Monday, April 20, 2009

The Nonsense About Current Account Imbalances And Super-Sovereign Reserve Currency

``There is no simple understanding of what makes it necessary for people under certain conditions to believe certain things. The evolution of ideas has its own laws and depends very largely on developments which we cannot predict. I mean, I'm trying to move opinion in a certain direction, but I wouldn't dare to predict what direction it will really move. I'm hoping that I can just divert it moderately.”- F. A. Hayek The Road from Serfdom Forseeing the Fall

Some macroeconomists have been obsessing over imputing current account imbalances as the source of today’s crisis and have chimed over China’s recent call to create a "super-sovereign reserve currency".

We find this charge that Asian savings has been the source of today’s crisis as absurdly politically colored or as pretentious knowledge.

First of all savings isn’t the problem, borrow and spending policies is.

Morgan Stanley Asia’s Stephen Roach hits the nail in the head with his recent commentary, ``The problem with the apologists is that they failed to appreciate the deeper meaning of these imbalances. The U.S. current account deficit didn’t emerge out of thin air. It was the outgrowth of an unprecedented shortfall of domestic saving. Saving itself was depressed by the illusions of an asset- dependent U.S. economy and especially by the willingness of consumers to live well beyond their means by extracting equity from over-valued homes.”

``In short, America’s external imbalance was joined at the hip to the toxic interplay between asset and credit bubbles. Moreover, denial was global in scope. Export-led economies were delighted to draw support from bubble-dependent American consumers. And now, that house of cards has collapsed.”

Next, China, which has been the center of the blame for “currency manipulation”, isn’t only the surplus country but many of the emerging markets such as the oil exporting Gulf Cooperation Council (GCC).

Figure 8: World's largest current account surpluses

The fact is that there are 6 unofficial dollarized economies and 22 pegged currencies, according to

So China bashers aren’t only guilty of the fallacy of composition but likewise selective perception and the survivalship bias.

The fact is that many emerging markets economies merely took advantage of the US borrow and spend policies to accumulate reserves as means to expand domestic industries and for purposes of insurance against a financial crisis.

In other words, had China opted NOT to take advantage of the flawed US policies, others would have gladly taken China’s place.

Hence, current account imbalances reflect on the symptoms and not the cause.

Another, China didn’t force the US to borrow and spend, the US did.’s Tim Swanson shoots a bullsye with this commentary (bold highlights mine),

``At no point did Asian savers force Fannie Mae to reduce down payments on houses or reduce mortgage rates. At no point did Asian savers force American banks to allow consumers to use their home equity as ATM machines. At no point did Asian savers force the Bush administration to run deficits to pay for foreign wars and domestic welfare. At no point did Asian savers force government-sanctioned ratings agencies to rubber stamp risk assessments. And at no point did Asian savers force Alan Greenspan to lower interest rates.

``Neither the US government nor its federally controlled housing agencies had to spend the money it received from Asia. In fact, they could have refused the money altogether.

``In addition, the government could have paid off its obligations and maintained a balanced budget. Instead it spent it all and continued borrowing. As a consequence, it is pure balderdash to insinuate that the uptick in Asian savings somehow coerced the House Committee on Ways and Means to appropriate billions in extra liabilities. No one in Asia pointed chopsticks, bamboo, or a gun at Larry Summers, Paul O'Neall, Dennis Hastert, Bill Thomas or American consumers and told them to spend the money.”

Moreover, the US dollar as the world’s currency reserve system is inherently subject to the trade deficits simply because it needs to provide the rest of the world with liquidity to facilitate the global trading system-a phenomenon presciently predicted by Yale University economist Robert Triffin known as the Triffin Dilemma some 50 years ago!

Notes Walter Todd of American Institute for Economic Research,

``Unfortunately, Triffin wrote, U.S. trade deficits eventually would undermine the foreign exchange value of the dollar because foreign accounts would hold an increasing quantity of dollars…

``Issuing the reserve currency gives domestic policy makers an advantage by making it easier to finance either domestic budget deficits or foreign trade deficits because there always is a ready bidders' market for any financing instruments from that issuer. Issuing the reserve currency enables the domestic population to consume more goods and services from whatever source than otherwise would be feasible. And issuing the reserve currency gives foreign policy officials of that nation the upper hand in determining multilateral approaches to either diplomacy or military action.”

Given the paradoxes in the technicalities (tradeoff between proportionality of US dollar claims held abroad and the US dollars interest rates) of the Triffin Dilemma…

From which Mr. Todd explains, ``Either the currency remains overvalued (good for the reserve currency status) and the trade deficits continue to increase, or the currency maintains fair external value (implicitly, a proportional devaluation, which is bad for the reserve currency status) and the trade deficits either stabilize or shrink. This latter proposition is what Professor Triffin was writing about in 1960, and it has been called Triffin's dilemma ever since.”

…implies that maintaining a sustainable equilibrium for a reserve currency seems virtually impossible.

Lastly, the parochial solution proposed by macroeconomists from the current account imbalances camp is to ultimately maintain (artificial) demand through the same borrow and spending policies by forcing China to appreciate their currencies and adopt the same borrow and spend policies to replace diminishing US demand or by expanding “money printing operations” by the US government.

Morgan Stanley’s Stephen Roach gives a great rejoinder,

``Once again, the U.S. is leading the charge. The Fed wants to get credit flowing again to still overextended American consumers, especially in mortgage markets. The Congress wants to stop the bleeding in the housing market -- irrespective of the persistent imbalance between supply and demand. And the White House wants consumers to start spending again -- to avoid the perceived pitfalls of the “paradox of thrift” brought about by too much saving.

``Put it together and it all smacks of a dangerous sense of déjà vu: promoting a false recovery by kick-starting overextended, saving-short American consumers to borrow once again by leveraging their major asset.’

In essence, misdiagnosis leads to wrong prescriptions which worsen the problem.

Nonetheless, the same camp cheers over China’s call for "super-sovereign reserve currency".

It’s odd how these prominent experts, who seem to know the rightful answers to their laboratory view of the world, have been taken for a ride by People’s Bank of China’s Zhou Xiaochuan by swallowing hook line and sinker what looks to be a decoy.

Figure 8: China Daily: Drive To Make The Yuan an Global Currency

China has been expanding the use of its domestic currency for overseas trade settlement or as an alternative medium of exchange for trade among its neighbors as earlier discussed in Government Guarantees And the US Dollar Standard. The pilot program includes 5 major trading cities which includes Shanghai and four cities in the Pearl River Delta - Guangzhou, Shenzhen, Dongguan and Zhuhai along with its ASEAN trade partners.

Moreover, China has signed currency swap agreements worth 650 billion yuan or $95 billion, with Argentina, Indonesia, South Korea, Malaysia, Belarus and the Hong Kong Special Administrative Region which basically allows these nations to use their yuan reserves to directly trade with the Chinese mainland under a defined trade limit in terms of volume. (China Daily)

In addition China has been providing project financing and loans to some Latin American countries like Venezuela, Ecuador, Brazil and Argentina in exchange for locking in supplies of natural resources as oil. (New York Times)

Finally China seems to be aggressively securing supplies of copper and other base metals which has prompted speculation that perhaps China could be working towards backing up its currency with the proposed Keynesian model called “Bancor” which is anchored on 30 commodities as discussed in Has China Begun Preparing For The Crack-Up Boom?.

The point is action speaks louder than words.

China doesn’t seem to be going after an SDR (Special Drawing Rights) of "super-sovereign reserve currency", instead it has been utilizing today’s crisis to aggressively promote the use of its currency to possibly challenge the US dollar as the world’s international reserve currency.

Finally, the same group of macroeconomists simplistically generalizes that the world hardly adopts to the changing environments. They have come to believe that only by their instructions will people react.

F.A. Hayek lambasted this mindset in “The Fatal Conceit”, when he wrote that ``The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."

For instance, none of them have captured China’s thrust to push growth from the Coastal cities to the inland.

According to the New York Times, ``The shift, which has rough parallels with America’s westward migration in the 19th century, has the potential to narrow the noxious income gap between China’s vast, neglected interior and a relatively well-off seaboard that has hitherto attracted most of the investment by the Chinese government and foreign companies.”

So what has China been doing to expand inlands?

From the same article of the NYT, ``Apart from spending more on rural infrastructure and subsidies, the current leadership has abolished the centuries-old agricultural tax, made compulsory education free in the countryside and set up a rural medical insurance scheme.

``Recently, the central government has allowed local governments to issue bonds for the first time and has given the western and central provinces bigger quotas than those in the east.”

Lastly we can point to another development which seems beyond the ken of these sanctimonious experts.

Japan has been reorienting its export economy from one catering to traditional export markets to alternative markets…particularly Asia and the Emerging Markets.

Researchrecap quotes Oxford Analytica, ``Saving an unlikely restoration of consumption-based external demand (and therefore in availability and absorption of credit), Japan is faced with the prospect of prolonged economic stagnation in the absence of any new growth paradigm.

``Emphasis may therefore shift towards exploiting hitherto untapped markets within Asia. For example, Toyota has indicated its intention to shift from a ‘vertical to a horizontal’ production model in Asia, whereby it manufactures motor vehicles designed for and produced in local markets rather than vehicles assembled in various countries for export to third markets. Nissan has indicated its interest in basic models designed for the China-market, along the lines of Tata’s Nano car in India.

``Japan is also likely to exploit the capability of its heavy industrial sector in meeting demand for new transport, power and communications infrastructure (as well as for environmental engineering) in Asia — China and India especially.”

People react to changes in the environment faster than the ideas of ivory tower ensconced experts can think of.

No comments: