Friday, January 24, 2014

In the spot light: … CHINA and beyond



China and beyond...
I still think that China is one of the most mis-analyzed countries in the world. It goes back to Richard Nixon who “opened China” and excited entrepreneurs around the world who dreamed of selling just one item to everybody in China and getting rich. How did that work out?   China was not that kind of place. The Chinese were poor; the Chinese were not going to buy anything from you. The Chinese were going to work and sell things to you. Capital around the world was going to locate in China. Chinese workers would make things, take your job and sell things to you, lending you the money to buy from them and to get into deep debt at the same time. That is the fact it was not Nixon’s dream.

Freak trade
This is the great paradox of China that no one seems to have grasped. Entrepreneurs in America now think it’s fair game to pick up a factory and re-locate in China displacing workers in the United States and producing at cheaper prices overseas. This game works if the international trade game is fair. We have a watchdog organization that took over from GATT (The General Agreements on Tariffs and Trade), an organization called the WTO to enforce free trade rules.    But, in this new regime, no one looks at exchange rates. In this new regime no one minds persisting and excessive current account deficits or surpluses. So in this game currencies get misaligned and trade occurs over long periods -at persistently misaligned exchange rates. That is NOT free trade: its freak trade.

China, of course, has been one of the main contributors to the international trade game played on this uneven ground. Even though China is a large developing nation, during the period when it developed and attracted huge capital flows from abroad it oddly ran persistent current account surpluses and built up gigantic foreign-exchange reserves. This is a country that was supposed to be trying to develop. Instead of using its resources to improve the lot of its people it simply piled up money at the central bank. And, as an example of the kind of development it encouraged, the proportion of consumption in GDP fell dramatically. China was interested in increasing its share of world output. It was completely uninterested in improving the welfare of its people. It kept its exchange rate too low. It paid its workers badly. It polluted and violated international law.

Because of its low costs all was forgiven and China became a Nirvana for firms looking to cut costs and become more competitive. But don’t mistake this for something that it’s not. This was not free trade. This kind of investment is not fair under the rules of international trade. Since the exchange rates were ‘cooked’ trade was not occurring under optimal free trade conditions –as if I have to point that out…but I do..

In the chart below we show the US current account deficit as a percentage of US GDP. In it you can see that after the 1980s something rather dramatic happens with US trade. Prior to that time recessions put the US current account into surplus. The 1991 sharp and brief US current account surplus was the last that we have seen. Because of China and other countries that sought export-led growth and pegged their currencies to the dollar at rates that were advantageous to them, the US was no longer able to run current account surpluses under any situation. Even in the dear dark days of the financial crisis when the current account contracted sharply as US demand dried up… the deficit as a percent of GDP remained around 2.5% to 3% - a figure we used to think of as huge..
 

During this period when the US was running large and persistent current account deficits, it’s important to note that the exchange rate system was not operated to dissipate the US deficits. Nor did they operate to dissipate the Chinese surpluses. Nor did they dissipate the surpluses in any other country that had employed the technique of export-led growth. Exchange rates were controlled and since the US is the center country in the system, every other country picked its exchange rate against the US. Countries have been willing to give up improved purchasing power in order to gain improvements in output and export penetration. And, this has thrust the US into deeper debt and made the US less rich, less profitable and less competitive.

The financial crisis ruined much of the US economy and other economies as well and made it clear that they could no longer create the kind of growth they had in the past. China, whose economy is so big and dependent on exports, suddenly was stymied. Its never-ending export growth game had, in fact, come to an end.

Because of the realization that the Western world could no longer absorb the huge flow of Chinese exports, because the US deficits were too big and its debt was too high and unemployment rates had skyrocketed, China was forced to look internally for its growth solution. This brings China to where it is today.

China has been engaged in this broad game of structural change. No longer able to achieve its growth targets by siphoning off domestic demand abroad, China now has to develop its own domestic demand and this is going to change the game dramatically. In order for China to develop its domestic demand it’s going to have to pay its workers. If you don’t pay your workers they don’t have any free income to generate any domestic demand. And if China pays its workers it is going to lose his competitive advantage. And this is the game that has been in progress in many other countries in Asia. Recently others in Asia have become lower cost centers than China. This also explains why China’s growth targets are harder to make, because the game has changed and China is trying to develop demand at home and its own service sector.

Because of this, I don’t see the weakness in China, a weakness that is represented by some minor backtracking in its manufacturing purchaser index, as meaningful to the global economy. China is not the export dependent juggernaut that it once was. And so a backing off of China’s growth does not reflect the weakening in global growth. Instead, it reflects an irregularity in China’s ability to develop its own domestic demand.

Even now as we have been forced into this change by events beyond our control (or at least by events we chose not to control) we have still not re-balance the world economy. Germany now has the largest current account surplus in the world. When Germany grows, because it’s the most important economy in the European Monetary Union, its growth boosts the EMU growth rate; but its growth is not necessarily helping Germany’s fellow EMU members. In fact German growth may be a detriment to growth in its fellow EMU members as a highly competitive German economy swoops in to take the modicum of domestic demand that is there in fellow EMU nations, leaving less for domestic companies in its fellow EMU countries.

How did this happen?
Under a system of fixed exchange rates based on the gold standard, a persistent current account deficit causes a country to lose gold. The US would never have allowed China to amass the kind of surpluses it did were we on the gold standard– especially the bilateral surpluses against the United States. Under that system the US would have raised its interest rates to keep capital at home and that hike would’ve slowed the economy and slowed the demand for foreign goods, reduced domestic inflation and improved US competitiveness. US growth and development would’ve been restrained in order to keep our gold reserves intact. There likely would’ve been other political developments to try to restrain China (and others) from predatory export practices. But under a fixed rate system their rates would also be FIXED.

Under a fluctuating exchange rate system, a country that builds a surplus should see its currency appreciate, with that currency rise eventually undercutting its competitiveness and causing its surplus to be reduced, leaving the country with higher purchasing power. The deficit country would see its currency drop; that would cause imports to be more expensive and exports to be cheaper. Those forces would help to equilibrate a current account deficit. These things simply haven’t happened because exchange markets are BROKEN.

If you say bad things about free trade, they revoke your PhD in economics. As a result everyone has been a cheerleader for this expansion in world trade. However, if you look at what has happened during this period you find that trade did not occur under the conditions we associate with free trade. Exchange rates did not behave the way they would under a system of market-determined exchange rates. Current account positions do not conform with the ongoing economic conditions in various countries. Current account surpluses and deficits persisted for periods far longer than one would expect if the system of exchange rates were market determined. Surplus country currencies did not rise. Deficit country currencies did not fall. There were no ‘equilibrating forces.’ And as a result of this China and some other Asian countries became the persistent low-cost providers and capital accumulated there instead of accumulating in other places. As a result China and other Asian countries have developed remarkably. Some of the more traditional core developed countries have been starved of the kind of investment that they should have been able to attain. They now suffer lower growth rates as a result.

The impact of these export flows and capital investment shifts was blunted at first because as China exploded with growth, it also invested funds abroad in its target export markets.  The free availability of capital covered up the erosion in US competitiveness. But eventually the excess capital that was floating around in the US got into the inexorable mess it was bound to find. There was way too much capital in the United States and not enough productive investments to absorb it. Crazy mortgages allowed unqualified buyers to purchase lavish properties, at least for a while.

Aftermath
What we are left with in the aftermath is an economy that is no longer very competitive. The US has a very high rate of unemployment and we have workers lacking the skills that they need to compete in the global economy. Our educational system has gone to pot because we care more about preserving the jobs of teachers rather than making sure that they really educate students. Our political parties support these various interest groups and attract contributions from corporations that want to continue to place the factories overseas where the labor costs are still cheaper – while that game is still in play.

Democrats and Republicans would prefer to point fingers of blame at one another rather than to look in the mirror and place the blame where it belongs. We have a bipartisan system and we’ve got into this mess under a combination of Democrat and Republican administrations. To me it’s a clear signal that our economy has been failed by our leaders. That 47% of the people who file federal tax returns and pay no federal income tax is a sure sign this economy is not generating the kind of jobs it used to. And with our dependence on buying goods from abroad, stimulating demand isn’t an option since demand stimulus will only stimulate output from overseas. What we need to do is to stimulate output United States. That’s a much more difficult job.

In part that means putting rules in place that will keep factories here. This is not an argument for trade restrictions or investment restriction. This is an argument to make exchange rates fair. This is an argument to make sure the countries that run surpluses do not run them forever. This is an argument to make sure that the dollar, which is the central currency in our international trading system, is fairly valued in all of its bilateral pairs. It’s also a warning that developing our energy sector and reducing our current account deficit by reducing energy imports and increasing energy exports does not by itself change any of this. The US non-oil trade deficit, which excludes oil and oil products from exports and imports, is still worsening. That’s a sign of still fading US competitiveness.

It’s a lot easier to find boogie men than it is to find solutions. In my view China has been a pariah of international trade. It has been allowed to develop under the fiction of international free trade and the pressure from US corporations that were looking to exploit the cheap labor in China regardless of the cost of that on America. Even Wal-Mart, a company that has no operations in China has continued to seek a strong dollar because it’s wanted to access cheap goods in the Chinese market to sell to its customers.

The political pressure for this continues. US businessmen see it as their right and responsibility to save money by moving capital equipment into China to take advantage of low costs. But now China labor costs arising. And if China’s exchange rate also rose to reflect its wealth and undercut this competitiveness we would find China a much less attractive place to be. If China plays by the rules its ability to continue this game will be limited. And now circumstances are forcing China to play this game differently. And so it may be that the competitive pressures on US firms in the future will be less but we still have the legacy of past investment in China to deal with.

When you look at the US economy you see jobs as a problem. But jobs do not spring forth out of the head of Zeus. They come from businesses, businesses that locate in United States, expand or develop de novo when circumstances warrant. When it comes to US competitiveness no one has been minding the store. Our two political parties have been much more interested in satisfying the global interests of US multinational corporations than forcing them to pay attention to their obligations at home. Having pressured China earlier on its exchange rate could have – could have, but did not – change the way corporate America saw its incentives. Once Nixon opened the China firms viewed China as a safer place to do business; the new game was on.

When Japan developed and when its exchange rate was forced higher Japan naturally sought to extend its factories into the Asian region around it, where it felt comfortable. US firms did not have the same comfort in that area. But eventually as the area developed, their comfort level improved.

Previously, US interests had been focused on Latin America. Here’s a revelation: Latin America is not Asia. In Latin America consumers love to spend money. Business was much more lax and less ready to be highly productive. When you lent money to Latin America demand boomed. When you lent money in Asia supply boomed… and American jobs disappeared.

Economics is largely about understanding how these large systems interact with one another. And forgetting the attributes of free trade and using that name to justify so much, does a great injustice to the US economy and to the science of economics. We still have no foreign-exchange police. It’s clear that markets do not perform this function. In a country like China the currency is not market-determined. And so the exchange rate result that you get needs to be part of the bargaining process- not part of the unilateral fiat.

To me China is simply an example of something gone very wrong. And even for the Chinese it has not gone terribly right. China has amassed a great deal of capital. Its workers are not well-paid. Its consumption is a small part of its GDP. Its property right enforcement is suspect. Piracy is commonplace. Trade-marks are not protected. Its investment capital has been poorly put to work in public structures as buildings and bridges are constantly collapsing. China is mired in terrible pollution. China is a classic example of a country that has developed far too fast. Its banks are banks in name only and God only knows the value of the stuff on their books that they call assets.

But China’s supercharged growth phase is over. In America there is a new richness in energy that’s been discovered and possibly can be harnessed to recharge the economy. However, it also can be misused. And it can be developed in a way that will make it seem as though the economy has been righted even when it hasn’t. I don’t see anything in the political sphere that makes me think that our politicians have learned any lesson or that they are any different than they have been... I don’t see that they are being better-policed by the public to pursue the public interest instead of their own personal interests.

I am concerned that the economy that produces jobs for half its people that are of such low quality that taxpayers can’t afford to pay federal income tax is an economy that has failed.

I am further concerned that when an economy fails this way someone looks to rearrange the deck chairs on the Titanic by increasing taxes on those who have been successful.

For a time, there is probably no other choice. But as a tactic it undermines capitalism just as surely as having jobs that are too poor for half the population undermines capitalism. If capitalism is not fair to the people in its country the system will not endure. You can look across America at cities that have been governed by Democrats persistently or by Republicans persistently and you will find that poverty has hardly been eliminated. Some states have huge debt bills and as far as I can see little to show for it.

We need to rethink what we’re doing. We need to live within our means. The same old same old is not going to cut it. That China will be less of a competitor in this new environment is only a small bit of solace. The bigger challenge is for us at home. We have challenges of fairness, of equal opportunity and of improving our competitiveness. And this is not some sop to ethics. It’s a realization that if an economic system isn’t fair, it can’t last and it won’t last. And we already have the trappings of a system against which people are rebelling.

Capitalism is a very subtle thing. People need to sign onto it and believe in it in order for it to work. You don’t think about all the little things that make it work; there many things you simply accept. And when you stop accepting these things, you no longer see the system as fair and you stop obeying its rules. And that’s when things get out of hand.

I’m worried that were getting close to this boundary. The tax share of GDP is already historically high and yet we’ve got Obamacare in the works and we have an aging population that is going to put even more strain on government finances. The solution is not more taxes or higher taxes on the higher income members of the population. The solution is better productivity, more growth, and more jobs. The solution is better education. And these are solutions that will take a great deal of time to implement. And so I’m concerned that that figure that Mitt Romney uncovered in his lost bid for the presidency is already at 47%. What’s next?

Wednesday, July 31, 2013

Fed policy statements compared-June and July


Fed policy statements compared

Big surprise comes in small revision package




The chart below is the most important new piece of information we had on the economy in quite a long time. Released today ahead of the FOMC meeting or as it was in progress. It shows that the economy was relatively stronger in 2012 than we thought and that the deceleration in the 2013 is much more severe than what we thought. As such it would be surprising if the Fed did not become more concerned about its projecting that the job market is going to do better since over the last 24 months private sector job growth has averaged 196,000 persons per month. When the economy was going 3% that made sense, now that the economy’s year-over-year growth rate is under 1.5% it would be prudent to question if such job market growth can continue. Yet, the Fed did not go there today. In fact, it seems to have gone in the opposite direction.

 

Economists are being raked over coals frequently for their microscopic parsing of the changes the Federal Reserve statements. However, when the Fed makes the kind of very small changes from statement to statement you’d be foolish to not realize that the Fed is trying to communicate something to us. In the second paragraph the Fed makes what appears to be an extraordinarily small change in language which seems to have a relatively large effect on what the paragraph means.

 The Fed used to say that it anticipates inflation will grow ‘at or below its 2% objective’. However the Fed has been under pressure from James Bullard who dissented last meeting but did not dissent at this meeting. He had urged the Fed to not ignore the inflation undershoot and risk from it. So interestingly, this month the Fed changed the language, it now reads as follows: The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.

I have to say I find this change disturbing. The Fed seems to have changed its forecast or assessment of the economy for the sake of creating language that removes Bullard’s dissent. The Fed language now says that it realizes that inflation persistently below 2% could pose an economic risk, acknowledging the criticism that Bullard launched at the last meeting, but sets it aside by saying that it expects inflation will move back towards its objective over the medium-term. That does take-care Bullard’s criticism and also the concerns and I had registered in line with Bullard’s criticism at the last meeting. However, it’s completely different from saying that it expects inflation to remain at or below 2%, also over the medium-term…which is what the passage used to say. Which is it? Does the Fed really believe inflation will stay below 2% or go back up to 2%?

I believe this is the first time in a long time that we’ve caught the Fed red-handed, with hand in the cookie jar. The Fed has just changed some language and it’s totally changed the way it claims that it sees the evolution of inflation. This plays into our worst fears: that the FOMC policy statement is a statement intended to justify whatever policy the Fed wants to implement rather than laying out a true roadmap that it intends to follow and to be governed by. That in fact was essentially the gist of the Bullard criticism last meeting.

In the fifth paragraph the Fed makes the following change in language which is an extremely small tweak with another big impact: “To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens”.

The highlighted yellow language replaces the word “expects”. Why would I make a big deal out of that? Of course it is a big deal! It’s a big deal because the Fed made the change. Look at how little of this statement was altered! Why would they make THAT change? Clearly the Fed thinks it is significant to say that it ‘reaffirmed its view’ rather than to say that it ‘expects’. The Fed apparently now has a view that does not reflect its expectation! And, oh, does that make MY head hurt. I really don’t want to haul out my dictionary or find someone with a PhD in English to carefully ‘Splain’ to me like Ricky might to Lucy what this means. It seems clear that the Fed has had another FOMC mud-wrestling match that has resulted in the English language being taken to the mat. And now it appears that there is more dissent within the Fed about keeping this highly accommodative stance of policy for considerable time after the asset purchase program ends. Why else would they change the language?

Does this mean that forward guidance is being attacked from within? What else could it mean? Isn’t this view the whole notion behind the extended accommodative forward guidance the Fed has?

Put on your thinking cap! Something is afoot at the Fed. Policy is hanging by the thinnest threads of hair splitting verbiage. And you thought that you needed to know ‘math’ to be an economist! A PhD in English might help- or not. It makes me wonder if Plosser, George, Fisher and Lacker are drawing support from other members of the committee. Also I wonder if Bernanke is losing influence now that he is being made a lame duck by Obama. This, of course is not evidence of Yellen gaining since this is a shift away from her desired policy. I wonder if Yellen is being handcuffed by the fact that she is under the microscope as a potential Bernanke successor?  The Fed, and its balance of power, appears to be in play.



Minutes from June 19 2003 Meetings
Information received since the Federal Open Market Committee met in May suggests that economic activity has been expanding at a moderate pace. Labor market conditions have shown further improvement in recent months, on balance, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth. Partly reflecting transitory influences, inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable.



Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic growth will proceed at a moderate pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall. The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective.


No Change
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.



The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Jerome H. Powell; Sarah Bloom Raskin; Eric S. Rosengren; Jeremy C. Stein; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action was James Bullard, who believed that the Committee should signal more strongly its willingness to defend its inflation goal in light of recent low inflation readings, and Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations.




Minutes from July 31, 2013 Meeting
Information received since the Federal Open Market Committee met in June suggests that economic activity expanded at a modest pace during the first half of the year. Labor market conditions have shown further improvement in recent months, on balance, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen somewhat and fiscal policy is restraining economic growth. Partly reflecting transitory influences, inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.

No Change
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.



The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Charles L. Evans; Jerome H. Powell; Sarah Bloom Raskin; Eric S. Rosengren; Jeremy C. Stein; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action was Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations.