“Soft despotism is a term coined by Alexis de Tocqueville describing the state into which a country overrun by "a network of small complicated rules" might degrade. Soft despotism is different from despotism (also called 'hard despotism') in the sense that it is not obvious to the people."

Monday, October 11, 2010

Pick Your Poison. This is Dangerous Territory.

Currency wars are necessary if all else fails

The overwhelming fact of the global currency system is that America needs a much weaker dollar to bring its economy back into kilter and avoid slow ruin, yet the rest of the world cannot easily handle the consequences of such a wrenching adjustment. There is not enough demand to go around.

Asian investment in plant has run ahead of Western ability to consume. The debt-strapped households of Middle America, or Britain and Spain, can no longer hold up the dysfunctional edifice. Asians must take over, or it will come down on their own heads.

The countries actively intervening in exchange markets to suppress their currencies – China, Japan, Korea, Thailand, even Switzerland, to name a few – are all too often the same ones that have the biggest trade surpluses with the US.They are taking active steps to prevent America extricating itself from the worst unemployment since the Great Depression, now 17.1pc on the latest U6 index and rising again.

Each country is doing so for understandable reasons: Japan to avoid a deflationary crisis, China to hold together a political order that is more fragile than it looks. In both these cases they are trapped because they clung too long to a mercantilist export strategy, failing to wean themselves off American demand when the going was good.

Yet this is an intolerable situation for the US. It should be no surprise that Washington has begun to retaliate in earnest, and not just by passing the Reform for Fair Trade Act in the House (not yet the Senate), clearing the way for punitive tariffs against currency manipulators.

The atomic bomb, of course, is quantitative easing by the Federal Reserve. America has in effect issued an ultimatum to China and G20: either you stop this predatory behaviour and agree to some formula for global rebalancing, or we will deploy QE2 `a l’outrance’ to flood your economies with excess liquidity. We will cause you to overheat and drive up your wage costs. We will impose a de facto currency revaluation by more brutal and disruptive means, and there is little you can do to stop it. Pick your poison.

This is what QE2 means, though Fed officials prefer to talk of their “mandate” of supporting employment. It is nothing like QE1, which was emergency action to halt the economic free-fall of late 2008 and early 2009. This time the Fed is using QE as a long-term tool to manage America’s chronic ailments.

Uber-dovish Fed comments over recent days have been enough to send the dollar crashing to a 15-year low of 82 against the Japanese yen, to below parity against Swiss franc, and back to the EMU pain barrier of $1.40 against the euro.

There was much tut-tutting about currency warfare at the IMF meeting over the weekend. "If one lets this slide into protectionism, we run the risk of the mistakes of the 1930," said World Bank chief Robert Zoellick.

You have to say this kind of thing if you run a Bretton Woods institution, but in real life wars occur because somebody finds the status quo unacceptable, perhaps justifiably so. As Nobel economist Paul Krugman puts it: “people are looking for innocuous ways to deal with this problem, and there aren’t any”.

Devaluation was not the mistake of the 1930s: it was the cure, albeit a bad one. The Gold Standard broke down during the inter-war years because the US and France had structurally undervalued exchange rates (like China/Asia today) and ceased recycling their trade surpluses (like China/Asia today). This caused a deflationary downward spiral for everybody.

Escaping from such a deformed system was a path to recovery. The parallel with modern globalization – though not exact – is obvious. So is the 1930s lesson that currency and trade clashes are asymmetric: they are calamitous for surplus countries, but not always for deficit countries. Britain enjoyed a five-year mini-boom after retreating into an Empire trade bloc in 1932.

Fed chair Ben Bernanke knows his history. In a speech as a junior Fed governor he described Roosevelt’s 40pc devaluation against gold as “an effective weapon” against deflation and slump, adding “1934 was one of the best years of the century for the stock market”.

I suspect that the Bernanke Fed is working with the Treasury to steer the dollar lower, and above all to stop it rising again, since the global dollar index looks poised for a powerful rebound.

There is certainly something odd about the latest Fed rhetoric. New York chief William Dudley said inflation had fallen to “unacceptable” levels. Has it really? The Dallas Fed’s `trimmed-mean’ CPE inflation index has been creeping up over the last three months.

His Chicago colleague Charles Evans has called for “much more accommodation". Why now? Bank credit has stopped contracting. The M2 money supply growth has accelerated sharply to a 7.4pc rate over the last month of published data. The St Louis Fed’s monetary multiplier has edged up at last. By the Fed’s own account, the double-dip scare of the early summer has abated.

I happen to think that the Fed will need to launch QE2 on a big scale as US fiscal tightening bites, the inventory spike fades, and the housing foreclosure crisis gathers pace. But we are not there yet. Fresh QE cannot be justified at this juncture under any normal understanding of central bank policy.

Is the Fed in reality trying to shore up consumption by juicing asset prices, and trying to ensure that the effect boosts jobs at home rather than in China, Germany, or Japan by holding down the dollar?

This is a dangerous moment for the world, and may backfire against the US itself. We are already starting to see the same sort of rush into oil and resources that played such havoc in mid-2008, and may have been a key trigger for the Great Recession. There is a risk that this commodity shock will hit before QE stimulus filters through.

And while the French deny that they are in talks with China over the creation of a new currency regime, I heard French finance minister Christine Lagarde say in person at a meeting in Italy that France would use its G20 presidency to push for an alternative to the dollar. She specifically cited the “Bancor”, the idea floated by Keynes in the 1940s for a commodity currency priced off a basket of metals. The US risks gambling away the “exorbitant privilege” it has enjoyed for two thirds of a century as currency hegemon.

Yet the surplus states have most to lose if this brinkmanship tips into commercial war. They must know this, but what we are witnessing may run deeper than a calculus of advantage. Was it naïve to think that Confucian Asia and the old democracies of the Atlantic seaboard can share an open global trading system?



  1. mark fowler
    Today 12:06 AM

    QE is a desperate measure, an admission of failure.

    How can you punish the prudent in favour of wasters, spivs and big borrowers, then expect everything to be ok.

    How can you import huge numbers of unemployed drive down wages, export jobs and money in unprecedented quantities and just carry on as normal.

    How can a three bed house be worth enough to fund a retirement the whole thing is bonkers. And throw billions at the banks in an effort to support the inflated assets of banks. Sorry but this cant go on. The USA and the UK are utterly dependant on easy money and like all hopeless addicts are in complete denial.

    Aaaagh one more shot oh, its you and me mate everything is gonna be all right, ere lend us a tenner will ya mate.

    Come on somebody just tell me I am a pessimist and I should look on the bright side. Every cloud has a silver lining well it might have if you bought precious metals.

  2. China is moving to add more emerging-market currencies to its foreign-exchange reserves, a strategy central banks around the world are following to diversify their $8.7 trillion in holdings.

    “We can diversify more the foreign reserves, to consider not only smaller countries, but some emerging-market economies,” central bank Governor Zhou Xiaochuan said at an event during a meeting of the International Monetary Fund in Washington yesterday. With increased assets, “you can shift some to riskier, but higher-return investment instruments,” said Zhou.

    China almost tripled its holdings of South Korean government bonds to 5.15 trillion won ($4.6 billion) in the first nine months of this year, according to South Korea’s Financial Supervisory Service. Peruvian central bank President Julio Velarde said in an interview in August he is “surprised” to see several monetary authorities buying government bonds denominated in the sol.

    China Seeks to Add Emerging-Market Currencies to Its Exchange Reserves

  3. China’s international reserves, the world’s largest, increased 15 percent over the past year to almost $2.5 trillion as of June as the central bank bought the dollar to keep the yuan from appreciating. China is the biggest holder of U.S. Treasuries, with $846.7 billion in August. It started a sovereign wealth fund, China Investment Corp., in September 2007 to help diversify the reserves to generate better returns.

    Mexico is seeing “very active” interest from Chinese investors in the country’s local-currency government bonds, Octavio Lara, deputy general director of debt issuance at Mexico’s Ministry of Finance, said Sept. 15.

  4. “Reserve currencies have to be a good store of value, good medium of exchange, in great demand, in great supply, etc.,” Philippine central bank Deputy Governor Diwa Guinigundo said in an interview last month. “The Chinese yuan and Russia’s ruble are strong currencies, and it will just be a matter of time before they qualify as reserve currencies.”

    China is also moving to promote the yuan’s role in international trade and financial markets. The central bank said last month it will allow more regions and companies to settle cross-border trade in the nation’s currency and boost offshore usage of the yuan. Bank of Thailand Assistant Governor Suchada Kirakul said the bank plans to buy yuan-denominated bond.

    “What we will see is probably a future with more and more currencies within the reserves,” said Peruvian central bank President Velarde. “Diversification makes all the sense.”

  5. China oil firm buys Texas assets

    BBC News - ‎1 hour ago‎
    Chinese oil company CNOOC has agreed to pay $1.08bn (£677m) for a 33% stake in a South Texas shale oil and gas field. CNOOC announced the deal with ...

  6. Reuters - ‎22 minutes ago‎
    HANOI Oct 11 (Reuters) - Chinese Defence Minister Liang Guanglie on Monday formally invited his US counterpart, Robert Gates, to China in another step towards normalising relations between the two nations' militaries.