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Sunday, April 17, 2005 10:46 AM

Would Floating the Renminbi Solve Anything?

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Political pressure on "forcing" China to float the RMB rose to new highs last week as the US the appears to have stepped aside from its "talk softly approach" under pressure from lawmakers on Capitol Hill who are demanding immediate action and threatening trade sanctions.

Here is an accusation by Debbie Stabenow (D-MI) and 66 other senators who want to send a strong message to China telling them to "Stop Manipulating Their Currency". This article by Business Week says that the Bush administration is blaming China's undervalued currency for contributing to America's record $162 billion trade deficit with China last year and the loss of 3 million U.S. manufacturing jobs since 2000. See The Nonsense on "Free Trade" Continues for more discussion on trade issues.

China does not like public political pressure however and failed to send their top leaders Friday's G7 meeting in retaliation.

Let's take a step back from all the political posturing and take a look at what problems we are attempting to solve: US job losses and the current account deficit. What is interesting is that we have an administration that is bragging about an unemployment rate of 5.2% and "job expansion" while bitching about huge losses of jobs to China because of the RMB peg. OK which is it?

Political and economic pundits also argue that the US current account deficit is a "sign of strength" that foreign countries are "investing" in the US because of our marvelous "growth engine" at the same time the same people are calling this a problem. Once again, which is it?

Here is the latest chart of the trade deficit:

Anyone that believes that chart of the US current account deficit is a sign of strength is a complete fool. The notion is simply preposterous. We were once the worlds biggest creditor. With month after month after month of current account deficits we are now the world's biggest debtor nation. How can that be a sign of strength? Were we not once bragging about being the biggest creditor nation? Were we right then, or now?

Here is the bottom line: The US is living well beyond its means.
We are flooding the world with US$ and in order for other countries to keep their exports flowing to US consumers, countries such as Japan and China have kept massive US reserves and investments not because they wanted to but because they HAD to keep their export business booming because of lack of internal demand.

As we discussed in Searching For Jobs, the unemployment rate of 5.2% is a total an complete distortion of reality. Unless you believe in "contradictory doublespeak" we are not an engine of growth and jobs are a real problem.

Now that the doublespeak contradictions have been eliminated we are left with two real problems to discuss: jobs and the current account deficit.

Last year, Japan's current account surplus was $159 billion and the euro zone's was $72 billion. China's current account surplus was a mere $39 billion. Is China really the problem here?

Bert Keidel, an economist at the Carnegie Endowment for International Peace, a Washington-based think-tank, and former US Treasury official, said: "China has a bilateral trade surplus with the US but deficits with much of the rest of the world. It makes no sense to concentrate on the US's bilateral trade deficit with China. China is often only the last stop for a complicated Asian supply chain, in which China imports intermediate goods and puts together the final products. The right way to look at this is who has the big trade surpluses in the world, and it is Europe and Japan."

According to theory, a sinking US$ would cure the trade deficit but as you can see in the chart above it has not. Since that theory failed to produce any results, the mindless pundits have modified that theory slightly. The latest misguided theory goes something like this: "The Euro has born the brunt of the falling US$ and that what we REALLY need is for the RMB to float and for Japan to 'stop interfering' with a de-facto peg as well". While it is true that the EURO has born the brunt of the falling US$, will floating the RMB cure anything? First let's consider jobs:

At 20-1 or 30-1 wage differentials between China and the US, floating the RMB most assuredly is NOT going to do a damn thing about solving the loss of jobs unless one believes that the US$ would fall far enough to allow all of the factories moved to China to relocate back to the US. With manufacturing wages in China at $1 per hour or less it is absurd to believe we can bring those jobs back. Sorry folks, it's not going to happen.

Please note that we essentially used China to help cure a huge debt problem looming over US corporations like the Sword of Damocles. Outsourcing of jobs to India and China along with an easy supply of credit to any consumer that could breathe helped restore the balance sheets of many US corporations. US corporate profits soared and at 1% Fed Fund rates, there was plenty of demand for capital. We flooded the world with US dollars but the only jobs created were housing related or in China or India. We forestalled a severe economic recession, effectively going on a massive and blatant "weak dollar" policy all the while Treasury Secretary Snow was talking lies about our "strong dollar" policy.

Our implicit weak dollar campaign added fuel to the fire and accelerated jobs leaving the US. Notice I said "accelerated" not "caused". We are losing jobs because of global wage arbitrage in conjunction with a worldwide glut of cheap labor. The weak dollar policy of the FED merely accelerated that primary trend, it did not cause it. Nothing can stop that trend other than exhaustion. It will continue until it has played out. The primary trend can be accelerated or temporarily slowed; it can not be stopped or reversed.

Let's move on to the problem of the current account deficit. The problem is simple: The US is living beyond its means, consuming too much of the world's savings at a rate that is simply unsustainable. The savings rate in the US now is less that 1%. Since some of the wealthy are indeed saving large amounts of money, the average Joe is really going to town loading up on debt.

Currently it takes $2 billion dollars a day of foreign capital (loans) to support our appetite for "stuff" manufactured in other countries. In return for temporarily bailing out US corporations with our implicit "weak dollar policy" we paid an enormous price. We are now in the midst of a mind boggling US housing bubble as well as a horrendous consumer debt bubble. Effectively we traded one problem for an even bigger one now looming over our heads.

Since there has been no job growth and no wage growth, this consumption binge was only possible because of rising home prices. Consumers have literally been treating their houses as ATM's with cash out refis to support consumption. The administration is finally starting to get more than a little worried about the sustainability of this "grand reflation experiment" now that current account balance that just hit a new high of $61 billion in spite of "the falling dollar" that was "supposed" to be the cure. Our experiment has now gone amiss and the "China Boom" which helped restore corporate balance sheets is now being used as the scapegoat for our loss of jobs and our current account deficit. The real problem all along is that the US government and the US public are both spending beyond their means.

We have laid the case that those problems can not be cured by currency corrections. Unfortunately that is not stopping the "Blame Game", since there is no fewer that eight bills in Congress "demanding action" from China. Senator Evan Bayh (D-Ind.) is threatening to hold up the confirmation of the Bush administration's nominee for trade representative, Rep. Rob Portman (R-Ohio), unless the Senate considers his bill aimed at stemming China trade. Another bill would slap 27.5% tariffs unless Beijing stops pegging its currency, the renmimbi, to the dollar. Given the fact that the bulk of our deficit with China comes from US corporations shipping back goods to the U.S. goods made in China by U.S. companies, these bills are pure insanity.

Let's approach this subject from another point of view. Exactly what is it that we make in the US that anyone wants? Cars (take a look at GM and laugh), trucks (take a look at Ford and laugh), SUVs, television sets, clothing, computers, oil, anything? OK we are the world’s biggest manufacturer of weapons but then again we refuse to sell to China. No doubt Europe will get that trade. We do make Moss Tents in the US and they are damn good tents too! I have one and recommend them but I hardly expect that the nation of Japan is going to take up camping and start requesting Moss Tents. Grains can be just as easily grown in Brazil as the US and I expect that agricultural products, one of our previous bright spots is about to "take a hit".

If we don't make much of anything here that anyone wants, exactly what is it we expect Europe and Japan to import from the US?

Can Tariffs solve the problem? NO! Tariffs can never solve a problem. For starters we already discussed the 20-1 wage differential that will be impossible to overcome and secondly, it is highly unlikely that would bring back any factories anyway. Imagine goods from China going up 27.5% across the board. Do you thing the average Walmart shopper will be pleased? Will anyone be pleased? Can you say instant recession?

In an article entitled Tough Love Stephen Roach, one of my favorite economists, accurately describes the problem: "In macro terms, trade and current-account deficits are emblematic of an economy that is living beyond its means...... Which takes us to the heart of the problem — America’s consumption binge. Imports don’t come out of thin air. They are a very much a by-product of growth in domestic demand, especially private consumption. And if there is anyone in the US guilty of living beyond his or her means, the American consumer certainly gets the prize. Since 1996, average growth in real consumption (3.9%) has exceeded gains in real disposable personal income (3.4%) by 0.5% per year. Over that period, the income-short consumer has been converted into an asset-dependent spending machine — first drawing sustenance from the equity bubble and more recently from the property bubble. As a result, the income-based personal saving rate has plunged toward zero and households have taken on record debt loads as they extract newfound purchasing power from increasingly over-valued homes."

Unfortunately Roach goes off the deep end as to the solution: "A further decline in the dollar is needed, as is a meaningful increase in real US interest rates. The longer we wait, the more treacherous the endgame."

For starters we have already had a MEANINGFUL rise in interest rates. A rise from 1% to 3.00% (assuming one more hike) is a very meaningful rise. By my math we will have a 200% rise in interest rates. It's not necessarily "how high" as opposed to how high in relation to where we were that adds stress. For that same reason most economists are wrong about gasoline prices. Yes, in real terms gas prices have not risen as much as during earlier oil shocks. However, try explaing that to cash strapped US consumers where every marginal rise in prices matters greatly.

There are huge signs of stress right now in the stock markets, in consumer confidence numbers, in housing (in some areas), in cities like Detroit, and in other places as well. It takes time for rate hikes and oil shocks to work their way through the system and the indications are there right now that these hikes are starting to take their toll. Roach and other economists ignore the affect that rising rates will have on the job market!

I am not purposely trying to be overly critical but it is important to discuss the issues. I also note that he is calling for both a decline in the US$ as well as rising rates. Hmmm. Wouldn't rising rates help stabilize the US dollar? I think so and I think that is why the US$ stopped falling recently. Perhaps I am mistaken but didn't the falling US$ help accelerate the loss of US jobs to China and India? Don't get me wrong. China does need to float the RMB and they will eventually do so. In the meantime blaming the RMB which might be about 5-10% of our problem for the whole shebang is simply nuts. If we focused on the 90% problem I believe China would be happy to tackle the other 10%.

Now that interest rates are back to neutral (yes I really believe that, in fact I think we overshot as a 200% rise is pretty steep medicine) the only other thing we can do would be to rein in government spending and perhaps pass a revenue neutral consumption tax or so. Unfortunately the problem has gone on for so long and the consumer debt bubbles and mal-investment in real estate are so huge the only way out is the tried and true: a massive consumer-led recession.

As a result of cutting rates to 1% we accelerated the outsourcing of jobs to China, we created an overcapacity in nearly everything imaginable, we took the single strongest point of our economy (housing) and put growth that might have taken place over 10 years and accelerated it into two or three years of bubble mania producing the biggest global housing bubble since the bursting of Japan's bubble about 20 years ago. That attempt by the FED to forestall and shorten the normal economic cycle did nothing but sow the seeds for the greatest worldwide economic decline since the great depression.

Where we really need "Tough Love" is from Congress. They are partially to blame for this mess, as is Bush's nonsensical war in Iraq and as is the FED. Instead we have silly threats (bluffs) of 27.5% tariffs against China when the problem is right here staring us in the face.

At this point there is simply no good solution. We really NEED a recession to wipe out the mal-investments in production capacity and to cut US consumer spending. Why is everyone so afraid of saying that it will take a recession to cure these imbalances? We will not need to see mammoth rate hikes from here to bring it on. It has already taken more hikes than I have expected but now the stock market is finally hinting at signs of increasingly severe stress as is the increasingly protectionist rhetoric coming from Congress.

In the meantime, the call to float the RMB is just scapegoat noise.
1) It will not happen until China is damn good and ready
2) It would not solve anything (not now at least)
3) Why does EVERONE (and I mean everyone) assume that the RMB would rocket up and stay up vs. the US$. Can you name one person that believes the RMB would sink vs. the US$ if it was floated? Is this that rare moment when all economists are correct? Has such a moment ever happened before?

As for me, I am skeptical that the RMB would stage a strong rally and stay there. I believe China understands that and that is why they will not float the RMB anytime soon. The Chinese banking system is too fragile right now and their internal market procedures are not yet in place for them to float the RMB. What is it about that assertion that the world outside of China fails to understand? If and when they do float the RMB, it will be because China is ready. When they finally do float the RMB I suggest we will not like the result one bit.

The China "Scapegoat Blame Game" does serve one political purpose. It throws attention outward instead of forcing Congress to focus on the real problems. Is that the intent or are we really that stupid?

Here is the bottom line: Even IF China gives in now (which I seriously doubt) it will not solve a single thing. I suggest Congress and the President level with the American people about what the REAL problems are: US citizens and the US government are living beyond their means. Since that is extremely unlikely to say the least, the problems will contine to get worse until the next recession forces the issue.


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