26/03/2010: Trade is not sports

One of the oldest misconceptions in the field of economics is that trade has something to do with competition. When talking about competition, we usually mean sports. The year has only just begun, but it is very likely that the supposedly witty comparison (or not?) by Germany's Finance Minister, Wolfgang Schäuble, on 16 March of trade tensions between France and Germany with the rivalry between the soccer teams of Olympique Lyonnais and Bayern Munich will in retrospect be seen as this year's intellectual low point, at least by economists.

Competition supposes a winner and a loser. Long gone are the days when the motto “it’s the taking part that counts” was valid in sports. Now, the mentality in professional sports, given the huge amounts of money involved, is much more about the “winner takes all”. This sort of attitude is also the one that most politicians take when talking about international trade, and how their respective countries should be positioned: “we should be competitive, we should have national champions, we need to fight and survive, and win market share”.

Many German newspapers recently lamented the fact that Germany had lost its title of “Exportweltmeister” to China. What a tragedy! Actually, it is completely ridiculous. How can a country of with a population of 80 million really believe that, in the long run, it will export more in absolute terms than a country with a population of 1.4 billion? And who profits from this title anyway? Does the small amount of pride that the average German worker might feel about being part of the team that is exports world champion, really justify 10 years of belt tightening and wage restraint?

In the days of France's King Louis XIV and his Finance and Trade Minister, Jean-Baptiste Colbert, mercantilism, the theory that trade should make a nation and its sovereign rich or richer, at the expenses of rivals, could still be understood. After all, countries with trade surpluses were importing and accumulating gold, which could then be used to buy troops to fight Spain, the Dutch or England, hence ensuring the king's glory.

Now, a trade surplus means that a country extends credit abroad. A trade deficit means that a country gets into debt abroad. So a trade surplus does not generate an influx of gold but just an influx of paper with the promise that the country that gets into debt will repay the principal later (most likely with interest). This is not a very safe perspective. Chinese officials are currently expressing growing concerns about the value and purchasing power of the more than USD 2.3 trillion of foreign exchange reserves that China has accumulated.

Yu Yongding, former member of the monetary policy committee of the Peoples’ Bank of China and now President of China Society of World Economics, recently wrote a very interesting open editorial, in which he stressed that the “value of China’s hard-earned wealth” is “facing a triple whammy: a decline in the US dollar’s purchasing power, a fall in the price of US government securities, and possible inflation in the longer run”. We can only agree with this analysis.

However, that is the price that countries with large trade surpluses ultimately have to pay for their frugality and competitiveness. Trade is not about gold or silver medals, and the so-called winner only takes home paper, whose value is determined by confidence in the debtor's ability to repay.

So if trade is not about winning, why bother? The most profound, beautiful and still counterintuitive insight of economics is that there are gains from trade. Through specialization, through absolute and through comparative advantages, those countries that engage in international trade will be better off than those that do not. Unlike in modern sports, at least in trade it is still the taking part that counts.

22/03/2010: From fixed to floating exchange rates

The Bretton Woods system, named after an idyllic ski resort in New Hampshire, was the international exchange rate system that was in place until the early 1970s. Essentially, the US dollar as the anchor currency was backed by gold at a rate of USD 35 per ounce, and all the world's important currencies at the time were pegged to the US dollar at fixed exchange rates. During its lifetime, some currency adjustments were made to reflect changes in the competitiveness of different countries, but overall the system was stable for a quarter of a century.

There are several reasons why the Bretton Woods system eventually collapsed. Many American historians and economists believe that, starting in the early 1960s, Europe (France and Germany, in particular), were 'pillaging' the US gold reserves that backed the US dollar by systematically exchanging their accumulated dollars for the yellow metal. At one stage, US gold reserves were no longer sufficient to back the US dollars outstanding. This loss of confidence ultimately led to the collapse of the whole system.

European historians and economists (especially those in Germany), although acknowledging the systematic exchange of US dollar holdings for gold by France and Germany, counter that the US in the 1960s was living beyond its means by fighting the war in Vietnam and by implementing an increasing number of ambitious social programs, which led to both unsustainable government and trade deficits.

As is often the case, the truth lies somewhere between the two explanations. Following World War II, Western Europe and Japan rebuilt their economies between the 1950s and the 1970s, catching up with the world's leading economy, the US, by achieving higher productivity growth. Such a catch-up implies an appreciation of the real exchange rate, i.e., the exchange rate adjusted for foreign and domestic prices. This is an unavoidable law of economics. In a system of fixed exchange rates such a real appreciation, because it cannot be absorbed by a nominal appreciation of the currency, will lead to inflationary pressures. In the early 1970s, those inflationary pressures had become increasingly unbearable for inflation-adverse countries like Germany, but also Switzerland and Japan, leading to the collapse of the Bretton Woods system.

Bretton Woods II and its challenges

The post-Bretton Woods system, in place for some 15 to 20 years, was one in which exchange rates were more or less free-floating until the Asian crisis in 1997. During that crisis, many overvalued Asian currencies crashed and fell below their fair value versus the US dollar. Then, following the crisis, many emerging countries in Asia, including China, unilaterally pegged their undervalued currencies against the US dollar.

Through foreign exchange interventions, those countries were able to alleviate the appreciation pressures on their currencies, despite generating large trade and current account surpluses. That, in turn, enabled those countries to build up massive foreign exchange reserves.

In 2003, three economists, Michael Dooley, Peter Garber, and David Folkerts-Landau, referred to this new environment, in which many emerging markets were de facto pegging their currencies to the US dollar, as 'Bretton Woods II'. This regime had worked well until the recent financial crisis. On the one hand, it allowed emerging markets to experience rather strong export-led growth, while, on the other hand, US households could consume, and build and buy houses on cheap credit offered by those same emerging markets, which wanted to have their currencies pegged.

Bretton Woods II is also a good explanation for Alan Greenspan’s interest rate “conundrum” (long-term US interest rates having become rather insensitive to Federal Reserve actions), or Ben Bernanke’s “saving glut” theory (the US having to absorb the worldwide excess savings). However, by 2005, the first cracks in this new foreign exchange regime appeared.

As was the case with the original Bretton Woods system, the catching-up by emerging markets, especially China, put increasing pressure on a real appreciation of the emerging market currencies. As indicated above, such a real exchange rate appreciation can occur in one of two ways: 1) the nominal exchange rate appreciates, or 2) inflation rises in the country with real exchange rate appreciation pressures. With hindsight, one can also state it like this: both Germany and Italy experienced real exchange rate appreciation pressures in the 1960s and 1970s. However, while for Germany it was a surge in the Deutschmark accompanied by low inflation, for Italy it was a constantly depreciating Lira accompanied by high inflation.

By 2005, many emerging markets in Asian had reached the same crossroad as Italy and Germany had in the 1970s: they could either let their currencies appreciate (Germany's approach), or they could let inflation surge (Italy's approach). Facing increasing inflationary pressures and surging commodity prices, China chose, for a while, to abandon the US dollar peg and let its currency appreciate against that currency. By mid-2008, in the wake of the financial crisis, China re-pegged its currency, which had appreciated by roughly 20% since 2005, to the US dollar.

Towards Post-Bretton Woods II

This re-pegging has certainly helped China to weather the global financial crisis much better than if its currency had appreciated. Thanks to this, as well as to a strong fiscal stimulus package, the Chinese economy is now running at full speed. However, China and other Asian countries are once again confronted with the old dilemma: the catching-up of their economies will likely lead to an appreciation of their real exchange rates.

The question now is which approach each emerging market will choose:keeping its currency close to the US dollar and letting inflation surge (the Italian approach), or keeping inflation under control with an appreciation of the currency (the German approach). There is no good economic advice one can give here. Ultimately, it boils down to a social or political choice. However, one should be aware that (as always in economics), there is an inescapable trade-off.

Investment implications

It should be noted that the collapse of the first Bretton Woods exchange rate regime led to extremely volatile exchange rate markets as well as sharp rises in commodity prices and overall inflation. It was also the time of an overall depreciation of the US dollar and the British pound, the currencies of the two leading economies at that time. A collapse of Bretton Woods II could lead to a return to the 1970s market environment: i.e., a surge in inflation, higher commodity prices and highly-volatile exchange rates.

It will most certainly lead to a real appreciation of those emerging market currencies that are pegged to the US dollar, not only versus the US dollar, but also versus the euro, the yen and the pound; the currencies of the world's current leading economies. This real appreciation of emerging market currencies could occur either because of a nominal appreciation (the German experience) or because of accelerating inflation (the Italian experience); most likely, though, by a combination of both.

12/03/2010: The opposite of Reagan

One cannot stress enough how Margaret Thatcher and Ronald Reagan shaped the world we have grown accustomed to over the past three decades. At the end of the 1970s, the US and the UK were miserable from both a political and economic standpoint. In 1976, the UK government under Prime Minister Callaghan made its economic walk to Canossa when it was forced to borrow 2.3 billion pounds from the International Monetary Fund, making the UK the last developed country to be the subject of an IMF rescue program. The US hit a low point in 1979 when members of the US embassy staff in Tehran were seized as hostages following the Iranian revolution.

However, Thatcher and Reagan did much more than just put their countries back on track. They instilled a new (or, more accurately, a renewed) way to look at the world in general and economics in particular. They saw to it that free market values once again became the progressive ideal worth striving for while government interventionism was marked as a backward concept to be shunned. Similarly, in the current battle of ideas touched off by the recent financial crisis, the accepted wisdom about what is "right" and what is "wrong" is once again being reversed.

The policy-mixes more and more in place in the developed countries form a nearly perfect mirror image of those that were put to work by Thatcher and Reagan. Remember, in the late 1970s in both the US and the UK, unemployment was surging and inflation was running at double-digit rates. Reagan, and to a lesser extent Thatcher, tackled both issues through very expansive fiscal policies in the form of tax cuts and very tight monetary policies, which were implemented in the US by then Fed Chairman Paul Volker, who ironically enough is now advising the Obama administration. Today, monetary policies are ultra-expansive with interest rates at zero amid quantitative easing measures. Fiscal policies, which have been very lax in the aftermath of the financial crisis, are now more and more challenged against a background of exploding public debt.

Due to those challenges, the fiscal standing of most developed countries will be neutral at best in 2010 and beyond. But some countries are already seeing a heavily negative impact from fiscal policy on growth. In Greece, for example, we estimate that austerity measures could lead to a decline in the economy of up to 5% this year. This contrasts with monetary policy, which, despite the first signs of a possible tightening in the US or Europe in the second half of the year, will, if we interpret the comments of central banks’ officials at face value, remain very expansive for a very long time.

In the 1980s after an initially rather brutal recession, the economies of the US and the UK enjoyed a decade of almost perfect conditions. At the beginning of the 1990s, inflation and unemployment were significantly lower. Moreover, the policy mix of loose fiscal and tight monetary conditions paved the way for a decade-long bull market in equities. If we take this experience as the mirror image of what is happening today, what can we conclude?

If opposite causes are leading to opposite consequences, then the current policy-mixes of tight fiscal and loose monetary conditions could, after an initially spectacular recovery (like the one we are experiencing today), lead to much higher inflation and much lower growth than the conditions we have become accustomed to during the past three decades. Moreover, the bear market in equities could last longer than we currently expect. This is a rather bleak outlook, and it should be taken cautiously, but the current prospects for the pound and the dollar tend to support a more pessimistic view.

In the 1980s, the US and UK trade deficits worsened quite dramatically and the US saw a rather strong appreciation if its currency. If we take the opposite here again, then the current trade situation of both countries should improve (at least one positive aspect of the current policy-mix) along with their depreciating currencies. However, the current weakness in the pound and the likely resumption of dollar weakness once the Greek crisis is solved could very well be the harbingers of a sobering economic environment yet to come.

11/03/2010: Chinese currency dilemmas

The Chinese currency once again finds itself on the centre stage of attention for financial markets. Will the Chinese let their currency appreciate or won’t they?

When it comes to the Chinese currency, one needs to disentangle between myths, wishful thinking and facts. It starts with the name of the currency itself. Two days ago, two of my friends were debating whether it is called the “yuan” or the “renminbi”. Actually it is very simple, like the “pound sterling” it has a dual name, where yuan is the unit of account and renminbi the name of the currency. So you can say “renminbi yuan” (in Chinese the unit of account comes after the name of the currency). Of course, like the pound sterling, you can use either part of the official name.

Another intriguing aspect of the renminbi yuan of course is its current status. It is definitively not a free-floating currency. Between 1997, year of the Asian crisis, and July 2005 it was pegged against the US dollar at a rate of 8.27 yuan per dollar. Since July 21, 2005 the yuan officially was “managed against a basket of currencies”. However, after three years of rapid appreciation of roughly 15% against the US currency, since July 2009 the yuan once again is de facto pegged to the US dollar at around 6.82.

This re-pegging has certainly helped China to weather the global financial crisis much better than if the currency would have appreciated. Thanks to this, as well as to a strong fiscal boost, the Chinese economy is currently running at full speed. However, China once again is confronted with a dilemma. The catching-up of its economy will lead to an appreciation of its real exchange rate, i.e. the exchange rate adjusted with the foreign and home prices. This is an unavoidable law of economics.

In the 1960s, Japan and many European economies catching-up with the US went through a similar process. Their real exchange rates appreciated. Such a real exchange rate appreciation can occur in two ways: the nominal exchange rate appreciates or inflation rises in the country with real exchange rate appreciation pressure. One can also state it as a German or an Italian way: both countries experienced real exchange rate appreciation. However, while it was a surge in the Deutschmark accompanied by low inflation in Germany, Italy experienced a constant to depreciating Lira with high inflation.

The question now is which path will China choose: keeping its currency close to the US dollar and letting inflation surge (the Italian way), or holding inflation under control with an appreciation of the yuan (the German way). There is no good economic advice one can give here. Ultimately, it boils down to a social or political choice. However, one should be aware that (as always in economics) there is an inescapable trade-off that even the Chinese cannot ignore.

04/03/2010: Crash for clunkers

That the crisis would dramatically reshape the financial intermediaries’ landscape seems pretty obvious. Indeed, it is where the crisis started. That the car industry would face similar challenges was rather surprising, but only at a first glance.

Founded in 1923 as an equity-trading house, it survived the 1929 stock market crash without laying-off a single employee. It grew steadily and managed to become the most admired securities firm by 2005, according to Fortune magazine; a title it would hold until 2007. In March 2008, it disappeared, becoming the first major US casualty of the unfolding financial crisis. Everyone will have recognized Bears Stearns, once a proud Wall Street name.

Founded in 1926, when it came to cars it was considered by many buyers to represent a smart mixture of luxury, safety and economy. It rose to international fame in the early 1980s, when one of its models, the Trans Am, played the main character in a very famous TV series called Knight Rider. In November 2009, it became the most prominent victim of a refocusing and downsizing of General Motors’ operations. Many will have recognized Pontiac, once an icon of US car making.

One can find many reasons why automobiles would be hit as hard as banks globally and especially in the US. First and foremost, the sector was and continues to be characterized by huge overcapacities in the mature and saturated automobile marketplace. Second, the tremendous increase in gasoline prices just before the financial crisis unfolded found US carmakers on the wrong foot. Having focused for years on cars, which were not at all fuel efficient, they could not respond to a rapid shift in demand. Lastly, several car manufacturers needed to be rescued big time by governments over the past few years. So here, like in the banking industry, a moral hazard issue has arisen.

With the current crisis, the problems of the car industry remain unsolved. Again governments felt the need to intervene, this time on a rather large scale. According to the New York Times, which has tracked the US Trouble Asset Relief Program (TARP) of USD 700 billion, almost one-seventh of it was spent on US automakers in the form of direct injections of cash. Much more money was put on the table, not only in the US but also elsewhere in the OECD, in the guise of “cash-for-clunkers” subsidies. Although this was a temporarily relief for the industry in 2009, the payback (i.e., fewer cars sold this year because too many were sold last year) is now the biggest threat to the mass car market and likely one of the most discussed topics at the 80^th international motor show in Geneva.

If one takes a very long perspective, one can ultimately see the car industry in a similar position as the agriculture sector. Many governments around the world consider it worthwhile to preserve national champions despite them no longer being very competitive. If this interpretation bears some truth, then the latest crisis in the automobile industry is by far not the last one.