Brad Setser Has Lots to Say--All of It Interesting

Brad Setser is happy with Martin Wolf:

Brad Setser's Web Log: Martin Wolf makes sense (the Economist does not) : Martin Wolf's FT column makes a number of crucial points:

1. Asia has let undervalued exchange rates (and reserve accumulation) substitute for policies to promote domestic demand. The (growing) backlash in the US toward these policies hardly should be a surprise: "So long as exports remain competitive and trade balances strong, the need to promote domestic demand, thereby reducing the surplus of savings over investment, is diminished. Net exports support demand instead. This is modern mercantilism. The adverse reaction now seen in the US congress is predictable and understandable."
2. Continuing this system is risky: "They [the US deficit and emerging market surpluses] generate growing protectionist pressure in the US; they force the US into monetary and fiscal policies whose consequence is growing indebtedness, both domestic and externally, they are likely to end in a brutal correction, and that correction is likely to be more brutal the longer it is delayed."
3. China's scale constrains its ability to continue to rely on exports to substitute for a lack of domestic demand: "A country with a population of 1.3 billion cannot grow at 10% a year and remain as dependent on trade as one with 50m without provoking a backlash from its trading partners."
4. Adjustment ultimately hinges on China's willingness to adopt policies -- exchange rate adjustment, stimulus to domestic demand -- that will reduce its current account surplus significantly: "A world in which emerging market economies not only run vast current account surpluses but also recycle the capital investors want to place in their economies is unprecedented, undesirable and unsustainable." "China, for example, has foreign currency reserves almost as big as annual imports. With current policies, those reserves are likely to continue to grow rapidly for indefinite future. This is not a reasonable pattern of development in the medium term.

The IMF estimates China's 2005 current account surplus [at] $80 billion. That... is low... $120 billion this year (even with oil at $60). That current account surplus combines with net FDI inflows of $70 billion... to generate a basic [financial] balance of close to $200b, or above 10% of China's GDP. To quote Wolf, that "is enormous by any standards."

Brad Setser is unhappy with the Economist:

[It] manage[s] to argue that a country with a large and growing current account surplus even in the face of a massive investment surge is not really undervalued. The Economist article argues that... it makes sense to look at a country's behavioral equilibrium exchange rate... Using work from Stephen "Current account deficits do not matter" Jen, the Economist concludes that yuan is only modestly undervalued. Let's repeat that. The Economist looks at a country with a current account surplus of 6-8% of GDP in the midst of an investment boom, and says its currency is NOT undervalued.

I am not sure what the "behavioral" exchange rate measures in the context of a country whose government is spending more than 10% of its GDP to manage its exchange rate.... We all know that they have fixed their exchange rate to the dollar, and have spent huge sums -- over $150 b in 2003, over $200 b in 2004, and probably over $250 b in 2005 -- to keep that peg....

The other argument made by the Economist is that "internal balance" in China -- keeping China's workers employed -- requires an undervalued exchange rate.... It is hard to dispute the fact that China's undervalued exchange rate is stimulating employment in China's export sector.... Wolf... argues that it is neither politically or economically sustainable for a country as large as China to offset the absence of internal demand with a huge-- at least 5% of GDP and perhaps closer to 8% of GDP this year -- current account surplus. I agree....

[U]nprecedented deficits in one key part of the global economy, and unprecedented reserve accumulation and current account surpluses in another. But you would never know that there was a real problem in the world just from reading the Economist...

Brad Setser is puzzled by the Federal Reserve:

Brad Setser's Web Log: How does the Fed imagine the US current account deficit will adjust?: Greenspan does not think a revaluation of the RMB would have a major impact on the US trade balance. The Fed does not think that reducing the fiscal deficit would generate a major reduction in the current account deficit. Bernanke thinks a smaller fiscal deficit would just produce a bigger housing boom. Empirically, work from the Fed staff -- work summarized by Roger Ferguson in his current account deficit speech -- suggests that changes in private savings and investment offset a rising (or falling) budget deficit, so a $1 fall in the fiscal deficit only reduces the current account deficit by 20 cents.

If you take "Houthakker-Magee" seriously... the Bush Administration's preferred solution... faster growth abroad... won't do much either.... According to Menzie Chinn, one percentage point faster growth abroad increases exports by 1.7-2%.... Given that exports have to grow something like 60% faster than imports to keep the trade deficit from expanding, faster growth abroad only works if accompanied by slower growth in the US. Remember, the world as a whole grew extremely rapidly in 2004 -- and the US current account deficit still expanded significantly.... Plus, wouldn't faster growth abroad just push up oil prices and hte US oil import bill even more?...

My own view? The US deficit is now so large in relation to the US export base that... [no] individual action in isolation [will] have an enormous impact.... Get rid of China's current account surplus of $120b (projected 2005) through increased US exports to China and the US current account deficit would fall from an enormous $820b (projected 2005) to an only slightly less enormous $700b. The only thing guaranteed to bring about a big adjustment fast is just what no one wants. A hard landing.

Bringing down a 7% of GDP current account deficit (that is where we are heading, fast) and 7% of GDP trade and transfers deficit without a crash will take time, and a bit of everything. Exchange rate adjustment. Steps to stimulate domestic-demand led growth abroad. Fiscal adjustment in the US. Lower oil prices would be a nice bonus. Slower consumption growth in the US.

Exchange rate moves matter. Bringing down the trade deficit won't necessarily be a lot of fun -- living beyond your means usually is nicer than living within your means. But a fair amount of evidence suggests that a weak exchange rate can make the external adjustment process a bit more pleasant...

Comments

[China Hand]

The Chinese economy--not its export sector alone--is growing at 10%. And that's a sign that domestic demand is insufficiently stimulated? Seems to me this is a small obstacle to the "China is to blame for having excessive savings/the savings glut is to blame for the yawning US capital account deficit" meme. Maybe China should be doing more than the OPEC states did in their heyday to inject dollars into productive investment in the internal economy, instead of pouring it into vanity projects and T-bills--but the Chinese seem to be doing a pretty good job as it is.

[Ian Whitchurch]

China Hand,

Productive investments like buying Unocal ?

[Steven Rogers]

Is the Chinese economy growing at 10 percent? What is the source for the numbers? The Chinese Government?

[John]

The Chinese economy will overcome ours. At this rate, China will own America in 20 years.

[anne]

There are many many productive investments that have been made by the Chinese. There has been for instance education, and there will be more and more investment here as schooling becomes freer and freer. There is investment in a public health care system, and there are of course limits but public health is impressive. There are utilities and roads and communication systems... China saves and invests and growth is the reward.

[anne]

There is absolutely no reason to believe that China can not continue to develop at a rapid rate, though there will be unevenness, nor reason that we should not be friends as nations. The lives of 1.4 billion Chinese are gradually being transformed in economic promise, and I am assured by every friend from Africa that such promise is a hope and partial model for many many others. What then is so different with Ireland?

[anne]

http://www.nytimes.com/2005/06/29/opinion/29friedman.html

The End of the Rainbow
By THOMAS L. FRIEDMAN

Dublin

Here's something you probably didn't know: Ireland today is the richest country in the European Union after Luxembourg.

Yes, the country that for hundreds of years was best known for emigration, tragic poets, famines, civil wars and leprechauns today has a per capita G.D.P. higher than that of Germany, France and Britain. How Ireland went from the sick man of Europe to the rich man in less than a generation is an amazing story. It tells you a lot about Europe today: all the innovation is happening on the periphery by those countries embracing globalization in their own ways - Ireland, Britain, Scandinavia and Eastern Europe - while those following the French-German social model are suffering high unemployment and low growth.

Ireland's turnaround began in the late 1960's when the government made secondary education free, enabling a lot more working-class kids to get a high school or technical degree. As a result, when Ireland joined the E.U. in 1973, it was able to draw on a much more educated work force.

By the mid-1980's, though, Ireland had reaped the initial benefits of E.U. membership - subsidies to build better infrastructure and a big market to sell into. But it still did not have enough competitive products to sell, because of years of protectionism and fiscal mismanagement. The country was going broke, and most college grads were emigrating.

"We went on a borrowing, spending and taxing spree, and that nearly drove us under," said Deputy Prime Minister Mary Harney. "It was because we nearly went under that we got the courage to change."

And change Ireland did. In a quite unusual development, the government, the main trade unions, farmers and industrialists came together and agreed on a program of fiscal austerity, slashing corporate taxes to 12.5 percent, far below the rest of Europe, moderating wages and prices, and aggressively courting foreign investment. In 1996, Ireland made college education basically free, creating an even more educated work force.

The results have been phenomenal....

[jlcg]

I have the feeling that economists wish a disaster in order to see their theories validated in exactly the same way that fundamentalists want an Armageddon to have their religious beliefs validated.

[anne]

A nice benefit of investment in basic needs and development in China, is that India will continually be challenged to invest similarly. More education and public health investment is essentially for India, as other infrastructure investment needs.

[Jack]

Ireland has played its hand well but the combination of speaking english and having a low corporate tax rate explains an awful lot and much of the gdp is based on bookin transfer pricing profits through the optimum tax domicile. For example Ireland is the European logistics hub for Dell and Apple despite being a long way fro the centre and having a very poor road system. This is not a bad strategy for Ireland but hardly a triumph of strategic investment in human capital and not universalisable. To a large extent it represents an indirect subsidy from the larger European economies. The proximity in the list to famous tax haven Luxemburg is not pure coincidence.

[Paul Alexander]

The June 29 FT has an article about China trying to limit exports in some specific goods (like some speciatly steel products) in order to reduce trade frictions. This is important: the Chinese would rather impose export limits than open up their markets to the kind of trade which would genuinely either reduce the trade deficit or make it harder to complain about the opening up of their markets. (FYI: don't make the mistake that the VAT rebate on exported products is a "subsidy" of exports. There is no way to recoup VAT already paid if the product is not sold in China, so the VAT rebate for exported products simply equalizes costs for producers.) This kind of heavy-handed management of the economy is not going to help keep China's economy growing at close to 10 percent for that many more years. If you think our housing boom is bad, imagine a place where most of the relatively well-off people in the larger cities have at least 2 houses and often several more. If China's economy is so solid and strong, why is the government wasting its time stoking nationalist fears about Japan, Taiwan, and the U.S? Why are internet restrictions getting tighter and tighter? These aren't the actions of a calm and confident government.

[bakho]

Is it a mistake to project current trends ad finitum into the future?

The US currently has net imports of 12 million barrels per day of oil or about 4.3 Billion barrels per year. At $60/b, that is about $260 Billion in imports 1/4 of the accounts deficit. If the US geared up its conservation to cut use by 10 % that could drive the price down to around $30/b and knock off over $140 Billion in trade deficit. Note: This is larger than the entire account deficit for China. We are paying the price for the oil lobby getting their way and blocking conservation efforts.

[Nels Nelson]

China's Ministry of Railways signed a 5 year cooperation agreement with the Burlington Northern Santa Fe Railroad for intermodal rail development. China will spend $242 billion over 15 years to develop an efficient high volume intermodal network to major ports. They plan to build 18 mega-terminals with 7 at seaports and 40 smaller intermodal terminals.

In addition to this, Construction began this month on the Jiangnan Shipyard that will expand its ship building capacity from the current 800,000 deadweight tons a year to 4.5 million by 2010. This is part of a larger plan to make China the world's leading ship builder.

It would appear China plans on increasing its export capabilities.

[Maynard Handley]

"Asia has let undervalued exchange rates (and reserve accumulation) substitute for policies to promote domestic demand. The (growing) backlash in the US toward these policies hardly should be a surprise: "So long as exports remain competitive and trade balances strong, the need to promote domestic demand, thereby reducing the surplus of savings over investment, is diminished. Net exports support demand instead. This is modern mercantilism. The adverse reaction now seen in the US congress is predictable and understandable.""

Was Japan's exchange rate that undervalued in the 80's?
As far as I can tell, ANY country doing well via ANY mechanism that in any way threatens US dominance (or even self-confidence, simply by being different) is going to generate an adverse reaction in congress.

[anne]

There is an interesting question presented. Why are we not at least as concerned with the cost and trade imbalance of energy imports as with the products we import from China? All the Chinese have done is tie their currency to the dollar, which we encouraged in the 1990s. As Alan Greenspan has mentioned, if the Chinese increase the value of Yuan there will be minimal trade impact. As with Japan in the 1980s China is developing rapidly, but Japan was no threat to us nor should China be. China is trying to accomplish in a few decades what took a century and a half in America, and trying to do so with a population of 1.4 billion. Stability and cohesion is of much concern, as has been the case for centuries of Chinese history, but this concern may foster development in an increasingly open China in a way that has eluded country after country.

[kharris]

Anne,

I suspect that, whatever the truth of the matter, Chinese imports are seen as direct substitutes for domestic US production, while energy imports are not. There is probably also an awareness, in the post-Carter US, that our own behavior is the thing that must change in order to reduce energy consumption. We'd rather that the Chinese change their behavior.

It is part of the standard energy market analysis right now to note that China is the fastest growing user of energy (subtext - if China weren't growing so fast, oil wouldn't be a problem). While true, this ignores conservation altogether. Chinese consumption per capita is still well below ours. If we put as much effort into saving energy as China puts into needing energy, we could, as bakho points out, make a big dent in world oil markets.

[T-do]

Paul Alexander says - "The June 29 FT has an article about China trying to limit exports in some specific goods (like some specialty steel products) in order to reduce trade frictions. This is important: the Chinese would rather impose export limits than open up their markets to the kind of trade which would genuinely either reduce the trade deficit or make it harder to complain about the opening up of their markets."

This is an interesting phenomenon, however, I must disagree with your assessment that this policy is "heavy handed" and "stoking nationalist fears about Japan, Taiwan, and the U.S". China is simply protecting itself against retaliatory tariffs/quotas brought on by the US, Japan and others. This is quite common - for example, Japan's car industry has done the same thing in the past. When Japanese cars began to flood the U.S. market in the late 70's/early 80's, Japan imposed voluntary export quotas in order to assuage U.S. trade unions and the U.S. auto industry and avoid the U.S. gov't imposing it's own protectionist policies. From Japan's point of view, it worked great. They have slowly removed these quotas, and now I see as many Hondas, Toyotas, etc. on the road as I do Ford's and GMC's. These policies from the Chinese gov't are perfectly logical, even savvy. They are not simply intended to reduce the trade deficit or to avoid opening up their markets. It's (U.S.) politics, not economics, that is driving these policies.

That said, while China's economy has become quite liberalized over the past 10+ years, it is still quite a backward country socially (from what I understand). I don't think this can continue as it has - something's gonna have to give in China either economically or socially. I don't know which it will be or when, but I have a feeling it'll be big when it does.

[Paul Alexander]

T-do--

you are right that other countries have done these kinds of export limitations as well. My point is that they not only add to the bureaucratic complexity of trade, but actively punish both Chinese and U.S. consumers. Japan didn't have to limit exports--they could have opened up their domestic markets and reduced trade frictions that way (they would still be selling lots of cars here). China's economy over the past twenty years has been a series of spectacularly successful gambles (from their perspective) that expanding trade is a good thing. I would like to see the government recognize that pattern and continue it, rather than seeing them do the same stupid things other countries have done.

I agree with you completely that something is going to have to change in China over the next several years. Anyone who straight lines current economic and social trends in China is going to look mighty foolish in several years.

[bradsetser]

anne -- much as i respect the chairman, i don't share his analysis of the impact of a (significant) change the RMB peg on the trade deficit. After the initial J-curve spike in imports (b/c of higher prices), the bilateral trade deficit would tend to be smaller than it otherwise would have been (right now it is on a $150b heading to $200b heading to $250b trajectory), and i suspect a RMB move would have an impact on the more important US global deficit as well.

One other note. if GDP grows by 10% and consumption grows by 6%, consumption falls as a share of GDP, even if it increases absolutely. consumption recently has been rising as a share of US GDP, and falling as a share of Chinese GDP.

[anne]

KHarris

Agreed, but we simply are not going to manufacture certain products whether we limit severely trade with China or not. There are Africa and Central America and other Asian countries, even our territory Guam, offering significant cost savings to companies. Now, I would like to see a rise in the value of the Yuan of about 20% but this does not solve the trade balance problem we have. Also, I am not sure just how China sets about cutting household saving and do not consider that our issue to push. Of course, I miss many things, how could we not in regard to China, but I respect what is happening economically and culturally and am rather optimistic.

[T-do]

Paul -

Agreed that these Chinese policies are bad for both Chinese and US consumers - I too would like to see minimal trade barriers. But I think it's a mistake to underestimate China's ability to maneuver in the global marketplace and disregard Chinese policies as naive or driven by nationalist fears. The Chinese export tariffs are as much a result of U.S. policies as Chinese. Remember that 1) Mr. Bush already protected the US steel industry once during his administration and 2) certain members of congress (from both parties) have been clamoring to introduce protectionist policies en masse (well, some have anyway).

[Urinated State of America]

"Asia has let undervalued exchange rates (and reserve accumulation) substitute for policies to promote domestic demand. .... The adverse reaction now seen in the US congress is predictable and understandable."

I hate to ask a naive question, but why (aside from the squeaking of industry groups) should we in the US consider this a problem?

If nations like China are delibrately interfering with the market to undervalue their currency, then we're buying their stuff for cheaper than it's really worth, and they're buying our assets at an overvalued rate. What's not to like?

[tom N]

Why not have the dollar streghten istead of the Renumbi sink? ;-)

Two sides of the same coin? Perhaps, but as Setzer points out the magnitude of the deficits is larger than just china.

The policies leading to debt creation are policies that cheapen the dollar for the purpose of greater economic growth, namely using currency supply as a tool for economic stimulus.

The fear of "deflation" was the intial reason asserted for "rolling the printing presses" and perhaps the political element of not wanting to cause a recession has kept the prinitng binge going.

Somehow "conservatives" feel comfortable with the printing press sort of keynesian stimulus, but in doing so with finacial markets lending at rates below the print rate, the "conservatives" I think are risking the soundness of the economic system by promoting indivdual brinksmanship by citizens.

Citizens knowing full well that money in the bank is being halflived away at the rate of the printing press run, while "investments" are reduced to "specualtions" where any field can be entered and investments destroyed by cometitors borrowing money at less that the IRR with conservative amortization, ...citzens know that its either speculate, or use other peoples money and take an agency profit on it as ways to get rich.

Try to find a venture where you can enter it, plan never to sell to a greater fool, and pay investment grade interest including amortizing the capital expense? What industries still operate this way? Proabably only those in china...we're exporting captialism and importing beuarcratic patronage sorts of industry? Certainly overstated but the structure of the argument and its inverstion might shake up some worry among "conservatives'

A truly "conservative" approach would be to allow the money supply to grow at the rate of population growth.

"deflation" , meaning that people could buy more with their same dollar might be the result.

But productivity gains should have us buying more with the same dollar every year.

The "fake-conservatives' are trying to hide that reality because the reality might not fit the game plan that is not "conservative" but more of a class orientated (don't know how to coing the term) desire not to have the same wage somehow buy more? (not really sure why "deflation" would be bad other than it might allow the same dollar of wages to keep buying the same portion of the economy and the same dollar of social security to buy more stuff ).

Deflationary expectations might be a problem for the economy and perhaps some massive stimulus would be needed to ward of innaction, however ruining the currency and the trade system and encouraging private debt seems wierd to call "conservative".

Those Republicans who feel a need to stimulate the domestic economy ought to find a more "conservative" way to stimulate it than weakening the currency...if debt creation is the goal perhaps they could provide below market loans i nmore focused areas like localities building pridges, the 300k per home (GI loans twisted?) loans, loan subsideis for student loans...grants on healtcare research facities at universities who knows which subsidies could seem less predatory on individual industries (bankers could be cut in) rather than just a pell mell borrow for whatever you want below the latent inflation rate we have currently.

[W. Raymond Mills]

If the standard tools for reducing a trade deficit are not working (currency devaluation), shouldn't we: 1) figure out why they are not working? and 2) try something else?

Suggestion: 1)The belief that returns to investment in the U. S. stock market are better in the short run than voting against the dollar is the reason the dollar is not devaluaing continuously as theory requires. 2) The available options that have some chance of success require rejection of free trade theory. The U. S. government must intervene decisively to reduce the U. S. trade deficit. Governmental intervention was acceptable in 1985 but the mechanisms used was esoteric and is no longer available (international agreement to devalue the dollar). Import restictions is the only option available to the U. S. Our problem is to gather international support for some form of import restrictions. But first, we must reach agreement among ourselves on a course of action.