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On Monday and Tuesday of this week, Treasury Secretary Geithner—and Secretary of State Clinton—meet with a high-level Chinese delegation.
According to official previews (i.e., the apparent contents of background briefings given to wire services), the economic topics are China's concerns about the value of the dollar (i.e., their investments in the U.S.) and the amount of debt that the U.S. will issue this year.
This is absurd.
China decided to accumulate over $2 trillion worth of reserves, most of which they are presumed to hold in dollars. No one compelled, suggested, or was even particularly pleased by their massive current account surplus (peaked at 11% of GDP in 2007, but still projected at 9.5% of GDP for 2009). We can argue about whether this surplus—arguably the largest on modern record for a major country—was intentional or the result of various policy accidents.
Irrespective of underlying cause, any country that runs such a current account surplus is implicitly taking a great deal of currency risk—China was in effect deciding to take the biggest ever official long-dollar position. The idea that the US government should spend time reassuring them is somewhere between quaint and not good strategy.
If China decides to now shift out of dollars, what would happen? Remember that the US left the world of fixed exchange rates and associated rigidities a long time ago—back in the early 1970s. The dollar would surely depreciate and inflation would likely rise. But who cares?
A weaker dollar would help our exports. It's not honorable for the issuer of a reserve currency to talk down its own exchange rate (hence the Rubinesque "strong dollar" rhetorical trap), but if a third party leads a big sell-off, what can we do about it?
Treasury's concern is not really the value of the dollar—particularly as they would like a bit of inflation at this point; again, if it's China's fault that the real value of our debts falls, that might play (or spin) well in Peoria. Instead, Treasury's concern is the large amount of debt that they/we are trying to issue.
If China is worried about the future value of our debt in renminbi, then Treasury will have to pay higher long term interest rates. But, as Treasury and the White House have been emphasizing, what really matters for our long-term fiscal solvency is bringing Medicare and associated costs under control. Any strategy that relies instead on indefinitely low long-term interest rates is illusory—and any investor who thinks we will be like Japan in this regard is in for some disappointment.
The real issue for discussion this week should be China's current account surplus and the pressing actions needed to bring this under control. The US should put on the table the possibility of more assertively taking China to the World Trade Organization over its fundamentally undervalued exchange rate and associated trade policies (Arvind Subramanian's idea). The exchange rate dimension should have been dealt with by the IMF, but unfortunately that organization has (again) ducked its responsibilities on this issue.
The Treasury apparently thinks it should be deferential and on the defensive vis-a-vis China. This is not only bad economics, this is bad geopolitical strategy.
Also posted on Simon Johnson's blog, Baseline Scenario. Following were previously posted on Baseline Scenario.
After Peak Finance: Larry Summers's Bubble (July 24)
There are three kinds of "bubbles"—a term often used loosely when asset prices rise a great deal and then fall sharply, without an obvious corresponding shift in "fundamentals."
- A short-run bubble. Think about 17th century Dutch Tulip Mania: spectacular, probably disruptive, but not a major reason for the decline of the Netherlands as a global power.
- A distorting bubble. In this case, the increase in asset prices contributes to a reallocation of resources across sectors. Think of the Dot-com Bubble: fortunes were made and lost, the collapse was scary to many, and—at the end of the day—you've built the Internet and some good companies.
- A political bubble. Here rising asset prices generate resources that can be fed into the political process, through bribes, building politicians' careers, and lobbying of all kinds. Bubbles in Emerging Markets often generate resources that impact the political process, sometimes in good ways—but most often in bad ways, which eventually contribute to a collapse.
Larry Summers seems to think we are dealing with the consequences of bubble type #1. In his speech at PIIE earlier this month, "the bubble" is a modern deus ex machina—it explains why we have a crisis, but there is no explanation of where this bubble came from, what exactly was bubbling, and what changes this bubble brought to the real economy or to our politics.
To the extent that Summers talks about the bubble at all, it seems to be in residential real estate. It's hard to argue that there was an unsustainable run-up in housing prices and that the fall has real consequences. But what model—or even story—can explain the size of the global disruption we are facing without reference to what happened specifically in the financial sector?
The overall official consensus—which Summers continues to shape—seems to be that our problems are: housing bubble plus bad management in a few big financial firms and slightly too weak regulation. So we'll tweak regulation, ever so gently, and let the "good" big firms gobble up the people, market share, and perhaps even assets of those that fall by the wayside.
But what if we are looking at the effects of a distorting bubble? In previous formulations—but not this month—Summers acknowledged that when financial sector profits hit 40 percent of total corporate profits, a few years ago, we should have seen that as a "warning sign." But was this a warning sign of something just about houses, or more broadly about the financial process in and around securitization that was both feeding the housing price increase and also reflecting a longer-run shift of resources into the financial sector?
Even James Surowiecki, a most articulate defender of our current financial sector, implicitly concedes that as a percent of GDP, finance is likely to fall from around 8 percent to GDP back towards 6 percent of GDP (its level of the mid-1990s; see slide 19 in my recent presentation . Of course, there is no way to know exactly where finance is heading—except that it is likely down as a share of the economy.
If the bubble (or metaboom with a series of bubbles) was in finance and pulled resources into that sector, we face an adjustment away from Peak Finance—and perhaps this will even more overshadow the next decade than Peak Oil.
The economic adjustment will not be easy for the U.S. but it will be much more painful for smaller countries that have specialized in finance. The U.S., however, will likely struggle with the political adjustment—the financiers will not easily give up their license to extract resources from citizens, either directly or through newly found rents channeled through the state (and coming ultimately out of your pocket, of course).
The political consequences of Peak Finance greatly complicate our economic recovery.
Bernanke and the Lobbies: Confidence Illusion (July 23)
Ben Bernanke is opposed to the creation of a new Consumer Financial Protection Agency. Disregarding his organization's disappointing track record in this regard, he claims that the Fed can handle this issue perfectly well going forward.
He thus adds his voice to the cacophony of financial sector lobbyists favoring the status quo.
At the same time, Bernanke and the lobbyists talk about the importance of consumer confidence for the recovery. But how can you expect anyone to have confidence enough to spend and borrow when so many people have been so badly treated by the financial sector in recent years?
What happens when there is a scare regarding food contamination in the US or globally? People buy less of that kind of food until the government assures them that (1) we know understand the cause of the problem, and (2) it will not happen again.
Word has got around that many financial products are not safe—as well as the idea that the debt levels encouraged by the finance industry are not always healthy. Consumers are going to be more careful and, if there is no way to reassure them fully, they may be excessively careful.
In addition, we have learned that allowing financial firms to abuse consumers is very bad for our overall financial system health—leading directly to the current crisis, loss of jobs, and still rising unemployment; all of this further undermines confidence of all kinds. If the financial system can turn nasty or even nastier, we should all carry more "precautionary" savings.
There's no question that some financial firms would like to return to abusive practices, figuring they can once again make money and then move on. Yet serious financial sector firms would prefer to clean up their acts and work with properly informed customers. These firms are making a bad mistake in opposing the CFPA.
If the CFPA does not make it through Congress—and right now it seems a toss-up—this will just feed the backlash against finance more generally, e.g., in the 2010 midterm elections and beyond. There is no way that is good for overall confidence. It just doesn't make sense for well-run financial firms to go down this road.
Industry thought leaders, the American Bankers' Association, the Financial Services Roundtable, and other interest groups should switch their positions and support the CFPA—if they really want consumer confidence in financial products and more generally to return.
The Fed, it seems, just wants to defend its turf. This is unfortunate, particularly given its ambition to become even more responsible for the safety and soundness of the entire financial system. How can our financial system ever be sound when so many elements prey on so many consumers' confidence?
(The material after the break is an excerpt from my Economix column on NYT.com July 23.)
