The Curme-udgeon Column
Ben Bernanke: Between Scylla and Charybdis?
Or Iraq and a Hard Place?
The turmoil in the markets over the past two months has renewed speculation that we may be approaching a Tipping Point. It all started on February 15 when Bernanke made his congressional debut. In it he stressed the “considerable uncertainty” in the economic outlook, with a strong economy and significant inflation worries, but a potentially slowing economy as a result of the end of the housing bubble. When confused congressmen requested clarification, Bernanke sent a letter on March 21 to Representative Harold Ford, saying, in part, that a “decline in the value of the dollar” would not have a “worrisome” effect on the American economy. That was all the markets needed to hear. Since then, the dollar has lost 8% against the Euro.
$US versus Euro
What’s going on here? Why are people dumping dollars when our economy is the world engine of economic growth, with GDP growth of 5.3% in the first quarter? More importantly, which way is our economy headed, and where should we invest? It is easy to answer these questions subjectively, maybe citing a few statistics, but to understand where things are headed, we must first understand the measurements that economists cite in their arguments.
Globalization: New Math for Economists
All that macro economics you learned in college is now wrong. It wasn’t wrong then, but that was before globalization came on the scene. The problem is that in the past, macro economics modeled countries as closed economies. As an example, in the old school, if the Fed tightened interest rates significantly, the economy would slow down, leading to a slowdown in spending, higher unemployment and lower prices (lower inflation). Conversely, if the Fed dropped rates dramatically, the economy would speed up, leading to higher spending, higher capacity utilization, higher prices, and lower unemployment.
Most business commentators are stuck in this old school. They were puzzled when the Fed took interest rates from 6% in 2000 to 1% in 2003, yet wage and consumer price inflation remained benign. And they didn’t see the link between interest rate declines and the tech stock mania of the 1990s, or the housing bubble of this decade. Much of this history is covered in my tribute to Alan Greenspan.
The explanation for these “conundrums” can be laid at the doorstep of globalization. Wage inflation has been contained because the American worker is scared stiff that his job will be outsourced to India or China. Consumer prices have stayed low because almost all the consumer products that you buy at Walmart are made in China by workers who earn $0.61 per hour.
Globalization of currency flows also explains the behavior of the dollar. The dollar strengthened significantly in 2005 much to the surprise of people like Warren Buffet who had bet against it. The explanation, as outlined in my article Tipping Point, is due to the fact that the Fed was aggressively raising rates ahead of the central banks in Europe and Japan. The surge of liquidity that the Fed created in its tight money policy from 2000 to 2005 couldn’t spill over into wages or consumer products, so it drove a huge asset bubble in US housing:
Consumers celebrated the wealth effect in their houses by sending the savings rate into negative territory, and borrowing massive amounts of money:
The amount of cash pulled out of refinanced mortgages (“mortgage equity withdrawal”) is estimated to be $1.6 trillion in just the past three years. This money has been the primary driver of the US consumer spending and GDP growth over the past four years.
Oil and Commodity Prices
Oil and commodity prices have also skyrocketed but not because of inflation or monetary liquidity. Oil and commodity prices simply reflect the tradeoff between supply and demand. Oil has skyrocketed because China’s automobile sector has taken off in a few years and it is currently the third largest world market for cars, with 5 million sold in 2005. At the same time, most of the world’s oil fields are producing at full capacity, and there are few new megafield discoveries to counteract the decline in large fields like the North Sea or Alaskan North slope. The same current supply demand imbalance applies to most metals: it will take years to satisfy the gargantuan appetite of China by bringing new mines into production.
Will a recession reduce the demand for oil? Not likely. Oil is used primarily as a transportation fuel and secondarily as a source of heating oil. The demand for oil is extremely inelastic with respect to price. Despite wild gyrations in oil price and two recessions since 1990, the demand for oil in the US has increased completely linearly.
Inflation and the Fed
Chairman Bernanke has said “Achieving and maintaining price stability is the bedrock principle of a sound monetary policy.” However, you can now see that in a global economy, the Fed has almost no control over many of the factors that lead to inflation. Government data shows that inflation is moderate, averaging about 3.5% recently, while core inflation, which strips out volatile food and energy components is currently 2.1%, which is above the Fed’s comfort zone of 1-2%. However, the government has taken a variety of steps to “adjust” the consumer price inflation data, such as emphasizing items of decreasing price (computers) and deemphasizing items of increasing price (energy). If CPI were calculated as it was before 1996, the rate of inflation would be closer to 7%:
Since food and energy account for 23% of consumer spending and housing another 32%, it is difficult to see how real inflation can stay contained, as increases in interest rates, energy, and housing ripple through the economy.
Other Economic Terms: Consumption, Debt and Deficits
The Merriam
Webster dictionary defines consumption
as:
1 : a progressive wasting away of the body especially from pulmonary
tuberculosis
2 : the act or process of consuming
3 : the utilization of economic goods in the
satisfaction of wants or in the process of production resulting chiefly in their
destruction, deterioration, or transformation
None of these terms sounds very virtuous, yet consumption is celebrated by economists as a leading component of GDP. In fact, private consumption represents 70% of GDP, the highest portion of consumer demand ever recorded by a major developed economy. In 2005, private consumption totaled $8.75 trillion of our $12.5 trillion economy. Again, in a country with a closed economic system, it would be virtuous, because consumption would be financed by individual’s savings. But since the US has a negative savings rate, consumer consumption must be financed by the rest of the world’s savings.
Similarly, the US government last year spent $2.36 trillion, which would be good, except for the fact that $318 billion of that was not covered by tax receipts. In addition, as you might guess, the government also puts a lot of expenditures “off budget” so as to disguise their fiscal laxity. All the various government debts add up, so that the national debt, the amount of Treasury bills and bonds outstanding now stands at $8.34 trillion. This does not include future payments which will be required to fund Medicare, Social Security, or government pensions, but if the Fed can inflate the currency while keeping the CPI low, hopefully those won’t be too expensive when they become due.
The Trade Deficit is simply US Imports less Exports. The current account is equal to the trade deficit plus investment flows. In 2005, the US imported $2.03 trillion and exported $1.3 trillion, thus generating a trade deficit of $726 billion. This is a massive deficit, requiring foreign sales of US securities at the rate of $3 billion/business day. A trade deficit of over 5% of GDP has triggered sovereign defaults in countries such as Mexico or Argentina. Much of our trade deficit winds up as dollar holdings in foreign central banks. We buy shoes from China, and pay the Chinese manufacturer in dollars. The Chinese manufacturer can’t hold dollars so they convert the dollars to yuan at their bank, which in turn exchanges dollars for yuan with the Chinese government. The Chinese government buys Tbills or Tbonds with the dollars, thus accumulating foreign exchange reserves. In 2006, China surpassed Japan as the country with the highest levels of foreign exchange: $875 billion at the end of March.
Unsustainable Imbalances
The phrase for today, from the IMF or the G7 or Stephen Roach, chief economist of Morgan Stanley, is “unsustainable imbalances.” The trade deficit of $720 billion/year is 75% financed by foreign central banks. And the foreign central banks don’t want to keep buying our Tbills just to facilitate trade with the US. Especially since the implicit policy of the US seems to be to deflate our currency, so we can pay these IOUs back with cheaper dollars. All around the world, foreign leaders are complaining that the US’ trade deficit is causing overweight in their foreign exchange portfolios and it has to stop. On April 21, Sweden’s central bank announced it has halved its holdings of dollars in favor of euros. Kuwait, Qatar and United Arab Emirates also said they were buying Euros. In April, Russia’s finance minister questioned the dollar’s absolute status as the world’s reserve currency. “The greenback’s recent volatility and the yawning US trade deficit are definitely causing concern with regard to its reserve currency status,” he said. “The international community can hardly be satisfied with this instability.” Russia is the world’s second largest oil exporter, and in May Vladimir Putin suggested that they should sell oil denominated in rubles instead of dollars. Officials in Norway have suggested selling oil in euros and Iran is preparing an oil exchange which trades in euros. Any of these moves would reduce the need for foreign countries to hold dollars in foreign exchange reserves.
All this talk about the euro hides the obvious: China and Asia are by far the largest foreign holders of US treasuries, holding $960 billion out of total foreign holdings of $2.08 trillion. So their view on the dollar is important. Ba Shusong, researcher with China’s State Council Development Research Center recently said, “The U.S. is a minter while huge forex reserve holders like China receive and accumulate ‘junk dollars’… that has made the dollar ‘a spoiled child’.” Japan's Finance Minister Sadakazu Tanigaki said recently that differences in global trade shouldn't only be addressed by exchange rates. This was interpreted as meaning that Japan supported a strong yen, weak dollar policy, and the dollar could decline to 100 yen by year end. This flies in the face of conventional wisdom which for years has said that the Japanese and Chinese economies are completely dependent on US trade. If the US sneezes, Japan and China catch colds. The conventional wisdom states that China and Japan will have to continue to support the dollar, or else run the risk of tanking their export-driven economies. Let’s tackle that issue. But before we do, let’s turn from the depressing side of global economics and enjoy an uplifting story of a country that’s the polar economic and geographic opposite of the US:
China: Land of Opportunity!
What an economy! China has been the world’s fastest growing economy over the last quarter century, growing at a compound rate of 9.6% between 1979 and 2005.
Source: China Statistical Yearbook, 2003, Table 3-1, p.55.
Deng Xiaoping led the transition from a centrally planned economy to a capitalist one, especially after his 1992 summer tour where he praised the tentative capitalist ventures in Guangzhou and Shanghai. This spurred a first wave of foreign direct investment in the early 1990s. This wave was ill-fated however, as only joint ventures with state-owned industries were allowed, and between the bureaucratic inefficiency of the state-owned businesses and raw corruption, most of those investments failed. During the 1990s and early 2000s, much of Taiwan’s businesses moved to the mainland, despite Taiwanese government opposition. Also, privately-owned companies were legalized, leading to a wave of entrepreneurship that has transformed over half of Chinese business away from the state into private hands. In 2005, the 4.19 million registered private companies in China employed two-thirds of the labor force, contributed more than 60% of tax revenues, and were responsible for over 90% of China’s exports.
China’s labor force is its huge natural advantage. There is an annual flow of tens of millions of people leaving the countryside and streaming into the developed coastal regions looking for higher paying jobs. The Chinese government’s number one concern is finding jobs for all these people, to reduce civil unrest. The Chinese education system has had national placement examinations for over 1,000 years, in an effort to send the brightest students to higher universities. As a result, China graduates more than 600,000 engineers and technical students annually, by far the largest number of any other country:
A series of technology IPOs on the Nasdaq starting in 2003 has caused a rush of technology investments in China. These technology IPOs as well as the success of many industrial company IPOs in Hong Kong has turned China into the second largest IPO market in the world in 2005, with $24 billion raised by 114 Chinese companies, compared to $33 billion raised by 210 US companies.
China’s growth is driven by a savings rate of 40%. This provides the capital for massive investment in infrastructure as well as business. And even though China’s banking system comes in for criticism, the financial system is modernizing fast; 40% of capital invested in China is being raised by equity and bond issuances. This has augmented foreign direct investment which totaled $60 billion last year, as compared to $86 billion in the US. $60 billion is a big number, but small compared to internally generated capital. FDI might affect China’s growth at the margin, but it isn’t the tail which wags the dog.
China’s GDP is estimated by the CIA to be $2.225 trillion, versus the US’ $12.5 trillion. Many observers predict it will be 2040 before China’s GDP catches the US. However, China’s GDP is measured with undervalued yuan. The CIA estimates that China’s GDP at purchasing power parity is the second largest in the world, at $8.85 trillion. If China’s foreign exchange controls are slowly relaxed over the next decade or two, and the yuan appreciates by a factor of 3 or more to approach purchasing power parity, China could easily become the world’s largest economy much more quickly than is generally acknowledged.
China’s current account surplus of $129 billion is the largest of any industrialized country, and at 6% of GDP it is the mirror image of the US’ current account deficit of -6.5% of GDP. It is the accumulation of trade surpluses which have allowed China to accumulate $875 billion: the largest foreign exchange reserves in the world.
Another way to measure China’s economy is in consumption. According to Earth Policy Institute, China is the world’s largest market for each of the following: steel, aluminum, copper, coal, grain, fertilizer, meat, cell phones, TVs, and refrigerators. China is the world’s second largest market for oil and air transportation. This shows the huge growth of China’s middle class. The Chinese government is quite aware of the trade friction caused by China’s manufacturing exports and in the last five-year plan placed heavy emphasis on moving the economy towards a self sustaining internal consumption market. With 1.3 billion people, maybe all those dreams of consumer marketers will finally come true!
“Please Kind Sir, I Only Need $60 Billion a Month!”
Which brings us back to the question: Can China afford to slow down its purchases of US dollars, let the dollar fall, and have its imports increase in price? It is instructive to look back at the last currency crisis, the Asian Contagion of 1997. In that crisis, there was massive capital flight, starting with Thailand, and spreading to Korea and most of the rest of Asia, as their currencies and stock exchanges collapsed. It was a classic emerging market crisis, which was only resolved after the IMF and World Bank stepped in with emergency loans and heavy handed economic restructuring plans. Interestingly, during that crisis, with every economy around it tanking, China continued its growth:
Why was China resistant to the economic flu? Because unlike the US or emerging markets, China’s monetary system is closed. Investors can’t pull money out of China without permission from the government. The yuan is not yet freely convertible. This provides substantial insulation from the huge monetary swings caused by hot money.
What about the drop in US exports that China would suffer? Let’s look at the imports and exports between the world’s major economies and the US:
This shows that, although China has the largest net trade surplus of any of the US’ trading partners, at $108 billion, it is smaller than one might think. If the US dollar were devalued and Chinese exports became more expensive in the US, China’s $150 billion of exports to the US would suffer, but China’s imports from the US of $42 billion would be much cheaper. The argument for Japan is much stronger: Japan only has $32 billion of net trade surplus with the US. It makes no economic sense for China and Japan to invest a large portion of $720 billion per year in US securities in order to protect $140 billion of net trade. If China allowed its currency to appreciate against the dollar, all of its total imports of $632 billion, consisting of machinery and equipment, oil and minerals, plastics, optical and medical equipment, organic chemicals, iron and steel would become much cheaper. And since it still has a huge labor arbitrage against the industrialized countries, most of the export price hikes would pass through, with only a small amount of trade shifting to lower cost countries such as Vietnam.
Conclusion
The Fed has had a choice between a strong dollar and inflation, and over the past 10 years, it has chosen the course of inflation, despite their rhetoric. It now faces a choice between continuing the rise in interest rates to defend the dollar against further depreciation, versus pausing in its rate rises and risking a further dollar slide. In order to defend the dollar, US rates will have to stay well above those in Europe, whose finance ministers really are inflation hawks. Given the leverage in the household sector, with up to half of all mortgages in recent years being adjustable rate, higher interest rates would cause a political uproar as consumers — who are already squeezed by increasing energy prices — pay ever higher mortgages against depreciating real estate assets. The other path of dollar depreciation is not without pain, but the concomitant inflation will be somewhat hidden by adjustments in the CPI. The inflation path is also easier on businesses, which can pay back debts with depreciating dollars, to say nothing of the government. I think the Fed will pause, perhaps as early as the June meeting, and target a slow slide in the dollar, with reduced consumption leading to smaller trade deficits.
If global investors all recognize a concerted policy to let the dollar slide, individuals could rush for the exits, turning a slow dollar slide into a precipitous drop. From the pronouncements of the G7 and the IMF, it is clear that the major central banks will adopt coordinated policies to prevent a rout. China and Japan will be active participants, gradually increasing the value of their currencies, and allowing their economies to adjust from a US-centric position to more of an Asian-centric position. Over the next few years, as consumption in the US is reduced, the Asian region will become the world’s new engine of growth.
Email
Ollie Curme
© 2006 Battery Ventures. All rights reserved.