More on Foreign Currency Values

I posted a comment on my blog as I happened to see an article from Volcker today and then checked to see if you happened to be running another "the trade deficit doesn't matter" posts.

http://samethoughts.blogspot.com/2007/02/note-to-don-from-volcker.html

and the story:

http://www.washingtonpost.com/wp-dyn/articles/A...>

"We sit here absorbed in a debate about how to maintain Social Security -- and, more important, Medicare -- when the baby boomers retire. But right now, those same boomers are spending like there's no tomorrow. If we can believe the numbers, personal savings in the United States have practically disappeared.

To be sure, businesses have begun to rebuild their financial reserves. But in the space of a few years, the federal deficit has come to offset that source of national savings.

We are buying a lot of housing at rising prices, but home ownership has become a vehicle for borrowing as much as a source of financial security. As a nation we are consuming and investing about 6 percent more than we are producing.

What holds it all together is a massive and growing flow of capital from abroad, running to more than $2 billion every working day, and growing. There is no sense of strain. As a nation we don't consciously borrow or beg. We aren't even offering attractive interest rates, nor do we have to offer our creditors protection against the risk of a declining dollar."

I'm not really up on these sorts of things, so this may be a stupid question. Couldn't the Chinese government lower the value of the Yuan directly by printing more money? Would the resultant inflation be more detrimental than the direct purchase of US dollars?

Isaac

Isaac-The printing press is the only way inflation takes place or the money is seen as completely worthless. Where the dollar bill or the yuan is seen as only paper, just as good as toilet paper. Where the paper has no backing of substance as a medium of exchange.

One should not ask "Why should Americans complain?" The real question is "Why should the Chinese (or Japanese) not complain?"

The answer may be in the microcosm drama occuring in Michigan these days. If we look at the loss of manufacturing and research (automotive and medical) jobs to other states and countries as an example of what happens when a region or nation is no longer competitive (pricing, costs, etc.), then we can see the "trickle down" effects to all other sectors of that economy.

So far, the U.S. has been able to absorb the loss of manufacturing through consumer spending (yes by dipping into savings). But Ben Bernanke has put the brakes on that by making housing "investments" tank and home equity loans a bigger risk. Foreclosures are up; industrial production has trended down the last 6 months; service sector jobs are beginning to feel the pinch as their manufacturing customers are cutting back.

So, "Why should the Chinese (or Japanese) not complain?" Perhaps they realize that current sacrifices are not that great. Perhaps it is because they see the tangible benefits from keeping their currencies low: a growing industrial base driving a growing service sector driving new wealth and savings. Maybe?

Why should we think that currency manipulation is the only manipulation going on. For decades, Toyota used fictitiously high transfer costs of vehicles and components to the U.S. to avoid billions of dollars in U.S. taxes (and keep billions of dollars of profits in Japan for the benefit of the Japanese). Why should U.S. taxpayers not complain about tax breaks for Japanese manufacturers?

So, to answer the original question: "because of the results" is the answer.

We should complain because the subsides that the Chinese are using are creating, like many governmental interventions, a market failure. The point of any trade is to use the priciple of comparative avantage to increase the well being of both parties. When a government picks winners and losers through things like subsidies, regulations, and currency manipulation it is changing the realtive terms of the trade. This leads to malinvestment of capital. In this case as Bruce Hall points out a lot of that investment is taking place in China in the creation of a growing industrial base. I don't think the individuals residing in the political entity known as the U.S.A. would be sending to China as much capital goods as they are now if it weren't for the currency manipulation. Maybe we would but it's hard to tell becuase of govenmental intervention.

The same argument can be made in the U.S. in regards to agricultural subsidies. I feel that the U.S. should not subsidize agriculture because it harms third world farmers even though it provides cheaper food to the potential customer of the third world farmers because of the distortion of the markets.

National savings rate is totally useless. Let me repeat, USELESS, Bruce! What is the national equity rate? That is the more appropriate question. Estimates have NET American wealth at 54 trillion dollars (if you do not believe me I'll send you the link to the data). And why should we save (read: buy debt) when the interest is taxed every payment, when debt hardly keeps pace with inflation, and when equity has more handsome returns. National savings rate, pffttt!

"So far, the U.S. has been able to absorb the loss of manufacturing through consumer spending (yes by dipping into savings)."

Bruce, do I understand you correctly? Are you saying that in the United States, revenue from manufacturing is declining, and as a result Americans as a group aren't making as much money as they used to?

If I'm reading the Statistical Abstract correctly, neither claim is true. Manufacturing output is rising:

http://www.census.gov/compendia/statab/tables/07s0767.xls

As for total income, this table of various measures of per capita income shows an upward trajectory:

http://www.census.gov/compendia/statab/tables/07s0655.xls

Eric,

My source:

http://www.econbrowser.com/archives/2007/02/wor...>

You know what, Bruce, I am going to anticipate you asking for the link. So, here it is!

http://www.federalreserve.gov/releases/z1/current/z1.pdf

Look on page 110 of this .pdf file. It is Table B.100 and titled Balance Sheet of Households and Nonprofit Orginizations. Read it but don't weep; this is actually very good news...unless of course you insist on being a doom & gloom pesimist who only receives satisfaction when Henny Penney-like predictions come to fruition.

Beware the fear mongers, their goal is not to alert us to danger, but to manipulate us for their own purposes.

Bruce,

Our sources agree, although yours includes more recent data. On a scale of decades (or even any given 10-year period), American manufacturing output is clearly rising. The article you linked to points out that output declined 0.5% in January, and the author worries that a recession is coming. I thought you were worried about something taking place over a larger time scale.

Eric,

Overall manufacturing has done fairly well. The example of Michigan is one where an industry has recently been gutted by competition... as a result of its own inability to recognize competitive trends compounded by practices in both Japan and China that give manufacturers like Toyota certain financial benefits distinct from products and processes.

These dislocations have been fairly well contained when looking at the national picture, but one should consider the possibility of more frequent and widespread problems.

I was trying to point out that there must be more to Chinese and Japanese actions than altruism when it comes to "subsidizing" the U.S. Any downturn of manufacturing aka industrial output is not necessarily a good economic signal for the rest of the economy... especially with inflation hawks like Bernanke circling.

Don,

You are wrong twice. First, you say that the Chinese government must buy up dollars and keep them out of circulation. Second, you say that the Chinese government buys the dollars by taxing their citizens.


Let me explain you how it works. China's state banks have been able to mobilize a huge amount of deposits (and the annual flow still is large). Part of these deposits are invested in US Treasury bonds and other foreign assets (I don't have the data but most likely over 25% of the stock of deposits are invested abroad).


How does this investment in foreign assets take place? The state banks must surrender part of their deposits to the central bank (the People's Bank of China) as reserve requirements. Also the state banks can invest directly abroad (but I'm not quite sure how this is regulated). The People's Bank of China invests the bank reserves abroad and for this it buy dollars but it does not keep them; it uses the dollars to buy bonds. Thus, the Chinese government (the People's Bank of China) intermediates the funds deposited into state banks so the Chinese people can invest part of them abroad. Milton Friedman used to say that there are two way to finance government: taxes and credit. So the Chinese government is borrowing from their people to finance the accumulation of foreign assets. In other words, no tax is used to finance this accumulation.


The relevant issue is whether the Chinese policy of investing abroad part of the huge amount of domestic savings is good or not. I believe it is good because state banks have been lending too much to risky domestic borrowers and the only way to have some liquidity is by investing abroad.

Edgardo,

It's true that simply printing more yuan will decrease the value of the yuan relative to the value of the dollar. (But – a la Robert Mundell – will such inflation really make Chinese exports cheaper for Americans to buy over the long-run?)

It is not true, though, that when the Chinese government borrows from its citizens -- that is, engages in deficit budget financing -- that it does not raise taxes. Those debts must be repaid or repudiated or inflated away -- all of which require the Chinese government, at some point, to forcibly take more resources from its citizens (i.e., tax its citizens).

In my column, I explicitly mention deficit financing as a means of getting the funds required for exchange-rate intervention. I called it there an indirect tax -- a fair and correct description, I believe.

Sorry, Don, but the People's Bank of China is investing the borrowed funds in foreign bonds. They are not spending them in bridges to nowhere or in welfare programs. This is a standard financial intermediation transaction and the only way it could get wrong is if foreign debtors failed to pay back. Actually the main problem that the People's Bank of China faces is the repayment of bank loans by domestic borrowers--and this is the liquidity reason for the People's Bank to invest abroad part of the bank deposits.

GIVEN CHINA'S STATE BANKING SYSTEM, most likely the best way to intermediate funds between the Chinese people and foreign borrowers (in particular the US government) is through the People's Bank. They have followed this policy for more than 10 years, and they will have to follow it until either the state banks are reformed or the Chinese people stop investing their savings in the state banks. Let us hope that they are able to reform the state banks well before people start to invest their funds outside the banking system. By the way, I don't have the data, but the stock of deposits in the state banks are well over 100% of GDP, so the Chinese banking system may be the largest one in the world.


In general you can say that government debt amounts to future taxation, but if the funds are tied to financing the accumulation of low-risk financial assets, the debt can be repaid without increasing taxes.

We can probably agree that China ultimately has little respect for its people if it is indeed taxing them in this way (and I am persuaded by you that they are). What is to stop them, then, from hurting them again while at the same time hurting the United States by flooding the world markets with unwanted dollars? And how easy would it be for them, in the court of current world opinion, to pin the blame on America if such an economic catastrophe were to occur?

In my opinion a good way to maintain the relative value is investing in the foreign currency because you can come back it when the foreign currency rates is better.

laura.

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