Uncharted Territory

December 3, 2008

“Blame China!”, Cries Wolf

Filed under: Credit crisis, Economics, Housing market, Markets, Risk — Tim Joslin @ 9:40 pm

I’ve been thinking of posting about the inevitability of the current economic crisis for a little while now. I was a little worried about the title, since I don’t want to upset 1.3 billion people. I thought of substituting Germany for China, but that’s still 90 million, and they’re not so far away. Fortunately, though, Martin Wolf has written a fairly strongly worded piece in the FT on a similar topic. I know he didn’t actually use the words “Blame China!”, but if anyone’s offended, please see Mr Wolf, he’s bigger and badder than I am!

Wolf’s point is that, if we’re to escape from the mess we’re in:

“… the global economy will have to rebalance.  If the surplus countries do not expand domestic demand relative to potential output, the open world economy may even break down.  As in the 1930s, this is now a real danger.”

Rather worryingly, Germany doesn’t seem too keen to do its bit for the global economy.  China seems to be flying into the tackle with both feet, trying to increase demand at home, while at the same time holding its currency back.  True to form, they’re single-mindedly concerned about… China.  Of course, there is an automatic stabiliser in the system in that oil (and other resource) producer surpluses will automatically fall as oil (and other commodity) prices go through the floor.  I guess we’ll muddle through somehow.

Wolf is primarily concerned about how the global economy recovers.  Quite right too.  He also points out that household borrowing in deficit countries will have to decline.  I agree (contrary, it seems, to the UK political mainstream) – we (UK, US etc.) have to reduce mortgage and consumer lending, and invest instead.  Brown and Merkel seem to agree on one thing: perversely, both seem to think we can put things right by doing more of what got us into this mess in the first place.  Germany expects other countries to restore demand for its products.  Could be a long wait.

You have to conclude that many do not seem to understand the nature of money.  Back in the day (or in Second Life) it might make sense to accumulate gold ad infinitum.  OK, I’ll go even further.  On an individual level, money can, I suppose, be rationally accumulated and stored.  But, as they say in China, what if everyone does it?  Huge trade surpluses, Sovereign Wealth Funds and vast savings pools are, collectively, unsustainable.  This is because money eventually loses its value.  Sterling, or any other currency, is only any use for buying sterling-denominated assets, goods or services.  If too little of the sterling used to pay for our imports is spent on our exports, then eventually too much sterling finds itself chasing too few assets, since this sterling must go somewhere.  The result is that either the value of sterling falls (against other currencies) or sterling asset prices rise (aka yields falling) – and then likely crash as everyone tries to bale out.  Recognise anything yet?  I read somewhere that China was losing 15% pa on its dollar funds because of the low yield on US Treasuries and slowly rising renminbi.  Once the total fund value exceeds 100/15x of the annual dollar increment, then, of course, 1.3 billion Chinese are running to stand still in terms of what they can buy with their dollars (all else being equal).  If they intended to blow the dosh on oil, of course, they’d have been running backwards until recently.  As they say, you can’t take it with you.  You can’t even keep writing IOUs indefinitely and expect them all to be paid back.  Especially when they’re in a currency you don’t control.

Money is there to mediate trade.  It’s not a physical thing with intrinsic value.  It can only be stored temporarily.  It’s value is contingent.

All this is a lead-in to my main point.  These surpluses and corresponding deficits are a problem for everyone.  The surplus money has to go somewhere.  And there’s been so much of it (especially dollars) sloshing about for the last few years that it’s drowned everything.  After the dotcom crash, everyone wanted safety, of course.  As alluded to already, Treasury yields hit the floor.  Private equity could only find so many safe utilities to buy out.  So Wall Street and the City tried to meet the demand.  They didn’t create all those mortgage-backed securities and so on for nothing.  No, no, no.  Low-risk paper with a respectable yield was precisely what the customer wanted.  Shame the yield was – how shall we put it? – temporary.  If attitudes to risk had been a little different, then the financial crisis would have played out differently.

So, this is my proposition: as trade surpluses built up, a disaster of some kind was inevitable.  The hot money was the critical factor – sub-prime mortgages, SIVs and the rest were just detail.  Dollar assets were of course most vulnerable – who’d want to be responsible for the world’s reserve currency, eh?  Hmm, the ECB, apparently.  Not only are reserve currency asset prices driven up by demand, the problem is compounded by the currency having a higher exchange rate (amd therefore inevitably larger trade deficit) than would otherwise be the case.

Wolf is right.  We’ve got to find ways – other than protectionism, of course – to dramatically reduce global trade imbalances, not just to escape the present imbroglio, but to avoid the next one.

A few years of decent growth, then total economic disaster out of a clear blue sky – a financial 9/11.  Something’s got to have been seriously wrong all along.  We can’t just put it all down to a few dodgy mortgage salesmen.


1 Comment »

  1. […] the horse inside!  More specifically, are we really expecting sovereign debt defaults?  As Wolf himself argues, the countries likely to be vulnerable in a crisis have built up huge foreign currency positions.  […]

    Pingback by Good Banks, Bad Banks and Nouriel Roubini « Uncharted Territory — February 13, 2009 @ 12:23 pm

RSS feed for comments on this post. TrackBack URI

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Create a free website or blog at WordPress.com.

%d bloggers like this: