Wednesday, October 26, 2011

Making the Impossible, Possible

Recently I attended a conference discussing the Dodd-Frank financial regulation bill and the problem of "Too Big to Fail" (TBTF) banks. Speaking on one of the panels was Mark Zandi, chief economist at Moody's. Before making his remarks, Zandi prefaced that the potential solutions he would offer for fixing the US housing market were not necessarily ideal but held the greatest potential for actually being adopted. This was certainly not the first time I'd heard a speech prefaced in that fashion, but for whatever reason it struck me differently and led to some perplexing questions.

Most people likely agree that our current economic and political environment is not ideal. Incredible amounts of time and effort is being spent across the country by intelligent people, all trying to find answers to the current problems. Although the options considered in these efforts are surely vast, those recommendations made by politicians and pundits alike, typically focus only on those plans deemed politically feasible. Yet in a democracy, feasibility, to some extent, relies on the public's ability to support a decision. I think it's fair to say that most individuals, myself included, have not spent (and simply don't have) the requisite time necessary to be aware of the ideal options for fixing each sector of the economy. If individuals, broadly, are never made aware of these possibilities, then the odds of public support are clearly diminished. But what if these choices were presented candidly as being ideal along side other options that were deemed more feasible. Would this outlay of options generate more or less support for those policies considered feasible? Would the public occasionally show widespread support for an ideal resolution? Would politicians be praised for providing more information or punished for appearing unwilling to fight for the best outcome?

Breaking with tradition is always risky, but I wonder if more transparency might not lead to greater feasibility. My belief is that expanding knowledge will ultimately lead to better decisions and better outcomes. My hope is that politicians will be willing to test these waters more often and be rewarded by voters for taking that risk.

What are different readers' perspectives on this topic and the questions noted above?

Please share your thoughts through comments...

Friday, October 14, 2011

Please Don't Sell Us Your Goods So Cheaply!

As the weak economic recovery continues, a natural response of individuals is to seek out a scapegoat to blame for the problems. One potential scapegoat that has garnered significant attention the past couple years is China. The problem, as stated by many pundits, politicians and economists, is that China has intentionally undervalued its currency. Supposedly this action not only steals jobs from Americans but also impairs our economic growth. Attempting to right these wrongs, Congress is once again proposing to formally label China a currency manipulator and impose import tariffs. Although this proposal has been debated numerous times previously (and failed to pass each time), an unacceptably high unemployment rate heading into a presidential election year has created some urgency for action. Unfortunately the actual effects of currency manipulation have been substantially misrepresented and passing this legislation will almost certainly hurt employment and economic growth.

To better understand the effects of currency manipulation, it’s important to offer a brief comment about currency valuations more generally. Currencies have value for two primary reasons: the ability to purchase goods and to pay taxes. A currency’s value is based on the amount of goods it can purchase. When multiple currencies are involved, an exchange rate provides a measure by which to compare the purchasing power of two different currencies. If exchange rates were left entirely to markets, the values would be primarily affected by changes in the supply of each currency and the supply of goods. In reality, exchange rates are also impacted by interest rates, inflation, and speculation. At a basic level, exchange rates help balance international trade and reduce transaction costs.

Many Americans are currently taking issue with China’s policy of pegging their currency, the renimbi (or yuan), to the US dollar at a below market level. China accomplishes this feat by increasing the supply of their own currency and buying US dollars. Based on these simple actions, it seems obvious that China is manipulating the value of its’ currency. However, if we consider the actions of other governments around the globe, it becomes clear that practically all governments manipulate the supply of their own currency and interest rates. In fact, the US government has been very active in recent years, increasing the supply of dollars and holding interest rates effectively at zero percent. From this standpoint, practically all countries are currency manipulators.

Getting back to China and the policy debate, maintaining an undervalued currency makes one countries’ goods effectively cheaper. The idea behind this policy is to encourage businesses involved in exporting goods and reduce competition from abroad. To date, this policy has been very effective for China in stimulating exports and preventing imports, as displayed by their sizable trade surplus. Delving a bit deeper, a significant portion of China’s exports are manufactured goods. The primary American argument made against China’s currency policy is therefore based on the notion that China is stealing American jobs, specifically within the manufacturing sector.

While I don’t dispute that US manufacturing jobs are most directly hurt by China’s policy, focusing on the lost jobs ignores all other less obvious effects. From the perspective of US consumers, China is intentionally offering products at below market prices. When Americans purchase goods made in China, the cost is therefore less than that expected in a “free” market, hence US consumers are technically saving money. A question not frequently considered is, what happens to the extra dollars Americans save from buying cheap Chinese goods? Apart from a small amount of saving, these funds are largely used in other means of consumption. If some of this demand goes towards American goods or services, than new jobs will be created to counter those lost in manufacturing. Although it is far easier to explain direct job losses in manufacturing, the positive effects on consumption and demand almost certainly outweigh those costs.

A fascinating aspect of tax and trade policy is the ability to achieve similar outcomes through entirely different measures. Using the Senate’s current bill as an example, one of the proposals is to charge an import tax on Chinese goods. This policy increases the price of those goods, reducing the difference between US and Chinese goods. Another way of achieving this result is directly subsidizing American production of those goods currently being imported from China. Under this plan, tax revenue lowers the price of US goods, thereby shrinking the price discrepancy between the two countries. In both cases, most Americans will spend more of their income for the same amount of goods. While these options attack the “problem” from different angles, the economic effects on Americans is basically identical. Despite this fact, my guess is most Americans would oppose a bill explicitly subsidizing a small group of manufacturers using everyone’s tax dollars.

The situations described above reflect a market with only two competing nations, which is certainly not reflective of today’s global economy. In relation to proposed legislation, it’s important to consider how this alters the effects. America remains the global super power in terms of its economic wealth and is still largely unrivaled. Based on wealth and numerous regulations, the cost of living (in dollars) in the US is much higher that most other countries. China, with a much lower cost of living, is primarily competing with other developing nations to sell its exports to Americans. Raising the cost of Chinese imports is therefore much more likely to shift demand to another developing nation than increase domestic demand. Unless import tariffs are applied broadly to all nations (which would be a terrible policy), US manufacturing jobs will remain expensive on the global market.

Another consideration regarding US trade with China concerns the enormous sum of dollars that China receives for all its exports. As mentioned earlier, the value of currency stems from the ability to purchase goods and pay taxes. Clearly China has no use for dollars in paying taxes. Since China pegs their currency to the US dollar, the option of converting dollars into another currency is largely taken off the table. The remaining option, which China uses, involves investing their dollars in US dollar-denominated assets such as Treasuries. Many of the dollars used to purchase Chinese goods actually return to the US in the form of investment and are then spent employing other capital.

Looking beyond the potential impact on US manufacturing jobs, it’s fairly obvious that Americans incur large benefits from China’s currency policy. I think this point becomes even clearer when considering the policy’s effects on the Chinese people. In China, many workers are employed to manufacture goods largely consumed by Americans. The dollars obtained from these exports are then invested in the US. As the US runs large deficits and holds interest rates at zero, China’s dollar-denominated assets are losing value in real terms. Also, due to the currency peg, US monetary policy is effectively imported and currently enhancing inflationary pressures. For many Chinese workers, these policies are effectively suppressing their wages while pushing food and energy prices higher. In effect, China’s currency policy is now causing the real wages of individuals to decline.

Although my economic views favor free trade, I should note that negative consequences stemming from China’s currency policy do exist. By subsidizing their own exports, China has generated an incredibly large trade surplus in total and with the US. This policy increases economic dependence between nations. Partially due to China’s reliance on exports, when global demand falls (especially in the US and Europe), domestic demand is not strong enough to support current production. The result is a surplus of unwanted goods and significant losses on investment. As witnessed during the last recession, a stimulus package, three times the size of that enacted in the US (based on % of GDP), was needed to prevent economic contraction. Systemic risk is certainly increased by China’s trade policy.

In today’s world, policies are frequently established to correct specific problems while ignoring the wide-ranging consequences of those initiatives. Current claims about China stealing American jobs dismisses the massive benefits consumers obtain and overlooks the nature of shifting demand in global trade. During the 1930’s, countries on the gold standard erected tariffs to prevent losing capital to other nations. Global trade fell dramatically, further exacerbating the Great Depression. Creating new barriers to trades, while earning brownie points for some politicians, will only increase our economic struggles and make a sustainable recovery that much more difficult. Hopefully the current debate on China’s currency policy will prove only for show and not be foolishly enacted.

(Note: Don Boudreaux at Cafe Hayek has written a number of great posts on the same theme recently. For anyone interested in further examples of the benefits of China’s currency policy, I strongly suggest reading through his blog posts.)

Sunday, October 9, 2011

Slovakia Party Leader Sets Good Example

Sorry posts have been lacking recently as my schedule has become increasingly busier. In terms of the global economy and markets, not much has changed as politicians continue to talk of solutions but no action has been taken. As the Euro-zone heads toward recession and problems escalate, an initial expansion of the EFSF (much more will be necessary) is being held up by two smaller countries within the EU. The following is an interview of Richard Sulik, a party leader in Slovakia, posted by Zero hedge. Although I had previously been unaware of Mr. Sulik, his comments are particularly noteworthy for being honest about the extent of problems within the economic and political realm. Most notably, Sulik recognizes that too much debt cannot be cured with more debt, politicians should not bailout banks that knowingly made risky bets and countries must be constrained by some rules. If only other politicians were willing to be this honest...

Slovakia On Why It Votes "No" To EFSF Expansion: "The Greatest Threat To The Euro Is The Bailout Fund Itself":

Yesterday we reported that tiny Slovakia's refusal to ratify the expansion of the EFSF 2.0 (even though a 4.0 version will be required this week after the "Dexia-event"), may throw the Eurozone into a tailspin as all 17 countries have to agree to agree to kick the can down the road: even one defector kills the entire Swiss Watch plan. Yet an interview conducted between German Spiegel and Slovakia party head Richard Sulik confirms that tiny does not mean irrelevant, and certainly not stupid. In fact, just the opposite: his words are precisely what the heads ot the bigger and far less credible countries should be saying. Alas they are not. Which is precisely why the euro is doomed.

From Spiegel:

Only two countries, Malta and Slovakia, have yet to ratify the expansion of the euro bailout fund. Its fate may be in the hands of a minor Slovak party headed by Richard Sulik. In an interview, the politician explains why he hopes the fund will fail and what he sees as the only way to save the euro.

SPIEGEL ONLINE: Mr. Sulik, do you want to go down in European Union history as the man who destroyed the euro?

Richard Sulik : No. Where did you get that idea?

SPIEGEL ONLINE: Slovakia has yet to approve the expansion of the euro backstop fund, the European Financial Stability Facility (EFSF), because your Freedom and Solidarity (SaS) party is blocking the reform. If a majority of Slovak parliamentarians don't support the EFSF expansion, it could ultimately mean the end of the common currency.

Sulik: The opposite is actually the case. The greatest threat to the euro is the bailout fund itself.


Sulik: It's an attempt to use fresh debt to solve the debt crisis. That will never work. But, for me, the main issue is protecting the money of Slovak taxpayers. We're supposed to contribute the largest share of the bailout fund measured in terms of economic strength. That's unacceptable.

SPIEGEL ONLINE: That sounds almost nationalist. But, at the same time, you've had what might be considered an ideal European career. When you were 12, you came to Germany and attended school and university here. After the Cold War ended, you returned home to help build up your homeland. Do you care nothing about European solidarity?

Sulik: If we now choose to follow our own path, the solidarity of the others will also crumble. And that would be for the best. Once that happens, we would finally stop with all this debt nonsense. Continuously taking on more debts hurts the euro. Every country has to help itself. That's very easy; one just has to make it happen.

SPIEGEL ONLINE: Slovakia's parliament is scheduled to vote on the bailout fund expansion on Oct. 11. How do you predict the vote will turn out?

Sulik: It's still open. The ruling coalition is composed of four parties. My party will vote "no"; the other three coalition parties intend to say "yes." What the opposition says is decisive.

SPIEGEL ONLINE: The Social Democrats have offered your coalition partners to support the reform in return for new elections. Do you think the coalition is in danger of collapse?

Sulik: I don't see any reason why it would.

SPIEGEL ONLINE: What will you do should the EFSF reform pass despite your opposition?

Sulik: For Slovakia, it would be best not to join the bailout fund. Our membership in the euro zone, after all, was not conditional on us becoming members of strange associations like the EFSF, which damage the currency.

SPIEGEL ONLINE: If the euro only causes problems, why doesn't Slovakia's government just pull the country out of the euro zone?

Sulik: I don't see the euro as the problem. It's a good project. Everyone involved can benefit from it -- but only if they stick to the ground rules. And that's exactly what we're demanding.

SPIEGEL ONLINE: Which ground rules should we be following?

Sulik: We have to observe three points: First, we have to strictly adhere to the existing rules, such as not being liable for others' debts, just as it's spelled out in Article 125 of the Lisbon Treaty. Second, we have to let Greece go bankrupt and have the banks involved in the debt-restructuring. The creditors will have to relinquish 50 to perhaps 70 percent of their claims. So far, the agreements on that have been a joke. Third, we have to be adamant about cost-cutting and manage budgets in a responsible way.

SPIEGEL ONLINE: Many experts fear that a conflagration would break out across Europe should Greece go bankrupt and that the crisis will spill over into other countries, including Portugal, Spain and Italy.

Sulik: Politicians can't allow themselves to be pressured by the financial markets. Just because equity prices fall and the euro loses value against the dollar is no reason for giving in to panic.

SPIEGEL ONLINE: But do you really believe that politicians can calm the financial markets by stubbornly sticking to their principles?

Sulik: Let's just ignore the markets. It's ridiculous how politicians orient themselves based on whether stock prices rise or fall a few percentage points.

SPIEGEL ONLINE: You're not afraid that a Greek insolvency could mark the beginning of the crisis instead of the end?

Sulik: No. There's not going to be a domino effect along the lines of "first Greece, then Portugal and finally Italy." Just because one country goes broke doesn't mean the other ones automatically will.

SPIEGEL ONLINE: Nevertheless, banks could run into significant problems should they be forced to write down billions in sovereign bond holdings.

Sulik: So what? They took on too much risk. That one might go broke as a consequence of bad decisions is just part of the market economy. Of course, states have to protect the savings of their populations. But that's much cheaper than bailing banks out. And that, in turn, is much cheaper than bailing entire states out.

SPIEGEL ONLINE: Does one of your reasons for not wanting to help Greece have to do with the fact that Slovakia itself is one of the poorest countries in the EU?

Sulík: A few years back, we survived an economic crisis. With great effort and tough reforms, we put it behind us. Today, Slovakia has the lowest average salaries in the euro zone. How am I supposed to explain to people that they are going to have to pay a higher value-added tax (VAT) so that Greeks can get pensions three times as high as the ones in Slovakia?

SPIEGEL ONLINE: What can the Greeks learn from the reforms carried out in Slovakia?

Sulik: They have to make cuts in the state apparatus. The Slovaks could also give them a few good ideas about the tax system. We have a flat tax when it comes to income taxes. Our tax system is simple and clear.

SPIEGEL ONLINE: One last time: Do you honestly believe the euro has any future at all?

Sulík: I believe the euro has a future. But only if the rules are followed.

Interview conducted by Maria Marquart