Rumors of the dollar's death: greatly exaggerated

So says Martin Wolf of the Financial Times in his most recent column. Excerpt:

It is the season of dollar panic. These panic-mongers are varied: gold bugs, fiscal hawks and many others agree that the dollar, the dominant currency since the first world war, is on its death bed. Hyperinflationary collapse is in store. Does this make sense? No. All the same, the dollar-based global monetary system is defective. It would be good to start building alternative arrangements.

It's worth reading Wolf's column in full, but he makes a point there similar to one David Merkel made on his Aleph blog¹ recently [Merkel]:

Whatever country of our world has the status of reserve currency must issue debt, and a lot of it, that other countries can invest in to park their idle cash balances.

Wolf sketches out the "Triffin dilemma" this leads to: an overhang of debt that eventually undermines confidence in the reserve currency. Wolf's proposed solution is to look for an alternative to the dollar as a reserve currency, but I wonder if a simpler alternative would make sense in the near-term: instead of having surplus countries buy up U.S. debt to satiate their demand for dollar-based assets, why doesn't the U.S. government offer them an equity-like investment instead? Specifically, why not offer shares in a sort of massive master limited partnership that would invest its assets in nuclear power plants and other infrastructure, and pay dividends out of the revenues generated from those infrastructure assets?

Unlike the proceeds from the sale of Treasuries, which can go to fund transfer payments and health care for retirees, or extended military expeditions, proceeds from the sale of shares in this master limited partnership would go toward increasing productive capacity, which would fuel future economic growth in the U.S. This idea is a similar to (but simpler than) one proposed by Professor Yu Qiao of the School of Public Policy and Management, Tsinghua University, Beijing, in the Financial Times last spring.

¹Speaking of Merkel's blog, last month he asked if any readers had any stock ideas to share. I mentioned three: USEG, AYSI.OB, and DSNY.OB. As of yesterday's close, they were up 26%, 390%, and 60%, respectively.

China's New, Self-Propelled Economy

A few months ago, we mentioned James Kynge's 'China Continental' thesis. In that post, we excerpted an essay Kynge had written in the Financial Times explicating his thesis for China's continuing growth in the wake of declining exports. This was the excerpt we quoted from Kynge's essay:

China is going continental. Just as the US during the 19th century underwent a transition from export-oriented growth to a greater reliance on inner dynamism, so China is looking inwards for the engine to drive its economy.

In China’s case it is still early days, but evidence suggests the conventional view of an export-dependent, river delta-driven economy no longer matches the reality. The argument here is not that trade has somehow become unimportant to China, but rather that the energy generating the world’s fastest economic growth rate this year is increasingly coming from within.

A series of indicators reveals the shift to “China Continental” – the transition of the world’s most populous country into an increasingly self-propelling economic force.

A couple of items that appeared earlier this week in the Financial Times suggest that Kynge's thesis may have been correct. This item from Monday's Lex column, "China's Stimulus" is one, and Martin Wolf's column from Monday's FT, "Wheel of fortune turns as China outdoes west", is another. Here are a couple of brief excerpts from both.

Lex:

There is no precise breakdown of stimulus spending by geography. But $366bn falls under the heading of infrastructure and post-quake recovery; another $113bn under public housing and rural development. Only a small slice – $54bn to stimulate “technological innovation” – seems to explicitly favour developed regions. Output in 12 western provinces grew an average 8 per cent in the first half – a whole percentage point better than 11 provinces in the east.

This structural shift was evident in first-half figures from ICBC, China’s largest commercial lender. Its year-on-year percentage increase in operating income in the Yangtze and Pearl river deltas fell, but rose in central and western regions. In short, China would rather finance roads in Chengdu than sweatshops in Guangdong. Many private, export-led companies in coastal areas, lacking collateral in the form of land or government relationships, are still struggling for funds. Trade data on Friday showed exports and imports falling for the 10th month, year-on-year. Weak external demand is not the only cause; this is an unabashed internalisation of growth.

Martin Wolf:

China has emerged as the most significant winner from the financial and economic crisis. At the end of 2008, many questioned whether China would achieve its growth target of 8 per cent in 2009. Who now dares to do so?

Cushioned by its more than $2,100bn (€1,440bn, £1,260bn) of foreign currency reserves, huge trade and current account surpluses and a robust fiscal position, Beijing has been able to deploy all its levers over the financial system and the economy.

[...]

Three immediate questions arise. How has China responded to the crisis? Is its resurgent growth sustainable? How far will its recovery help the world economy?

The answer to the first question is: astonishingly. According to data reported at the end of last week, industrial output expanded 12.3 per cent in the 12 months to August, up from a 10.8 per cent increase in July. This is the fastest growth for a year.

[...]

Is this growth surge sustainable? In a word, yes. Inevitably, the torrid growth of bank credit and money is spilling over into asset prices, particularly equities. But there is little danger of excessive inflation in an economy with an appreciating currency, fully embedded in a world economy still threatened more by deflation than by inflation, at least in the near term. Moreover, the government is solvent. As premier Wen Jiabao noted in Dalian, "we . . . kept budget deficit and government debt at around 3 per cent and 20 per cent of the GDP respectively". Should bad loans increase, China is well able to recapitalise its financial system.

This is good news, of course, for companies selling raw materials to China, for vendors to those companies (e.g., Alloy Steel International), and, more broadly, for countries such as Australia and Brazil that export significant amounts of raw materials to China.

More on the Inflation Debate: Hussman and Wolf Weigh In

In his market commentary this week, "Anything But Academic", John Hussman weighed in on the debate between Paul Krugman and John Taylor. Dr. Hussman first summarizes Dr. Krugman's thesis:

Krugman's argument boils down to the recognition that "monetary velocity" is currently very low - that is very accurate. The problem is that unless it remains low indefinitely, the more than doubling of the U.S. monetary base over the past year, along with the additional issuance of Treasury debt, leaves a far larger quantity of government liabilities to be absorbed until and unless those liabilities are extinguished by fiscal surpluses. The only way to absorb them without driving up the price level is to hold down velocity indefinitely, or to have an equal expansion in real economic output without any further expansion on the monetary side.

And then summarizes Dr. Taylor's thesis (while parenthetically noting his personal connection to Taylor):

In the other academic corner is John Taylor, an economics professor at Stanford (and more to the point, one of my former dissertation advisors), who wrote in the Financial Times last week “To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling in prices. That 100 percent increase would make nominal GDP twice as high, and thus cut the debt-to-GDP ratio in half, back to 41 from 82 percent. A 100 percent increase in the price level means about 10 percent inflation for 10 years^[1], but that would not be smooth – probably more like the great inflation of the late 1960s and 1970s, with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.”

Dr. Hussman seems to agree with Krugman's benign view of inflation in the short-term (i.e., the next few years) but share Taylor's view of a doubling of the price level within the next 10 years. Hussman also included an entertaining anecdote in his column which I'll quote below.

There's an economists' riddle that goes “Why are the debates in academia so bitter?” – the answer – “Because the stakes are so low.”^[2] Now, very often, that's true. I remember a presentation that Paul Krugman gave at Stanford where he was talking about a model of economic development. Paul drew a diagram on the board, and as he described it, he drew a few little arrows indicating migration of businesses from one area to another. A respected economic theorist at Stanford, Mordecai Kurz (who never drew an arrow without a differential equation), immediately jumped up and shouted “You haven't described the dynamics!!” to which Paul responded that he was indicating a general movement of economic activity toward one place to improve efficiency. Dr. Kurz pounded the table and screamed “Then erase the arrows!! ERASE THE ARROWS!!” and then stormed out of the room and slammed the door behind him. I think that was probably the exact moment that I decided to go into finance.

Martin Wolf also weighed in on this debate in his Financial Times column earlier this week, "Rising government bond rates prove policy works". It's worth reading in its entirety, as is Hussman's commentary, but here are the most salient excerpts:

Is the US (and a number of other high-income countries) on the road to fiscal Armageddon? Are recent jumps in government bond rates proof that investors are worried about fiscal prospects? My answers to these questions are: No and No. This does not mean there is no reason for worry. It is rather that there are powerful arguments against fiscal retrenchment right now and strong reasons for welcoming recent moves in the bond markets.

[...]

People need to believe that the extraordinarily aggressive monetary and fiscal policies of today will be reversed. If they do not believe this, there could well be a big upsurge in inflationary expectations long before the world economy has recovered. If that were to happen, policymakers would be caught in a painful squeeze and the world might indeed end up in 1970s-style stagflation.

The exceptional policies used to deal with extreme circumstances are working. Now, as a result, policymakers are walking a tightrope: on one side are premature withdrawal and a return to deep recession; on the other side are soaring inflationary expectations and stagflation. It is irresponsible to insist either on immediate tightening or on persistently loose policies. Both the US and the UK now risk the latter. But their critics risk making an equal and opposite mistake. The answer is both clear and tricky: choose sharp tightening, but not yet.

The illustration above, by Ingram Pinn, accompanied Martin Wolf's column.

^[1]Here Dr. Hussman, a former options mathematician, repeats the basic math error Dr. Taylor made in his Financial Times column: due to compounding, it wouldn't take 10 years for 10% annual inflation to double the price level; it would only take about 7.3 years. This error was noted by an FT letter writer earlier this week, who in turn made his own mathematical error in his letter, which was corrected by a subsequent letter writer. All of this raises the question of why one of the world's leading business newspapers didn't have a numerate enough editor to catch Taylor's error in the first place.

^[2]Dick Armey, the economics professor and former GOP House Majority Leader once shared this same quote when asked by a reporter if the debates in academia were more civil than those in Congress.

Martin Wolf on Lessons from Japan's "Lost Decade"

The graphic above accompanies Martin Wolf's latest Financial Times column, ("Japan’s lessons for a world of balance-sheet deflation"), and he uses it to make the point that, although the balance sheet deflation in the U.S. is a lot shallower than Japan's, the crisis is a lot broader today because it's global, i.e., Japan was still able to increase its exports (and thus ameliorate its economic situation) during its "lost decade" because there was healthy demand for those exports in countries with strong economies.

Another point Wolf makes is about the relative effectiveness of Japanese fiscal policy during its "lost decade":

[T]hose who argue that the Japanese government’s fiscal expansion failed are, again, mistaken. When the private sector tries to repay debt over many years, a country has three options: let the government do the borrowing; expand net exports; or let the economy collapse in a downward spiral of mass bankruptcy.

Despite a loss in wealth of three times GDP and a shift of 20 per cent of GDP in the financial balance of the corporate sector, from deficits into surpluses, Japan did not suffer a depression. This was a triumph. The explanation was the big fiscal deficits. When, in 1997, the Hashimoto government tried to reduce the fiscal deficits, the economy collapsed and actual fiscal deficits rose.

Something to consider when reading comments on various blogs about how Japan spent a lot of expensive infrastructure and still had a "lost decade".

Another Perspective on, and Proposed Solution to the Financial Crisis

In the Financial Times, Martin Wolf objects to Paulson's proposed solution to the current crisis and offers his own ("Paulson’s plan was not a true solution to the crisis"). The charts above were published along with his column in the FT, and the first two of them illustrate the dramatic growth of leverage in the last few decades among households and in the financial sector.

One of Wolf's objections to the Paulson plan is that a lot of mortgage-backed securities are so difficult to value that the government will invariably overpay for them, thus "guaranteeing big losses for taxpayers and providing an open-ended bail-out to the most irresponsible investors"¹. He prefers an approach centered on recapitalizing the financial institutions:

The simplest way to recapitalise institutions is by forcing them to raise equity and halt dividends. If that did not work, there could be forced conversions of debt into equity. The attraction of debt-equity swaps is that they would create losses for creditors, which are essential for the long-run health of any financial system.

The advantage of these schemes is that they would require not a penny of public money. Their drawback is that they would be disruptive and highly unpopular: banking institutions would have to be valued, whereupon undercapitalised entities would have to adopt one of the ways to improve their capital positions.

If, as seems plausible, a scheme that imposes such pain on the financial sector would be rejected out of hand, the next best alternative would be injection of preference shares by the government into decapitalised institutions, on the lines proposed by Charles Calomiris of Columbia University. This would be a bail-out, but one that constrained the behaviour of beneficiaries, not least on payment of dividends. That would make it far better than dropping benefits on the unworthy, via mass purchases of overpriced toxic paper.

¹A simple way to avoid this, in my opinion, would be for the government to only buy mortgages themselves (at a significant discount to the value of the underlying properties), and not to buy the mortgage backed securities derived from them or the more complex CDOs derived from the mortgage backed securities. Once the prices of the underlying mortgages and real estate were stabilized, one would think the market for the more complex securities would stabilize as well. If not, then the same financial engineers who put those securities together could be tasked by their respective firms with unwinding them. Unfortunately, the bailout as currently proposed wouldn't limit itself to just buying mortgages.