Council on Foreign Relations

In case you haven't noticed, the dollar is now closer to 1.30 (v. the euro) than 1.20 – or even 1.15.  Carry is no longer king.   There is talk of a "regime change" in the fx market.  Or at least an attitude change.    If the G-7 takes imbalances seriously, the fx market will too …   

It isn't just the euro either.    The pound generally seems to move in tandem with the euro (Sorry, Maggie).  And Canada has a strong dollar policy even if the US doesn't.   The loonie, like oil, is testing multi-year highs.  

It sort of feels a bit like 2004 all over again.  At around $1.26 for euro, the dollar is about where it started 2004 – and about where in started in the fourth quarter of 2004 as well.   Korea is back in the market as well, fighting won appreciation.   Steve Johnson of the FT:

Furthermore, the final communique from last weekend's G7 meeting, which called for greater currency flexibility in emerging Asia to help reduce global imbalances … also led to expectations that the dollar might finally weaken against Asian currencies.

Indeed this happened – for an entire 24 hours – before Japan started complaining about the speed of the move and South Korea backed up its own complaints with a wall of intervention to stop the won from strengthening.

I feel for the Koreans.   The Bank of Korea seems to want to run an independent monetary policy.   They don't want to be part of the dollar block.   But it is hard out there for a won …   when the rest of North Asia sits out the dollar move.  Japan's Vice Minister is working hard to keep the yen very, very weak in real terms. And China decided not to operate a basket peg last week. The won isn't just strong v. the dollar.  It is also strong v. its etymological cousins the yen and the yuan.   

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I have turned the trackback function off.  Too much spam, unfortunately. 

Don't hesitate to bring a link to my attention in the comments section.

If there are topics that you want to discuss, feel free. 

And if there are topics you think I should explore, suggestions are welcome.  My recent posts have fit in a certain pattern: I go from the US trade deficit is going to get bigger, to China should revalue, the savings surplus in the oil states is huge, Saudi Arabia and the rest of the GCC should revalue, dark matter ain't all its cracked up to me and betting on macroeconomic stability and continued low volatility in a world with enormous imbalances is risky.    I did get into Iceland for a while and dabbled with the French real estate market, but maybe I should cast my eye even further …  

We know why the global economy grew strongly in the first quarter.   Nothing changed.  Or rather, the basic pattern that has driven global growth for the past few years intensified.

The US continued to be the engine of global demand growth.  We don't have US import data for March, but the port data suggests that imports will bounce back, big time, from their blip down in February.   Non-oil import growth is likely to be almost as impressive as the US oil import bill … and that's saying something.

China continues to supply that demand.  China exports are up close to 30% y/y.  And China is now to investment what the US is to consumption.   Fixed asset investment is up 30% y/y.  China's investment boom also provides impetus for global demand – even if in aggregate, China still saves more than it invests.

It isn't hard to figure out why Chinese investment growth accelerated in q1.  After several quarters of restraint, Chinese banks lent like mad in q1.   With a guaranteed spread between deposits and loans, the banks have a strong incentive to grow their lending book.   The equation is simpe: More lending = more current profits.   Nore future risks too, but that doesn't seem to worry many bankers right now. 

China's central bank had been holding back lending growth with administrative controls, leading deposits to pile up in the banking system.  In the first quarter, the central bank either eased up or the banks stopped paying attention.   Who knows.  But if the PBoC did want to ease up to generate a bit more domestic demand, it now seems to worry that it may have unleashed a bit too much of a good thing. 

Like Dr Roubini, I am not convinced a massive 27 bp increase in an economy growing — in nominal terms — at 15% will have any impact on lending growth.  Even after their recent lending spree, the banks are very liquid, with lots more deposits than loans.  That has put downward pressure on lending margins.  I don't see that changing quickly.   The central bank will need to continue to use administrative controls to limit lending growth.

UPDATE:  Andrew Browne and Michael Phillips — or at least the WSJ's headline writers — play China's 27 bp rate increase as a signal of "movement toward market economy."   They are drawing on quotes from Andrew Bernard of Dartmouth.    I still have a rather different take.  China's various baby steps (27bp here, a 2.1% revaluation there) strike me as too small to matter.   And as a result, to me, they reflect continued resistance to letting key prices — the price of money, the price of energy, the price of foreign exchange — drive the allocation of economic activity.    Some are struck me the fact that China has moved a bit, I remain far more struck by the fact that the moves are so small in the face of the economic forces now working through China that, in practical terms, they have next to no impact.  And they force China to rely on other policy tools — notably administrative guidance on credit — to try to rein the economy in.

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Bill Cline of the IIE rightly took Nouriel and me to task (politely) for assuming that the average return on US FDI abroad would equal the average return on foreign FDI in the US in our 2004 paper on US external debt dyanmics.  We didn't explicitly intend to make that assumption, but we used a common interest rate for all US external liabilities and US external assets.  It makes the math easier.  But, to use the current terminology, we also assumed dark matter away.

But the implied interest rate on US government debt held abroad in Cline's data always has struck me as a bit strange.  He calculated it by dividing government payments in the balance of payments data by the stock of Treasuries held abroad.  The resulting implied interest rate, though, seems a bit too high.  I did a bit of digging, and it turns out that the interest on Agencies held abroad are counted in government payments, so the data on US government payments really should be divided by the stock of both Agencies and Treasuries held abroad, not just the stock of Treasuries.

That isn't just wonky data mining.  Recalculating the implied interest rate on US government debt (including Agencies) held abroad helps to clarify some important dynamics.  Interest payments on Treasuries and Agencies held abroad have been rather flat for the past few years.  

Why?  Falling rates have offset a rising stock of Treasuries and Agencies in foreign hands!

Alas, as we all know, interest rates are rising.    And with a lag, the average interest rate on US debt should move up.

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I downplayed the most recent gathering of the great and good in Washington, arguing that those gathered in DC didn't really commit to the policy changes needed to avoid an another year of widening imbalances so much as reassure each other that they wouldn't make any real changes.

The market seems to have a different view.  The dollar fell against most currencies after — take your pick — the G-7 released its communique/ the IMF unveiled its new focus on imbalances/ the FT headline writers decided that something really had changed over the weekend/ the IMF stated the obvious.   The dollar would be down even more if Japan hadn't intervened verbally and if Korea hadn't intervened with cold hard cash (see the FT).  And no doubt China continued to spend big bucks to avoid joining in the general trend – though China spends big bucks to keep its currency from appreciating against the dollar even when the dollar isn't depreciating against everyone else.

One interesting point: those who think the world should take steps to reduce imbalances generally have downplayed the impact of the IMF's new mandate, and the G-7's communiqué, while those who don't think the world should do much are disappointed that the G-7 and IMF are signalling that they are not totally happy with the world as it is.  

Those skeptical that the G-7 communique — and the IMF's new process of multilateral surveillance - signal real change note:

• The US has made it clear it doesn't intend to address is structural revenue shortage, guaranteeing large deficits.   Rather, the US Treasury Secretary argued – contrary to much evidence – that fiscal deficits have little to no impact on the current account deficit.
• The Chinese have made it clear that they don't intend to let their currency rise, even though a stronger currency and higher interest rates would be a natural way to help cool what looks to be an overheated economy.  30% investment growth and close to 30% export growth are hard to square with the image of a fragile Chinese economy that cannot manage even a modest change …
• The GCC isn't willing to change its dollar peg (GCC = Gulf Cooperative Council), even though its dollar peg makes even less sense than China's peg.    Oil is way up this year, if you haven't noticed.  But the purchasing power of the GCC currencies is down, since they all peg to the dollar.   If anyone wants to explain why that makes economic sense, be my guest.  The argument that countries that sell oil for dollars should peg to the dollar doesn't cut it.   The dollar price of oil isn't constant. 
• The yen is about as weak as it ever has been in real terms, yet Japan still tries to talk the yen down.   Or at least keep it from rising.   Incidentally, Korea is by far the most responsible of the big economies in north Asia.  It has let the won appreciate in real as well as nominal terms.   Korea now has a small current account deficit.  It imports oil.  And last I checked, Korea's economy was managing just fine.

As Jens Nystedt, Deutsche Bank's new G-10 currency strategists (full disclosure: I worked with Jens at the IMF), observed, the G-7 statement was a lot stronger than the IMFC statement.   Yet, setting Japan aside, the countries of the world with big current account surpluses are not members of the G-7.  The G-7 remains a lot better at telling others what to do than figuring out what its own members should do.

Yet those betting on an ever more imbalanced world – or perhaps betting on a financially stable world in the face of ongoing imbalances – seem a bit more worried.  Not because they think imbalances are anything to worry about – Stephen Jen calls imbalances a natural byproduct of globalization.   No matter that globalization started well before the US current account deficit started to get big in 1998, and well before Chinese export growth and investment metasized in 2002-2003.    Rather they are worried that efforts to reduce imbalances will trip up the markets.

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Many have noted that the White House botched the stagecraft of Hu's not-quite-a state visit.  Forget Falun Gong.   Focus on announcing China's national anthem as the anthem of the "Republic of China" …    

But focusing narrowly on the staging of the not-quite-a state visit I think misses a much bigger point.   The "optics" or "visuals" of the entire trip were terrible, and the rhetoric not much better.

I'll start with China.   Hu seemed to spend his entire trip with China's friends in corporate America.    The leader of the world's most profitable property company (China's communist party) started out his trip with a visit to America's richest man, and promised to make him even richer (by paying for his software).    And the China's top real estate baron proceeded to spend many more hours cavorting with the corporate titans (See this WSJ article) who are the biggest beneficiaries of America's new gilded age.

China likes to reward its American friends.   But rewarding those already "winning" from the US-Chinese relationship isn't going to help those who are not sharing in the benefits created of the current China trade.  The alliance between Chinese bureaucratic capitalists, American CEOs and Wall Street bond traders betting on the continuation of Bretton Woods two leaves a lot of folks out. 

Yes, American consumers benefit from cheap Chinese goods.   But Chinese demand for commodities has also pushed up the price Americans pay for things like gas.   China cuts both ways for low-income consumers.   Real wage growth for most Americans has stalled; median real compensation growth hasn't kept up with productivity growth.   Yes, American homeowners benefit from rising home prices, in part because of cheap Chinese financing. But not all parts of America shared equally in the windfall – those in manufacturing flatland for example.  And more importantly, rising home prices don't help those who don't (yet) have homes.  They actually are worse off.

I recently saw a graph showing the widening discrepancy between urban and rural income in China.  Both are growing, but urban income is growing much, much faster.  So income inequality is growing.   I suspect if you did a similar graph plotting the compensation of the median US manufacturing worker in Ohio against the median wage of a US CEO over time (See Martin Wolf today) or the median compensation (including bonus) of a Wall Street prop bond trader since 2001 the discrepancy would be even more striking. 

You say manufacturing is a dead industry in the US.  Fine.  If you did the plot with median wages in the service sector, it wouldn't look much different. 

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Patrick Smith seems to be based in Hong Kong, so I guess I can forgive him for thinking I work for the IIE (the Institute for International Economics).  The IIE is a great place, but they , alas, don't pay my salary and they hardly need any additional publicity.    Roubini Global Economics, by contrast, does pay me and it needs the publicity.  I did write a book that the IIE published, but that doesn't mean I am a fellow there.    

Smith's article focuses on the debate between those who believe in a new paradigm for international economics, where globalization and dark matter render old measures like the current account deficit obsolete, and stubborn traditionalists who cling to discredited measures that the market currently chooses to ignore. 

Currently may be the wrong word; the dollar tumbled today.  But certainly the market didn't focus on the US current account deficit last year.   Smith tries to explain why:

"The markets are powering ahead, and we need to understand why," said Louis-Vincent Gave, a partner at GaveKal Research, a Hong Kong economic and market research firm. "We need to understand why the scenario of the permabears, as we call them, hasn't come to pass."
 
 [Those think the current situation is sustainable make] two core arguments: Either the globalized economy has made traditional economic measures inaccurate, or if they are still valid, they are no longer relevant.
 
Either way, those favoring a new look at accepted economic thinking arrive at the same conclusion: There is no cause for concern over those quaint things called structural problems, they say.
 
For a time those of a bearish bent could dismiss such notions as little more than the flying of kites – a more sophisticated story in the markets but a story nonetheless. With the emergence of new theoretical backing, however, those who justify the high valuations now found in many share markets are gaining adherents.
 
… Two economists, Ricardo Hausmann of Harvard University and Federico Sturzenegger of Harvard and the Universidad Torcuato di Tella in Buenos Aires, say that current account statistics mismeasure a country's financial position because they are based on the geographic origin of goods – an outmoded concept.
 
…  "When we apply our methodology," the authors wrote in a much-circulated paper, "we find that the U.S. has run no current account deficits over the last two decades and that global imbalances are relatively small and very stable."
 
….   If there is one theory that draws these strands neatly together into a compelling whole, it belongs to GaveKal, a small, independent research firm whose startling ideas draw large clients.
 
The shift from industry to services in the advanced economies, the outsourcing of manufacturing to developing nations, the real estate "revolution," as Gave calls it – all of this has yet to be fully reckoned into the data and has brought us into "Our Brave New World," which is the title of a book GaveKal published last year.
 
"The bears argue that the structure of the world economy today is unsustainable," Gave said during an interview.
 
"We argue that it's not only sustainable but that it's stronger than it was."  …
 
GaveKal's clients include the huge U.S. hedge fund Tudor Investments and J.P. Morgan Chase.

Meanwhile, Brad Setser, a fellow at the Institute for International Economics in Washington and a former official at the U.S. Treasury Department, tries to incorporate the sum of "dark matter" into his analysis of the current account.  

The last sentence caught my attention, for obvious reasons.    I do try to calculate "dark matter" or more precisely changes in dark matter.    It isn't hard: dark matter is just another way of measuring the US income balance.

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The FT's headline writers managed to summarize the Eurozone economy in four words. 

And unlike much recent commentary, which is based on a pervasive but inaccurate perception that France isn't growing, the FT gets the basic story right.

France is growing and spending because French housing prices are up:

Soaring household durables sales reflected the buoyant housing market and low interest rates, which have encouraged borrowing, said Mathieu Kaiser, economist at BNP Paribas in Paris, who suggested that the European Central Bank's moves to increase borrowing costs were persuading consumers not to wait before shopping. "They are perhaps getting in their purchases in a hurry."

And Germans aren't spending because German housing prices aren't up.   And German real wages are down.  Falling unit labor costs have increased the profitability of German firms and helped German exports, but they haven't spurred German consumption.  German workers fear for the future, so – unlike their American counterparts, they haven't reduced their savings to make up for disappointing wage growth.

In contrast with counterparts in France, German households have been hit by falling real wages and house prices. Germans have also continued to save at a furious pace because of their fears about the future of the welfare state.

My main critique of the proposed plan for reducing global imbalances embedded in the IMF communiqué and the G-7 statement is that both place more emphasis on structural reform in Europe than seems justified, and less emphasis on the oil exporters than seems warranted.   

Some structural reforms – letting stores in Germany stay open longer – might increase European consumption.     But the impact of the standard set of labor market reforms on domestic demand growth seems rather ambiguous.  Germany has done more to reform than France over the past few years.  Yet France, not Germany, has enjoyed domestic-demand led growth.

Freeing up labor markets may encourage more investment, and thus spur demand growth.

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How is that for brevity?  The world economy reduced to a single rhyme.  

The BRICS are Brazil, Russia, India and China – Goldman's set of big emerging economies.     With oil at $75, they really should have added in the Saudis.  Not many people, but lots of oil.

They lend to the US.  In dollars at low rates.   They probably won't get repaid in dollars with an equal (external) purchasing power.   External debt is a claim on future export revenues.   And it is pretty clear that the US is not taking on external debt to build up its future export capacity.   That suggests that the dollar will have to fall at some point. 

The BRICS might be better off lending to the US in their own currencies, not in dollars.   That is what the US did back when it was a creditor … let the other guy take the exchange rate risk.

But right now the BRICs lend to the US in dollars, and the US is happy to spend what the BRICs want to lend.    The federal government does its part.   The sunbelt construction industry does its part.  Or at least it did.   US homeowners do their part. Even those Americans stuck in flatland with stagnant real wages and relatively stagnant home prices do their part.  They want to keep up with the Jones' on the coast.    Or at least not cut back even as they pay more to fill up their gas tanks (and Saudi and Russian bank accounts)

So long as the US generates the demand growth the world needs, the global economy grows.   What's not to like?

No one at the plethora of international meetings taking place this weekend – or for that matter, President Hu and President Bush — will admit that they want one more year of unbalanced (but strong) global growth.  The talk, at least on the surface, is about the need to deal with global imbalances.

But I increasingly suspect that such conferences actually serve an altogether different purpose.

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The policy makers gathered in Washington this weekend listened to Martin Wolf's advice.  And skimmed his powerpoints.  

Everyone with authority in the global economy read Gian Maria Milesi-Ferretti's box on global imbalances in the first chapter of the WEO (charts here, and here).   My translation from IMFese: The US current account deficit is only sustainable if everyone continues to dump money into the US when they would have gotten a better return if they joined Americans in investing outside the US.   Since the US is running a big deficit, it needs a lot of financing.  But to keep the US net debt from going up, US markets have to do much worse than foreign markets.   Like the IMF, I don't think that combination is very likely to last for a long time.  And yes, the dollar does need to fall against both East Asia and the oil exporters.

The Wall Street Journal replaced its appallingly bad Moody's economy.com data feed in its global economic snapshot with data from the IMF WEO's statistical appendix.  That way the Journal's readers would know that China's 2006 current account surplus will be close to 7% of its GDP, not 2.3% as economy.com seems to think.

More articles were written pointing out that Asia's current account surplus hasn't fallen even as the oil exporters' surplus has exploded.  In 2004, Asia (Japan, NICs and emerging Asia in the IMF data) ran a surplus of $356.  It went up to $405 billion in 2005.  Fuel exporter's surplus went from $189 billion to $347 billion.  If the surpluses of the two surplus regions (one oil exporting and one oil importing) of the global economy go up by $200 billion, the global current account can only balance if either there is a huge swing in Europe's balance or the US goes deeper into deficit.     The euro zone's surplus did fall.  But the US deficit widened even more.

More people took note of the fact — judging from the WEO data — that the real exchange rate of the major oil producing countries in the Gulf has depreciated significantly since 2002, despite the run-up in oil prices.  No wonder their imports haven't increased more.

Economic journalists started to use the WEO statistical appendix to fact check their articles.   

Right now, US economic journalists – including really, really good journalists – consistently write articles indicating that France isn't growing when, in fact, it has grown faster than its major continental counterparts (Germany, Italy) over the past ten years, it grew faster in both 2004 and 2005, and the IMF forecasts that it will grow faster than Germany and Italy in 2006 as well.    And France is growing on the back of domestic demand.   After you adjust for the fact that France has lower population growth than the US, there isn't a huge difference between the IMF's forecast for 2006 demand growth in the US (3.2%) and in France (2.6%).

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