Joseph Stiglitz: Is Mercantilism Doomed to Fail? And With It the US Dollar?

This is Joe Stiglitz' presentation at the INET conference in Berlin last week. He speaks about mercantilism, and I added the tagline about the dollar.

The one point I wish to make emphatically is that only under a fiat currency trade system can these large deficits and surpluses be created, in the same manner as the debt bubbles, and asset bubbles.

This is not a new idea, of the natural balance that hard currencies present in a global trading system. But it has been forgotten, put aside in recent years. My friend Hugo Salinas-Price has written a nice presentation of those ideas in his essay Gold Standard: Protector and Generator of Jobs.

I have written on the topic many times, most recent in The Great Flaw In Free Trade Theory and other Vain Beliefs, Hoaxes, and Follies.

Under a hard currency or asset system of trade, as one country draws down its stock of gold, for example, its gold-backed currency would automatically become devalued since there would be less gold underpinning it.

Conversely, as a country built up a trade surplus, over time so much gold would flow to that country so that its currency would appreciate relative to the currencies of the debtor nations.

These changes in valuation would tend to 'balance' the trade flows naturally, and unilateral mercantilism would fail long before it threatened the stability of the international monetary system.  That is not to say that exploitative trade might not exist, such as under the British Empire.  These took more of a form of colonialism, a kind of mercantilism among master and vassals.  But any trade imbalances between developed nations with their own currencies could only grow large with great difficulty.

A fiat currency regime allows huge imbalances not only to exist, but to grow to dangerous and unsustainable levels that threaten the very system itself.

Some of today's problems are indeed because the US is acting as the 'deficit of last resort' because it owns the world's reserve currency. This is known as Triffin's dilemma.

My thoughts about Triffin's Dilemma and the international trade structure  that as a businessman I was operating within during the 1990's, especially after Bill Clinton allowed China to obtain free trade status after a large currency devaluation and without a floating currency stipulation, was that ultimately the world would be plunged into a currency war that would likely either lead to a unified financial order, possibly a triumvirate of spheres of influence, or the failure of the dollar and a radical restructuring of the global financial power structure.

So far we seem to be on track.

The Marriage of Mercantilism and Corporatism: When Free Trade Is Not 'Free'

"The consequences of this policy are also stark and simple: in effect, China is taxing imports while subsidizing exports, feeding a huge trade surplus. You may see claims that China’s trade surplus has nothing to do with its currency policy; if so, that would be a first in world economic history. An undervalued currency always promotes trade surpluses, and China is no different." Paul Krugman

And he is exactly right. As regular readers know this matter of Chinese mercantilism and its toleration and acceptance by the West has been a key observation and objection here since 2000. Any economist who does not understand that devaluing and then maintaining an artificially low currency peg with a trading partner distorts the nature of that trade should review their knowledge of algebra.

Sophisticated oligarchs do not need to send real tanks against their people. They can accomplish the same objectives using fraud, debt, and corruption. Control the supply of money and care not who makes the laws. But it helps to have the lawmakers and regulators on the payroll.

It was in 1994 during the Clinton Administration that China was permitted to obtain full trading partner "Most Favored Nation" status, while vaguely promising to float their recently devalued currency some day, and address the human rights issues that were endogenous to their non-democratic, totalitarian government.

"From 1981 to 1993 there were six major devaluations in China. Their amounts ranged from 9.6 percent to 44.9 percent, and the official exchange rate went from 2.8 yuan per U.S. dollar to 5.32 yuan per U.S. dollar. On January 1, 1994, China unified the two-tier exchange rates by devaluing the official rate to the prevailing swap rate of 8.7 yuan per U.S. dollar." Sonia Wong, China's Export Growth

This served Mr. Clinton's constituents in Bentonville quite well, and has some interesting implications for the Chinese campaign contributions scandals. It supported the Rubin doctrine of a 'strong dollar' while facilitating the financialization of the US economy and the continuing decline of the middle class wage earners, under pressure to surrender a standard of living achieved at great cost. "How I Learned to Stop Worrying and Love the Currency Collapse." and China's Mercantilism: Selling Them the Rope

Not to limit this, George W. ratified the arrangement when he took office, and so it has gone on for almost fifteen years now, with China 'taxing imports while subsidizing exports' to the disadvantage of its western trading partners.

I expect certain economists who are serving their Chinese clients to make their case to muddy the waters, since this is what they are paid to do. But the silence of the many in this matter was so striking as to be incredible, almost mind boggling. But given the acquiescence of the many in the face of equally absurd theories such as the impossibility of a national housing bubble or pervasive market fraud in naturally efficient markets, we should not be surprised.

Even now someone as knowledgeable as Mr. Krugman can distinguish the inappropriateness of the Chinese unfair trade practice "in current environment" through currency manipulation with prior periods, as if it was all right back then, but somehow is no longer acceptable because of the current economic slump. How can one argue with a straight face that a currency peg that continues for years is not inherently unfair, and a contributing factor to economic imbalances, given the assumption that it imposes a de facto subsidy for exports and penalty for imports?

This is not a trivial distinction but tied to a generational assault on the US middle class. Class Warfare and the Decline of the West.

Perhaps it is a good time to reconsider the principle of the 'neutrality of money' with respect to exchange rates controls and global trade in a purely fiat reserve currency regime as was done with the 'efficient markets hypothesis.' Currency Manipulation and World Trade: A Caution. China is certainly standing western capitalism on its ear and giving it a spin. But this is not without historical precedent, and was predicted by V.I. Lenin himself. I would enjoy this spectacle perhaps if I were observing it from a distance in time.

In a global trade environment tied to external standards such as gold or silver, such egregious imbalances could not grow so large because the metals would impose a certain market discipline requiring a reconciliation and adjustment before monetary excesses became a potentially systemic catastrophe as pointed out so skillfully by Hugo Salinas-Price in Gold Standard: Protector and Generator of Jobs.

The policy errors of the Greenspan and Bernanke Fed, and the outrageously unrealistic if not romantic and utopian theories promulgated by economists about self-correcting markets make me, to borrow a phrase, want to 'bang my head against a wall.'

NYT
China, Japan, America
By Paul Krugman
September 12, 2010

Last week Japan’s minister of finance declared that he and his colleagues wanted a discussion with China about the latter’s purchases of Japanese bonds, to “examine its intention” — diplomat-speak for “Stop it right now.” The news made me want to bang my head against the wall in frustration.

You see, senior American policy figures have repeatedly balked at doing anything about Chinese currency manipulation, at least in part out of fear that the Chinese would stop buying our bonds. Yet in the current environment, Chinese purchases of our bonds don’t help us — they hurt us. The Japanese understand that. Why don’t we?

Some background: If discussion of Chinese currency policy seems confusing, it’s only because many people don’t want to face up to the stark, simple reality — namely, that China is deliberately keeping its currency artificially weak.

The consequences of this policy are also stark and simple: in effect, China is taxing imports while subsidizing exports, feeding a huge trade surplus. You may see claims that China’s trade surplus has nothing to do with its currency policy; if so, that would be a first in world economic history. An undervalued currency always promotes trade surpluses, and China is no different.

And in a depressed world economy, any country running an artificial trade surplus is depriving other nations of much-needed sales and jobs. Again, anyone who asserts otherwise is claiming that China is somehow exempt from the economic logic that has always applied to everyone else.

So what should we be doing? U.S. officials have tried to reason with their Chinese counterparts, arguing that a stronger currency would be in China’s own interest. They’re right about that: an undervalued currency promotes inflation, erodes the real wages of Chinese workers and squanders Chinese resources. But while currency manipulation is bad for China as a whole, it’s good for politically influential Chinese companies — many of them state-owned. And so the currency manipulation goes on.

Time and again, U.S. officials have announced progress on the currency issue; each time, it turns out that they’ve been had. Back in June, Timothy Geithner, the Treasury secretary, praised China’s announcement that it would move to a more flexible exchange rate. Since then, the renminbi has risen a grand total of 1, that’s right, 1 percent against the dollar — with much of the rise taking place in just the past few days, ahead of planned Congressional hearings on the currency issue. And since the dollar has fallen against other major currencies, China’s artificial cost advantage has actually increased.

Clearly, nothing will happen until or unless the United States shows that it’s willing to do what it normally does when another country subsidizes its exports: impose a temporary tariff that offsets the subsidy. So why has such action never been on the table?

One answer, as I’ve already suggested, is fear of what would happen if the Chinese stopped buying American bonds. But this fear is completely misplaced: in a world awash with excess savings, we don’t need China’s money — especially because the Federal Reserve could and should buy up any bonds the Chinese sell.

It’s true that the dollar would fall if China decided to dump some American holdings. But this would actually help the U.S. economy, making our exports more competitive. Ask the Japanese, who want China to stop buying their bonds because those purchases are driving up the yen. (Cui bono, Mr. Krugman, cui bono? - Jesse)

Aside from unjustified financial fears, there’s a more sinister cause of U.S. passivity: business fear of Chinese retaliation.

Consider a related issue: the clearly illegal subsidies China provides to its clean-energy industry. These subsidies should have led to a formal complaint from American businesses; in fact, the only organization willing to file a complaint was the steelworkers union. Why? As The Times reported, “multinational companies and trade associations in the clean energy business, as in many other industries, have been wary of filing trade cases, fearing Chinese officials’ reputation for retaliating against joint ventures in their country and potentially denying market access to any company that takes sides against China.”

Similar intimidation has surely helped discourage action on the currency front. So this is a good time to remember that what’s good for multinational companies is often bad for America, especially its workers.

So here’s the question: Will U.S. policy makers let themselves be spooked by financial phantoms and bullied by business intimidation? Will they continue to do nothing in the face of policies that benefit Chinese special interests at the expense of both Chinese and American workers? Or will they finally, finally act? Stay tuned

Of Bubbles and Busts: Which Way for China?

"Mischief springs from the power which the monied interest derives from a paper currency which they are able to control, and from the multitude of corporations with exclusive privileges...which are employed for their benefit." Andrew Jackson

While the crowd has been chortling over the anticipated decline and fall of the American Empire, they may also be overlooking the dangerously unstable bubble in China, and the implications for that phenomenon when the global economy shifts again.

There has been little doubt in our minds for a long time that China was in an impressive growth cycle that was fueled by overly cheap money and a spectacular equity bubble. This is why we posted that documentary about the Crash of 1929 yesterday, in commemoration of the 80th anniversary of Black Thursday tomorrow.

The collapse of bubbles will not be in the US alone, and the description and atmosphere as described in that film sounds much more like China today than it does the US.

The reasoning behind this is fairly straightforward.

It may be hard to remember from the current lofty heights of the 'China miracle' but their economy was a train wreck in the latter part of the 20th century. Prior to 1980 the state owned People's Bank controlled all the financial resources of the command driven economy. The government created State Chartered Banks (SCB's) in the 1980's, but their business activities were still driven by state policy initiatives, and they quickly became burdened by bad debts.

A speculative push and some tax breaks for foreign direct investment helped to further distort the economy, which led to a severe domestic slump, with banks burdened by Non-Performing Loans. But it was still a centralized economic regime, with a reminder served by the brutal suppression of the student demonstrations in Tiananmen Square in 1989.

In 1994 China tried to cure the serious problems in their domestic economy by devaluing the yuan from 5 to 8.3 to the US dollar in order to facilitate an export driven recovery. That is a 40% devaluation! All your costs were just marked down 40% relative to the competition.

China was able to make key investments in the 1996 Democratic party campaign, and Bill Clinton championed China's favored nation status in 1998, smoothing the way for China's admission into the World Trade Organization in 2000, while still maintaining a deeply devalued currency that was 'pegged' to the US dollar.

As a general note, a country does not engage in unrestricted trade with another country that maintains a currency peg after a devaluation, unless there is some significant ulterior motive. The rational economic response is to first maintain trade tariffs to control the flow of goods and the de facto subsidies and barriers imposed by an artificially manipulated currency. Whenever anyone says that a currency that is 'pegged' and subject to tight exchange controls is not manipulated, except in highly unusual circumstances such as a gold standard, the people in the room just should laugh them on their way out the door.

Pegging the yuan to the dollar helped to encourage foreign direct investment, and helped to stabilize the artificially low prices that US importers could achieve, most notably the Arkansas based WalMart.

Those are the roots of the China bubble: cheap money. It used to be said that the Japan Miracle was a result of their real estate price explosion, the 'monetization of the land.'

 This is a bit of an oversimplification since was a bubble fueled by government industrial policy known as mercantilism. But using this analogy, China was monetizing the cheap labor of its people, as a means to provide cheap goods to the West, and allow business to erode the wage gains which labor had achieved through the worker's union movements of 1930 to 1970. And if one looks at the progress of the US median wage from 1980 to 2009, it worked. The US middle class is flat on its back.

All that history aside, what is going to happen now with China? It was important to take some time to establish the roots of its current bubble, because people have become wide-eyed and accepting of the miracle. Yes, cheap labor helps, but there are plenty of countries around the world that have cheap labor. It tends to get less cheap when the country develops, and when the domestic economy and education and infrastructure improves, while the government can continue to provide subsidies via tax breaks and cheap currency and subsidized debt from banks that are still controlled by the State.

The trade surpluses that have created China's enormous two trillion dollar reserves are a direct result and indicator of the China bubble formulated by Western banks and a domestic government made increasingly nervous by popular unrest due to their economic blundering. Those surpluses in turn have fueled a monumental asset bubble in China that they must handle with care.

The China miracle is a new paradigm in the same way that the tech bubble introduced a new era of permanent prosperity in the US in 2000, and trading margin created a vibrant US economy in 1929. There are many true believers in this miracle, most notably Jimmy Rogers, but that does not mean it is not simply what it is: a bubble created by monetary and policy manipulation.

China is faced with a period of transition. It must move from a export economy to a more balanced domestic consumption economy. This will raise living standards and education levels, and disposable incomes of its people. If a ruling party is an oligarchy, whatever political label one wishes to attach to it, then they are often jealous and insecure of their power base, and anxious about losing control.

If there is a continuing collapse in trade, and the world economy, the theory of decoupling promoted by analysts like Peter Schiff appears to be exceptionally unlikely, unless China can make the transition to either a regional predatory power or more domestically self sufficient.

China can do this, but it is quite important to remember that they do not have market capitalism at their backs and a history of well regulated banks and markets to help them allocate their new found riches in productive, non-corrupt ways. The China miracle is highly dependent on Western multinationals.

In some dimensions, China is more like the US in 1929 than the US itself resembles that paradigm today. This would imply that China is more likely to experience the kind of devastating crash and long economic Depression if world trade collapses.

As you may recall, the US was a heavy net exporter and an economic miracle itself in the 1920s having largely escaped the economic devastation of the first World War.

Perhaps this is a long way of saying that the outcome for China is hardly pre-determined, but it is not nearly so rosy as the believers in the miracle might think. They will have a choice, but that choice is going to lead them to a crossroads quickly, between becoming a free nation with a burgeoning middle class that is increasingly free to make its own choices, or a military dictatorship that seeks to establish client states to provide raw materials and receive its manufactured goods in return.

We should expect the 'One World Government' crowd to make another play when things get particularly bad. Never waste a crisis. The oligarchies do not particularly care whether your flag is red, yellow, or red, white and blue, as long as they are in control. Early on Bill Gates went to China, and upon his return said, "This is my idea of capitalism." The China Bubble and the Convergence of Oligarchies

So, in summary, there is a great deal of facade around the China miracle that is of recent and somewhat shaky construction than most people realize. The Chinese economy is still highly artificial and centrally controlled, with enormous rot underneath that shiny facade in the form of bad debts, malinvestment and over capacity in some areas with insufficient development in others.

China will continue on, as well as the US. The question is really about how and what they will become, and what investment opportunities and perils they represent to the individual. Will the yuan appreciate if the economy collapses into a nasty deflation, as the deflationary theorists think happens when a currency credit bubble breaks?

Oh, if only life were that simple and linear. The strength of a currency can fluctuate short term in response to temporary contractions and squeezes, as the US dollar had done in reaction to the eurodollar short squeeze caused by the collapse of dollar securitized debt assets and some remarkably bad risk management practices by the large European banks.

At the end of the day, a currency is going to be supported by the underlying value of what it represents, because unless it is specie, that is all it represents. And in many ways this is one of the most quiet, almost hidden reasons for the rush to commodities and the bull market in gold. Investors around the world are running from bubbles and monetary manipulation, and seeking safer harbors in those things that have undeniable value and usefulness, or have stood the test of time as nations and currencies have risen and fallen.

Empires may dwindle, but all bubbles collapse, and sometimes spectacularly.