Monday, October 19, 2009

Bernanke's Speech and its implications

What the world needs now?

It’s not love sweet love.

Bernanke in the speech he gave today, besides looking at the circumstances of Asian economies in the business cycle, the ostensible topic of his speech, returned to a theme he has visited in the past. This is the danger of persisting imbalances: surpluses and deficits alike.

While he was very vague about how this should be approached, he was again clear on what needs to be achieved. High savings countries need to consume more and reduce the gap between savings and investment at home. High spending countries need to save more. There is a little something for everyone.

At the same time there is little evidence that any country is taking up a stand to pursue these objectives. Yet the risks are growing

Perspective on imbalances

One issue is that under the gold standard there were rules to the game. Deficit countries were forced to adjust because under the gold standard they lost gold reserves if they let current account deficits persist. No one wanted to run out of gold. So deficit counties usually hiked interest rates and slowed their economies down, contracting imports in the process to rebalance their trade, maybe they even ran a recession. While that system was disciplined it was also confining and it had the side effect that it rewarded countries that had gold mines. The current loose FX system that has few rules and none enforced has been short on discipline – very short. Hence imbalances have arisen, persisted and become enlarged in way that they never could under the gold standard.

G-20 not up to the challenge

The G-20 tried to consider a US treasury proposed to accomplish these same ‘Bernanke’ objectives when it last met. The proposal got lip service only. Absent some concerted effort to accomplish the goals of adjusting savings/investment imbalances, the pressure for adjustment will fall on the exchange rate.

Connections and linkages

The imbalances are one of the reasons for the dollar to be losing ground. The exchange rate is a remedy for US BOP ills since a weaker dollar will choke off US exports and spur US imports. But the dollar’s drop brings other tensions to the surface. Moreover, it is unlikely that the dollar can fall enough to purge the US structural deficit problem. The need for some sort of coordinated effort involving the realization of enlightened self-interest is long overdue. Yet the world’s most important economies are not about to cut any deals. Each sees its current state as in some way optimal for its own needs even though the whole picture is one of a very dysfunctional economic community.

The risk

History suggests that the sorts of problems that arise in the wake of these huge imbalances persisting and being extended are not minor inconveniences. Yet there is no agreement even on pursuing the goals that Bernanke has spoken of repeatedly and that were put on the table at the recent G-20 meeting. Growing payment imbalances have ended badly whether it was due to OPEC countries’ rising wealth, rising Japanese trade surpluses or China’s huge foreign exchange reserve accumulation. We can only wonder if the fallout from these imbalances will get worse as the imbalances themselves get bigger and they are getting bigger - in absolute terms and larger relative to GDP.

Can’t have your Egg Foo Yung and eat it too

China has goals that are bizarre. They are mutually inconsistent. It wants a weak currency to keep its competiveness in tact yet it does not want to keep accumulating dollar assets of which it has in abundance. But if it does not purchase those dollar investments, its currency will rise in value. The lack of a foreign exchange system with clear rules allows China to act like this lost soul with deeply conflicted goals.

The point, the risk, the dysfunction

To be sure Bernanke’s point is a sharp one. No one can tell you when we must get off this path onto one like the one Bernanke urges. By not adjusting, and letting a normal business cycle recovery occur led by US growth with surging US imports and a widening US current account deficit we are playing with fire. It’s a prescription for something bad to happen. It’s like high blood pressure. No one knows what price you pay for it, but we know it puts you more at risk to various health issues. So why leave this problem untreated when we have options and when better systemic health is in everyone’s best interest? That is the unanswered question.