Legend has it that, after tasting succulent noodles during his travels, one of the discoveries that Marco Polo brought back from China became Italian pasta. We think Italy can finally repay this long-overdue debt by exporting its postwar currency policy to China.
Like many emerging markets, China is engaged in a convergence process. Its GDP-per-capita is catching up with levels in developed economies. Given where it started and its vast population, this process will still take many years. But it seems that China, like South Korea, Singapore or Malaysia before it, is inexorably advancing on the convergence path.
When a country grows richer and slowly closes the wealth gap with more developed economies, there are several inevitable consequences. One is that the prices it asks for its exports increase over time. Or, in more technical language, its domestic currency appreciates in real terms.
Real exchange rates not only express the nominal exchange rate – that is, how many units of one currency you get for another. They also determine the relationship between domestic and foreign prices, for example, how many Chinese noodles you can buy in the US for the price of a kilo of noodles in China. As China converges towards the US, then a real appreciation of its currency would mean you get more noodles in the US for the price you pay in China. China would be catching up with the Americans and hence becoming relatively richer.
The convergence that we are seeing today in China and other emerging markets took place in Europe following World War II. Both Germany and Italy exited the war with very low GDP-per-capita levels relative to the US. As they developed in the decades following the war, they caught up with America and saw a real appreciation of their currencies. However, this real appreciation took two different forms.
Germany’s pre-war history gave it a severe case of inflation phobia. The real appreciation of the German mark occurred through nominal exchange rate appreciation, while Germany’s inflation was kept very low. If you get more dollars for one German mark, then you will get more German sausages in the US for the price of a kilo of sausages in Germany, even though the price in Germany remains constant.
In Italy, the real appreciation took another route. The nominal exchange rate was kept constant (the lira actually even depreciated against the US dollar), but Italy experienced a very high inflation rate. If the price of pasta increases in Italy (inflation), then you will obviously get more pasta in the US when you spend an amount equal to the price of a kilo pasta in Italy, even though the exchange rate between the US dollar and the Italian lira remains constant.
Confronted with the real appreciation of their currencies, today’s converging economies have a choice. To state the extremes, they can either let their currencies appreciate nominally and keep inflation low, the German way, or they can follow the Italian way and keep their exchange rates under control, with the risk of surging inflation. Economics is ultimately a science of choices and trade-offs.
Calling for the yuan to appreciate, the US wants China to pursue the German way. The Chinese disagree. They argue that an abrupt appreciation would harm their economy. Opting for the more subtle, Italian way – more inflation in exchange for a constant exchange rate – China thinks it can boost domestic demand with less disruption than the German route offers. And more domestic demand in China will also mean more exports to China, even for the US.
An ancient Chinese proverb states: “With time and patience, the mulberry leaf becomes satin.” With time and patience, the yuan’s real appreciation through inflation will benefit US exporters much more than a quick-fix nominal exchange rate surge.
Friday, October 22, 2010
Saturday, October 16, 2010
16/10/2010: Will this QE2 really float?
No, we are not talking about a British cruise ship. Our QE2 stands for a second round of quantitative easing, which is when central banks buy up government-issued debt, injecting money into the system to revive a sagging economy. The US Federal Reserve is considering another such buying spree to battle persistent deflationary pressures.
Another way to view QE is to see it as creating inflation. The minutes of the latest Fed meeting were explicit: Instead of avoiding deflation, the Fed now aims at provoking a healthy, in its view, round of inflation. While at first glance this might seem a minor shift in focus, a mere nuance, in fact it reflects a major policy bias.
Depending on the source of the numbers, QE2 could expand central bank money in the US by as much as two trillion dollars. If completely implemented, it would swell the US monetary base – all the money in public circulation or in commercial bank deposits held by the Fed – to five times its 2008 size, from USD 800bn to over USD 4trn (as in trillion).
QE1, as we might call the first wave of US quantitative easing, totaled roughly USD 1.5trn. It was aimed at stabilizing the banking system, which it did by purchasing the toxic assets from the balance sheets of financial intermediaries. This fresh money remained largely with the financial intermediaries and did not circulate in the broader economy. While it successfully stopped the liquidity crisis in the banking sector after the Lehman Brothers collapse, it did not reflate the economy. Indeed, credit remains the missing link in the struggling US recovery. Banks are still reluctant to lend, and overly indebted private households are still reluctant to borrow.
QE2 is likely to be a different sort of beast. Instead of healing the hemorrhages of financial intermediaries, the money will flow directly into the economy via the purchase of US government debt. As I noted in a previous editorial, this is nothing other than a monetization of debt, and it could, in my view, lead to a massive increase of inflation down the line.
With QE2, the Fed aims to accomplish several things. First and foremost, it wants to keep interest rates low at the long end of the yield curve, at least as long as investors’ inflation expectations remain subdued. Those low interest rates should be an incentive for households to borrow again, kick-starting the sluggish credit market.
That is the plan on paper, but it could well backfire. One thing is fairly likely: by flattening the yield curve, the Fed will make the lives of financial intermediaries more difficult. These institutions usually profit from steep yield curves, borrowing at the short end and lending at the long end. A flatter yield curve will slow the ongoing balance sheet repairs of financial intermediaries, which could make them even more reluctant to lend.
Not only that. By fanning expectations that interest rates could go even lower than they already are, the Fed could actually induce a wave of interest rate deflation. By this, I mean that households could postpone their borrowing in anticipation of even lower interest rates in the future. This is akin to deflation’s nasty effect, when purchases are delayed with the expectation that prices will decline yet further.
Another channel through which QE2 is supposed to support the US economy is the exchange rate. By buying US government debt with freshly printed money, the Fed is increasing the amount of US dollars in circulation. Hence, the price of the US dollar expressed in a foreign currency should fall, making US exports more competitive on international markets.
Here, again, the dots do not necessarily connect. If the Fed wants to use the printing presses to weaken the dollar, it needs to run them faster than the printing presses of all the other countries who are also trying to weaken their currencies (see: Japan, China or the UK). And should there be another euro crisis – which in my view is not unthinkable given the two-tiered recovery in Europe – the US dollar could strengthen again anyway.
Moreover, it is not certain that US exporters will really benefit even if the US dollar weakens. US growth has not been export-led for half a century. The notion that a weaker dollar would unleash a flood of US exports to China presumes that the US makes things that China actually wants to buy. We are not so sure.
In sum, QE2 offers a rather shaky prospect of a payoff for the real economy and an increased risk that inflation could dramatically surge. Defending quantitative easing, Fed Chairman Ben Bernanke recently said, “I do think that the additional purchases [of government bonds], although we don’t have precise numbers for how big the effects are … I do think they have the ability to ease financial conditions.” In my view, coming from the captain of this exercise, the person who should signal that he has everything under control, this hedged and foggy argument hardly inspires confidence.
Given the powerful tides and unpredictable currents it faces, this QE2 does not look very seaworthy at this point. Lifeboats, anyone?
Another way to view QE is to see it as creating inflation. The minutes of the latest Fed meeting were explicit: Instead of avoiding deflation, the Fed now aims at provoking a healthy, in its view, round of inflation. While at first glance this might seem a minor shift in focus, a mere nuance, in fact it reflects a major policy bias.
Depending on the source of the numbers, QE2 could expand central bank money in the US by as much as two trillion dollars. If completely implemented, it would swell the US monetary base – all the money in public circulation or in commercial bank deposits held by the Fed – to five times its 2008 size, from USD 800bn to over USD 4trn (as in trillion).
QE1, as we might call the first wave of US quantitative easing, totaled roughly USD 1.5trn. It was aimed at stabilizing the banking system, which it did by purchasing the toxic assets from the balance sheets of financial intermediaries. This fresh money remained largely with the financial intermediaries and did not circulate in the broader economy. While it successfully stopped the liquidity crisis in the banking sector after the Lehman Brothers collapse, it did not reflate the economy. Indeed, credit remains the missing link in the struggling US recovery. Banks are still reluctant to lend, and overly indebted private households are still reluctant to borrow.
QE2 is likely to be a different sort of beast. Instead of healing the hemorrhages of financial intermediaries, the money will flow directly into the economy via the purchase of US government debt. As I noted in a previous editorial, this is nothing other than a monetization of debt, and it could, in my view, lead to a massive increase of inflation down the line.
With QE2, the Fed aims to accomplish several things. First and foremost, it wants to keep interest rates low at the long end of the yield curve, at least as long as investors’ inflation expectations remain subdued. Those low interest rates should be an incentive for households to borrow again, kick-starting the sluggish credit market.
That is the plan on paper, but it could well backfire. One thing is fairly likely: by flattening the yield curve, the Fed will make the lives of financial intermediaries more difficult. These institutions usually profit from steep yield curves, borrowing at the short end and lending at the long end. A flatter yield curve will slow the ongoing balance sheet repairs of financial intermediaries, which could make them even more reluctant to lend.
Not only that. By fanning expectations that interest rates could go even lower than they already are, the Fed could actually induce a wave of interest rate deflation. By this, I mean that households could postpone their borrowing in anticipation of even lower interest rates in the future. This is akin to deflation’s nasty effect, when purchases are delayed with the expectation that prices will decline yet further.
Another channel through which QE2 is supposed to support the US economy is the exchange rate. By buying US government debt with freshly printed money, the Fed is increasing the amount of US dollars in circulation. Hence, the price of the US dollar expressed in a foreign currency should fall, making US exports more competitive on international markets.
Here, again, the dots do not necessarily connect. If the Fed wants to use the printing presses to weaken the dollar, it needs to run them faster than the printing presses of all the other countries who are also trying to weaken their currencies (see: Japan, China or the UK). And should there be another euro crisis – which in my view is not unthinkable given the two-tiered recovery in Europe – the US dollar could strengthen again anyway.
Moreover, it is not certain that US exporters will really benefit even if the US dollar weakens. US growth has not been export-led for half a century. The notion that a weaker dollar would unleash a flood of US exports to China presumes that the US makes things that China actually wants to buy. We are not so sure.
In sum, QE2 offers a rather shaky prospect of a payoff for the real economy and an increased risk that inflation could dramatically surge. Defending quantitative easing, Fed Chairman Ben Bernanke recently said, “I do think that the additional purchases [of government bonds], although we don’t have precise numbers for how big the effects are … I do think they have the ability to ease financial conditions.” In my view, coming from the captain of this exercise, the person who should signal that he has everything under control, this hedged and foggy argument hardly inspires confidence.
Given the powerful tides and unpredictable currents it faces, this QE2 does not look very seaworthy at this point. Lifeboats, anyone?
Sunday, October 10, 2010
10/10/2010: The perils of normality
Shattered nerves. Jumpy markets. The long hangover from the financial crisis is making everyone nostalgic for the bygone days of financial market stability.
The plague of uncertainty stalking the market today has been spawned by two violently opposed economic forces. On the one hand, we have the deflationary pandemic of deleveraging and debt reduction that followed the burst credit bubble. On the other, we have monetary and fiscal resuscitation measures of such astronomical dimensions that, without the context of a financial crisis, a tsunami of inflation would be a certainty.
One victim of these unprecedented circumstances is economic analysis itself. Forecasts and outlooks are, frankly, all over the place, which makes them even less useful than usual. The more extreme the scenario, it seems, the more space it wins in the media and the blogosphere.
Apocalyptic economic prophets are prospering in these untethered times. About the only point economists can agree on is that a return to “normality” is unlikely. What do we mean by normality? For the US it would be growth slightly above 3% and for Europe closer to 2%, with inflation for both regions at between 2 and 3%. Paradoxically, such an improbably rosy scenario – one that most people would welcome – could prove disastrous for many assets that have lately been appreciating. Why?
We often hear that investors are driven by one of two emotions – fear or greed. Today, those who are fearful focus on preserving their wealth by investing in what have traditionally been the safest of assets: gold, the Swiss franc and US Treasuries. Each of these assets has surged this year, making some pundits worry that they could be forming bubbles.
The greedy investors take another route. They pursue yield anywhere they can find it in today’s low-interest-rate environment. And lately they have extended their activities far beyond their normal boundaries, moving briskly into emerging markets and even into “frontier” markets.
This leads to some interesting paradoxes. For example, despite ever-bigger current account deficits, Turkey and Brazil are seeing foreign exchange reserves at their central banks soar, lifting their currencies to new highs against the US dollar and the euro. This phenomenon can be explained by one common factor: the massive inflows of foreign capital into these emerging markets.
We want to make a small observation here: The return to a “normal” macroeconomic environment would weaken the assets of both the wealth-preservers and the yield-seekers. With normalization, investors would return to more traditional assets and the funds now flowing into the crisis-driven investments would dry up.
Investors who do not fully embrace the pessimism currently espoused by many economists should be even more cautious than the fearful investors. We think they should diversify wisely now, to ready themselves for the perils of normality’s possible return.
The plague of uncertainty stalking the market today has been spawned by two violently opposed economic forces. On the one hand, we have the deflationary pandemic of deleveraging and debt reduction that followed the burst credit bubble. On the other, we have monetary and fiscal resuscitation measures of such astronomical dimensions that, without the context of a financial crisis, a tsunami of inflation would be a certainty.
One victim of these unprecedented circumstances is economic analysis itself. Forecasts and outlooks are, frankly, all over the place, which makes them even less useful than usual. The more extreme the scenario, it seems, the more space it wins in the media and the blogosphere.
Apocalyptic economic prophets are prospering in these untethered times. About the only point economists can agree on is that a return to “normality” is unlikely. What do we mean by normality? For the US it would be growth slightly above 3% and for Europe closer to 2%, with inflation for both regions at between 2 and 3%. Paradoxically, such an improbably rosy scenario – one that most people would welcome – could prove disastrous for many assets that have lately been appreciating. Why?
We often hear that investors are driven by one of two emotions – fear or greed. Today, those who are fearful focus on preserving their wealth by investing in what have traditionally been the safest of assets: gold, the Swiss franc and US Treasuries. Each of these assets has surged this year, making some pundits worry that they could be forming bubbles.
The greedy investors take another route. They pursue yield anywhere they can find it in today’s low-interest-rate environment. And lately they have extended their activities far beyond their normal boundaries, moving briskly into emerging markets and even into “frontier” markets.
This leads to some interesting paradoxes. For example, despite ever-bigger current account deficits, Turkey and Brazil are seeing foreign exchange reserves at their central banks soar, lifting their currencies to new highs against the US dollar and the euro. This phenomenon can be explained by one common factor: the massive inflows of foreign capital into these emerging markets.
We want to make a small observation here: The return to a “normal” macroeconomic environment would weaken the assets of both the wealth-preservers and the yield-seekers. With normalization, investors would return to more traditional assets and the funds now flowing into the crisis-driven investments would dry up.
Investors who do not fully embrace the pessimism currently espoused by many economists should be even more cautious than the fearful investors. We think they should diversify wisely now, to ready themselves for the perils of normality’s possible return.
Friday, October 8, 2010
08/10/2010: No plan B for the A-team
If you don’t feel inspired to draft an economic treatise, you’ve finished the newest Swedish crime novel, and sleep still eludes you on an intercontinental flight, you can always catch up on the latest Hollywood blockbusters. You might not bother to see them in a theater, but it’s a long flight.
A couple of days ago, trapped in such a state of mind and body, I watched “The A-Team” on the in-flight entertainment panel. Thinly based on the formulaic hit TV series of the 1980s, there was plenty of good-guys-versus-bad-guys action and lots of pyrotechnical chase scenes. In the end, rest assured, the good guys win, and one of them even gets the girl. But what tickled my economist’s antennae was the storyline: The A-Team’s mission was to recover stolen plates used for printing US hundred-dollar bills. As their CIA handler put it, they had to get those plates back before some rogue element uses them to print “unbacked currency.” Sounds grave, doesn’t it?
Indeed, my reaction was, “So what?” Currency hasn’t been backed since the collapse of the Bretton Woods system in 1973. Until then, you could get a dollar’s worth of gold from the Federal Reserve for each dollar bill you turned in. Now, all you’re likely to get in exchange from the Fed is another dollar bill (and a puzzled look from the person behind the counter).
What actually supports a paper currency’s value? Nothing, it turns out, other than our steadfast belief that it is “worth” something. The entire, vast international monetary system is built upon this self-fulfilling confidence. Inflation – when a currency is losing its value – reflects waning confidence in that currency. This would logically mean that deflation’s lower prices indicate a currency has risen in value. In other words, our confidence in it as a store of value has increased.
But this is one of those times when logic and reality remain far apart. Economists have a useful term for describing how much money flows through an economy. They call it the monetary base. This refers to money in public circulation or in commercial bank deposits held at the central bank. Does the tidal wave of unbacked US dollars now flooding the monetary base of the US really reflect greater confidence in the dollar’s value? This amount has soared from 800 billion to a dizzying 2 trillion dollars since 2008.
Has the financial crisis really made us more confident in our governments and central banks? Some well-regarded economists argue that the Fed can print as much unbacked currency as it wants. As long as this money doesn’t find its way to the public, through loans made by financial intermediaries, they say it has no impact at all. The Fed and the other central banks are just “pushing on a string,” as the much-used metaphor goes.
This is a rather half-baked thesis, in my view. Carried to its logical conclusion, it would mean that countries without financial intermediaries would never face inflation, which is simply not the case. Such countries are usually very poor and the printing press has always been a major source of government revenue, and inflation. The technical term for this type of revenue comes from the Middle Ages: seigniorage. It describes a situation where only lords (in French, seigneurs) had the right to mint coins, which allowed them to profit from the difference between the face value and the intrinsic value of the coins.
In a similar vein, governments in very poor countries often use unbacked currency to pay their bills. This practice tends to erode confidence in the value of their currency and, thus, fuel inflation. In the developed world, when we read press reports that, “under quantitative easing, the Fed is buying US Treasuries,” it sounds like rather serious high finance, doesn’t it? In fact, it is good old seigniorage.
It comes wrapped in more complex terminology to hide the fact that things may no longer be quite under control. My view on the ongoing deflation/inflation debate is that, yes, due to various misperceptions, deflationary pressure may persist for a while yet. But in a world awash with unbacked currency, the inevitable outcome of running the printing presses is inflation. As Colonel Hannibal Smith, leader of the A-Team and played by the redoubtable Liam Neeson, tellingly says, “There is no Plan B.”
A couple of days ago, trapped in such a state of mind and body, I watched “The A-Team” on the in-flight entertainment panel. Thinly based on the formulaic hit TV series of the 1980s, there was plenty of good-guys-versus-bad-guys action and lots of pyrotechnical chase scenes. In the end, rest assured, the good guys win, and one of them even gets the girl. But what tickled my economist’s antennae was the storyline: The A-Team’s mission was to recover stolen plates used for printing US hundred-dollar bills. As their CIA handler put it, they had to get those plates back before some rogue element uses them to print “unbacked currency.” Sounds grave, doesn’t it?
Indeed, my reaction was, “So what?” Currency hasn’t been backed since the collapse of the Bretton Woods system in 1973. Until then, you could get a dollar’s worth of gold from the Federal Reserve for each dollar bill you turned in. Now, all you’re likely to get in exchange from the Fed is another dollar bill (and a puzzled look from the person behind the counter).
What actually supports a paper currency’s value? Nothing, it turns out, other than our steadfast belief that it is “worth” something. The entire, vast international monetary system is built upon this self-fulfilling confidence. Inflation – when a currency is losing its value – reflects waning confidence in that currency. This would logically mean that deflation’s lower prices indicate a currency has risen in value. In other words, our confidence in it as a store of value has increased.
But this is one of those times when logic and reality remain far apart. Economists have a useful term for describing how much money flows through an economy. They call it the monetary base. This refers to money in public circulation or in commercial bank deposits held at the central bank. Does the tidal wave of unbacked US dollars now flooding the monetary base of the US really reflect greater confidence in the dollar’s value? This amount has soared from 800 billion to a dizzying 2 trillion dollars since 2008.
Has the financial crisis really made us more confident in our governments and central banks? Some well-regarded economists argue that the Fed can print as much unbacked currency as it wants. As long as this money doesn’t find its way to the public, through loans made by financial intermediaries, they say it has no impact at all. The Fed and the other central banks are just “pushing on a string,” as the much-used metaphor goes.
This is a rather half-baked thesis, in my view. Carried to its logical conclusion, it would mean that countries without financial intermediaries would never face inflation, which is simply not the case. Such countries are usually very poor and the printing press has always been a major source of government revenue, and inflation. The technical term for this type of revenue comes from the Middle Ages: seigniorage. It describes a situation where only lords (in French, seigneurs) had the right to mint coins, which allowed them to profit from the difference between the face value and the intrinsic value of the coins.
In a similar vein, governments in very poor countries often use unbacked currency to pay their bills. This practice tends to erode confidence in the value of their currency and, thus, fuel inflation. In the developed world, when we read press reports that, “under quantitative easing, the Fed is buying US Treasuries,” it sounds like rather serious high finance, doesn’t it? In fact, it is good old seigniorage.
It comes wrapped in more complex terminology to hide the fact that things may no longer be quite under control. My view on the ongoing deflation/inflation debate is that, yes, due to various misperceptions, deflationary pressure may persist for a while yet. But in a world awash with unbacked currency, the inevitable outcome of running the printing presses is inflation. As Colonel Hannibal Smith, leader of the A-Team and played by the redoubtable Liam Neeson, tellingly says, “There is no Plan B.”
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