Thursday, October 28, 2010

The G20, gruel, and low-hanging fruit

The G20 is meeting in Seoul to deliberate and the buzz is that they are going to focus on exchange rates and trade, among other things. Expectations are high among some people that this body will help resolve current trade issues. There were similar high expectations when the members of the World Trade Organization started the Doha Round. And there was good reason for optimism.  Globalization has shrunk the world. We are all more highly related in terms of business and economic policy. The global recession called for a coordinated approach to the slowdown and the financial problems that caused the worst economic collapse since the Great Depression.  Yet little has come of the Doha Round, coordinated financial reform, solutions to trade imbalances or currency competition. While it is true that protectionism has not raised its ugly face as much as it could have, there seems to be more than the usual amount of finger-pointing and populist face saving.  Deficit countries complain about surplus countries and vice versa. Germany wags its boney finger at the US for its inability to let go of its warm blanket – stimulus. Others worry that Germany, Great Britain and Canada maybe over-doing austerity.

Wazzup? Nothing more than common sense. While most of us love the benefits we get from clubs and teams we are not ready to give up who we are just for the sake of camaraderie. You love golf and are willing to shell out the monthly dues for the country club, but you aren’t about to throw out your favorite golf shirt just because other members are offended by it. Or you love the friends you met in your new bicycle club but you draw the line at 50 mile rides at 7 am on Sunday morning. And what is this – say again – I have to drive across town to meet with my Chocolate Martini Club because some of the members don’t have cars and prefer a location closer to their apartments? In short, we like the benefits from integration but there are limits to how much we really want.

The same can be said for international integration. While 16 countries of Europe decided to tie their sails to the euro, that doesn’t mean that the French will give up their snails or the Germans will welcome you in the morning with a bon jour. Politicians in each country are elected by their citizens. If globalization brings benefits to Spaniards, then they will applaud further integration. But when they believe that a particular new attempt at further integration will bring negatives to Italy, then Italians will throw their pastas in the face of any Italian politician who dares to sign the new free trade agreement.

In a paper I wrote some years ago, I talked about low-hanging fruit. Starting in the 1980s it seemed that globalization brought easy benefits to most countries. As tariffs came down in leaps and bounds, countries found that freer trade was like a tide that raised most boats. But as we approach 2011 and countries seem to have more equal strength and say-so than ever, the new  agreements seem more like zero-sum games. So each side fights tooth and nail. Each politician would rather say NO and go home and be honored, than make an  agreement that has some potential to harm his or her citizens.

The low-hanging fruit is gone. The WTO and other formats require consensus. How do you get such consensus with 20 diverse countries much less 160 of them? What you should expect – in the real world – is discussion and more discussion.  Clearly as the value of the dollar continues to fall, export-oriented countries whose well-beings are tied to strong exports will want to push harder to stop the dollar’s trajectory. Already we read more and more about weaknesses showing up in Germany, Korea, and several other countries. And many countries are not happy with the US for flooding their economies with dollars. But it is not in the immediate interest of US policymakers to have a stronger dollar or a more responsible monetary policy. Wam bam – there is no warm hug there.  With respect to trade problems in general – we cannot expect much fun in the sun either. Even with a declining dollar the US trade deficit is not going to disappear until US savings increases or our foreign friends reduce their savings.  But national savings in any country do not easily change since they are tied to culture, institutions, and very long habits.

So what we can conclude about this G20 meeting in Korea is that there will be no home runs and no singing in the sauna. The leaders are smart enough to know that nothing will be gained by sharp rhetoric and mean disagreements. Instead we will receive flowery speeches and unintelligible communiqu├ęs.  Milk toast will be abundant.  We have two things going on. We have a very difficult world economy  with no easy solutions. But we also have leaders who want to appear like they are doing something for their people. Since they know the real solutions are just about impossible and may mean some real sacrifice, we will get gruel. No low hanging fruit means we eat gruel! Bon apetit


Thursday, October 21, 2010

Currency War – My Mom’s tougher than your mom

The current discussion about a Currency War gives me pause to think about how far we have come during my life. I am at the leading edge of the baby boom because my father had one thing on his mind when he jumped ship at the end of World War II. So while I didn’t really live during WWII I feel that I can claim a connection. That was a hot war and there was no question about the meaning of war and that we don’t want to do anything like that again. While I missed the Korean War by being too young, I was just perfect to join the US Air Force and was able to participate in Vietnam.  I swore to the medical officer during my draft physical that I had flat and very smelly feet, but that didn’t seem to deter them from inviting me to join. Those wars were nothing to replay again. I spent most of my enlistment in an air conditioned office but we all know the horrible outcomes that all sides suffered from in Korea and Vietnam.

Most of my life, however, was impacted by a cold war which pitted my home country against the Soviet Union. I recall being a teenage boy and looking south in the Miami sky on the day that Kennedy called Krushchev’s bluff – a little game of missile chicken near Cuba.  I was wishing that I was from a richer family that could afford to dig a fallout shelter in South Florida. That was no fun either and we were all relieved if not elated when the Soviet Union imploded. I remember a jubilant colleague telling me that we would now be in an era of peace. No more war! What a great feeling.

Of course, what neither he nor I really foresaw was how the cold war between two key giants froze the outward manifestations of hundreds of years of animosity in many places of the world. As the cold war disappeared from memory banks, we have seen increased levels of conflict in former Soviet Republics, the former Yugoslavia, the Middle East, and more. We couldn’t be farther from a world of peace! In some ways we are even worse off than we were during the Cold War.

In this present context we read about currency wars. My first reaction is that this currency stuff has no connection whatsoever with a war. I don’t know why the press describes it in those terms. Maybe it sells more soap? In fact, I am not even sure that I understand who the enemy is and how we would fight them. In international trade as in all forms of trade there is competition among the players and they each try to gain their shares of the pie. In a time of great economic uncertainty when the world economy is growing slowly it makes sense that every firm and every government will want to compete harder to keep from losing business.  While war does involve a form of competition, competition frequently exists without any hint of war – from Dictionary.com here is one definition of war –“a conflict carried on by force of arms, as between nations or between parties within a nation; warfare, as by land, sea, or air.”

It is self-defeating to call trade competition a war even if there are elements of unfair competition and protectionism. It confuses people and you know how easy it is to confuse the people in our government!
In my last post I documented a trend in financial trading that when combined with our goods trade deficits makes it pretty clear why the value of the dollar has been falling. Add the Fed’s alleged policy of a new vigorous round of quantitative easing and you have even more pressure on the dollar to fall. In today’s world of global competition where many countries are VERY reliant on their exports – no self-respecting populist official can sit around drinking expensive imported beer and let their currency appreciate against the dollar. 

Holy cow –imagine the leaders in Brazil or Singapore or Japan drinking their Budweisers in their new hot Chevrolet Cobalts telling the folks at home that it would be great for world order if the dollar depreciated another 20%. And it’s not just the dollar. Recall that our friends in China like to peg their currency to the dollar. So when the dollar depreciates against most world currencies, the yuan is also depreciating again the yen and the won and the real and the Singapore dollar. Hmm – not only is the US seemingly getting a trade advantage, so is China. Now that gets my jets in an uproar and it makes me want to depreciate and I don’t even have a currency.

Okay – so back to war. Who are we going to fight here? Answer – no one. Put your Rocky dolls back in their holders and cool your jets. What we have here is a bout of international trade instability. And it is a unique bout. In past currency crises it was possible for enough nations to come together and decide it was a good time to work together to either appreciate or depreciate the dollar. But as I described above – that would not really fit the current situation because just about EVERYONE wants to depreciate. You can pine away all you want for a return to the gold standard or gold exchange standard – a time when exchange rates were largely fixed – but that ain’t gonna happen here either!

So what is the solution? First, quit calling this a war. Second, use common sense. There are fundamentals that are causing exchange rate problems. Fundamentals often take time to manifest and therefore it takes time to solve the problem. So don’t be in too much of a hurry. Third the US has to save more at home and spend less abroad. That will help reduce the downward pressure on the dollar. Fourth, the Chinese need to save less and spend more at home and that will reduce their need to rely on exports. That will make it easier for them to tolerate a yuan appreciation. As the dollar rises this will take some pressure off the need to have the Yuan fall and the other countries will be able to let their currencies float without harm.

You can call it a war and you can scream that you want the government to fight for your country’s exports, but none of that is going to do a thing in the face of real and fundamental international trends and cycles. A string of competitive devaluations or other forms of export protection will do nothing but exacerbate the problems. “My mom is meaner than your mom” just gets flung back in your face squared. Once people begin to see China, the US, Germany, Korea, and other countries addressing the real causes of trade imbalances then you will see this exchange rate issue diminish. Until then, let’s hope Obama doesn’t jump in the ring with a sumo wrestler or a Chinese bear.



Friday, October 15, 2010

The dollar is down for the 10-count

Recently the dollar’s value has depreciated and there are quite a few stories being written. As in most interesting topics in economics, the answers are not simple. There are many things that impact the value of the dollar but in this post I want to focus on a three year trend of global financial flows. The main conclusion of this post is that recent changes in the value of the dollar have very little to do with all the fuss over China. Many of us have worried about what would happen when foreigners decided to sell their US assets. Well– the future is here now and the trends do not look like they are going to reverse. It will not be easy to restore foreign faith in US assets especially when the substitutes are looking increasing better.


But before we oooohhh and aaaahhhh over pictures of hot data in skimpy pink pants, let’s just discuss the basic or fundamental forces that impact exchange values. These have to do with the fact that many cross border trades require a domestic citizen of one country to first purchase the currency of the other country. If a US citizen wants to buy goods or services in South Korea or China – she often will sell dollars and buy Korean won or Chinese yuan. We already know well that the US buys more goods from other countries than they buy from us. The implication is that this deficit in goods trades means that we are selling more dollars than foreigners really want or need to buy our goods. Thus, there is a glut of dollars on world markets because of goods trade. This glut pushes the value of the dollar down. But this is old news – let’s move on to groovier stuff.

It is also true that when US citizens buy foreign bonds, stocks, and other financial assets they generally need foreign currency to make the purchases. In the chart from the link below you see the net of US purchases of foreign assets (BOPO) in each quarter since 2000. You can see that between 2000 and early 2007 the US was building up its foreign assets (it is conventional to assign a negative sign when US citizens take money out of the US to add to foreign asset postions). So the BOPO line is going downward as US citizens buy more assets abroad. But afterward, the building slowed and by the end of 2008 we were net sellers of foreign bonds, stocks, bank deposits, etc (line is rising). As a result we were first net sellers of dollars and then became net buyers. That speaks well for a rising dollar since 2007. But read on -- that's only part of the story.
BOPI shows foreign interest in US financial assets. It is conventional to use a positive sign when foriegners Notice a similar pattern with foreigners wanting more US assets until the end of 2006 followed by a diminished appetite for increasing their net purchases of US assets. While there has been some recovery of their interest in US assets through the first quarter of 2010, the overall result is at first an increased demand for dollars and then a reduced need for dollars.

http://research.stlouisfed.org/fred2/graph/?printgraph&chart_type=line&graph_id=&category_id=&recession_bars=On&width=630&height=378&bgcolor=%23B3CDE7&graph_bgcolor=%23FFFFFF&txtcolor=%23000000&ts=8&preserve_ratio=true&fo=ve&id=BOPI,BOPO&transformation=lin,lin&scale=Left,Left&range=Custom,Custom&cosd=2000-01-01,2000-01-01&coed=2010-04-01,2010-04-01&line_color=%230000FF,%23FF0000&link_values=,&mark_type=NONE,NONE&mw=4,4&line_style=Solid,Solid&lw=1,1&vintage_date=2010-10-14,2010-10-14&revision_date=2010-10-14,2010-10-14&mma=0,0&nd=,&ost=,&oet=,&fml=a,a

The net effect on the demand for US dollars from cross border asset flows can be seen by subtracting the US Net Purchases of Foreign Assets from the Foreign Net Purchases of US assets. This net amount is shown in the table below. The peak value of the net amount in early 2006 of $780 billion shows that foreigners needs for dollars to buy US assets exceeded by $780 billion dollars the sales of dollars by US purchases of foreign assets. Until 2006, therefore, we clearly see an increasing demand for dollars that should have been pushing the value of the dollar upward. Since 2006, we see less and less upward pressure on the dollar. The net amount fell to $165 billion in 2009 and looks headed even lower than that in 2010. Recent news suggest this is tue.

Year     NET Dollar Demand in billions of dollars based on BOPI and BOPO
2000     478
2001     400
2002     501
2003     533
2004     532
2005     701
2006     780
2007     631
2008     611
2009     165
2010*     55
* based on two quarters

Whereas speculators and governments can influence the value of the dollar – it is pretty clear that if we combine the long-term impact of goods trade deficits with a movement towards a finance deficit – we can see why there is plenty of fundamental pressure pushing the dollar down. Recent press stories are focusing on the relative strengths of emerging markets and the flow of investments moving to China, South Korea, Brazil, and many other countries. If this is the wave of the future, then it is difficult to imagine the dollar rising unless there is a change in the desire of foreigners for US goods, service, or financial assets. A rising dollar cannot come until the US clearly signals a return to competitiveness and strength.

These international asset transactions have several components – so I wanted to look further into the causes of these changes. What was accounting for financial transactions and money changing directions? What asset categories accounted for US citizens holding fewer assets abroad and foreigners wanting fewer US assets? To answer these questions I compared two time periods of equal length (12 quarters) – 2004 Q1 to 2007 Q1 versus 2007 Q2 to 2010 Q2.

Consider the US citizens holdings first. US net holdings of foreign assets fell by a total $1.9 trillion when you compare the changes in the second period to those in the first. That amounted to a decline of 58%. Foreign bank account holdings fell by about $840 billion and US citizens held about $587 billion less in foreign securities. But the largest reduction in US asset holdings abroad came in the category called “U.S. claims on unaffiliated foreigners reported by U.S. nonbanking concerns.” US financial intermediaries reduced their holdings of assets of their foreign counterparts by approximately $1 trillion. It is worth pointing out that virtually none of these swings were attributable to official or government flows in gold, currency, or reserves.

Foreigners held $2.9 trillion less of US assets in the time period from mid-2007 to mid-2010 when compared to the time period from early 2004 to early 2007. This withdrawal of foreign holdings from US markets was almost fully explained by a reduction in bank accounts of $1.6 trillion and a reduction in securities (not bonds) by $1.4 trillion. Again, almost none of the changes across these time periods had anything to do with recorded changes in official government activities regarding gold, currencies, or reserves.

Taking both US and foreign asset swings into account shows a net increase of a trillion dollars ($2.9 trillion minus $1.9 trillion) in sales of internationally trade dollars. We don’t yet have figures for 2010 Q3 but the current business and economic news suggest that these trends have picked up. Low US interest rates coupled with movement of funds into higher yielding assets in emerging markets suggest this trend could go for some time. When it looked like the US was emerging from its recession funds hung around for a while and the dollar played its role as a safe haven. But now that there is increasing worry about the US expansion while other nations promise stronger growth, the effect of these international transaction flows are having a more profound impact on the value of the dollar – moving it in a southerly direction.

While southern fried chicken is delicious, a currency crisis is not what this country needs. Quantitative easing and more stimulus will not help since QE will simply move more dollars off shore exacerbating the trends mentioned above. More stimulus will create bigger worries about US financial credibility and further movements away from US assets. It is time to move away from populism to solid thinking about the US economy. The future is here and there is no easy way out.

Thursday, October 7, 2010

A Circular Flow of Ideas and Backward Thinking: Should we attack unemployment first?

This week the news is buzzing about the next jobs announcement. Once the jobs number comes out on Friday morning planets will fall from the sky and well-behaved dogs will bite. I am sure of it because I saw it on CNN. While the House of Representatives will want to enact new laws to protect us from falling planets and viscous dogs, I am more worried that they will do something about the economy. Since they have the story backwards one can only expect more bad ideas in the next sack of legislation.

As I am writing I don’t know what number they will announce for jobs this week – and I don’t pretend to know its value. I can hardly forecast how many times I will get up to pee at night – so how would I know the future value of the unemployment rate?

What I am spouting about has more to do with the idea that if the number comes in as expected (or worse) people will increasingly worry that the lack of strong job growth will further restrain consumer spending and we will be stuck in macro purgatory. So if I can use a little professorial pedantry – I would write on a white board (what was wrong with black or green?) the following to describe the theory behind all this:

Employment → Consumer spending

I apologize for this little fit of mathematical elegance but this is the macro-theory all the talking heads are brandishing. The arrow indicates the direction of causality. This might seem pretty cool but the simple truth is that it is wrong and its policy implications are wrong too. This theory suggests that if policymakers could just find a way to increase employment then more workers would have more income and they would go out and buy lots of diamond earrings, steering wheels, and full body massages. And that’s just the firecrackers. When the first round of fireworks ends – then all those manufacturers (of earrings, steering wheels, and massages) will hire more workers who will buy even more stuff (stuff is a very technical term used by sophisticated economists). Before you know it, the unemployment rate will equal 5.5% and government can declare a holiday and take private jets to exotic islands with their stenographers. Note the essence of the theory – we start with a policy aimed directly at employment and that will generate more spending – and even more employment.

What could be wrong with this theory? To answer that question we have to take another sip of JD and review one of the first simple models first taught in dank caves in prehistoric times called the circular flow of income. In its simplest format, it can be expressed without calculus or a neutron microscope as follows:

Employment → Consumer spending

Consumer spending→ Employment

Here is the crux of the issue – this is called circular flow because there is no beginning and there is no end. We just go around and around and around and around. That’s fun for a while but at some point you wonder if there is some way to stop the merry-go-round because you are late for dinner and your honey doesn’t know that you are at the Office Lounge drinking beers with your students. That’s a no-win situation.

So you look at the model and try to decide where to interrupt it. Here is where such things as common sense or cause & effect come into play. If the circular flow is moving too slow – then the first question you ask is WHY. What is CAUSING consumers to spend and firms to hire workers at a slow rate?

Maybe I am way off track, but it seems to me that the answer has something to do with the recent history of the US economy. Consumers and firms took on too much borrowing/debt/ leverage and got themselves into financial trouble. Of course it is much more complicated than that – but the issue here is which of these two alternatives do you think was the main CAUSE of the slowdown today? Did all this get started because firms decided to lay off workers? Or did we get into this mess because of a financial collapse that led to consumers and firms being unable to continue spending and borrowing as they had in the past. I think the latter is the true cause -- we had a Wall Street Problem that spilled over to Main Street and employment. It was NOT the reverse.

If that is true, then it makes no sense to direct our immediate attention to employment. It reminds me of the physician who comes upon a person who is bleeding profusely from a bullet wound. He is screaming at the blood – “get back into that hole”. Surely, the patient would be helped if he had his blood back. But the doctor would have been more helpful if he attended to addressing the cause of the blood flow – a bullet they opened a wound. It would be better to remove the bullet and close the hole.

If the CAUSAL variable was really the finances and spending, then we should start there. And this is the real challenge right now– how do you make consumers and firms want to spend more? First, notice that since too much spending was a CAUSE of this mess – it hardly seems rational that simply encouraging consumers to spend more could be a solution. So the first part of logic is to accept the fact that households are going to take some time paying off debt and restoring saving before they run out and buy three Lexi (plural of Lexus) and a vacation in French Lick. The data show that households are doing just that and while they are not spending a lot, there is some further recent evidence that there is solidification and gradual growth. In short, if you want households to be more optimistic and you want them to spend more – work on the remaining issues with respect to the housing and financial problems and have some patience.

The second way to improve household psychology is to stop confusing people. I realize we have an election coming up and there are important reasons for the two political parties to clarify their separate and highly superior ideologies but there is just too much uncertainty arising from all this political clatter for households to believe that all is really getting better. Isn’t that sad that things really are getting better but our government is making it almost impossible to believe. And this gets me back to all the talk about the coming employment release. If the number is considered to be a bad one – it will be a lightning rod for even more activism by the President, the Congress, and the Fed. Unfortunately, the popular and wrong thing for these policymakers to do is to try to intervene in labor markets and/or induce households to spend at a rapid rate. This will create even more uncertainty and push them farther away from what we really need.

The employment market did not break down and cause our ills. It makes no sense to begin there. Households are waiting for their own financial situations to improve and for some certainty that the economy is improving. Policies that patiently and realistically address the true causes of a slow circular flow of income are the only ones that have a chance of succeeding now. More fireworks may burn down the barn!