring pablum out of our bag. This ends up confusing everyone, and allows the incompetent folks who buy and sell stocks for a living to justify anything. Thus today’s new claims data, which can only be described as the greyest of greys, is greeted in the manner once reserved for the returning Caesars of Rome.

My advice: ignore the hoopla. The claims number represents one of a long series of indifferent and indistinguishable data points, none of which tells us much other than that our malaise continues. Allow me to repeat: we need that claims number to be under 400,000. Better yet, we need it to drop to the mid 300,000 range before we reach for the celebratory fireworks.

Meanwhile ignore Wall Street. Remember they are the folks who trashed the place in the first place. The one fact we have at present is that they know nothing worth our learning.

In other news we are reading a great deal about the brewing trade and currency wars about to blight the world.

The reason is simple: practically every government facing a domestic crisis has written into its escape plan that it will grow out of crisis by pumping up exports. Those of you with an eye for detail will notice that there is a slight problem with this. Someone has to import. Not everyone can export. Whoops. In the old days the game was extremely simple. Japan, Germany, and China exported. The US and the UK imported. That meant that German, Japanese, and Chinese workers lived below their means while Americans and Brits lived above theirs. A better way to look at this is that the Germans, Japanese and Chinese exported unemployment by deliberately under-consuming goods that they made. The surplus was sent abroad. Further: the spare cash that this generated for those economies was recycled back into the US and UK where it pumped up asset prices. This “surplus” of savings on world markets created by the deliberate under consumption in the exporting nations was a major factor in the real estate bubble. At least that’s one theory doing the rounds. Bernanke is a leader of that train of thought.

Now, in the depths of crisis, the importers need to rebalance their economies and reduce the import inflow. But that implies the exporters have to adjust as well. Therein lies the source of tension. The exporters do not want to change their game. Too many local jobs depend on trade. In the case of China, whole industries depend on it, which means millions of recently displaced agricultural workers do too. That’s a big social problem waiting to burst if exporters have to change course. China’s middle class is insufficient to buy all those goods. At least not yet. So they need to keep on exporting. To us.

Which is why they rig their currency and try to play beggar-thy-neighbor with the rest of the world, and particularly with the US. If China were to allow its currency to float by unfixing its relationship with the dollar, it would be revalued upwards. That would make Chinese goods more expensive in foreign markets like the US and would thus reduce their exports. The displaced goods would have to be sold internally within China or those factories would have to close down. Either way the adjustment could be difficult. It would cramp Chinese growth which has averaged 8% a year for a while now. A slowdown from that pace would – potentially – hit their agricultural and poor workers the most since it would remove their opportunity to earn higher wages. The result? Civil unrest. The entire structure of the Chinese elite would feel the strain. It has already been hit by waves of strikes as workers lobby for better conditions and wages. Add in the loss of export industry jobs and the country gets shaky quickly.

Hence the current stand off.

Of course this scenario is being played out across the globe as countries seek to devalue their currencies to dampen Chinese and other exports and boost their own. It is particularly acute in Europe where the German refusal to rebalance their economy is weighing heavily on places like Spain. Since Spain and Germany use the same currency the poor Spanish cannot devalue. They have only one option which is to throw themselves into massive austerity programs. The Germans meanwhile preach such austerity, apparently oblivious that their failure to boost domestic demand created the excess cash that blew Spanish real estate into its bubble – all those German second homes on the Mediterranean coast, not to mention the tourists and their wads of Euros – and is now exporting unemployment along with those BMW’s.

I won’t mention the dire straits the poor Irish are in. Suffice to say that they make the Icelanders look like amateurs when it comes to self destruction.

So, all of a sudden, attention worldwide is on how to rebalance the flow of trade so that excess cash doesn’t slop about creating bubbles, and the exporting nations don’t foist unemployment on everyone else. The recipe for a full blown trade war is nearly complete. Which is very worrisome, since one of the factors that made the Great Depression truly “great” was the trade war of the 1930’s.

And, finally, on a more comical note: the banks are at it again.

This time they are all in a huff over the new capital regulations introduced by the folks in Basel, which is where the organization that dictates these things is based.

The banks argue, rightly, that higher capital implies less credit available. This is correct because capital is held in proportion to assets. So if that proportion is forced higher, the banks have two choices: they can raise more capital and not deploy it as loans; or they can keep their current capital, and reduce the amount of loans from where they now are. Either way the level of lending will drop. The entirely neutral analysts at Goldman Sachs tell us that the drop could cut about 1% off of GDP over the next few years. Conveniently we are not told how much GDP was destroyed by the excess lending of the last few years – that would mess up the story. In any case, the bleating from the banks is now very loud. Fewer loans means lower profits. And we all know what that means: lower bonuses. So I think we can ignore the warnings of lower GDP and cut straight to the one thing we know they care about: that fifth New York apartment. Or: how awful that they might have to forgo the Hamptons home and the Aspen retreat. How mean spirited of us to force such choices on the poor dears. Now this is a true national policy issue.

Not really.

A cursory review of Hyman Minsky and his financial instability hypothesis tells us that less lending is a very good thing. It reduces long run volatility because more of the economy’s wealth relies on equity funding and not debt. That makes it less susceptible to the swings of interest rates and thus more stable. This is good. Very good. The cost for getting this stability is that we will generate less wealth on paper. GDP will, indeed, grow less quickly. But, as we recently learned, wealth that relies on debt is often an illusion – just as illusory as Lehman’s asset values were.

Frankly we could do with less illusion and more reality. Hence we should gird ourselves to ignore the weeping and wailing of Wall Street, even if they have a technically correct point. After all our economy is not theirs to play with. It’s ours.

Not only that, but we want it back.

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What Went Wrong?

Much as I try it is becoming more difficult for me to avoid the thought that we are headed back into recession. Or at least into such low growth that it feels like a recession. If we get much above 1.5% GDP growth for the rest of the year I think we should congratulate ourselves. It didn’t have to be this way, but we have failed. A renewed recession, or ‘near’ recession, is the punishment for our failure.

There is plenty of blame to go around:

There is a conspicuous lack of leadership from the White House. The Democratic caucus in Congress is not to blame: they have attempted to shovel stimulus at the economy, but the White House provided little or no political cover for the necessary actions. The public is now so spooked about debt – and you all know I think that is a foolish concern – that we are very unlikely able to get any concerted policy action to stem the decline. Worrying about debt during a moment of crisis such as this is a bit like fretting over the paintwork of a sinking ship. Who cares what it looks like tomorrow if it’s at the bottom of the ocean and not floating? The lack of urgency in our policy response to the drop in demand two years ago is staggering when we compare it with the drama that surrounded the bank bail outs. It’s as if policy makers thought that by saving the banks from their lunacy was sufficient to re-float the economy that the banks had trashed. Nobody seems to have calculated the correct depth of the abyss into which the banks threw us. This complacency was particularly evident at the White House after Obama came into office. His advisors miscalculated the political backlash against stimulus and didn’t even make the effort to sell the right policy. Instead they caved in before the fight and opted for a ‘get by’ package in the false hope that it would blunt the decline and that GDP would reflate by itself.

That was feckless and stupid. We are all suffering the consequence.

The Republicans are also to blame. They have advocated Hoover style economics from the start. I cannot think of a single policy position they have proposed that helps rather than hinders growth. At times they have been downright nasty: Senator Kyl’s statements in the past few days about unemployment assistance typifies the GOP position. Somehow the unemployed are evil hangers on and freeloaders who need to be punished rather than helped. To give Kyl his due he acknowledged that some assistance was in order, but that it should only come at the price of cuts elsewhere. As economic policy this makes no sense: unemployment assistance pays us back in the extra demand that it creates. That it is also socially beneficial from a moral standpoint is secondary to the main point. It is sound economics. That the GOP fails to recognize this is testimony to their deep commitment to the pre-1930’s social structure. Pre-middle class, pre-entitlement, pre-modern, they cling to disproven economic theory as if it is an enduring truth.

Also feckless and stupid.

The economic profession is also to blame. One would have thought that the last 70 years would have been ample time to sort out an economic theory to deal with Depression like slumps. Instead we have regressed to pre-Keynsian free market dogma and enshrined it within a web of abstruse and incomprehensible mathematics, as if a ton of neat formulae make it right. Wrong. Unfortunately the entire academic effort of the last 30 to 40 years has been a total waste of time. Yet the theories that emerged from that period are the ones that infest the minds of our business and political elites. So much so we have a collective block against the policies that saved the day in the Depression and would do so again now. Government spending and radical action by the Fed are still needed, but until we shed the wrongheaded theories of the likes of Milton Friedman and Robert Lucas we are doomed to repeat Hoover’s errors. We know where they lead.

Also stupid and feckless.

Then there’s all those damn foreigners.

One of the big problems we face is that we are too connected with the global economy for our own policies to be sufficient. We need other countries to move correctly also. They are not. One of the original causes of the crisis was the massive imbalance in the global economy between nations that consumed and those that saved. The US was obviously a consuming economy. This meant that it spend more than it earned. This imbalance showed up in the horrid Federal budget deficits of the Reagan and Bush eras; and in the ever present trade deficit. That trade deficit implied an equal surplus on the capital account – there are two side to trade: the goods and services balance, which is the ‘trade’ account; and the cash balance needed to pay for those goods, which is the ‘capital’ account. If the trade account is in deficit, which ours has ben for decades, then we need to have an equal surplus on the capital account to pay for it. That capital surplus shows up in all sorts of ways: foreign purchases of US government debt, companies, and property are all ways in which we acquire the cash we need to pay for the goods we import. Think of it this way: we sell Rockefeller Center to the Japanese and use the cash to buy Sony TV’s.

This flood of capital into the US was recycled through our real estate market and provided much of the cash used to inflate the property bubble. Without our trade deficit there would have been much less cash to pump that bubble up.

But: the problem is not all ours.

The German, Japanese, and Chinese economies are doing the opposite. They are deliberately under-consuming. Their domestic policies are designed to encourage exports. That means their economies are generating excess savings – German workers save rather than borrow and rely on exports to create jobs. Those savings flow into the global economy as part of the capital flow towards the consumer countries. In effect German, Chinese, and Japanese workers are lending to American [and UK etc] consumers so that the latter will continue to import and thus create jobs for those workers.

Now we reach the crux of the problem: if Americans turn to savings, as they have done during the crisis – the resultant huge drop in demand is a definition of recession – then we need that drop in consumption here to be offset by a surge in consumption in the former ‘savings’ economies. Have we had that? Not at all. Those economies have re-trenched too. So not only were they under-consuming in the good times, they are even worse now. So they are adding to the problem and not helping. When nation’s pursue economic policies built around exports they are implicitly seeking to undermine those of the consumer economies. They are deliberately exporting unemployment, debt, and the disruption that are associated with those factors. Typically such policies have been normal for emerging economies: the US followed the same path in the late 1800’s. But once an economy reaches maturity the export based economy becomes a problem because of the implications for global imbalance. Japan and Germany both are particularly culpable since they have a vast capacity to consume domestically, but steadfastly refuse to enact policies to encourage such activity.

The best example is Germany. Europe’s largest economy is being thrown through a bout of austerity to ensure its budget is balanced. That protects Germans but essentially exports unemployment to its weaker neighbors like Greece and Spain. So those two are forced to over-react to their internal problems because they are dealing not only with domestic crises, but also part of the German refusal to consume. Yet it was German capital flooding into Spain that inflated the Spanish real estate bubble and blew up the Spanish banks! Prior to the crisis unemployment was much lower in Spain than in Germany, and the government accounts were in better balance. It was German economic policies that threw Spain into the fire, yet the Germans see fit to lecture the Spanish on the need for austerity.

This is truly stupid and doubly feckless.

So there you have it. Inept policy making, weak leadership, and rotten theorizing. That’s quite a mountain for the economy to climb. I don’t expect it to succeed.

It’s all gone wrong.

The second half will reveal just how wrong.

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GDP: Good News

Everyone – well almost everyone – predicted that the second quarter GDP figures would show an improvement over the miserable performance of the last six months. That much was not hard to do, after all businesses will eventually run out of stuff to cut, slash, burn or otherwise eliminate. Once we reach that point even the most radical cost cutter has to turn his or her attention to growth. Rebuilding inventories, replacing worn out machinery, and generally fixing things then becomes the norm and GDP consequently sinks no further.

So this morning’s report that GDP fell only 1% during the second quarter came as a surprise only so far as the decline was so small. After having dropped by 5.9% over the past six months the economy’s free fall has finally started to slow down a bit. And after four straight quarters of contraction we can look forward, tentatively, to a slight upturn in the third quarter. Those four quarters of decline make this the longest recession since the Great Depression, although between then and now we have seen some sharper, but much shorter, declines.

The story within the numbers supports the notion that businesses are past the deepest part of retrenchment. Business investment declined ‘only’ 8.9% during the second quarter, which is a sad state of affairs until we realize it dropped at a 39.2% rate in the first quarter. After that appalling decline earlier in the year it was not too difficult to forecast an improvement!

The change in business spending – or rather the slowing down of the reduction in spending – contrasts with personal consumption: in the first quarter it grew very slightly – by 0.6% – while in the second it dropped by 1.2%. This turn for the worse was driven mainly by a sharp reduction in durable goods spending – stuff like cars and refrigerators – which fell 7.1% in the second quarter after having grown well, by 3.9% earlier in the year.

For those of you who need more evidence of the stimulus working: government spending kicked into gear nicely – it grew buy a heady 10.9% during the quarter; and even our beleaguered state governments managed to grow their spending 2.4 %.

Finally trade also contributed to the turn about. Both exports and imports declined less rapidly than before, with exports declining ‘only’ 7.0% and imports by 15.1%, compared with 29.9% and 36.4% respectively in the first quarter.

What do we make of this?

Obviously things are turning around. As I mentioned, this was inevitable given the depth of the retrenchment that businesses went through. The much harder question concerns the next few quarters and the shape of the recovery. There, I think, is not much evidence of enduring strength. At least not yet. That drop in consumption last quarter concerns me somewhat, especially when we couple it with the downturn in consumer sentiment of recent months. The other aspect of today’ report that suggests a sluggish recovery is, ironically the savings rate, which perked up some more from 4.0% in the first quarter to 5.2% in the second.

It is this steady accumulation of savings by American consumers that will turn out to be the most important single issue for the entire world economy over the next year or so.

Here’s why:

  1. It was ‘over spending’ by Americans that enabled growth in the exporting countries like China, Japan, and Germany over the past few years. Americans lived way beyond their mean and went deeply into debt.
  2. That indebtedness led America into a very fragile position where a collapse in banking became inevitable. Sloppy credit standards became the norm, which led to an accumulation of bad debts.
  3. That is now being unwound.
  4. This unwinding or ‘de-leveraging’ implies less consumption – by definition – and thus much more sluggish growth here in America, but also in countries who relied on selling goods here.
  5. It also affects the world’s capital markets: because some countries, notably China, Japan, and Germany saved rather than consumed the world became awash with spare capital for investment: these countries ‘saved too much’. That capital found its way to America via our trade imbalance, and fueled our binge of debt.
  6. So a slower US economy means that those countries either grow more slowly or they increase consumption/investment at home.
  7. The other hidden story here is that the US dependence on foreigners for money is decreasing, so the proportion of the Federal Deficit that we finance by borrowing from China etc will drop sharply – in fact it already has. We know this because our trade deficit has dropped sharply during the recession and the trade deficit is a measure of how much foreign capital we are importing to support our indebtedness.

So, for all these reason the US drop in consumption is about to be the big story.

It means we will see much slower growth than we are used to for a while. It will mean the recovery in employment will be slow. And it will mean that our dependence on foreign debt will diminish.

In other words we will start to deal with our underlying economic imbalances at last. It’s about time the illusion of the Reagan/Bush era was stripped away and we got back to basics rather than living in a pretend world where we imagined that our competitive position was that of the 1950’s.

Adjusting to the new reality and then rebuilding will be difficult and will require a great deal of discipline across the board – our Federal deficit will have to be reduced significantly and that means extra taxes, or painful cuts in things like defense spending – but reality is preferable to silly illusions like shining cities built in the clouds.

And it is also why things like health care reform and banking reform should be seen as part of an overall economic strategy: we need to re-allocate our resources towards future sources of wealth and away from either frivolous or ephemeral short term things.

But all that lies ahead. Right now all we can say is that we are not falling as badly as before.

And that’s really good news.