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Market Overview

‘Chimerica' Has Been a Chimera


There has been a considerable amount of discussion about current account imbalances in light of last weekend's failed G20 summit. For the most part, the meetings focused less on currency levels per se and more on the underlying trade imbalances, in particular the threshold at which both surplus and deficit nations should work to mitigate the extremes implied by deficits/surpluses in excess of 4% of GDP.

Of course one could argue that the focus on current account imbalances, rather than exchange rates per se, was simply a means by which the Americans could discuss China's pegged rate regime in a manner which did not cause Beijing to appear as if it was succumbing to external US pressure and thereby “lose face”. But fundamentally, the US dollar/Chinese yuan exchange rate has long constituted a huge source of financial instability in the global financial architecture. Although today's focus on China tends to highlight its huge and growing bilateral trade surpluses with the U.S. (and to a lesser extent, the Euro bloc), less appreciated is the degree to which its exchange rate policies have historically impacted on its Asian neighbors and continue to do so to this day. As recently as 1994, Beijing precipitously devalued the renminbi against the greenback, taking it from 5 to 8.4, a 60%+ devaluation. Even this action understates the magnitude of the change, since it was preceded by a period during which the country's monetary and financial authorities further devalued the RMB in 1992.

So much for the need for policy incrementalism, as the Chinese persistently respond today when confronted with calls for a substantial yuan revaluation! By the late 1990s, Beijing's earlier policy of “beggar thy neighbor” might have engendered comparatively minimal disruption domestically, but exported the economic dislocation to East Asia and Japan. We saw the full impact of that during the Asian financial crisis of 1997. The cumulative cost advantage these devaluations conferred on China's exporters significantly eroded the trade competitiveness of other East Asian and Japanese exporters, thereby throwing their collective current accounts into substantial deficit by the mid-1990s, and setting the stage for the Asian financial crisis of 1997 and Japan's “lost decade” (and the corresponding implementation in Japan of a zero-interest-rate policy, which ultimately provided the foundation for the so-called “yen carry trade”—another grave source of future financial instability).

Today, we have the spectacle of China angrily castigating the Federal Reserve for the latter's so-called “quantitative easing” policy. Although we have already argued that QE2 per se has minimal impact in terms of affecting the amount of new net dollars in existence (See here), the viscerally hostile Chinese response to the Fed's policy suggests that they see in it echoes of their own policy of the early 1990s (in spite of the fact that the US has a freely floating exchange rate, not a currency peg). They presumably are concerned, then, that the US is trying to “export” its own financial instability; a modern version of former Treasury Secretary John Connolly's idea that the dollar is “our currency, but your problem” (See here).

Most defenders of Beijing justify the country's decision to peg their currency on the grounds that the resultant export boom that it has helped to move the country up the technological curve and thereby enhance living standards. Perhaps, but India has moved up the technological curve (some of the best computer software engineers in the world are based in Bangalore) without adopting a similarly mercantilist policy. In any event that the improvements of living standards are facilitated by rapid export growth, the income gains in China are still heavily skewed toward the exterior regions rather than the interior of the country.

There would have been better ways for China to improve the living standards of its people. It is perfectly understandable why Beijing adopted the Asian mercantilist model, as it worked so well for the nations of Northeast and Southeast Asia, but it makes no sense for a country of 1.5 billion people with a huge domestic market which its manufacturers could potentially supply for decades. India also seems to have improved the living standards of its people, but it has adopted a much more balanced economic model (and correspondingly less trade friction with the US and EU).

Although Beijing no longer explicitly pegs its currency against the greenback, it does so against a basket of currencies, of which the dollar is still the largest component. It therefore remains a pegged rate regime in all but name. These types of currency regimes are generally not the best institutional structure for an economy because they entail a surrender of monetary/fiscal sovereignty and builds in an inherent financial fragility. In the case of China, the fragility has been somewhat masked by the fact that it continues to run trade surpluses but, as noted above, it has effectively “exported” the financial destabilization associated with currency pegs to its trading partners.

So what is the problem with a currency peg? A nation running a currency peg can run external deficits (on the current account) for a time as long as there are sufficient foreign reserves so that the central bank does not need to contract the monetary base (its liabilities). In particular, if investment is targeted at productive ventures building extra export capacity and if the nation has enough foreign reserves then a current account deficit for a time can be beneficial in the longer term.

But persistent current account deficits become particularly problematic for a nation running a currency board. The nation faces the continual drain of its foreign reserves which has two impacts. First, the peg comes under pressure. Second, the central bank has to contract the monetary base (its liabilities) which has a negative impact on aggregate demand. A sharp deterioration in the current account can create a crisis quickly follows because the economy has engineer a sharp domestic contraction (normally, by sharply raising interest rates) to reduce imports but also risks running out of reserves and occasionally has to default on foreign currency debt (either public or private).
While the higher rates may attract foreign capital inflow they are also deflationary. Proponents of this arrangement argue that the deflation starts a process of internal devaluation (wages and prices fall) and increase the competitiveness of the export sector. But it is clear that currency peg arrangements, which eliminate the capacity of the central bank to run discretionary monetary policy, lead to pro-cyclical policy outcomes. So in boom times, with exports strong, the monetary base expands and interest rates fall. So monetary policy reinforces the demand boom.

But if exports fall and thus aggregate demand weakens and/or foreign capital outflow occurs then the monetary base contracts and interest rates rise therefore causing a further contraction. Moreover, when times are bad, the treasury may not be able to fund its current budget position (if in deficit) and so fiscal policy has to contract which worsens the situation.
Clearly, this is not a problem for Beijing today, as it runs a huge current account surplus. But if it were to revalue the currency and retain the peg (rather than let it float), a future major collapse in export growth would be highly problematic because it would engender a loss of capacity to build foreign currency reserves and support local demand.

Needless to say, China's peg has NOT been particularly helpful to the US as a whole either. Revolutionary technological advances have enabled an unprecedented outsourcing by US companies seeking to maximise profits by employment of low cost foreign labour. The scale of this outsourcing is only recently possible because of advances in technology. Simply, and as we all recognize, US workers have been semi-permanently replaced by low cost foreign workers. Prior to these great advances in technology, displacement of the current labour force could only have occurred through immigration of workers into the country.

The ethics debate regarding immigration is similar to that regarding trade. The markets assume that protectionism and a trade war adversely impacts all economies to such a great degree that the politicians will not be so foolish and move toward protectionism and a trade war. I disagree. It is my assessment that protectionism and a trade war hurts greatly the mercantilist economies with their trade surpluses and net creditor positions but not the economies with the trade deficits and net debtor positions. I believe that this is the lesson of the 1930s.

Because of technological advances, today's trade policies are effectively an immigration policy. There are differences to be sure. The US and its municipalities do not benefit from the taxes that would normally accrue to them if the workers were based in the US. Yet, the US government, like in old world real immigration, must provide benefits for the displaced workers. Synthetic immigration leads to capital investment in the immigrant's country (China) resulting in a greater capital stock there and increased competitiveness. This process will continue until the US embraces a much more aggressive fiscal policy to promote employment growth, highly unlikely given the current political configuration in the US or a revolution.

Should policy be constructed with respect to domestic or global welfare? For the most part, it seems as if domestic concerns dominated immigration policy; whereas trade policy, haunted by misconceptions regarding the Smoot-Hawley tariff (which basically gave rise to the idea that all tariffs are bad, more free trade is best). Today, false ideas about great prospects for exporting into the enormous Chinese markets (what I call "the myth of the 2 billion armpits") hinder national policy and enable more employee displacement.

In any case, whether the U.S. recognizes this or not, the political pressures for protectionism in the U.S. are huge. The Obama administration is truly intent on re-industrializing the U.S. through the expansion of exports and the establishment of high tech industries. But, given the massive disparity between net investment in China and emerging Asia overall, on the one hand, and that of the U.S., on the other hand, this is simply a laughable position.

If Obama wants to be a one termer, he can continue to listen to the horrible Wall Street centric approach he's been getting from his current crop of advisors (who are the largest beneficiaries of this perverse symbiotic relationship embodied in "Chimerica"), or he can recognise that it has always been the government's duty to provide for and protect its citizens. Immigration policies differ everywhere and change as the government's responsibility to its citizens is enforced. Obama needs to view trade policy in these terms, if for no other reason than sheer electoral logic.

The Democrats sustained huge losses in the rust belt. These states have been traditionally Democratic. True, some went for Reagan in the 1980s, but Obama got them back in 2008 and thereby won the election. He needs this region. He can forget about the South: there, we have all kinds of constituencies that voted against him. He'll never win over the Christian right, the southern racists, the plutocrats who narrowly vote their pocketbooks, and so forth. Obama needs to win back members of his disaffected base, especially younger voters who didn't show up because they face a hopeless employment situation. But he won't get this group back to the polls in the absence of more focus on jobs; likewise, the independents who will be hard to get back otherwise, because they too are disgusted by the government's cronyism. But even if the President to win back a large number of disaffected independents and the youth vote, he still needs the rust belt. Because of that he has to attack China, the outsourcing of jobs, and focus on Beijing's currency (which he has recently called “undervalued” potentially setting the stage to name China as a “currency manipulator” with the World Trade Organization). If Obama doesn't do this, the Democrats should just wave a white flag in the next election and not waste the money campaigning. This is the US political reality as long as the unemployment rate is above seven percent and Corporate America is nuts about cutting costs by moving to low wage platforms abroad. A trade war, complete with tariffs, could well prove unpalatable, but necessary alternative to a government which appears handcuffed in its inability to deploy fiscal policy properly.

Marshall Auerback has 28 years of experience in the investment management business, and he is a senior fellow at the Roosevelt Institute. He is also an economic consultant to PIMCO, the world's largest bond fund management group. He writes a weekly column for Benzinga every Friday.


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