The sparring around RMB is kicking into a high gear, as the US Treasury Department will have to decide whether to label China a currency manipulator and 130 US law makers are pressing for action. Maybe it’s time for me to say something more in this blog.
First of all, let’s take a look at where the problem came from. Among many reasons that caused the current economic crisis, three of them are probably the most important. These are imbalance, imbalance and imbalance.
The first imbalance is created by the Berlin Wall. The Berlin Wall kept a large part of the world resource and almost 3 billion labors out of the global market. After it fell, the capital and technology flew to these places to utilize the resources and labor there. It brings a great improvement of productivity and living stand on both sides of the. This is a long process. I don’t think we have seen half of it yet. It is believed that one of the effects of this process was the decline of American manufacturing as American manufacturing factories being outsourced to Asian countries, but I think it is more a result of the second imbalance, the one created by the fall of Bretton-Woods System.
The fall of Berlin Wall unleashed 3 billion labors in the socialist world. The fall of Bretton-Woods System unleashed money printing machines in the capitalist world. Because US dollar is the sole international reserve currency, Fed effectively had become the defacto central bank of the world. As the process of printing money is also the process of wealth redistribution, America enjoyed an unprecedented level of prosperity since the 80s even though American manufacturing had been in decline since the 70s. The productivity growth of the 90s brought by the information revolution was real, but this productivity growth was largely offset by the rising cost of health care. The dollars kept by foreigners eventually become explicit or implicit debts for America. As a result, the U.S. national debt now exceeds $12 trillion and growing fast; That doesn’t include the state and municipal government debts, which California alone was $500 billion; That also doesn’t include the personal debts either. The mortgages, car loans, student loans, credit card debts may well exceeded $10,000 per person.
The continued capital infusion into a country on this scale and over a long period will inevitably change the capital structure of the country and have many other effects. 1) The American economy became more and more centered around spending these money rather than making stuff. America continued to run a large double trade and current account deficit. The financial engineering or flipping hamburgers replaced the traditional engineering; 2) The asset bubble; 3) Strong expansion of American international corporations, because they can get capital much easier than competitor from other countries. 4) Students began to shun away from the traditional engineering jobs, because their paying expectation is simply not that good enough, at least compared to the amount of work needed. And this of course reduces the quality of math and science education. Why would a kid wants to study math and science if he/she doesn’t want to be a scientist or an engineer. And this in turn exacerbated America’s manufacturing competitive position.
All these effects happened along with the Kondratiev wave or what I called three-generation cycle and their effects emphasize each other. You can blame the greedy bankers or big corporations, but the law makers wouldn’t loosen the fiscal discipline to such a degree 30 or 40 years ago and common consumers wouldn’t borrow so much either. It’s also tempting to blame the decline of American manufacturing on China. Aren’t American factories being packed and shifted offshore to China? Not really. I like to use an analogy that there are two leagues in the manufacturing world now. Team America is playing in the major league. Players in the Major League, like Japan, Germany, South Korea, Taiwan etc, compete with things like technological innovation, brand recognition etc. Team China, on the other hand, is still playing in the Minor League in spite of all the hype. The players in the minor league, like Vietnam, Indonesia, Mexico etc, compete only for one thing, the labor cost. Team America is accusing team China for breaking the rules and they are right. Team China is playing ‘burger thy neighbor’ on other teams, in fact I think it’s more like ‘burger thyself’, but it’s not the reason team America just had a bad season, because you know what, they are not playing in the same league. China keeps an artificially low exchange rate mostly because of inner reasons, which is the third imbalance, the one created by China’s double track system.
It’s a myth that China after 30 years of reform had become a largely capitalist country. No, it’s not true. The Chinese economy is still largely state owned. The state own all the land, natural resources and 80% of the financial resources. The state owned enterprises and banks, even though often public listed now, are still hopelessly inefficient and incompetent. Some of them are making big profits, but that’s mostly because of their monopoly status sanctioned by the state. Most importantly they contribute very little to the employment compared to the private enterprises. The result of this imbalance is the glut of savings in the state owned sector and the financial repression in the private sector. It’s another myth that Chinese are saving too much. The house hold saving rate of China is 20%, which is even lower than India. The overall saving rate of China is nearly 40% and it mostly comes from the state owned enterprises. They saved too much because they don’t have much channel to invest. The private business can’t increase employment because they are starving for capital and can not enter some markets because of the government policy. The common consumers can’t spend because they don’t have much money; they need to save to buy the super expensive houses and they are afraid they might lose their jobs or get sick someday. It’s this deadlock within China that makes export the only option to increase the employment even though it’s doing Chinese economy overall a big disservice.
Sorry for this long diversion. Now back to the topic: Will the RMB appreciation help U.S. to increase employment? Not much, 1% max probably, because even if RMB appreciate 40%, America still has to import from other minor league countries. Will China raise RMB value? No way. Will the law makers in U.S. take actions no matter the Department of Commerce label China a currency manipulator(I think the chance is above 50%) or not? Yes, if not an overall tariff at least tariffs on case by case basis, which is even worse, because things will spin out of control easier that way.
The financial crisis is surely one of the most unfortunate events in a long time, since many people are suffering the financial pain of it. Yet, like they said, even the darkest thing has a bright side. From the pure economics point of view, IMO, if things continue to unravel this way, we might be going to have a once in a century opportunity to put the fundamentals(esp the interest rate) of Keynesianism to test, because it was invented to save a big crisis exactly like this 80 years ago. In fact, I believe it has been proven wrong in the 70s’ by the stagflation, but anyway, let’s make another try.
Traditionally, interest rate is considered the price of capital. Like all other prices, the price of capital is decided by its relative abundance, which is decided by saving rate. What Keynes brought into the picture is the concept of liquidity preference, which is people’s preference to hold money instead of assets like bonds. So the interest rate is not the price of capital but the price of money, which is decided by people’s liquidity preference. From here, Keynes derived conclusions dramatically different from the traditional view. 1) Saving is bad, because it reduces consumption. 2) To encourage investment, you have cut interest rate. This is the theoretical base of central banks cutting interest rate today. It’s dramatically different from the traditional view because the traditional views hold that 1) Saving is good, because it’s the source of all investment; 2) To increase investment, you have to increase interest rate because it will encourage saving.
Which theory is correct? The traditional one, I believe. The capital a society invests can come only from two resources, saving or borrowing. Ultimately, only one resource, because the money one borrows has to come from another one’s saving. Cutting interest rate, in the modern fractional reserve banking system, is just a better covered way of printing money, which is just a better covered way of taxing. Ultimately, it’s just a way of spending the savings of a society, which in turn will hurt investment and consumption.
In fact, even Keynes himself acknowledged that cutting interest rate will cause inflation in the long run, but he argued, ‘In the long run, we are all dead.’ So an important problem is how long is it exactly ‘in the long run’? We already had many examples of countries cutting interest rate to stimulate the economy, but the effects were always obfuscated by many other factors. For example, Japan had a near zero interest rate in the 90s, but they also had a high saving rate and a continued deflation. China also progressively cut interest rate in the last decade, but China also had a high saving rate and high growth rate. That’s why the American economy will be the perfect test of Keynes theory. America now has a zero saving rate, near zero interest rate and a stable CPI. That’s possible only because the continued pouring in of foreign capital mostly in the form of treasury bonds. It means, if the Fed interest rate stays stable, there will be a direct relationship between foreign capital and inflation in the U.S. If the pouring in of foreign capital stops or slow down dramatically for some reasons, the inflation will respond very fast, if not immediately. If that happens, as far as I’m concerned, the Keynes theory won’t be able to explain the phenomenon.
The tricky part is if or when will the foreign capital stop coming to America. That would bring us back to the RMB problem. Since China is the biggest buyer of treasury bonds, all other buyers are speculating what China is going to do. If China stops buying, the demand of U.S. assets will drop. As long as China is running a big trade surplus with America, China will have no other place to put the dollars. Diversification is not much a choice for China. Euro is not much better an option than the dollar. There is simply not another big enough market for all the dollars China hold. Whatever China buys, its price will immediately go off the roof. For short, China is stucked. Another concern is whether the market will lose confidence in America’s ability to compensate the bonds. I actually don’t think that’s a problem because America is functioning more like the Bank of World than a traditional sovereign debtor. It sounds incredible but it’s how the fractional reserve banking works, isn’t it? You know as a fact the bank doesn’t have enough money to pay everybody back, but it doesn’t bother you as long as there is not a bank run. If the bank is managed well enough, they can even make a profit. Even a bank run indeed happened, I’m sure governments and IMF will find a way to bail America out, because America is too big to fail for the world economy. The risk of China dumping dollars is very small too IMO, because if China really tries to do that, Chinese government will find America has much more cards to play in this game. As they said, if I owe someone a thousand dollars, I have a big problem. If I owe someone a million dollars, he has a big problem. America has the upper hand in this game. The real risk comes from if Uncle Sam will overdeal his hand. If the tariffs U.S. put on Chinese products is so high, it effectively reduces import from China. I think that’s when the inflation will start. Fed then will face the most difficult choices, to raise the interest rate or ignore the inflation. I will continue to discuss this in the next blog, because this one is getting way too long.
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