Our Currency, Your Problem

Niall Ferguson writes in the Sunday Times magazine about the twin deficits, and the outlook for the US dollar.  His point - the Asian central banks are not supporting the dollar because of their kind hearts; rather, their support is based on a keen understanding of their long term self-interest:

Why are the Chinese monetary authorities so willing to underwrite American profligacy? Not out of altruism. The principal reason is that if they don't keep on buying dollars and dollar-based securities as fast as the Federal Reserve and the U.S. Treasury can print them, the dollar could slide substantially against the Chinese renminbi, much as it has declined against the euro over the past three years. Knowing the importance of the U.S. market to their export industries, the Chinese authorities dread such a dollar slide. The effect would be to raise the price, and hence reduce the appeal, of Chinese goods to American consumers -- and that includes everything from my snowproof hiking boots to the modem on my desk. A fall in exports would almost certainly translate into job losses in China at a time when millions of migrants from the countryside are pouring into the country's manufacturing sector.

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...Sadly, according to a growing number of eminent economists, this arrangement simply cannot last. The dollar pessimists argue that the Asian central banks are already dangerously overexposed both to the dollar and the U.S. bond market. Sooner or later, they have to get out -- at which point the dollar could plunge relative to Asian currencies by as much as a third or two-fifths, and U.S. interest rates could leap upward.

...Are the pessimists right? The U.S. current account deficit is now within sight of 6 percent of G.D.P., and net external debt stands at around 30 percent. The precipitous economic history of Latin America shows that an external-debt burden in excess of 20 percent of G.D.P. is potentially dangerous.

Yet there is one key difference between the United States and the countries south of the Rio Grande. Latin American economies have trouble with their foreign debts because those debts are denominated in foreign currency. The United States' external liabilities, by contrast, are almost entirely denominated in its own currency.

...Even the gloomiest pessimists accept that a steep dollar depreciation would inflict more suffering on China and other Asian economies than on the United States. John Snow's counterpart in the Nixon administration once told his European counterparts that ''the dollar is our currency, but your problem.'' Snow could say the same to Asians today. If the dollar fell by a third against the renminbi, according to Nouriel Roubini, an economist at New York University, the People's Bank of China could suffer a capital loss equivalent to 10 percent of China's gross domestic product. For that reason alone, the P.B.O.C. has every reason to carry on printing renminbi in order to buy dollars.

Though neither side wants to admit it, today's Sino-American economic relationship has an imperial character. Empires, remember, traditionally collect ''tributes'' from subject peoples. That is how their costs -- in terms of blood and treasure -- can best be justified to the populace back in the imperial capital. Today's ''tribute'' is effectively paid to the American empire by China and other East Asian economies in the form of underpriced exports and low-interest, high-risk loans.

How long can the Chinese go on financing America's twin deficits? The answer may be a lot longer than the dollar pessimists expect. After all, this form of tribute is much less humiliating than those exacted by the last Anglophone empire, which occupied China's best ports and took over the country's customs system (partly in order to flood the country with Indian opium). There was no obvious upside to that arrangement for the Chinese; the growth rate of per capita G.D.P. was probably negative in that era, compared with 8 or 9 percent a year since 1990.

Meanwhile, the United States may be discovering what the British found in their imperial heyday. If you are a truly powerful empire, you can borrow a lot of money at surprisingly reasonable rates. Today's deficits are in fact dwarfed in relative terms by the amounts the British borrowed to finance their Global War on (French) Terror between 1793 and 1815. Yet British long-term rates in that era averaged just 4.77 percent, and the pound's exchange rate was restored to its prewar level within a few years of peace.

It is only when your power wanes -- as the British learned after 1945 -- that owing a fortune in your own currency becomes a real problem. As opposed, that is, to someone else's problem.

Niall Ferguson can't be pegged as an ardent Bush-booster; here is a resume, and and a no-doubt fascinating interview (at which I have only glanced.)

My cocktail party soundbite on the dollar has been this: if the Chinese pull the plug on the dollar, we will have a recession in the US, and a revolution in China.  That is probably not what the current Chinese leadership wants. 

Brad DeLong opined on the end-game for the dollar; I mocked Krugman for his substitution of hand-wringing for analysis about China back in September 2003.

UPDATE:  The Week in Review on China's long term strategy on Taiwan; US reaction to the recent passage by China of the anti-secession law about Taiwan.

Comments

[Dave Schuler]

My cocktail party soundbite on the dollar has been this: if the Chinese pull the plug on the dollar, we will have a recession in the US, and a revolution in China.

That's my take, too, Tom. If the history of China is anything to judge by, the present oligarchs will be willing to go to very great lengths to preserve stability i.e. their own power.

[Warmongering Lunatic]

I'm glad to see other people, who presumably know more about economics than I do (my education coming entirely from buisness magazines) have reached the same conclusion I did.

[blah]

So if the "stability" of the Cold War was propped up by nuclear Mutually Assured Destruction, does this imply that any similar situation with China would be stability propped up by economic M.A.D.? Interesting...

[Forbes]

Ferguson is a funny guy. As a historian, or even as an economic historian, he develops these grand themes, e.g. "Empire" and "Colossus" being two of his recent self-defined book titles, and then proceeds to write essays for various periodicals propounding such themes, thereby promoting the sale of these tomes.

But his historical analyses fails to capture the dynamism of the information age in world trade. International trade of 50, 100, or 200 years ago were settled in all types of manner precisely for the purpose of converting the US currency received, back into the foreign (home) currency (or in gold), and vice versa. These were high cost, and high risk transactions, with very little transparency. (And hence, resulted in low relative levels of trade.)

Today, as in the case of China, they simply skip the currency conversion, and invest the proceeds in US Treasuries, or other securities--in the deepest (low cost) and most liquid (low risk) securities market in the world, with all the attendant price, trade execution, and custody that goes with our transparent (IT-driven) markets. (Making high, and growing, levels of trade possible.)

The flip side of the trade deficit coin is a capital surplus. Were our trade deficit not settled by capital surpluses supplied by foreign creditors, then the process of equilibrium would've found another way. The US dollar moving toward a (lower) exchange level would've been long underway. Such a process would've resulted in higher domestic interest rates (to attract foreign capital), higher import prices (reducing trade with foreign suppliers), and cheaper US export prices--all moving the trade deficit/capital surplus to equilibrium.

By fixing the exchange rate of the renminbi to the dollar, and investing their US trade surplus in US securities, Bejing is using the Federal Reserve, by proxy, to set China's monetary policy, thereby aiding low inflationary growth in both the US and China. China is aided in this policy by an extremely high domestic savings rate (and forbidding foreign investments by its people) thereby filling the Chinese domestic investment gap created by their US trade surplus invested in US securities. (And stocking their central bank balance sheet with securities denominated in the world's principal reserve currency.)

While this arrangement, to some, may appear as a sort of high-wire act, any comparison of the US to the demise of the British Empire in 1945 is fatuous, even as Ferguson hints at it. Certainly compared to the US, Britain's working age male population, along with its fiscal condition, had been fairly devastated in WW I & II. Britain fought for it's existence in WW II, and sacraficed its inperial power in exchage for its life--knowing that it could live as a second fiddle to the US.

In the pecking order of wealth and demographics, the US is both wealthier and younger than Europe and Japan. China's challenge is that they are likely to become old (due to one-child policy) before they become wealthy--defined as able to avoid old age poverty through savings. (Nick Eberstadt at AEI has done some interesting work in this area.) China is racing against time to grow their economy and raise their living standards before the significant burden of a largely old age population stagnates their economy.

Long way around to say that if the music stops, we'll have a recession, and China will have a revolution.

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