What A Difference a Decade Makes

Last week, I wrote this:

We should also expand the role and capabilities of the IMF, just in case it becomes necessary to bailout a fairly large country (e.g. Great Britain?).

Today, we learn that Japan has agreed to loan $100bn to the IMF, and the Fund is also considering issuing bonds for the first time in its history. This sudden need for extra cash has not arisen because the Fund is short, but because it expects to be dealing with bigger problems in the future than it has in the past:

The IMF isn't in danger of running out of money, said deputy managing director John Lipsky, though the fund has made commitments to lend about $50 billion in recent months to Pakistan, Iceland and a clutch of Eastern European countries, and is talking to others.

But the organization has wanted for months to double its lending ability to about $500 billion from $250 billion, to bolster confidence that it could handle other borrowers amid the crisis.

Asked whether Western European countries, outside tiny Iceland, might turn to the IMF for loans if the crisis worsens, Mr. Lipsky said, "in the current circumstances, the right approach is 'never say never.'" The IMF's executive board is expected to discuss potential new sources of funding next month.

10 years ago, in the wake of the Asian Financial Crisis, Japan tried to establish the Asian Monetary Fund to directly compete with the IMF by providing loans to needy Asian countries with fewer strings attached. The effort was scuttled by the US, but many observers saw that moment as the beginning of the end of IMF relevance. Now, Japan is the one shoring up the IMF so it will have the resources to stabilize more and larger countries (presumably, so those countries will be in a position to buy Japanese export goods). The fact that the IMF is looking for hundreds of billions more funding is a bad sign; it indicates to me that the IMF has updated its beliefs and now thinks it might have to step in and bail out a major economy. In any case, the IMF is making a push for renewed influence, and nobody seems to be stepping in their way.

Once again, it appears that the New Economic Order is gonna look a lot like the Old Economic Order.

UPDATE: Emmanuel pointed out in the comments that this is somewhat old news (from mid-November). I missed it the first time around, and apparently the Wall Street Journal did as well.

Payback Time

Whew! And I thought the World Economic Forum would be boring this year. Instead, in separate appearances today, Russian President Puppetmaster Prime Minister Vladimir Putin and Chinese Premier Wen Jiabao took turns blasting the U.S.'s role in the current economic crisis:

The premiers of Russia and China slammed the U.S. economic system in speeches Wednesday, holding it responsible for the global economic crisis.

Both focused on the role of the U.S. dollar, with China's Premier Wen Jiabao calling for better regulation of major reserve currencies and Russia's Prime Minister Vladimir Putin calling over-reliance on the dollar "dangerous." ...

Mr. Wen's comments came just days after U.S. Treasury Secretary Timothy Geithner accused China of manipulating its currency for economic gain. The Chinese premier gently, but firmly warned that if Washington and Beijing chose confrontation, both would be losers.

It is certainly true that a confrontation between Washington and Beijing would turn ugly very quickly, but I was heretofore unaware that the proximate cause of the economic crisis was lax regulation of the dollar. All this time I thought that the relative strength of the dollar (esp. to the RMB and ruble) led to a structural misalignment that inflated financial markets and led to excessive risk-taking (and that the Chinese were actively complicit in this arrangement). Now I'm being told that the problem is that the dollar hasn't been "regulated" enough, although I'm not sure exactly what that means. Neither Russia nor China want the dollar to slip, and the dollar has held its value or increased against almost all of the world's currencies in recent times. So what are they talking about?

Once again, I think that these sorts of statements, like Mr. Geithner's from the other day, are best read as cheap talk intended for domestic political audiences; Mr. Wen and Mr. Putin both face political pressures at home which will only be exacerbated by the economic crisis. For them, scapegoating the U.S. is an easy and popular way to galvanize support. Of course, the same is true in the U.S., so I don't expect the Obama administration to curtail public denunciations of Chinese policies any time soon.

Meta

For some reason Pravda, the former mouthpiece of the Soviet Union (now nationalist tabloid hack rag), decided to outright steal one of my previous posts, without permission. They were kind enough to give me my own byline, although I sort of wish they hadn't.

I posted a screen shot for proof, as i expect them to pull the actual article down. And if I come down with a nasty case of Polonium-210 poisoning, you'll all know why.

(Credit to Dr. Oatley for finding it.)

The Real Exchange Rate and the Current Account, 1992-2008

I realized this a.m. that I should have titled this post, "The Bigger Picture".

This graph plots the real exchange rate on a trade-weighted basis (right axis) and monthly goods and services balance in current dollars (left axis) from January 1992 to January 2008. One sees little evidence of a relationship between the real exchange rate and the current account adjustment. If anything, the relationship appears perverse. Indeed, the dollar weakened in real terms on a trade weighted basis between 2002 and 2008. Yet, between 2002 and 2007 the current account deficit widened. It's only since early 2007 that the current account has narrowed. I might also point out that the strengthening of the dollar in the 1990s had little impact on the current account, which remained largely stable until 1998. Maybe this is evidence of a very long lag between exchange rate change and the current account adjustment. Or maybe the two just are not tightly connected causally.

A Thousand Words

Left vertical axis: total U.S. exports, seasonally adjusted, in millions USD (source: BEA)
Right vertical axis: value of U.S. dollar vs. a basket of major foreign currencies (source: St. Louis Fed)

Something about Dr. Oatley's analysis below didn't seem right to me. Have a look at the graph above. Obviously, one graph doesn't prove or disprove anything, but a first glance at recent history seems to indicate that U.S. exports and the value of the dollar are negatively correlated. In other words, as the value of the dollar declines, exports rise. Or, in the language of the post below this one, it seems that the demand for U.S. good is sufficiently responsive to price changes -- i.e. demand is sufficiently elastic -- to produce an increase in exports as the value of the dollar decreases.

Now whether a dollar devaluation would lead to a net benefit to the U.S. is an open question, because (as Dr. Oatley pointed out) a weakening dollar also means a decline in relative national income. But with the economy in less than full employment, it seems that a moderate weakening of the dollar could generate some welfare gains by spurring the utilization of presently dormant resources.

Like I said, one graph doesn't prove or disprove anything. But this is one piece of evidence showing that demand for U.S. goods is not strongly inelastic. And if that's the case, then U.S. policymakers are acting rationally to seek a moderate devaluation of the dollar in order to boost employment. Unfortunately, if it's rational for the U.S., it's also rational for other governments, and a series of competitive devaluations will lead to even greater economic ruin.

(This says nothing about the capital inflows -- made necessary by running a current account deficit -- which helped fuel the dot com and subprime bubbles. Perhaps more on that later.)

Canard Pekinois

Update: Link to the IMF WEO fixed.

Emmanuel-across-the-pond and my co-blogger Will have been discussing the dollar-renminbi exchange rate and current account adjustment. They both seem to accept (along with Congress and the Obama administration) that a devaluation of the dollar will correct the current account deficit. I think this conclusion is wrong. Moreover, I think that only political economy analysis can help us understand why the political elite are obsessed with the exchange rate. As we shall see, it has nothing to do with current account adjustment.

Correcting the US current account deficit with a dollar devaluation is like trying to eliminate a deficit in your household budget by cutting your hourly wage. Although it could work, it's a bad idea because it makes you poorer. It is a doubly bad idea because it might not work, either. Let's focus on why an hourly wage cut might eliminate the deficit in your household budget. Then we can think about the conditions that determine whether it will work.

• i. price elasticity of demand for your labor: One might think that cutting your hourly wage would merely reduce your income. Yet, businesses might demand more of your labor at this lower wage so that total hours worked rise more rapidly than your hourly wage falls so that at the end of the (longer) work day you have higher total income. Hence, household earnings (exports) rise by cutting your hourly wage (devaluing).
• ii. price elasticity of your demand for consumption goods: Because everything you buy is now more expensive relative to your hourly wage, you consume less. Moreover, because your demand is highly sensitive to rising prices, the fall in the quantity you demand is greater than the price increase. Hence Quantity times Price yields a smaller total expenditure bill than at the prior real wage. Hence, household expenditures on goods from the outside (imports) fall.

Thus, with the right elasticities, you can balance your household budget by cutting your hourly wage. Your total earnings rise and your total expenditures fall. Yet, if demand by the world for your labor and yours for goods are price inelastic, then cutting your hourly wage just makes you poorer. If your demand for goods is inelastic (maybe you spend all of your income on food, shelter, and health care), you fall deeper into deficit.

Devaluing the dollar therefore makes us poorer. It might eliminate our current account deficit if demand for US imports and exports is highly price elastic. Or if demand is price inelastic, it could push us deeper into deficit. So, the question is, how price elastic is the demand for US imports and exports? The preponderance of evidence suggests that the answer is, "not very." To quote a relevant summary: "...price elasticities tend to be quite small...Thus, an exchange rate depreciation would weaken the trade balance as its negative effect on the terms of trade would outweigh its positive effect on trade volumes" (The IMF WEO linked above, at page 95). Devaluing the dollar will make us poorer and is more likely to worsen than improve the current account position. Devaluing thus seems to be a doubly bad idea.

All of which raises the political economy question: why does Congress want the Obama administration to implement a policy that will make us all poorer? I'll answer this in the next post. Until then, let me say that I think Congress' focus on the exchange rate misleads the public. I'll leave it to individual readers to decide whether the deception is intentional.

Blogging Gets More Cachet

William Easterly, development economist extraordinaire, has started a new blog. Self-recommending of course, but but from the looks of the first post, it's immediately a must-read.

And it's hosted on NYU's web site (complete with disclaimer). To my knowledge, this is the first time a university has hosted a blog. I wonder if he gets funding for it...

Just sayin'.

Financial Crisis' First Casualty?

News agencies are reporting that the Icelandic ruling coalition resigned on Sunday, thus incapacitating the government, "three months after the collapse of the country's currency, stock market and several major banks, and following months of public protests."

Iceland's financial system and currency collapsed in October following a series of bank failures, forcing the International Monetary Fund to intervene.

Iceland sought IMF help after its government was forced to nationalize three banks to head off a complete collapse of its financial system. Trading on the country's stock market was suspended for nearly a week, and inflation jumped to more than 12 percent.

The IMF announced in November it would pump about $827 million into the Icelandic economy immediately, with another $1.3 billion coming in eight installments. Iceland's Nordic neighbors -- the governments of Finland, Norway, Denmark and Sweden -- announced they would lend Iceland another $2.5 billion.

I believe this is the first direct government casualty as a result of the ongoing financial crisis, although one could argue that the American elections in November could also count as a casualty. I won't officially count it, as I think there are too many other reasons to point to that caused the collapse of Republican rule.  

Will mentioned Great Britain as another possible future candidate in an earlier post. Are there any other governments that could fail? Are there any other financial systems that could unravel?

Why Adjust?

Teutonic Knight, a commenter at Seeking Alpha (where some IPE at UNC posts are syndicated) asks a very good question apropos of this post:

What is the real motivation or perceived benefits to the U.S. of asking to Chinese to re-evaluate the Yuan upward? If say the Yuan is up another 15% (not a hugh magnitude in my view to begin with) then the "cheap" Chinese household goods may just rise 10 to 15% in price.

China and the United States have had a trade imbalance for quite a long time. In theory, when one country (the U.S.) imports more goods from a country (China) than it exports to it, the value of the currency of the importing country (the dollar) sinks relative to the value of the currency of the exporting country (the yuan). At least, this is supposed to happen when the value of currencies is allowed to float. If the value of the dollar sinks relative to the yuan, then imports from China to the U.S. become more expensive, while exports from the U.S. to China become less expensive. Therefore, exports from the U.S. should rise while imports from China should fall. The price mechanism prevents countries from running persistent trade deficits that can have adverse long-run effects on employment.

In the real world version of this example, China has subsidized its exports to make them cheaper, and has then used the proceeds from the trade imbalance to buy U.S. Treasuries and other dollar-denominated assets, thus propping up the dollar and making Chinese imports even more attractive to U.S. consumers. For a long time, the U.S. was more than happy to oblige, because this made it possible for us to extend cheap credit to businesses and consumers without generating a lot of inflation. The U.S. was running at or near full employment, so there seemed to be little short-run downside. China was content with this state of affairs because it allowed them to employ millions of its impoverished citizens in labor-intensive exporting industries, thus raising standards of living for the most people in the shortest amount of time.

However, everyone knew that in the long run this trade imbalance was unsustainable. This is why people like Nouriel Roubini have been predicting a currency crisis in the U.S. for several years now: eventually the dollar was going to have to fall. According to Roubini and others, the bigger the trade imbalance became, and the larger the U.S. national debt grew, the more painful the inevitable transition was going to be. A gradual adjustment is always preferable to a sudden shock, so the U.S. has been cajoling the Chinese to let the yuan rise against the dollar in stages. The Chinese have done this, but the U.S. has been concerned that the process is going too slowly. The Chinese have been reticent to move too quickly and forego the employment gains in their exporting sector.

Now that the U.S. is well below full employment, the matter has become more urgent: we need the dollar to decline some in order to boost our exporting industries and spur employment. Despite interest rates close to zero, the dollar has actually gained value against many of the world's currencies since last Fall. Unfortunately, China is facing a slowdown as well, and they want to keep their employment levels from slipping, so they want to keep the yuan from rising much more in the short run.

And that's basically the state of things right now. It appears that we may be at an impasse. Structural adjustment is needed, but the U.S. is hesitant to force that adjustment through tariffs or capital controls, and China is hesitant to let the yuan fall much further.

Of course, this simplistic explanation ignores all other countries besides China and the U.S., and all other currencies besides the yuan and dollar. The full story is much more complicated, as Russia moves to devalue the rouble, France gets concerned about the shocking weakness of the British pound, and the Japanese yen rises against all major currencies, leading to rising unemployment in the Land of the Rising Sun. In a global recession, nearly all countries are incentivized to devalue their currencies in order to boost employment and stave off deflation. But such competitive devaluation can have devastating consequences for the global economy.

What Happens in Davos...

This year's World Economic Forum meetings in Davos, Switzerland will be more somber than in recent years:

Not long ago, at the annual gathering of the World Economic Forum in Davos, Switzerland, Richard Fuld Jr. of Lehman Brothers held forth on the state of the global economy before mesmerized journalists and cowering subordinates while other Wall Street stars mingled after-hours with the likes of Claudia Schiffer, the German supermodel.

As business, government and nonprofit leaders trek up the peak made famous by Thomas Mann's novel, but now better known for the gabfest that begins Tuesday, star power no longer is in.

Politicians, not corporate titans, are poised to be the big draw this year, echoing the broader power shift away from the free market as one government after another tries to prop up its sinking economy.

Google is cutting back on the lavishness of their parties, as is Citigroup. AIG won't be attending at all, and neither will past attendees Brangelina and Bono. Still, it's hard to cry for Davos when "cutting back" means hiring a less expensive helicopter to shuttle you around:

Of course, when it comes to economizing at Davos, everything is relative. At BB Heli, which provides helicopter service to Davos, business is still strong, but more passengers are opting for a single-engine helicopter rather than the faster twin-engine model, said Marcus Baumann, the general manager. So instead of paying 9,800 francs for the 45-minute flight, the cost is cut to 4,900.