A couple of weeks ago, I promised to identify the causes of the current financial crisis, which I’m now terming The Great Crunch. And for once I’m keeping a promise.
I thought I’d make sure I knew what I was talking about before putting finger to keyboard. To that end, I spent last week’s pocket-money on “Fixing Global Finance”, by Martin Wolf. Best £18.99 I’ve spent this year (I couldn’t wait for a cheaper copy by post, so paid the full RRP for the only copy from Heffers – I was expecting the local bookshops to have stacks at them! And I was right, copies of this book should be selling like hot cross buns).
Everyone should read Wolf’s book, because this guy knows what he’s talking about. I agree, though, with (say) the Independent’s review, that: “The final chapter on possible solutions is the least persuasive.” At least Wolf has left some scraps for the rest of us!
The argument is very simple, though Wolf provides a great deal of background and discussion. And graphs. Dozens of them! After the financial crises of 1998, the East Asian emerging economies, and China – which is particularly significant because of its size – adopted a policy of export-led growth, maintaining trade surpluses and large foreign currency, particularly dollar, reserves. I’ve only used 3 Post-it notes for the whole book: Figures 4.8 and 4.9 (p. 70-1) show the savings build-up from 1998. The counterpart (as Wolf would put it) of the Chinese and other surpluses was, of course, massive borrowing in the US (see Wolf’s Fig. 4.30 on p.101).
A very important point to be aware of is the role of China’s monetary authorities. They have maintained their trade surplus by holding their currency down against the dollar (this is the currency peg they’ve chosen to target). Think about what’s happening. A Chinese company supplies toys in return for $ (or £, € etc.). It exchanges these for Chinese renminbi to pay staff, suppliers and so on. The dollar ends up owned by a bank or other foreign-currency dealer. But the Chinese central bank buys the dollar for renminbi. Where did it get these renminbi? Answer, it issues bonds, which Chinese are obliged banks to buy. Thus the revenue (more accurately the profit since there may be import costs in dollars) from export sales is converted into renminbi, but these are “sterilised” by bond issuance and do not add to the Chinese money supply, where they could stoke inflation.
We have a different situation to “normal” balanced trade. If money were just a medium of exchange the renminbi would be used to buy dollars, which would be exchanged for, say, a Britney Spears MP3 download. The net effect would be that a toy had travelled from China to the US and Britney from US to China. But because Britney doesn’t always make the trip, we end up with a different situation. The toy goes to US, but the $s stay in China (and a Chinese bank ends up with a local currency bond).
Or do the $s stay there? Wolf makes the point several times that, compared to the first era of globalisation (1870-1914) when the gold standard was in force, “fiat” currencies are now dominant. This makes all the difference, because China cannot store its dollars. Instead, it invests them, mainly in US Treasuries. This means there is a surplus of capital in the US. Treasury yields fall, so investors look for better returns elsewhere, say in corporate debt or mortgage-backed securities…
Cutting to the chase, an asset bubble in US (and other countries with a similar trade deficit) is almost inevitable as a result of the export-led growth policies of China and other countries.
There are not a lot of things that can happen as a result of the trade imbalances over the last decade or so:
1. General inflation in US (and elsewhere)
This has not occured, because globalisation has turned inflation into a global phenomenon. Or, rather, the inflation that is universally targeted by governments (essentially commodity and labour costs) is a global phenomenon. As I will argue in future posts, the major intellectual failure has been a failure to target, let alone control, asset prices.
2. Fiscal deficits in the US (and elsewhere)
One possible and logical policy response would have been for the US and other countries to run budget deficits corresponding to their trade position in order to soak up the excess dollars. True, after Clinton valiantly balanced the books, the US did indeed run up a massive budget deficit, but it was nowhere near big enough to soak up all the excess dollars. It’s not quite a case of unintended consequences of fiscal rectitude (a post title I may yet make use of) because the US government would in any case have had to spend the money, so it would still have led to asset bubbles, just by a different route.
The only way I can think of to avoid this would be if the US Treasury purchased renminbi (ignoring, for the moment, the existence of Chinese exchange controls), in effect engaging in a battle of wills with China as to the dollar-renminbi exchange rate! Or perhaps China would agree to such cross-holdings (whether the US taxpayer would is another matter) – at least this way China would be able to maintain large foreign currency reserves without damaging the global economy. This would, in effect, implement a US policy of “sterilisation”, corresponding to the Chinese one.
3. Equilibrium because of gradual renminbi revaluation
It’s obviously possible for China’s foreign currency reserves to decrease in $ value at around the rate at which it is adding to them, as the renminbi gradually rises in value. Indeed this is moreorless what’s been happening. This may (arguably) be OK for China – the poor return on investment may be worth it in order to maintain a foreign currency pool for emergencies – but is certainly not OK for the US, because even if its net external debt ceases to increase, it still has the problem of a surplus of cheap money.
4. Asset price bubbles in US
As I said, asset price bubbles in US became moreorless inevitable.
I’m a little disappointed that it’s a case of Good Wolf, Bad Wolf (sorry, another so far unused blog post title). If disaster was moreorless inevitable, then it’s no good blaming the banks. In fact it’s a wasteful (and increasingly distasteful) distraction and lets the politicians and regulators off the hook – and they’re the ones who oversee and need to change the system. And unfortunately Wolf has jumped on the bonus and nationalisation bandwagons. The first is an irrelevance and the second would be a disaster – governments’ primary concern really ought to be their own balance-sheets. If asset price bubbles are an inevitable result of global imbalances, as I believe they are, then why muddy the waters by complaining about the banks, as Wolf has done repeatedly? You may as well blame the weather (as Tony Blair used to say about the newspapers). I simply do not understand the logic – maybe Wolf had a bad experience with an overdraft (or a job application) in his youth!
In order to prevent a Second Great Crunch (which seems inevitable to me, at the moment), and to escape this one, we need to understand the causes. We won’t do that by engaging in an orgy of scapegoating of the bankers.
It’s difficult enough as it is to accept that the deepest cause of the Great Crunch has been those nice cheap fluffy toys from China. Wolf points out in his book that sufficiently determined countries can keep their currencies down (it’s more difficult to keep them up, because, as Russia is now finding, like Lamont and Major in the UK on Black Wednesday in 1992, you eventually run out of foreign currency reserves) and that there’s not that much other countries can do about it. As he puts it in his concluding remarks (Post-it note 3):
“Thus the United States is at least as much the victim of decisions made by others as the author of its own misfortunes. That is an unpopular view – in the United States, because it is easier for Americans to accept that they are impotent, and in the rest of the world, because it is far easier for others to accept that the United States is guilty than that they themselves are responsible.” (Fixing Global Finance, p.194)
The Chinese Mistake is to imagine that massive trade imbalances are sustainable. Governments should by all means maintain foreign currency reserves, but these must be reciprocal. Over time, global trade must be kept in balance. It’s easy to say that, but achieving such a nirvana may be a little difficult.