The next financial crisis
Posted on 28. Okt, 2009 by Geert in Uncategorized
I do not have a lot of time today, but just want to share some thoughts with you. As readers know from previous posts, I am very concerned about a double dip, first of the financial system and later of the economy. I am not pessimistic by nature, but I think that measures taken as from August 2007 – the first signs of the imminent financial crisis- are not addressing the problems. To cut a long story short, instead of rebalancing, we are increasing some imbalances. A new layer of debt has been added to the huge credit bubble, this time in the form of government debt. China has increased spending and stimulating more excess capacity and infrastructure. The US has stimulated consumption (cash for clunkers) instead of improving austerity and improving its production and export base. And Europe ? They have added a new layer of red tape, government intervention and promoting support for inactivity, instead of improving entrepreneurship or improving government efficiency.
Two articles have attracted my attention this morning. One by Alan Meltzer on preventing the next crisis:
The Obama administration chooses to blame outsize deficits on its predecessor. That’s a mistake, because it hides a structural flaw: The U.S. no longer has any way of imposing fiscal restraint and financial prudence. Federal, state and local governments understate future spending and run budget deficits in good times and bad. Budgets do not report these future obligations.
Except for a few years in the 1990s, both parties have been at fault for decades, and the Obama administration is one of the worst offenders. Its $780 billion stimulus bill, enacted earlier this year, has been wasteful and ineffective. The Council of Economic Advisers was so pressed to justify the spending spree that it shamefully invented a number called “jobs saved” that has never been seen before, has no agreed meaning, and no academic standing.
One reason for the great inflation of the 1970s was that the Federal Reserve gave primacy to reducing unemployment. But attempts to tame inflation later didn’t last, and the result was a decade of high and rising unemployment and prices. It did not end until the public accepted temporarily higher unemployment—more than 10.5% in the fall of 1982—to reduce inflation.
Another error of the 1970s was the assumption there was a necessary trade-off along a stable Phillips Curve between unemployment and inflation—in other words, that more inflation was supposed to lower unemployment. Instead, both rose. The Fed under Paul Volcker stopped making those errors, and inflation fell permanently for the first time since the 1950s.
Both errors are back. The Fed and most others do not see inflation in the near term. Neither do I. High inflation is unlikely in 2010. That’s why a program beginning now should start to lower excess reserves gradually so that the Fed will not have to make its usual big shift from excessive ease to severe contraction that causes a major downturn in the economy.
A steady, committed policy to reduce future inflation and lower future budget deficits will avoid the crisis that current policies will surely bring. Low inflation and fiscal prudence is the right way to strengthen the dollar and increase economic well being.
Another by Roubini, who is sharing my view that government interventions are causing the next bubble, and that a huge carry trade (the mother of all carry trades) is developing:
“There is a wall of liquidity…chasing assets,” Roubini told “Squawk Box.”
“Now we are in the mother of all carry trades,” he added.
Asset prices have been inflated by the cheap funds but the dollar cannot keep falling forever, and there could be “a market crash all over the world” when the currency’s course is reversed.
CNBC — Roubini on the Economy (Click for Report and Video) [8:16]
CNBC — Nouriel Roubini, chairman of RGEMonitor.com, shares his outlook on the economy.
________________________________________
CNBC — Roubini’s Parting Shots (Click for Video) [3:28]
CNBC — Discussing the dollar’s weakness and gold’s luster, with Nouriel Roubini, chairman of RGEMonitor.com.
_________________________________________
CNBC — The Fed’s New #1 Priority (Click for Video) [6:36]
CNBC — When it comes to both the Fed and Treasury, fixing the banks is the number one job, reports CNBC’s Steve Liesman. Nouriel Roubini, of RGEMonitor.com, shares his insight.
koen2
28. Okt, 2009
Sure, but when? October 2010? That will be a long wait then:
http://moneywatch.bnet.com/investing/blog/against-grain/grantham-after-forecasting-rally-warns-that-a-reversal-is-approaching/309/
“I have some modest hopes for a collective sensible resistance to the current Fed plot to have us all borrow and speculate again,” he went on to say. “I would still guess . . . that before next year is out, the market will drop painfully from current levels.”
koen2
28. Okt, 2009
munchau (financial times): bubble won’t last long (yes, sure, but it could last another year or so):
http://www.businessspectator.com.au/bs.nsf/Article/A-new-crisis-on-the-horizon-pd20091019-WXUVM?OpenDocument&src=sph
Our present situation can give rise to two scenarios – or some combination of the two. The first is that central banks start exiting at some point in 2010, triggering another fall in the prices of risky assets. In the UK, for example, any return to a normal monetary policy will almost inevitably imply another fall in the housing market, which is currently propped up by ultra-cheap mortgages.
Alternatively, central banks might prioritise financial stability over price stability and keep the monetary floodgates open for as long as possible. This, I believe, would cause the mother of all financial market crises – a bond market crash – to be followed by depression and deflation.
koen2
28. Okt, 2009
I like metaphors: our financial-economic system is the patient, crises (dot.com, real estate/banking) are waves of fever, the provision of conventional medicine (rate cuts, government deficits) against the fever has been depleted (rate cuts) or is running low (deficits). And it has made the patient even sicker (more debt).
Meanwhile, the stock market preachers are doing their thing again…
Everybody who advertises for investments (banks, investment magazines, …) should make an investment portfolio via a government website. So that we can keep track of their performance. That would be very interesting. I bet the performance of most would be negative over the last 5 to 10 years. And it will probably again be negative within 5 to 10 years.
koen2
28. Okt, 2009
http://www.cornerstoneri.com/PDFs/White/LEtsGEtBullish2.pdf
Theo
28. Okt, 2009
Textbook solution to a recession is depreciation of currency against currencies of more robust economies.
This is how and why I have thought and experienced the USA economy since 2001… not 2007.
Policies made and actions taken with regard to interest rates, trade and exchange rate had only one purpose: to stave off deflation!
As commodities are traded in $, every time the $ fell, the prices of commodities increased to keep up with the fall of the currency… not real demand!
This is what created speculation in commodities: people looking to lock in future supply at more stable prices, against the certainty of falling revenues in their own currency due to the continued trend of a falling $.
During that entire period, China kept its currency in line with the $ (and got continuous scolding for it), while the EU kept its currency strong, worried more about saving its face than its ass.
And now we are in a global economic crisis… one where the usual economic asymmetry can’t be taken care of by the usual text book fixes of using interest rates and currencies to smooth out differences and re-align advanced economies back on their path to perpetual growth.
Urizen
28. Okt, 2009
Nice theories, but how are you going to achieve a rebalancing?
I agree that the old remedy, opening the spigot and let the liqudity cycle do the rest, led or will lead to an asset bubble.
Deficit spending will put a serious dent on future consumption and must be handled with care.
Currency devaluation in the Eurozone became impossible and the PIGS countries will need to do with an internal deflation (or a social bloodbath but the Leisure class doesn’t care).
Currency devaluation and protectionism have become synonyms for bad and ugly.
And we sure cannot blame China for its pollution, protectionism, currency manipulation, corruption, … not even for its often flagrant incursions on human rights.
What’s left? Maybe one day economists will realize that this world cannot do without a sound drop of protectionism. Sorry for the curse!
Anyway, a second crisis? Quite possible but not precisely of the same kind. My bet is on a severe crisis within the Eurozone.
Jack en John Crooks wrote an interesting piece on this one back in June, but not available on the internet, sorry guys
Geert
28. Okt, 2009
@Urizen : It is curious that economists condemn protectionism but welcome inflation, devaluation, money printing etc.
carl
28. Okt, 2009
A new layer of debt has been added to the huge credit bubble :
Er is de fameuze “money multiplier” : elke dollar die de federal reserve creeert,zal leiden tot tien extra dollars in de reele economie.
Sinds 15 sep 2008 (failliet Lehmann Bros) steeg de monetary base ,nl bankbiletten in omloop plus reserves die banken aanhouden bij de Federal Resevre,met duizendhonderd miljard dollar.
Hierop passen we bovenstaande multiplier toe en we komen aan een stijging van de geldhoeveelheid van elfduizend miljard dollar.
Dit is tachtig procent van het Amerikaanse jaarlijkse BNP.
In Amerika pompt men dus 11000 miljard dollar vers geld in een economie die jaarlijks 14000 miljard dollar omzet in BNP.
Wat is de reactie van de President van de Fed,Mr BB ?
Ik heb een exit strategie : Ik haal na de recessie dat extra ingepompte geld weer terug uit de economie.
Hoe doen we dat?Door de transacties terug te draaien.
Tweederde van het balanstotaal van de FED zijn staatsobligaties en mortgage backed securities.
Deze moeten in de ideeen werled van de FED President dus worden verkocht. zodra de economie groene scheuten vertoont.
De Centrale Bank bezit voor 750 miljard dollar aan staatsleningen.Indien deze ineens in de markt worden geplaatse wat zal het efeect hiervan zijn door de marktpartijen aangedstuurd?
De prijs ervan zal in elkaar donderen.
De rente zal flink moeten worden opgedreven om dergelijke pakketten te plaatsen in de markt.
Maar als de rente om deze reden wel verplicht is om te stijgen,wat betekent dit voor de ondernemers in de reele economie?Stoppen met investeren.
Alleen al de intresten op de schulden in Amerika is meer dan twintig percent per jaar al van het BNP (3558 miljard dollar op 15000 miljard dollar)
En hierbij is nog een intrest van drie procent gerekend op een bedrag aan totale schulden van 118600 miljard dollar.
Of zitten er denkfouten in bovenstaande redenering?
carl
28. Okt, 2009
In 2009 is het tekort in Ameriuka 1500 miljard dollar.
De uitgaven zijn begroot op 3600 miljard dollar.
Dus het tekort bedraagt 41,7 procent van de uitgaven..
Een studie van Peter Bernholz toont aan dat na onderzoek van de twaalf grootste periodes van hyperinflatie in de wereld de tekorten veertig procent bedragen van de uitgaven.Dan is er echte crisis.
carl
28. Okt, 2009
Hierbij de cijfers voor 2006,2007 en 2008/
US Fedral government outlays as a percentage of unified budget deficit :
2006 : usa : – 9,3 %
2007 : – 5,9 %
2008 : – 15,4 %
2009 : -41,7 %
Geert
28. Okt, 2009
@carl: impressive !
De tax basis is kleiner in de VS, maar 42% tekort is erg veel.
koen2
28. Okt, 2009
Iedereen verwacht natuurlijk dat de volgende crisis een gevolg zal zijn van de volgende bubble die doorprikt wordt door het optrekken van de rente. Dat was de vorige twee keer ‘t geval. Vraag is dan: wat is de bubble en wanneer wordt de rente verhoogd. Maw: wanneer raakt de economie weer oververhit.
Maar dat zou een vergissing kunnen zijn. In Japan was er ook eerst een aandelenbubble die implodeerde, vervolgens een vastgoedbubble die implodeerde, dit bracht de banken in de problemen, en dit leidde dan weer tot deflatie.
Ik geloof dat bankkredieten héél laag liggen en dat M2 groei daalt.
koen2
28. Okt, 2009
De economie gaat niet meer oververhit raken. Om vervolgens door de fed gekoeld te worden. De zaken zijn nu omgekeerd: de economie gaat gewoon onderkoeld raken. En vervolgens door de overheid weer opgewarmd worden (tot een lauwe brei).
En dat gaat nog héél lang zo door gaan. Zonder een heel zware, zuiverende crisis raken we gewoon nooit meer uit het schuld- en overproductiemoeras. Een mogelijkheid is dat privé schulden dalen, en publieke schulden enorm stijgen. En dat overheden vervolgens ‘defaulten’. Dat is de evolutie in Japan (al hele deleverage in privé sector). Da’s in elk geval beter dan een wereldoorlog he : ) Een andere mogelijkheid is een hyperinflatoire vloedgolf die schulden wegspoelt.
Maar de timing is een grote vraag. Het kan gerust een paar jaar duren (vooraleer de economie afkoelt). Dat was, dacht ik, in Japan ook zo, na de vastgoed en bankcrisis.
Nick Doms
28. Okt, 2009
There are several factors and forces at work since 1993.
-Currently there is a battle between Geithner and Bernanke about the USD and control. The latter one wants a stronger USD to start an exit strategy, the former one wants to weaken the USD because of borrowing costs and exports.
-China has circumvented the traditional commodities markets by signing agreements with South America and Africa for future delivery without paying in USD.
-The future demand of commodities will exceed the supply and therefore increase the prices. Only China will not have to pay for the lesser supply, we will.
-China will continue to reduce its USD reserves and we know what that means for the US budget shortfall.
It is a roller coaster and it is not over yet.
Urizen
29. Okt, 2009
@Nick
I cannot see any relationship between the year 1993 and the events mentioned thereafter.
Moreover most don’t make any sense to me.
- No comment on the first one cause Bernanke nor Geithner wants to answer my call
- Of course they didn’t pay for future delivery, they’ll pay when delivery is done (you make it sound like they paid but not in USD??) ; I do have quite some experience in Africa and anecdotal evidence points out that the Chinese are hatred; the main difference in doing business is that Chinese have no moral limits at all when it concerns trading and gambling but in the long run it won’t pay
- China’s control over commodity supply should not be overestimated. The West is still very powerful on this matter
- China is still increasing its USD reserves; oddly enough now at a rate higher than the trade surplus with the US
Data (until August 2009)
Treasury purchases 154,056 million
http://www.treas.gov/tic/s1_41408.txt (154
Trade deficit with China: 143,699 million
http://www.census.gov/foreign-trade/balance/c5700.html#2009
And if Brad Setser would still be blogging, he would prove that China purchases even more treasuries
Geert
29. Okt, 2009
@Nick Doms: very interesting points you make.
Are you sure about the Geithner/Bernanke difference of opinion on the USD ?
Bart
29. Okt, 2009
@ Carl, heet jij in het echt Maarten?
peter
29. Okt, 2009
zoals altijd verhelderend:
http://www.sprott.com/Docs/MarketsataGlance/MAAG_10_2009.pdf
Koen D.
29. Okt, 2009
@ Nick
the following is just my two cents…
US Govt obviously wants a lower dollar (but a gradual descent over time). They must continue to talk about a strong dollar in public or risk a crash.
Bernanke will also have to stay a team player IMO, regardless of his personal beliefs – like Marc Faber likes to say : “he’s a money printer” – he is expected to do just that.
China is escaping from the dollar in the only way it possibly can, by exchanging paper dollar reserves for real goods and services (and making trade deals in it’s own currency for the future, using currency swaps with trade partners, avoiding the US dollar) .
At the same time China is still pegging it’s currency to the (weak) US dollar and they have given enormous stimulus to their economy. They are gaining/keeping control of the worlds manufacturing base in the process.
China obviously has it’s problems and challenges (China bubble?), but this looks like an economic struggle for power, and the West is not winning. When the US and/or it’s dollar goe(s) out with a bang (and it is possible we don’t see this happening for quite some time) , China will not be a victim.
Tectonic plates are moving so fast any observer that wants to look actually sees them move…
koen2
29. Okt, 2009
about the dollar carry trade:
http://tinyurl.com/yfqqsr9
The U.S. dollar, just like the Yen in 2007, is being used in “carry trades, which allow traders to borrow cheaply in low-yielding currencies” and “give speculators like big hedge funds and prop trading desks at major Wall Street firms extra leverage to engage in ultra-low-cost speculation and reap rich rewards.” Dr. Marc Faber assisted us in describing the Yen carry trade environment back in January of 2007: “the art dealers are bullish on art, the commodity traders bullish on commodities, the real estate guys bullish on real estate, the stock traders bullish on stocks, everybody has something to buy.”
Now, the dollar carry trade has created the same problem for wise investors looking for undervalued investments.
“Investors are moving in lockstep like never before, driving up stocks, commodities and emerging markets and risking a replay of last year, when they all plunged the most since World War II. The Standard & Poor’s 500 Index, whose increase in the past three months was the steepest in seven decades, is rallying in tandem with benchmark measures for raw materials, developing- country equities and hedge funds. The so-called correlation coefficient that measures how closely markets rise and fall together has reached the highest levels ever, according to data compiled by Bloomberg.” – Financial Times
In last year’s unwind, diversification did not reduce portfolio risk. When all asset prices are overinflated by credit (through a large supply of/weak currency) there is only one haven; the formerly weak currency. As we recommended two years ago: “Therefore the wise contrarian strategy is interest-bearing cash. Over the next few years, most assets will fall in value as risk returns to the market and leverage is unwound.” With sentiment levels extremely one sided (only 3% of traders surveyed were bullish on the dollar), a swing in the emotional pendulum will reverse the dollar carry trade and cause speculative investments (which would include most assets) to collapse.
Theo
29. Okt, 2009
Why do economist condemn protectionism but are not against inflation, deflation and all the rest of the currency manipulation techniques?
It’s well established by now that protectionist policies hurt those who issued them.
Free trade is a necessity due to national efficiency.
We promote Globalisation as long as it’s in our favor. Once it turns into Globality, we are not so much in favor of it.
Currency exchange rates and monetary policies become the tools of our “competitive advantage”. Currency is used to compete on price, interest rate and other financial/monetary measures to provide the credit necessary to finance that entire process.
Show me a corporation today which hasn’t funded its Globalisation with the help of its Financial arm, operating as a bank without being one.
On the other hand, if you wanted to do business in the USA, you had to give them the goods on consignment…. you were financing their operations and taking on all the risk.
USA GDP figures just came out.
All is good in Mickey’s land!
Imports are keeping inflation fears down.
Exports though are the scare crow of this Halloween season. And that’s why the $ will remain weak.
If Q4 is to be positive, exports will have to pick up.
Theo
29. Okt, 2009
@Koen D.
The USD has been descending gradually since the introduction of the Euro… after the initial surge.
Theo
29. Okt, 2009
@ Nick Doms
There is the growing cooperation with Russia as well. Let’s not forget the Russians helped the African countries discover their commodities and estimate their reserves, which in turn has completely changed the way concessions are being negotiated.
Currently there are commodities exchanges being set up in Africa.
Koen D.
29. Okt, 2009
@ Theo
Yes, and if you look back further (against DEM) it has been going down a lot longer. Against gold the USD has been going down starting with the US gold confiscation in the 1930’s
But my point is that they (US) want/need this trend to continue (debt too large at current USD valuation), without causing a crash in the dollar and losing USD reserve status in the process.
Nick Doms
29. Okt, 2009
I agree with both assessments but lets look into the future and what it will bring for the USD valuation.
Two days ago we got a serious taste of how fragile the currency really is. On the trading floor, the USD was about to go into a freefall were it not for the interventions taken.
Today it is stable again but it is a clear sign.
I can talk about the contradictions between the US and the Fed for a long time but that would make this post too long to read.
Geithner wants control of the Fed and supports the bill in Congress that will give him just that: a change of the 13.3 rule.
Sincerely,
Theo
29. Okt, 2009
@ Koen D.
I agree with you.
I made the same point.
Nick makes the same point as well.
Theo
29. Okt, 2009
@ Nick Doms
What’s the 13.3 rule? Does it have to do with this Frank’s bill?
If yes, would it pave the way to Bank and Financial firms to be allowed to fail?
Is this bill just a legislature fix after the facts, or a sign of what we should expect?
Thank you.
Nick Doms
29. Okt, 2009
@ Theo
The rule give the authority to the Fed to use emergency funding upon their discretion as well as invest or extend their funds to any particular public/private financial institution.
Barney Frank’s new bill, while much more elaborate, also includes to supercede the 13.3 rule and giving this power to the UST (Geithner).
This means two things:
-The Fed loses its independent status as a non-political entity.
-The UST can then set monetary policy because they can then decide how to ease or how to tighten.
The bill will fix certain things for sure, but it is a sign of what is to come.
Yannick Verdyck
29. Okt, 2009
@ Geert
Is het mogelijk dat ge de doctrines van Keynes en Friedman ooit gaat verlaten en met die doctrines ook de macro-µ-economie. Soms heb ik de indruk dat u meer en meer aan het vertrouwen bent op de zaken die uw instincten en uw gezond verstand u ingeven, eerder dan op de dingen die men u heeft aangeleerd tijdens uw academische opleiding. Stel dat Keynes inderdaad helemaal verkeerd zat met zijn “Malthusiaanse lek”, maakt dat niet dat al wat daarop zou volgen, niet meer dan los zand?
Urizen
30. Okt, 2009
That protectionism is labeled as “bad (for those who issue them)” is “established” alright. But to be more complete it is “established IN the minds of economists”.
I’ve a set of rules not to fall in the one-fits-all pitfall.
Too much to mention but here are three of them: see events in their dynamic context, keep in mind relationships and correlations do change with changing variables and nothing is ever given (more a trader’s rule) and finally nothing can be labeled as bad or good (not even human beings).
Basically it boils down to the principle that most of what happens is situational.
Whether protectionism is a viable policy tool cannot be discussed thoroughly via this communication tool, precisely because of the dynamics it makes part of. Depending on your time span, you can prove about everything you desire to prove.
Vulgarized one could claim that in history periods of free trade created imbalances that were answered by protectionism as a remedy which did not remediate the imbalances but worsened relationships in an unbalanced world and let to outcomes like the world wars. This too is a one-fit-all statement where freshwater economists who’s memory doesn’t reach any further than the latest event, put all the blame on the policy tool, not because it’s true but because it serves their ideology of an evil government.
It also intrigues me that one of the most narrow-sighted paragraphs ever written in economic history is one of the most praised and cited. I’m talking about Ricardo’s description of the benefits of free trade between England and Portugal. Of course nobody has ever paid any attention to the consequences for Portugal. As England found itself in a superior position in a world without international rules and no WTO, it succeeded in imposing its will on other less developed countries. The result was that Portugal remained underdeveloped for centuries. However economists will never envisage the link between free trade (and specialization) and a retarded economy. No, the reasons must be looked for elsewhere and partly they do but these can be linked with free trade quite easily. And Ricardo remained blind for this because he sat on the beneficial side of the trade-off.
(another nice example is Gresham’s Law which is dead wrong)
But you cannot label protectionism as good either. Friedman described it best in his Freedom To Choose. Politicians create institutions for good reasons and with the best intentions, but as times passes the institutions start a life of their own and finally all they aim at is their own interest (and the cost to keep them going becomes too high relative to the benefits for society). The same can be said about policy tools. Protectionism is a policy tool like another but as benefits flow in they become permanent and loose the link with the original intention and become counter-productive.
Now that I think of it, did I just make a case for freshwater economists? If politicians aren’t able to handle policy tools in an appropriate way in the long run, should they use them at all?
Well, sometimes there is no “Freedom To Choose” or would you have preferred central banks to let the financial crisis revolve itself? Maybe we crossed the Rubicon in government interventions a long time ago.
Anyway I don’t think I can learn much here cause what is established I can read in books.
Have fun!
Theo
30. Okt, 2009
@ Ulizen
Rules are made to be changed!
there are even people who are playing around with sea and fresh water…
Theo
30. Okt, 2009
Interesting article in the FT today.
Why the renminbi has to rise to address imbalances
By Martin Feldstein
Global leaders have agreed reducing global imbalances is a priority. In practice, that means reducing the US $500bn current account deficit and shrinking the $350bn surplus of China. All other current account imbalances pale by comparison.
Since a current account surplus is the difference between a nation’s savings and investment, that agreement means the US must raise its national saving to be less dependent on foreign funds. China must lift domestic spending to maintain high employment without producing so many exports.
Some progress is happening on both fronts. The US household savings rate has risen, driven by the need for US households to rebuild wealth. Corporate retained earnings have also begun to rise. But increasing private saving is not enough to raise US national saving if federal deficits remain high. The Obama administration must agree a budget that will reduce deficits in the years ahead.
China has succeeded in raising its domestic spending through fiscal incentives and an explosive growth of credit. Its real consumer spending has jumped 15 per cent in the past year, outpacing the almost double digit rise in gross domestic product. Chinese government spending has also increased domestic demand via major rises in infrastructure investment and building low income housing.
But while these two shifts are necessary to reduce global imbalances, they are not enough. For that, exchange rates must also adjust.
The dollar must decline relative to other currencies to make US products more attractive to foreign buyers and to cause Americans to substitute US goods and services for imports. Without that incentive to increase exports and reduce imports, the rise in domestic spending will just lead to US economic weakness and rising unemployment. That is why the recent decline in the dollar relative to the euro, the yen and other currencies is a natural and desirable part of the process of reducing the US trade deficit and shrinking global imbalances.
Unfortunately, the Chinese government has not allowed the renminbi to appreciate. It has kept it pegged at a rate of 6.82 renminbi per dollar. With the dollar falling relative to other major currencies, the fixed exchange rate of the renminbi relative to the dollar has caused the Chinese currency to fall relative to the euro, yen and other currencies. The trade-weighted value of the renminbi has therefore been declining, making Chinese exports more attractive and foreign goods more expensive in China.
The result has been an increase in China’s exports from $276bn in the second quarter of the current year to $325bn in the third quarter. This helps lift GDP and jobs in China but prevents reducing global imbalances.
China’s policy of keeping the renminbi weak means that the US dollar must decline more rapidly against the euro, yen and other currencies to achieve the same overall trade-weighted fall of the dollar. China’s weak renminbi policy therefore not only prevents remedying China’s large current account surplus but also reduces Europe’s exports.
China’s policy of expanding domestic spending while depressing the renminbi will lead to its economy overheating, particularly its manufacturing sector. Allowing the renminbi to rise would shift demand in China from manufacturing to services and prevent inflation. A stronger renminbi would thus reduce China’s domestic imbalance and global imbalances.
Although China has agreed to take steps to reduce global imbalances and its trade surplus, it is reluctant to let its currency rise. Chinese officials argue that the best way to reduce the US trade deficit is for the US to relax its restrictions on the sale to China of high technology military products.
The US will not allow these sales because of national security concerns. Even if the US were to do so, it would not change the size of the US trade deficit, only its composition. The basic fact is that the current account deficit is equal to the difference between national investment and national saving. The dollar exchange rate would therefore adjust to cause fewer exports to other countries or more imports from the rest of the world.
Fortunately, the Chinese economy is expanding rapidly and its growth is becoming less dependent on exports. When it has the confidence to allow the renminbi to rise, we will be on the path to reduced global imbalances.
The writer is professor of economics at Harvard University