Birth pains:A new global system is coming into existence

[phk]

Birth pains

May 14th 2009
From The Economist print edition
A new global system is coming into existence

ALL monetary and economic systems are a struggle between borrowers, who favour inflation, and creditors, who are determined to maintain the purchasing power of the currency. In a democracy, this is a very fluid battle. The creditors have the money and therefore the ear of the political elite; the borrowers tend to have the votes.

Creditors have periodically imposed monetary anchors in an attempt to defeat the borrowers’ lobby. These anchors are devised in prosperous times but run into difficulty during recessions. The gold standard failed to outlast the Depression. For nations with a shortage of gold, the “right” thing to do was to raise interest rates in an attempt to lure gold back; the austerity this imposed on the rest of the economy was politically unacceptable.

The Bretton Woods era replaced a gold standard with a dollar standard (albeit with the American currency theoretically linked to bullion). The system worked well for more than two decades, helped by the post-war economic boom, particularly in Germany and Japan which began the period with undervalued exchange rates. It broke down because America refused to pay the domestic price for bearing the system’s weight.

When Bretton Woods failed, it was not immediately obvious what would replace it. European nations, in particular, maintained a hankering for fixed exchange rates. But floating rates eventually prevailed, particularly for the major currencies of the dollar, yen and D-mark.

The problem for creditors was that the floating-rate system was based on fiat (paper) money. What would keep the inflationary instincts of governments in check? The answer took a couple of decades (and recessions) to hammer out.

Once it was accepted that the markets could set exchange rates, there was no real need for capital controls. And once capital could flow freely, ill-disciplined governments could be punished by higher bond yields. Politicians accordingly tried to reassure the markets by giving greater power to central banks, some of which set explicit inflation targets.

The post-Bretton Woods system worked well, engendering the long period of low inflation and steady growth known as the Great Moderation. But one of the reasons for its apparent success—the growth of India and China—may have sparked its demise. The addition of these two great nations to the international financial system was a supply shock that put downward pressure on inflation rates.

As Stephen King, an economist at HSBC, has pointed out, the result might have been a benign deflation that boosted Western living standards. But central banks struggled to avoid a deflationary outcome; the result was a loose monetary policy that encouraged asset bubbles. Those bubbles lasted longer than expected because the flood of savings from developing markets held down the risk-free rate.

Now it seems to be recognised that inflation targeting is not enough. Given the explicit government guarantee behind the banking system, central banks need to monitor both financial stability and asset prices. At the same time, some central banks have adopted (via quantitative easing) a policy of creating money to boost markets that also has the convenient side-effect of funding budget deficits. That is just what opponents of fiat money feared would happen in the long run.

The same old dilemma will eventually occur. Having spent a fortune bailing out their banks, Western governments will have to pay a price in terms of higher taxes to meet the interest on that debt. In the case of countries (like Britain and America) that have trade as well as budget deficits, those higher taxes will be needed to meet the claims of foreign creditors. Given the political implications of such austerity, the temptation will be to default by stealth, by letting their currencies depreciate. Investors are increasingly alive to this danger; ten-year Treasury bond yields are around a percentage point higher than they were at the start of the year.

Creditor nations tend to set the rules and the new global monetary system will be unable to operate without the approval of China, a creditor country that has capital controls and a managed currency. It has been assumed that China will have to move towards the Western model. But why not the other way round? Western countries adopted free capital markets, as the British adopted free trade in the 19th century, because it suited them. Will China now be able to call the shots? Uncomfortable as it might be for the West, the next monetary order is more likely to be made in Beijing than in New Hampshire

[opebo]

Will China now be able to call the shots? Uncomfortable as it might be for the West, the next monetary order is more likely to be made in Beijing than in New Hampshire

Haha, China's position is awful.  More moralizing nonsense from the Economist.  What's China going to do, withhold its savings?  We're in a depression - all there is is savings, and interests rates are nil (any interest that's occurring is more because of deflation than any economic activity).  No, there's no shortage of what China's got (savings), at the moment.  What we're missing is demand.

As for the cheap slave-made products that China turns out - they all used to be made here, so that's certainly an option.

And yes, Chinas got a few nukes, and enough military to threaten nearby nations, but enough to threaten the US or Europe?  No.  Heck probably not even Japan, seriously.  So what are we talking about?

Wishful thinking.

[Sam Spade]

Oddly enough, I tend to agree with opebo.  China (or any exporter nation) is in a much worse position here because they rely on our demand and rely on the strength of our currency.

If they try to overtake our currency position, they get screwed because the demand for their products from us will go to nil and they are far from being self-sufficient.  On the other hand, unless they are able to recreate demand (which I don't think is going to happen) they'll suffer from a persistent and deadly deflation.  Most of Asia will too.  See USA circa 1870-1940, when we were in the China position.

Right now, China and a lot of Asia is blowing its stimulus on an attempt to keep itself afloat.  I give it about another 6-9 months before that runs out (or they give up) and they really get it badly.

You see, in life, creditors are in control unless they aren't.  And when they aren't is when 1) they loan money improvidently; and most importantly 2) they rely on the debtor their own profits.  What would happen if the US was to de facto default like Britain did in 1931?  It would screw us, but imagine how bad China would get it...

In order to get a Bretton Woods situation, you need a country to have overwhelming control of the gold supply (i.e. US in 1944 held about 90% as memory serves me).  The rest of the world cannot be a functioning economy (e.g. 1944).  That ain't happening, now, at least.

[opebo]

Right now, China and a lot of Asia is blowing its stimulus on an attempt to keep itself afloat.  I give it about another 6-9 months before that runs out (or they give up) and they really get it badly.

There's no need for the stimulus to 'run out'.  Stimulus is just orders from the State.  It can always speak more and point the gun.  The fact that this is at the moment denominated in something called 'money' isn't all that relevant.

As for 'creditors being in control', yes, on an individual level they are - but that's not because of the loan, its because of the power relationship that made the loan occur.  Think of it this way - the debtor is the slave of the creditor, and the 'loan' is just a fiction to make this look better than back in the days when the former was actually in chains.  A kind of deception.

Obviously this doesn't apply in the case of debt between nations, at least not fully sovereign ones like China and the US.  In fact it is best to understand the 'loaning' of money by China to the US as a kind of tribute.

[Beet]

Folks, this article is entitled "birth pains", not "the first cry of the baby." As Sam likes to say, patience.

Yes the truth is, any scenario where the West goes down the toilet, the East, necessarily, also goes down the toilet. Because the West is the demand engine for the world economy, particularly the household sector, and this demand has been based in recent years not on income but rather on credit and financial innovation in general. These factors are now reversing themselves for reasons which most readers of this board know by now. The reverse is also true; if the West today attempted to take on all of the functions that the eastern manufacturers and southern resource exporters now perform, it would not be able to maintain its standard of living and would experience a great inflation if it tried to do so.

The world economy is not thus divided between the "United States" and "China" and "Europe", but rather works together as a single, interconnected organism, the success or failure of each part which contributes the same to the others, at least by the standards which generally matter.

To the attention posed on the trade imbalances and their contribution to the distorted concentration of demand to the industrialized West in the last 10 years, which I have written a great deal about, these problems are very real, and are at the heart of the problems we face today. But like a large ship they cannot be turned around on a dime. Attempting to do so would capsize the ship. Therefore, great efforts must be made to revive the very same system which failed us in the past, for the sake of buying some time, to accelerate the process of rebalancing the global economy. This will require demand stimulation on both sides of the Pacific and Atlantic.

[Swing low, sweet chariot. Comin' for to carry me home.]

that was a decent article until this part:

"Investors are increasingly alive to this danger; ten-year Treasury bond yields are around a percentage point higher than they were at the start of the year."

we are STILL at extremely low levels of interest rates on the 10 year bond compared with the last 30 years.  It's comparable to ringing the alarms over inflation if gold were to go down from $900/ounce to $200/ounce, then back up to $300/ounce.

*IF* the U.S. economy grows 3-5% in 2010 in terms of real GDP, do you think the 10 year yield will remain at today's levels?!  No way!  In that case, the yield will be about 200-300 basis points higher as money rotates out of bonds into higher yielding (and higher risk) investments.

That's why I hate Obama's budget - interest rates are sure to rise naturally once the recovery begins.  I'm fine with throwing trillions of dollars at the mess over the short term in order to save the system and avoid a another great depression, but once the patient is back on its feet, spending has to be slashed to the bone in order to get the annual deficit back to managable levels (% GDP).  Having government spending become an even greater portion of GDP while shrinking the tax base is a sure recipe for an anemic economy.

[opebo]

... once the patient is back on its feet, spending has to be slashed to the bone in order to get the annual deficit back to managable levels (% GDP).  Having government spending become an even greater portion of GDP while shrinking the tax base is a sure recipe for an anemic economy.

No.  Spending should not be 'slashed' or in fact reduced at all. It needs to grow to a much larger share of GDP.  But this can be perfectly balanced by simply increasing tax rates.

[J. J.]

... once the patient is back on its feet, spending has to be slashed to the bone in order to get the annual deficit back to managable levels (% GDP).  Having government spending become an even greater portion of GDP while shrinking the tax base is a sure recipe for an anemic economy.

No.  Spending should not be 'slashed' or in fact reduced at all. It needs to grow to a much larger share of GDP.  But this can be perfectly balanced by simply increasing tax rates.

Actually, the American stimulus program looks like a disaster, in terms of job creation.  Actually, 2010 is starting to look very bad.

[opebo]

... once the patient is back on its feet, spending has to be slashed to the bone in order to get the annual deficit back to managable levels (% GDP).  Having government spending become an even greater portion of GDP while shrinking the tax base is a sure recipe for an anemic economy.

No.  Spending should not be 'slashed' or in fact reduced at all. It needs to grow to a much larger share of GDP.  But this can be perfectly balanced by simply increasing tax rates.

Actually, the American stimulus program looks like a disaster, in terms of job creation.  Actually, 2010 is starting to look very bad.

Thanks and welcome back, Archie, but I don't see what your post has to do with mine.