Is Governor Zhou a closet Bernanke-ite?

I have recently finished reading Martin Wolf’s latest book, Fixing Global Finance, and I strongly recommend it for its very clear laying out of the global balance of payments issues behind the global crisis.  I should warn my readers that Wolf and I have come to very similar conclusions about the underlying root causes of the crisis – we are both in agreement, for example, about the distorting effect of Asian policies to constrain consumption and boost investment in manufacturing output – but I am mostly impressed by the fact that we come to the same conclusion from such different angles.

Wolf begins with a model based on analyzing the financial architecture of the past forty years and brings to his analysis a very US-centric view of the world, whereas my conceptual model is based on my obsessive reading in the history of financial flows between rich and poor countries and starts with a China-centric view.  Somehow we end up in almost exactly the same place, which suggests to me that we may be right or, at the very least, onto something important.

I won’t try to summarize the book but I do want to set out two paragraphs in which Wolf explains, far more clearly than I have ever been able to, how it is that reserve accumulation in Asia “forced” US households into overconsumption.  One of the most common fallacies in popular economic analysis is to assume that countries are somehow analogous to households, and the factors that lead a household to consume “beyond its means” are similar to those that cause a country to do so.  In that case if the US over-consumed, it is no different than if a stereotypical welfare family maxed out on its credit cards, and while we can fret at the stupidity of the bankers who gave them their credit cards, ultimately the blame for the mess must rest with the innate profligacy of mom and dad.

But this is not true at all when we are talking about overconsumption at a country level.  As I have tried to argue many times, the global balance of payments must balance, and significant change in any component of the balance necessarily requires adjustments elsewhere.  If Country A enacts trade policies that result in a surging current account surplus, for example, Country B must see its current account deficit surge by the same amount, and the way that happens will reflect a number of factors including the structure of its financial system. Country B could try to resist the growing deficit by engineering a recession and so causing total demand to drop, but this can be very painful for both countries.

Let us assume, then, that a group of countries, perhaps in response to the 1997 crisis, decide that in order to protect themselves from a repeat of that disaster decide to engineer polices aimed at accumulating reserves and limiting external debt.  The most obvious way would be to put into place policies that constrain consumption and boost savings (keep wages and interest rates low, limit credit availability to consumers, limit credit availability to small and medium enterprises and especially to the service sector, maintain an undervalued currency, etc.) and direct credit to the investment and manufacturing sector.  As a consequence growth in production would exceed growth in consumption and the balance would represent the trade surplus.  Trade surpluses, of course, have to be recycled as investment flows (or reserve accumulation) back to the country against which they are running these surpluses.  This is not a choice, or even a real lending decision.  It is the automatic and necessary consequence of running a trade surplus.

Since the US is the largest and most flexible economy in the world, and since the primary world reserve currency is the dollar (more on this later), in practical terms only the US can be the deficit country for any period of time, and so the surplus countries must accumulate US dollar assets as the obverse of their trade surplus.  Martin Wolf explains what happens next:

The rest of the world’s capital outflow supports the dollar.  At the resulting elevated real exchange rate for the United States, the output of the sectors in the US economy that produce tradable goods and services shrinks, other things being equal. The Federal Reserve cuts interest rates to expand the economy, thereby preventing excessive unemployment. As it does so, a large excess demand for tradable goods and services emerges in the United States. This finally, appears in the trade and current account deficits.

One consequence of all this is that US domestic demand has had to grow faster than real GDP, to ensure that the latter grows in line with potential. The difference between the two is, of course, the increase in the current account deficit, in real terms. With trend growth in GDP between 3 and 3.5 percent a year, domestic demand has to grow even faster. That is precisely what has happened.  US real demand (or gross domestic purchases) grew faster than real GDP in 1993 and 1994 and then again every year from 1996 to 2004 inclusive. Cumulatively, between 1993 and 2004 US real GDP grew by 46 percent, while gross domestic purchases rose by 53 percent.  That is how the current account deficit emerged.  It is also how the United States absorbed the supply of excess capital from abroad.

In the face of a sharp contraction in those sectors of the US economy that compete with Asian manufacturers, in other words, the Federal Reserve must either permit a rise in US unemployment, in which case US consumption will decline and with it imports from Asia will decline too, or it must prevent the rise in unemployment by putting into place monetary policies that are consistent with rapid GDP growth. This argument, by the way, is not at all affected by the very common (and incorrect) argument that the main cause of the US trade deficit with China is the fact that China produces things that the US doesn’t want to produce, which I have tried to address in a March 9 blog entry.

Global savings glut In either case US consumption must grow faster than US GDP, and the choice for the Fed is whether to target a “normal” growth in consumption, and permit rising unemployment, or a “normal” growth in GDP, and so permit rising indebtedness. The Fed must use US unemployment, in other words, as a tool to prevent Asian trade policies from leading to excess US indebtedness.

All this would have been bad enough if it hadn’t been for the need for the US to finance a very unpopular war, the Iraq invasion, in the way that unpopular wars have traditionally been financed – irresponsibly, through borrowing and money creation rather than taxes (remember that the Vietnam War was also associated with a credit bubble in the US). Asian policies, according to this view, definitely helped create the monetary distortions, but we must remember that there were plenty of bad domestic policies compounding the problem.

At any rate for the Fed to use US unemployment as a tool to prevent Asian trade policies from leading to excess US indebtedness is obviously politically very difficult, and it is also obvious that for the past ten year the Fed chose excess indebtedness.  Since the 1997 crisis we have seen both household savings and the US trade deficit break out of their normal ranges and either collapse (household savings) or surge (trade deficit). This is a necessary consequence of the process that Wolf describes.

In that light, as U.S. fiscal spending surges in response to the crisis, increased attention will be placed on the way that U.S. fiscal spending leaks out through the current account to boost employment in China and elsewhere. And just as the Chinese complain bitterly, and rightly, that the West outsources polluting activity to China via the trade account, the U.S. will complain, as Martin Wolf pointed out in a March 31 editorial in the Financial Times, that China is outsourcing fiscal indebtedness to the U.S., also via the trade account.  Surplus countries, he argues, “relied on the private sectors of deficit countries to do their irresponsible borrowing for them.” In response to the contraction in the borrowing among US households, the U.S. government, in other words, is currently choosing to borrow and spend the proceeds in order to generate job growth in the U.S. as well as in China. This can’t go on forever.

All of this is, of course, a variation on Ben Bernanke’s “global savings glut” hypothesis, and as everybody knows, Beijing wholly rejects this hypothesis as an explanation for the current global imbalances.  For Chinese policymakers, the cause of the crisis lays firmly and totally within US monetary and financial policies (or lack thereof), and absolutely no blame can be apportioned to Asian trade policies.

Or is this really Beijing’s view?  The extraordinary thing to me is that while Beijing has insisted almost desperately that any attempt to apportion blame to China is completely dishonest, they have nonetheless more or less welcomed Bernanke’s hypothesis, perhaps without realizing it, through the back door.  I say this because the widely-discussed essay by PBoC Governor Zhou last week, in which he assailed the reserve status of the US dollar as being the main cause of global imbalances, is as far as I can tell nothing more than Ben Bernanke’s hypothesis viewed from a slightly different angle.

Why? Because Governor Zhou makes the claim that the reserve status of the US dollar gives the US an unfair advantage in that it can borrow nearly unlimited amounts simply as consequences of the need for foreign countries to accept dollars as reserves and for the purpose of international trade and investment. Of course he is almost certainly right, and he is just as certainly not the first person to make this claim. Valery Giscard D’Estaing first discussed this “exorbitant privilege” as far back as the 1960s.

But remember that if we make the very simple (and necessary) assumption that the ability of a country to run current account deficits is constrained mainly by a country’s ability to finance those deficits, then the ability to borrow unlimited amounts also means the ability to run unlimited trade deficits. It was the reserve status of the dollar that permitted the US to run the massive trade deficits it has during the past decade.

Had the US dollar not been the reserve currency of choice (in other words had Asian trade surplus countries not recycled their trade surpluses into purchases of US government bonds), the dollar would have had to decline against world currencies as a consequence of the rising deficit – Asian currencies too, and not just European – and the US trade deficit would have stabilized at much lower levels. This is also another way of saying, as Martin Wolf’s piece directly implies, that the Fed would not have had to choose between unemployment and indebtedness and that the binge borrowing that characterized US household behavior would have been much, much lower.

The world loves dollars because the US seems to love deficits In fact I would go further. Because of the dollar’s reserve status, only the US could have possibly run the deficits necessary to absorb the huge surpluses that Asian trade policies were generating. Without the dollar’s status as a reserve currency, the Asian development model that stresses expanding production while constraining consumption – which among other things results in trade surpluses and net investment abroad (which of course is the same thing) – would have either required another reserve currency, or it would have failed.

Could there have been another reserve currency – and could it be that the dollar’s “exorbitant privilege” is something that Washington has enforced?  Yes and no.  The US economy comprises about one-quarter of the world’s economy and one-third of the rich-country economies.  In principle it would have been very easy for any country to accumulate reserves of other rich countries – nearly all of whose currencies are easily convertible – so that there is no reason why the dollar portion of all developing-country central bank reserves might not have exceeded roughly one-third of the total, instead of the two-thirds or more that it currently occupies.  Another third could be euros, and the rest a combination of the currencies of Japan, the UK, Switzerland, Canada, Australia, South Korea, and so on.

But it can’t just rest there. When a central bank chooses which currency to buy, unlike when you or I make our own portfolio decision, it is also determining the direction of net trade flows.  Those other countries would have had to match the investment surplus (net inflows on the capital account) with an equally large current account deficit.  If China had followed this balanced policy of reserve accumulation, in other words, the only thing that could possibly have stopped them, and a very big impediment it would have been, was the political or economic willingness and ability of those countries to run the corresponding trade deficits with China.

That, of course, is the problem.  Given their much more limited economic flexibility and their less ebullient financial systems, those other countries probably would have never been able to sustain the necessary levels of trade deficit, and they would have almost certainly moved aggressively against China to limit the development of unfavorable trade balances. China, in other words, chose to hold US dollars not because the US government has somehow enforced reserve status on the US dollar and denied it to other currencies (Washington could never have prevented China from buying euros or yen or anything else), but simply because no other country is able to run deficits of the necessary magnitude.

The argument, then, that the dollar’s status as the reserve currency and brings an exorbitant privilege is simply the other side of Ben Bernanke’s savings-glut coin.  Without the dollar’s reserve status, the global savings glut would have never occurred, or rather it would have never resolved itself in the way it did, and Asian development models aimed at engineering trade surpluses would have had to fail.

So is Governor Zhou a closet Bernanke-ite? He would probably be surprised at this question, and even more surprised at my answer, I think, but I cannot see how you can separate the two arguments – his on the perils of the dollar’s dominant reserve currency status and Bernanke’s on the impact of high Asian savings on the US balance of payments.  He and Bernanke agree fundamentally on the roots of the imbalance.

By the way, the model I have been using to explain the imbalances also addresses another contentious question between the US and China which I did not really think about until I read a fascinating short piece by MIT’s Simon Johnson on his blog, more in reference to Europe but relevant nonetheless.  China, as we know, is very worried that the US will resort to monetary policy rather than fiscal policy to address collapsing demand in the US.  The former hurts China (supposedly because it might cause an erosion in the value of the dollars the PBoC holds), whereas the latter helps by slowing the contraction in US net demand and giving China more time to adjust its overcapacity problem.

It turns out that there may be another reason, even more powerful, and as soon as I read this paragraph by Johnson I had one of those “Aha!” moments that means I am going to have think much more seriously about the implications:

Remember this.  If you run an expansionary fiscal policy (building bridges), I have an incentive to free ride (selling you BMWs) and not engage in a similar fiscal stimulus.  But if you run an expansionary monetary policy, your exchange rate will tend to depreciate, putting pressure on my exporters and I’ll be pushed – by BMW-type producers – towards providing a parallel monetary stimulus.

This may be why monetary rather than fiscal stimulus makes sense for the US, and less sense for trade surplus countries.  It prevents, or at least reduces, the leaking-out of employment generation effects of US borrowing and spending.

The other China Talking about BMWs, my argument, of course, is not so much about China and the US as it is about trade surplus and trade deficit countries.  In that light there was a very interesting article in Monday’s Financial Times about the difficulties Germany is facing in adjusting to the changes in the global balance.  Many people assumed that Germany, which was in a very “strong” position (high savings, large trade surplus, low debt – which are all more or less the same thing, really), would weather the crisis easily, but of course it should have been self-evident that a crisis that affects the deficit sides of the global balance of payments must also affect, by the same amount, the surplus sides:

The risk is that – like Japan in the 1990s – Germany faces a “lost decade”, or a protracted period of economic malaise as it waits for the global economic tides to turn and struggles to find domestically generated sources of growth. “I am convinced it is going to be a slow recovery,” says Mr Staake. “Who is going to be buying anything?”

This downfall is all the more galling because, even a year ago, the country could have expected to weather the global economic storms. There was no danger of a housing crash; prices had been flat for a decade. Consumers had saved; companies had not increased leverage dramatically. “From a structural point of view, this recession should never have happened,” says Commerzbank’s Mr Krämer.

With hindsight, however, Germany was a sitting target after the collapse of Lehman Brothers investment bank in mid-September. Its exports were equivalent to more than 47 per cent of GDP last year – compared with less than 20 per cent in Japan and about 13 per cent in the US. Its industrial base is skewed towards producing machinery and equipment – “investment goods” account for more than 40 per cent of its exports – and towards emerging European and Asian economies.

While the crisis was focused on US housing and capital markets, Germany was unaffected. But after Lehman’s failure paralysed banks, and confidence nosedived globally, companies around the world shelved investment plans – leaving German factories turning out goods nobody wanted to buy. Industrial production in January was more than 20 per cent lower than a year before; overseas orders for investment goods had almost halved.

“Who is going to buy anything?”  Good question, and one that must be answered by policymakers planning to export their way out of the crisis.

I especially love the statement “From a structural point of view, this recession should never have happened.”  One of my standard complaints about most economists, especially those who focus on a single country or group of countries, is that they ignore balance-sheet and balance-of-payments effects.  Of course it should have been obvious that a crisis in the deficit countries would affect the surplus countries – in fact it should have been obvious that the impact on the latter should have been worse.

Meanwhile, and as a continuing part of how the crisis will evolve, there is an interesting article in today’s Bloomberg about one of the ways in which the Chinese fiscal response to the crisis risks making the imbalance, and China’s long-term adjustment, worse.

China’s shipbuilding industry may be about to get a bailout — from its customers. The government may force state-owned shipping groups to buy more vessels as foreign carriers scrap orders, according to Steve Man, an HSBC Holdings Plc analyst in Hong Kong. That risks increasing costs and overcapacity among shipping lines grappling with a collapse in global trade.

“They ‘encourage,’ but my thinking is it’s more of a directive,” said Man. “It hurts every player in the industry and creates excess capacity that will take longer to absorb after an upturn.”

As I have argued many times, the constraints of the Chinese development model and limitations in the financial system mean that it will be very hard for China to shift its behavior quickly enough to match the possible adjustment in the US and elsewhere.  Bailing out the ship-building industry is one way in which Beijing’s fiscal reaction – while understandable from an employment point of view – may exacerbate the adjustment.  Washington’s bailing-out of the automobile industry is the same sort of mistake, I think, but in the US case it is much easier to justify.  The US must reduce its net consumption, and if boosting production is economically inefficient in the long term, at least it fits within the overall adjustment in the short term.  This is not the case with China – it should be boosting consumption directly, and not indirectly by boosting capacity.

There is a lot more I wanted to discuss today, but this blog entry is getting to be way too long.  But just one quick thing, yesterday I was having coffee with some visiting friends from Goldman when one of them received a notice that there were credible rumors on the March increase in new loans.  We had all been expecting a very big March number – between RMB 1.3 and RMB 1.6 trillion.

It turns out that the true number may have been an astonishing RMB 1.9 trillion.

That means that for the first three months of the year we have had loan increases of RMB1.6 trillion, RMB 1.1 trillion, and RMB 1.9 trillion.  This amounts to RMB 4.6 trillion for the first quarter of 2009, compared to RMB 4.5 trillion for all of 2008.  Notice to my students: learn more about how to resolve and restructure bad loans.  This will be a great career option for you over the next few years.

2 Responses to "Is Governor Zhou a closet Bernanke-ite?"

  1. Guest   April 10, 2009 at 4:18 am

    Fantastic piece,Michael !Gino Cavazzuti

  2. Miguel Otero   April 19, 2009 at 5:03 am

    I agree completely. Very interesting stuff, Michael. I liked the part where you focus on other possible reserve currency issuer countries or zones and how they are not willing to get so much into deficits as the US does. The Germans would never allow that in the eurozone, for instance. Looking forward to discuss these matters with you shortly.