Saturday, January 10, 2009

Follow the Money

That's the apt title of Brad Sester's column on central banking and macro-monetary policy. Today he is saying what I said yesterday, albeit a lot more eloquently. He steps through each piece in the housing bubble, demonstrating once again how we arrived at the time honored correlation between banking crises and real estate crashes. One key piece that I hadn't clearly fixed on before (though I did understand that pegging your currency is the original "Black Swan" idea -- which and in a beef completely beside the point, I find this Taleb guy to be a bit of a huckster and this black swan term pretty useless and/or abused. Currency pegs end in disaster, even though for a while they inevitably look like they are working wonders. Is that a black swan event just because it doesn't follow a log-normal probablitity distribution. Do we really need to pay a guy a guy a gazillion dollars per lecture to tell us that not everything works like physics? I mean, at least if we're not recovering physicists? And if you take the semantic high road and argue that black swan is not meant to refer to actually pretty predictable (though not log-normal) events like the sub-prime implosion or the sudden cracks that eventually rip open every pegged currency like it were a tectonic house of cards -- that is if you argue that instead it is meant to refer to events we can't predict at all, visionary events so to speak, then exactly how useful is that? I bet if you pay Donald Rumsfeld a gazillion dollars to have lunch he'll be happy to tell you about the unknowns unknowns too.)

... anyway, I hadn't clearly seen another difficulty that the RMB peg created in this situation.

The impact of US policies to restrain domestic demand on global adjustment is complicated by the the fact that the large savings surplus countries peg to the dollar. Suppose the US takes steps that restrain domestic demand growth (tighter regulation of risky lending, tighter fiscal policy, higher policy interest rates). The result would tend to be slower US growth — and less US import demand. Less import demand translates into a smaller current account surplus in the exporting countries. Their income falls a bit, and unless spending or investment falls, their savings would fall too. That is the first effect. But a US slowdown — at least one not induced by a strong rise in US rates — tends to put downward pressure on the dollar. The US imports a lot, but a US slump still has a bigger impact on activity in the US than activity in the world. And a slowdown in the US — especially one that leads to lower rates — tends to put downward pressure on the dollar. If say China (or any other major emerging economy) pegs to the dollar, their currencies go down too — and that tends to push up exports to places like Europe that let their currencies float. That keeps Chinese income and savings up.

And if a weaker dollar leads to higher commodity prices even as the US– still a big commodity importer — slows, that helps support savings in the commodity exporters.

Now we're putting together a lot of pieces in the recent puzzle ... housing, the dollar, commodities ... I wish I could say that this made it easier to see what happens next, but I'm not sure I can claim that. There is a fork just ahead in the road which is primarily political. After the political decision is (at least for a few years) taken or not taken to stick with the dollar system and its imbalances, then we will get some clarity on where we are headed. But the basic decision seems clearer and clearer -- we either try to patch together the system we had and restore the previous imbalances, or we try to move towards something more balanced and sustainable.

  1. Would imply that the current recession will be less horrific than anticipated, that the Fed's reflation will, with China's help, take hold, but that with 2 years we will be back in commodity bubble-landia, with results similar to those we have today.
  2. Would presumably imply a longer slowdown both here and in China as both side attempt to readjust their structural imbalances. The US can't learn to save overnight, and the Chinese can't learn to spend overnight, but I imagine that if we cooperate, we can both readjust over the period of a few years. I assume this would mean a period of subpar growth, but no major macro-economic changes.
  3. Would be 2 without the cooperation. These imbalances can end overnight, either now, or in two years, if everyone runs in the directions of protectionism.
Do you have to be crazy to think we can manage 2?

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