My previous post, 50 Days to Save the World! made a simple point. If we’re planning an economic solution to the climate change problem, it’s critical that, first, we fully understand the phenomenon we’re trying to modify – the global economy, in this case.
We also need to have at least an outline understanding of the shape of the global economy of the future. My thinking has been stimulated by today’s column in the Guardian by Larry Elliott, Eastern promise holds little hope for west. But Larry doesn’t consider what will happen to China’s currency peg to the dollar. We need to listen to Bernanke, among others.
What is a currency? I expect if we surf a bit we’d find a definition that lists the characteristics of a currency. A currency, I’m sure we’d find, must be fungible (exchangeable) and act as a store of value. But these attributes are only a matter of degree. All currencies are only exchangeable under specific circumstances, some more specific than others. And some store value better than others. In fact, these attributes are shared by many physical and promissory items that are not generally regarded as currencies: gold, oil, works of art, debts (certificated or not), company shares and so on all share many of the properties of currencies.
Now, my point is that we all agree that the value of gold, oil, works of art, debts and company shares all depend on supply and demand. Currencies, such as the dollar and the yuan are no different. To attempt to peg their value is akin to defying a law of nature. Just as the tide reached Canute, so currencies will resist an attempt to confine them. Eventually the dragon will breathe flame.
China has amassed a surplus in excess of $2trn and they’re not the only culprit. The future depends to a large extent on what happens to that surplus.
Let’s first consider the problem in terms of supply and demand for dollars. China’s $2trn will lose value to the extent that the supply of dollars increases and/or there is a decline in supply of what those dollars could buy.
On the supply side, QE, for example, will tend to inflate the dollar. But so, too, will releveraging as the global economy starts to grow and any increase in trade imbalances and attempted hoarding of dollars by surplus countries.
On the demand side, though, the dollars will become worth less or more, the less or more there is to buy with them. If, for example, oil becomes priced in euros, then the store of dollars will be worth less.
Let’s make some observations:
1. The value of China’s supply of dollars depends on the dollar-yuan exchange rate only to the extent that holders of dollars wish to purchase Chinese goods (requiring a foreign exchange transaction). Externally to the Chinese economy, the dollars will still be worth $2trn, should China revalue the yuan.
2. Foreign currency reserves are being held in dollars because there are things that can be bought with dollars. Holding reserves in gold or Swiss francs, say, would introduce a currency risk. More than that, in fact, the supply of gold or Swiss francs would exceed what can be bought with them. And, to repeat a critical point, if oil should become denominated in currencies other than the dollar, then China’s dollar reserves would immediately become worth less.
3. China relies on US demand for dollars, not just for Chinese goods. If the US reduces demand for dollars by fiscal tightening (i.e. by reducing the supply of government bonds) and by controls on lending (reducing money-market rates), then China’s dollars will be worth less.
4. If China’s dollars become worth less then the value of something – probably many things – they could buy will inflate.
Now let’s try to identify some scenarios depending on US and Chinese behaviour and then consider what other players might do.
0. Asset bubbles in US: China keeps peg, US borrows
I’ve added this case later for completeness. We might, I suppose, simply repeat the Credit Crunch. It’s possible, but unlikely, that we will simply go round the same loop again. But US consumers are no longer credit-worthy and the US is obliged to try to improve its fiscal position.
1. Asset bubble: China keeps peg, US is prudent
In the most likely outcome, China tries to be cautious, maintains its export-led growth and amasses ever larger dollar reserves, whilst the US also repairs its public and private finances. It will be impossible, though, for the US to repair its trade deficit, at least with China (and other dollar peg currencies). The surplus dollars create asset and commodity price bubbles before the inevitable crash.
Even worse, there is another aspect to the problem: dollars will be exchanged for other currencies where growth prospects provide better returns. Increasingly investors will bet (like Soros on the pound) on a gain when the dollar peg finally snaps.
There must, surely, come a point when China cannot further relax currency exchange controls without immediately being forced to reflate. Surely, as soon as China starts to allow trade in yuan, no-one will want to trade at the official dollar rate. People will assume that in the future they’ll be able to buy more with yuan (i.e. demand for yuan will increase) and seek to accumulate them. The yuan will inevitably rise against the dollar much as the dollar rose against the pound post-WWII. Eventually China’s trade position will reverse. Plus ca change…
2. Inflation saves us: China keeps peg but experiences inflation
I spent an hour or two last week reading about the Bretton Woods system. My scepticism as to the worth of currency pegs was reinforced. All currency pegs do (unless they prove to be a step towards successful currency unification, of course) is slow down currency movements and force them to happen with unnecessary drama and disruption, rather than by (at least sometimes) smooth market movements.
The problem is that the currency of the trade surplus country has to inflate to restore the balance. But there is no mechanism for this to happen in an orderly fashion. Rather, the trade surplus country benefits from improving economies of scale – and it’s no accident that manufacturing leads to increasing trade surpluses, for it is in manufacturing that productivity improvements are easiest to achieve – and the only way inflation can occur is through asset-price bubbles. The Great Depression is an example of what can happen.
The risk for China, of course, is that it finds itself in the eye of the storm of a second Great Depression (or at best a Lost Decade, like Japan) when asset bubbles burst. China would no doubt wish to avoid this by evening out across the economy any inflation that took place, but this is difficult. Allowing workers’ wages to rise would actually lead to productivity increases and an even greater surplus! If commodity prices are the focus then, again, industry will use these more wisely…
3. China keeps peg, but has to spend dollars on commodities
If the price of oil (and commodities such as iron, uranium and so on) goes stratospheric and China cannot wean itself off, then more of the dollar surplus will transfer to the resource exporting countries.
This scenario could lead to something resembling stability, at least for a time. The global economy would become characterised by a kind of triangular trade. China exports to US, which exports technology and knowledge products to resource countries, which export commodities to China.
The problem, of course, is that China will tend to find substitute products for scarce commodities and, because of the currency peg, restore its surplus.
Ultimately, too, the resource exporting countries will rely on US demand for dollars.
There is great danger, too, that this scenario would lead to 1970s style global inflation.
4. China relaxes peg
The only rational course for China is to relax its currency peg to restore a rough trade balance with the US. Why risk asset bubbles (1) or try to manage internal inflation (2) or global, commodity-led inflation (3)?
What about the UK?
Well, our policy aims should be:
1. Reduce our trade deficit so that we are less prone to asset bubbles arising from lending of foreign sterling reserves to consumers in the UK.
2. Reduce our fiscal deficit to ensure we can withstand future economic crises and to reduce demand for sterling. Forcing banks to purchase government debt reinforces this policy.
3. Further reduce demand for sterling by controls on lending.
The result will be that sterling used to purchase imports to the UK (or invested overseas) must be spent on exports. Other places it can go will be minimal.
Sterling, which, fortunately, is a truly floating currency will decline until its value ensures approximate trade balance.
One thing the global economy certainly does not need right now, though, is a transfer of a further $100bn a year from trade deficit to trade surplus countries.