Currencies After the Crash

by Sara Eisen

  As the old saying goes, however, actions speak louder than words, and Chinese actions and attitudes indicate no interest in opening the country’s currency and financial markets, as is required of an international currency. China runs a mercantilist system that would have made the eighteenth-century French green with envy. It basically imports raw materials and the equipment needed to turn them into manufactured exports. With the retrenchment of U.S. consumers who bought most of those exports directly or indirectly in earlier years, China needs to move toward a domestically driven economy, but it will take many years before consumer spending reaches Western shares of GDP.

  Meanwhile, China runs its economy with little regard for international free-trade norms. Earlier, because of “environmental concerns” (and not, of course, to control world trade), it restricted the production and export of rare earths, which are predominantly mined and refined in China. China also has a stop-go economic policy that is not attractive to foreign investors and currency holders. In reaction to the 2007–2009 global recession and retrenchment of U.S. consumers, it embarked on a massive stimulus largely through bank lending, which surged $1.4 trillion, or 32 percent, over the course of 2009 after having been flat since 2006, while the money supply leaped by 29 percent.

  Quick Results

  A tightly controlled economy can get results quickly, and that’s what happened in China. Unlike the $787 billion U.S. fiscal effort that same year, China’s stimulus faced no arguing in congressional committees, no need to wait for environmental approvals before infrastructure projects could be announced, and no holdups because mortgage lenders didn’t have the staffs to modify mortgages. Then, in response to the inflation and real estate booms that accompanied rapid economic revival, China has slammed on the brakes. The goal is to reduce real GDP growth to about the 8 percent needed to accommodate new job seekers, but I am looking for a hard landing, with growth dropping to 5 to 6 percent, as occurred in the Great Recession (Figure 1-27). That’s a major recession in China.

  Figure 1-27 Chinese GDP

  (Year/Year Percent Change)

  Source: Chinese National Bureau of Statistics

  Effecting a soft landing is extremely difficult, in part because China’s policy tools are extremely crude. The central bank relies on adjusting reserve requirements and placing limits on on- and off-the-books bank lending to implement monetary policy. Since January 2010, it has raised reserve requirements 12 times, from 15.5 percent to 21.5 percent, before reducing them to 21.0 percent in late 2011.

  In contrast, the central bank hiked lending rates only five times, to 6.56 percent from 5.31 percent, in order to accommodate inefficient state enterprise borrowers that employ lots of people. Recall that the Fed hasn’t changed reserve requirements in decades and considers such changes to be crude, caveman tactics. Reserve requirements limit bank lending, since they amount to credit rationing, while higher interest rates still accommodate the most promising investments.

  By my reckoning, in the post–World War II era, the Fed tried 12 times to slow an overheating economy without precipitating a recession. But it succeeded only once, in the mid-1990s; the other 11 times ended in recessions. Can the nonindependent Chinese central bank and the political leaders who really call the monetary shots be more successful with their crude policy tools than the independent, sophisticated Fed?

  Controls and Markets

  Furthermore, implementing any economic policy in an economy that is partly top-down controlled and partly free-market driven is tough. In a completely controlled economy, as China’s used to be, the leaders may make economically inefficient decisions, but their authority is not disputed—that is, by those who want to stay out of jail and continue to live. In an open economy, as in Singapore, the markets make the decisions, for better or for worse, and politicians aren’t involved. But in a partly open, partly market-driven economy, as is currently the case in China, government leaders making major decisions have to guess at market responses and unintended consequences.

  With a “managed floating exchange rate,” for example, they have to estimate how much hot money, the flood of speculative capital from around the world, will enter China in anticipation of a stronger currency, and then figure out how to neutralize any undesired consequences. Capital control makes it hard to bring hot money into China, but speculators have used regulatory loopholes to circumvent the rules. The weak yuan, protectionism, and other policies that encourage exports and trade surpluses have pushed China’s foreign currency reserves to $3.18 trillion in December 2011, up $334 billion from a year earlier. Until recently, all the foreign currency earnings of Chinese exporters had to be traded in for yuan, but then the central bank was forced to issue securities to sop up those funds that otherwise would have mushroomed the money supply. This magnified the central bank’s challenge in curtailing credit growth in order to fight inflation and real estate speculation.

  A hard landing in China, defined as a sharp and swift drop in economic growth, will no doubt precipitate another massive stimulus program, and the government is already taking preliminary steps in that direction. The leaders of the Mao Dynasty, as we’ve dubbed it, want to keep their jobs by holding down unemployment. Still, they are unlikely to react to a softening economy fast enough to prevent a hard landing and the resulting collapse in the underpinnings of the global commodities bubble.

  No Decoupling

  It’s also hard to envision a global currency for a country that depends on exports for economic growth. That makes China and other export-driven developing countries dependent on developed lands, especially the United States. They are not yet industrialized enough to have the vast middle classes that are needed to create economies that are led by domestic spending, as discussed earlier.

  The Yen

  International investors have certainly favored the yen over the last two decades—despite the collapse in Japanese stocks and land prices (Figures 1-28 and Figure 1-29) after the 1980s bubble economy burst. And, this has happened despite the sluggish economic growth and deflation since then, even in the face of huge government deficit spending that has exploded debt (Figure 1-30) and aggressive monetary policy. And, it has happened despite Japan’s very low fertility rate (Figure 1-23) and falling population, and despite the perennially low Japanese interest rates.

  Figure 1-28 Nikkei 225 Index

  Source: Yahoo! Finance

  Figure 1-29 Japanese Urban Land Prices

  (Six-City Average; 1Q 2000 5 100)

  Source: Japan Real Estate Research Institute

  Figure 1-30 Debt as a Percent of GDP, 2010

  (OECD Gross, OECD Net, IMF Gross. IMF Net)

  Sources: Organisation for Economic Co-operation and Development and International Monetary Fund

  Apparently, investors like the stability of virtually no-growth Japan in a sea of global turmoil. In any event, I argued in my recent book The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation (Hoboken, NJ: John Wiley & Sons, 2010), that Japan’s Achilles’ heel is its reliance on domestic funds to finance its ongoing huge government deficits. In the 1980s, the funds needed for this came from high household saving (Figure 1-31), but that source has faded as the rapidly aging population draws on its savings in retirement, as the stagnant economy reduces the ability to save, as the costs of old-age pensions and public long-term-care insurance increase, and as Japanese consumers progressively favor the good life now, with less concern for the future.

  Figure 1-31 Japanese Saving Rate

  Source: Organisation for Economic Co-operation and Development

  I also noted in that book that in recent years, business saving has replaced household saving in funding government deficits, as cash flow exceeds business investment. But that cash flow depends on exports in export-led Japan (Figure 1-32). So as U.S. consumers continue to retrench and negatively affect Japanese exports, corporate cash flow will fall and the current account balance will go negative (Figure 1-33). That will s
hift Japan from being a capital exporter to being a capital importer, pushing up bond yields (Figure 1-34) and government interest costs substantially. Not a happy prospect.

  So the yen is an unlikely candidate to be a primary global currency, in part because of Japan’s dependence on exports for economic growth. Furthermore, the Japanese, although not controlling their currency the way the Chinese do, don’t favor a global reserve currency role for the yen. Exports are essential for growth, but even then, they are a relatively small part of the economy, on a par with the United States with its huge domestic economy at 12 to 15 percent of GDP. Otherwise, the Japanese remain inward-looking and suspicious of foreigners.

  Figure 1-32 Japanese Real GDP and Exports

  (Year/Year Percent Change)

  Source: Japanese Cabinet Office

  Figure 1-33 Japanese Current Account and Trade Balance

  (100 million yen; seasonally adjusted)

  Source: Japanese Ministry of Finance

  Figure 1-34 10-Year Japanese Government Bond Yields

  Source: European Central Bank

  The Euro

  Europe in general and the eurozone in particular have considerable problems that preclude the euro’s becoming a major global currency any time soon, as discussed earlier. That is also probably true in the longer run as well, even though the eurozone economy is 83.5 percent as big as the U.S. economy and the population is larger. Recall that the eurozone contains very different economies, and the reason they’re together under one currency is the culmination of the German and French resolve after World War II to integrate Europe’s economy to reduce the risk of warfare, not because of similar cultures and economies.

  The United States was fortunate to have been largely settled after the advent of the railroad. This plus Lincoln’s decision to preserve the Union at all costs has given us a huge country with a basically uniform culture, one fiscal policy, and an economy so large that most businesses can achieve their full economies of scale within U.S. borders, even with today’s gigantic productive potentials.

  Europe, in contrast, was settled when people moved on foot or on horseback. That’s heaven for American tourists. We can travel 100 miles in Europe and enjoy an entirely different culture. But it’s hell for modern European businesses and for coordinated fiscal policy. And while the first decade under the common euro appears to have exacerbated the inconsistencies, global growth hid myriad eurozone problems. Indeed, in retrospect, the structure of the eurozone encouraged the divergences and imbalances that came to light when the eurozone crisis commenced in 2010.

  With the huge differences in work ethics and labor structures, unit labor costs in Germany have risen 6 percent since the euro’s advent, but labor costs have jumped 25 percent in France, 33 percent in Italy, 34 percent in Ireland, 36 percent in Spain, and 41 percent in Greece. Thus, Germany has been an export powerhouse while the Club Med set imported. These gulfs became especially stark as China wiped out low-tech manufacturing in Spain and Portugal, while Germany sold China the high-precision equipment used to produce those low-tech exports.

  No Devaluations

  If they had had their own currencies, the weak economies would have devalued—numerous times, no doubt—in the last 13 years to redress these imbalances. But with the common currency, they couldn’t. Cutting wages is just too painful politically, although Ireland has done so, but only in reaction to its financial and economic near collapse. Ireland is grouped with the southern economies, but maybe there’s something to be said for its northern location!

  In any event, the easier way out was to borrow, and the low euro interest rates inspired by the eurozone kingpin, Germany, made borrowing very attractive for the Club Med lands. In the 2000s, low euro interest rates, combined with high inflation in Spain, yielded negative real rates, which propelled excessive borrowing and a Spanish housing boom. Furthermore, lax lending rules allowed banks in Ireland, Spain, Germany, and France to load up on risky domestic mortgages as well as Greek and Portuguese government debt. That certainly encouraged Club Med profligacy. Greece, Portugal, and Spain also benefited from getting more from the EU budget than they contributed to it.

  For a common currency to work without fiscal integration, the business cycles of the countries involved need to be roughly in sync, workers need to be able to move freely and easily across borders to even out labor imbalances, and wages and prices need to be flexible. If these conditions aren’t fully met, mechanisms must be available to redress the imbalances by the transfer of resources. These conditions are far from being met in the eurozone.

  Forget the Rules

  The fiscal rules of the EU Stability and Growth Pact that were supposed to keep economies and finances in line—government deficits limited to 3 percent of GDP and debt-to-GDP ratios of no more than 40 percent—have been ignored. Wage and price flexibility within the eurozone is limited, and migration is largely a myth, since language barriers and vast cultural differences impede labor mobility. Sicilians seldom move out of their own villages and don’t speak German or like bratwurst. Therefore, they are highly unlikely to transfer to work in Germany, even though employees are allowed to move freely throughout the 27-country EU. Furthermore, the Germans and other Europeans are distinctly negative on immigration. Germany’s immigration rules are very strict, despite its declining population and future need for skilled workers. Since 2008, more non-Europeans have been leaving Germany than have been entering it.

  In October 2010, Chancellor Merkel said that multiculturalism in Germany had been a “total failure,” adding, “for a while, we kidded ourselves into believing that they wouldn’t stay and would leave. Naturally, the notion that we would live next to another and be happy about one another failed.”

  Emphasis on regulation rather than free markets in Europe also stifles the labor-market reforms needed to improve competitiveness. The costs of labor remain so high that many people go unhired even in boom times, and government costs for the unemployed continue to drag on those economies. Labor productivity growth rates in Europe have fallen since 1995, going from 1.5 percent annual rate from 1995–2000 to 1.1 percent per year in 2000–2005 to 0.6 percent annually in 2005–2010. The Germans became so concerned about local businesses moving production abroad that the government eased restrictive labor rules a decade ago, with notable success.

  In the United States, government policy has never put a lot of weight on guaranteeing incomes, but it goes to great lengths to ensure that when consumers spend their money, it will be in free and competitive markets, unencumbered by cartels. Europe has basically taken the reverse approach to the situation. Incomes are supported through curbs on layoffs, maximum workweeks, and large and long-lived unemployment benefits, but cartels in the markets in which consumers buy are relatively unchecked. Germany vigorously restricts discounts and rebates. Clearance sales are limited to several per year. From an economist’s viewpoint, the U.S. system is better and more efficient because it relies on free markets, allows unencumbered consumer choice, and lets prices effectively relay economic preferences to producers.

  Two Choices

  The current eurozone structure has proved to be unfeasible, so two long-run choices remain: allow and encourage weak members to leave the common currency, or move toward much more complete fiscal and even political integration to curb nonstop bailouts of the weaker economies. Departures would create a big mess, as noted earlier.

  Further and substantial fiscal and monetary integration is probably preferable to the demise of the eurozone, but it is also packed with problems. Former ECB president Trichet made a plea for further integration his swan song. Tacitly acknowledging that Europe’s institutional structures have failed, he called for a “new type of confederation of sovereign states.” He wanted a new ministry of finance with powers to override governments that receive aid but don’t live up to their promised reforms. He also wanted a fully integrated European banking system. In March 2011, Trichet told finance ministers that attempts to
tighten sanctions are “insufficient” because they don’t apply to wayward countries automatically and are subject to intervention by politicians. A very Germanic Frenchman!

  The IMF also desires further integration in Europe to avoid financial crises with “major global consequences.” It wants to reduce national sovereignty in the eurozone by having central authorities conduct more stringent surveillance of members’ budgets, have more input into national policies, and issue debt.

  The problem with these proposals is that to many of the smaller and weaker countries, they look like a European takeover by the Teutonic north, especially by Germany. The Greeks, remembering the German occupation in World War II, don’t want to be made into Germans by Germany. And it’s probably true that Germany, perhaps in conjunction with France, would call the shots.

  In 2011, smaller eurozone countries chafed at the plan by Germany and France to impose common economic measures to improve the competitiveness of the weak sisters. The German proposals, backed by France, would have made expansion of the bailout fund conditional on raising retirement ages across the eurozone, eliminating indexing of wages to inflation, harmonizing corporate and other taxes, and instituting limits on deficit financing to fund spending.

  Credibility

  Credibility is on my list of six criteria for a primary global trading and reserve currency. There can’t be major concerns about the country’s devaluing or otherwise debasing its currency. This, of course, is the vulnerable spot for the dollar, which has been falling against other major currencies on a trade-weighted basis since 1985 (Figure 1-14). In that year, major country officials hammered out the Plaza Accord (since they met at the Plaza Hotel in New York City), which called for coordinated efforts to push down what was regarded as an overly robust buck. My recollection is that the dollar was already starting to weaken, and that those officials simply climbed aboard the moving freight train and took credit for getting it rolling.