financial matters

Years back, when Raghuram Rajan was chief economist of the International Monetary Fund, I used to post about the fragility of the global economy.[1] I didn't write as an expert on the subject, but as a civilian struggling to understand a complicated situation that's too often discussed by economists and pretty much ignored by people like me.

Unlike almost all the others whose writings I attempted to master, Rajan wrote clearly and imparted a coherent and convincing point of view.[2] I was not the only one to feel this way and the blog posts I wrote gathered an unusually large number of hits. In 2007, when Rajan left the IMF, its press releases suddenly became much less useful from my point of view and, at about the same time, its influence was seen as waning. The world's economic condition was no less perilous, but I'd lost my primary source for understanding it.

Fortunately, I'd begun earmarking Steven Pearlstein's excellent columns in the Washington Post. The WaPo archive of his work, going back to July 5, 2006, can be found here.[3]

This week's column, The politics and economics of a falling dollar, is especially good.

He recognizes that people like me find it difficult to focus our attention on global financial matters, but, he says, "it turns out they are at the heart of most of the economic issues we're dealing with, from budget battles to the euro crisis to the rising price of gasoline." He explains how the US dollar became and continues to be the world's dominant currency, tells how this results in unimaginable quantities of dollars being held outside the United States, and predicts (as others have been doing) that America's debt problems are producing a devaluation of the dollar which will, in time, result in the decline of the dollar as dominant currency. He says "the global system is forced to rely on the currency of a once-dominant economy that has piled up too much debt and can't quite figure out how to deal with it."

He concludes:

There are two ways this dollar story can play out.

In the optimistic scenario, a credible budget deal is reached in Washington, the Fed manages to sop up all the excess liquidity it has created, and the long-term slide in the dollar remains gradual enough for the world to muddle through until a new order and a new architecture can emerge.

In the darker scenario, hinted at last week by the leading credit-rating agency, the failure to adopt a budget deal triggers a U.S. credit crisis that spawns a dollar crisis, which sets off another global financial crisis — one that makes the last one look like child’s play.

In the column, Pearlstein quotes Gordon Brown's speech at this year's Bretton Woods Conference. The speech is quite long, but admirably free of jargon and not difficult to understand. In it, Brown makes a persuasive call for a new set of international agreements for regulation of global finance. Here's a short summary of his talk by the New Yorker's John Cassidy.[4]

Gordon Brown, who was voted out of Downing Street last year, delivered a sweeping survey of global economic issues. Noting that he had recently enjoyed a “period of reflection, enforced reflection,” he argued that most of the problems facing the world—financial instability, recessions, trade disputes, environmental degradation — ”cannot be addressed on an individual basis and can only be resolved by global coördination.” In the area of financial regulation, Brown pointed out, coördination was sorely lacking, with some individual countries pursuing their own agendas and trying to cozy up to big financial institutions. “I believe we are going back to a race to the bottom,” Brown said.

Brown also pointed out that the old industrial nations of the North Atlantic would soon be surpassed in wealth by China and the other newer ones. It's virtually inevitable that the purchasing power of the Chinese population will dwarf that of the United States within the next two decades. Inhabitants of China will then be the world's greatest consumers; Americans may be able to export goods to feed this Chinese demand, but that's not a certainty. Careful oversight at the international level will be required to make likely a smooth transition from the past half century's American dominance to whatever is to follow it.

This graphic, from wikipedia, gives one economic projection for the next four decades. It estimates the ten largest economies in the world in 2050, measured in GDP nominal (millions of USD).


Here is the video of Gordon Brown's speech at this years Bretton Woods Conference.



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Notes:

[1] These posts, going back to 2006, are mostly on the global economy and are mostly drawn from the work of Rajan and the Washington Post's Steven Pearlstein.

• Travels of a T-Shirt
• kleptocratic cliques of looters and world trade
• China cuts back on financing US deficit
• something to think about (hard work & contentment)
• where does all the oil money go?
• a global monetary storm triggered by the Bank of Japan?
• a frightening prosperity
• the Japan carry trade, of all things
• sovereign wealth funds and US sovereignty
• whither China?
• economic inequality
• Rajan on resolving global imbalances
• a time for committed and credible American leadership
• Pearlstein on burst bubbles
• making nice to foreigners
• topsy-turvy economics
• credit and discredit, trust and mistrust
• who are we that this happened to us?
• I read the news today oh boy
• financial pundits of the FT
• easy living, not always easy to maintain
• a life that breathes its own breath

[2] The authors of the wikipedia article on Rajan say

In 2005, at a celebration honoring Alan Greenspan, who was about to retire as chairman of the U.S. Federal Reserve, Rajan delivered a controversial paper that was critical of the financial sector. In that paper, "Has Financial Development Made the World Riskier?", Rajan "argued that disaster might loom."Rajan argued that financial sector managers were encouraged to

(take) risks that generate severe adverse consequences with small probability but, in return, offer generous compensation the rest of the time. These risks are known as tail risks.[...] But perhaps the most important concern is whether banks will be able to provide liquidity to financial markets so that if the tail risk does materialize, financial positions can be unwound and losses allocated so that the consequences to the real economy are minimized.

Thus Rajan described the 2007-2008 collapse of the world's financial system.

The response to Rajan's paper at the time was negative. For example, former U.S. Treasury Secretary and former Harvard President Lawrence Summers called the warnings "misguided."

[3] Articles by Steven R. Pearlstein

[4] Cassidy is author of How Markets Fail: The Logic of Economic Calamities (which I recommend) and Dot.con: How America Lost Its Mind and Money in the Internet Era

who are we that this happened to us?

Who's to blame for the financial crisis that the US Treasury is now trying to mitigate? Its seriousness is obvious enough. How else explain the restraint our politicians are struggling to achieve? How even comprehend the quantities of money involved -- a trillion dollars or more in Federal payments and guarantees?

Press coverage is, understandably, vast. I note only three: two by a Washington Post business columnist and one by a hedge fund operator. Reading them I wonder what's happened to us? What's happened to US citizens, we who once prided ourselves on thrift and now are overwhelmed with mortgage and credit card debt? What happened between the Depression generation of tightwads and those intervening generations of more and more laid back consumers?

The press writes as if Americans who spend the earnings tomorrow may never bring are simply victims. What does that say about our collective intelligence and integrity, our collective power as voters in this democracy? Many of us seem to have caved in, given up, stopped t_h_i_n_k_i_n_g.

I also wonder about the rest of the world, so intertwined with the US economy that they suffer with us, some even more than us. And the rest of the world, too, who sustain our outrageous debt -- our government, household, and and corporate debt that cannot be funded without this foreign support. Have they become so dependent on the US as the world engine of prosperity that they cannot do otherwise?

I wonder but am unable to predict what will happen.

After my comments on the three commentators, I've put some info on Charles MacKay's old and interesting book.

In the first article, commentator Steven Pearlstein says that "when you strip away all the complexity and trappings from the magnificent new global infrastructure, finance is still a confidence game." But he says the bankers wouldn't have been able to work their con if the US economy hadn't been artificially buoyed up by low interest rates over the last decade. And he says Greenspan and the Fed were able to keep interest rates so low because foreigners remained willing to buy American debt instruments, American securities, American real estate and other assets of all sorts. Low interest rates provided Americans with cheap money. Households borrowed heavily "to buy houses, cars and college educations, along with more health care, extra vacations and all manner of consumer goods and governments used the cheap money to pay for services and benefits that citizens were not willing to pay for with higher taxes." When this credit bubble began to frighten foreign investors, the big New York banks found a way to keep these investors happy by inventing new credit instruments and working their con to keep the bubble growing. That meant that the inevitable bursting was a much more serious event than almost any previous meltdown (it's being compared to the 1929 crash of course).

Pearlstein says that the financial restructuring that we're now seeing should "force some financial discipline on the majority of U.S. households that relied on borrowed money to maintain their lifestyles," but he says it probably won't.

In the second article Pearlstein says the scale of the event is mind boggling but not so great that it can't be controlled. This week should show us life being lived normally in most US households and most companies outside Wall Street. The securities markets should return to normal. The main effect will prove to be a new way of looking at free market ideology: "There is little doubt we are witnessing a once-in-a-generation sea change. It will no longer be an easy applause line for a politician to declare that government is the problem and that markets always know better than regulators and politicians. Debates about the competitiveness of U.S. financial markets will focus less on how little regulated they are and more on how much protection and transparency they offer to investors. It will be harder to deny essential government agencies the talent, money and respect they need to do the job right."

He closes by addressing the confidence of foreign investors in the US economy: "No doubt there will be those who see in this crisis further proof of the inevitable decline of the United States as a world economic power. In fact, it may be just the opposite. The wild swings over the past week in financial markets from Moscow to Mumbai, were only the most recent reminder of the increasingly global nature of capital flows and the risks of financial contagion. They also were a reminder that, in times of stress, global investors still seek refuge in the safety of the U.S. dollar, U.S. Treasuries and the skillful crisis management of U.S. policy makers."

The opinion piece by the hedge fund operator is Calling Out the Culprits Who Caused the Crisis, by Eric D. Hovde. He's an interesting character. A financier who's wealthy enough to own both an investment bank and commercial banks, and also runs a hedge fund, he's not a sleazy character, but rather one who strongly supports charitable activity here and abroad. It's also obvious from this article that he's one who is blunt in his criticisms of his own industry.

Like Pearlstein he says the historically low interest rates put in place by the Greenspan Fed created a toxic environment for the US economy. The New York bankers who took advantage of this environment simple threw away all the internal checks that traditionally kept the banking business sound. He say the price of all this greed is an estimated $1 trillion and more in losses. While giving Greenspan much of the blame, he also says "One has to wonder why Treasury secretaries under Presidents Clinton and Bush -- Robert Rubin and Hank Paulson, respectively -- took no action to curb these abuses."

He says we might have gotten some help from congressional oversight if the financial industry hadn't corrupted congress: "The Wall Street investment banking firms, their executives, their families and their political action committees contribute more to U.S. Senate and House campaigns than any other industry in America. By sprinkling some of its massive gains into the pockets of our elected officials, Wall Street bought itself protection from any tough government enforcement."

He leaves us with no prognosis but only a wish: "there has not been a time since the 1920s when Wall Street has enjoyed as much influence over Washington as it has for the last 12 years. Let's hope that this influence fades rapidly -- and that this financial crisis doesn't end the same way as the one of nearly 80 years ago."

Here's the old and ever-popular book I mentioned at top. MacKay was one of the first to notice how easily people get carried away and how dreadful the results can be.

Memoirs of Extraordinary Popular Delusions and the Madness of Crowds

Prefaces

1. Money Mania.—The Mississippi Scheme

2. The South Sea Bubble

3. The Tulipomania

4. The Alchymists (file a.) 4. (cont.) The Alchymists (file b.)

5. Modern Prophecies

6. Fortune-Telling

7. The Magnetisers

8. Influence of Politics and Religion on the Hair and Beard

9. The Crusades (file a.) 9. (cont.) The Crusades (file b.)

10. The Witch Mania

11. The Slow Poisoners

12. Haunted Houses

13. Popular Follies of Great Cities

14. Popular Admiration of Great Thieves

15. Duels and Ordeals

16. Relics

Footnotes

About the Book and Author

Illustrations

the transformational power of abundance

This is a brief follow-up to yesterday's post.

The betrayal of public trust which is a main topic of that post seems ordinarily to lead to re-establishment of public trust via government regulation. This happened in the case of the South Sea Bubble, the Crash of '29, and the abuses of which G.B.S. wrote. It's happening as government agencies work to mitigate the damage of the sub-prime loans crisis and it's happening in an outfall of that crisis: the near collapse of the two largest US mortgage organizations, Freddie and Fannie.

Steven Paulson, author of the piece on pin-stripe immorality I wrote about yesterday, has today a good summary of the F&F takeover. Notice that he makes connection to the New Deal policies of FDR. (There's an indirect connection here with the founding of the Greenbelt community in Maryland, part of the context of yesterday's post.) Notice also that he tells us market regulation is not only necessary to correct problems created by the workings of the market, but also that regulation is needed to prevent future crises of a like nature.

In Crisis, Paulson's Stunning Use of Federal Power
By Steven Pearlstein
Washington Post Staff Writer
Monday, September 8, 2008; Page A01

Extracts:

Fannie and then Freddie began promising Wall Street double-digit earnings growth, which required them to grow their balance sheets well beyond what was necessary to assure liquidity in the mortgage market. Instead of just buying mortgages, insuring them and selling them in packages to investors, they bought more of them for their own portfolios, using ever-increasing amounts of borrowed money. Buying their own securities was profitable, but it left them highly exposed if anything went really wrong with the housing market, which is exactly what has happened.

Not since the early days of the Roosevelt administration, at the depth of the Great Depression, has the government taken such a direct role in the workings of the financial system.

Paulson only implicitly notices something that's the subject of another post that caught my attention this morning: people do not generally respond well when some resource that has been scarce suddenly becomes abundant. In the case of the South Sea Bubble, the industrial expansion of he late 19th-century, the stock market expansion that ended in 1929, and other economic excesses, governments stepped in to correct abuses and restore order.

In the following blog post Chris Anderson writes about other sorts of over-abundance and their consequences:

The Long Tail; Clay Shirky on the weird things that happen when things suddenly become abundant.

Extracts:

It takes a generation or two to figure out how to properly use some resource that used to be scarce but is now abundant. [For example the resource of] time, which we got more of in the prosperous decades after the Second World War. For the first few generations, we chose to fill that time with television. Only now are we learning to fill it more productively, and to greater satisfaction. To use Clay's term, it took fifty years for us to learn how to tap the cognitive surplus that came after the five-day work week.

[Chris quotes Clay: Another example is the 18th-century rush of agricultural populations to cities. In that case] "the critical technology, for the early phase of the industrial revolution, was gin. The transformation from rural to urban life was so sudden, and so wrenching, that the only thing society could do to manage was to drink itself into a stupor for a generation. The stories from that era are amazing—there were gin pushcarts working their way through the streets of London.

"And it wasn't until society woke up from that collective bender that we actually started to get the institutional structures that we associate with the industrial revolution today. Things like public libraries and museums, increasingly broad education for children, elected leaders—a lot of things we like—didn't happen until having all of those people together stopped seeming like a crisis and started seeming like an asset."

[Chris says:] This is the same phenomena that I described earlier, using a computer science analogy rather than an economic one, as the "awesome power of spare cycles."

A commenter adds: "Now consider this from the perspective of the developing world and especially China/India. What happens when the majority of the population shifts from spending 24 hours a day just surviving to having spare cycles to do something else?"

I find this very perceptive. We're seeing the consequences of that abundance with increasing frequency: huge increases in energy consumption, corresponding huge increases in pressure on the environment, acceleration of global warming, an agricultural crisis partly spawned by changes in the daily diet of Asians,.... And probably also an eventual shift in cultural dominance accompanying the shift in economic and political dominance from West to East.

topsy-turvy economics

This is brilliant. An editorial in the AARP Bulletin tells how much our economic well-being has deteriorated in the last 12 months: One Year Later, a New World.

The piece says the world is complex, fully interconnected, and volatile, enhancing the need for individuals to do what they can to ensure their own financial security. Here's the main graphic and excerpts:

In just 12 months, unemployment has risen from 4.5 percent with a growing workforce to 5.1 percent and a shrinking workforce as millions stopped seeking jobs. The average price of a gallon of gas has jumped 53 cents to $3.44, and crude oil has nearly doubled from $64 a barrel to

$115. Inflation is growing; medical costs are growing faster. Stock prices have dropped nearly 15 percent, and housing prices have plummeted more than 10 percent, part of a spiral of delayed payments, defaulted mortgages and home foreclosures. Banks and lenders around the world are in full retreat.

The U.S. trade deficit and the federal budget deficit continue to mushroom, and the national debt is $9.4 trillion—up 10 percent in a year. And the value of the dollar has fallen another 15 percent, driving the cost of imports ever higher and shaking the confidence of foreign investors.

If there is turmoil in the markets, there is chagrin and anxiety at home. Amid all the statistics, it is workers, home-owners, spouses, children and grandparents who feel the impact of this wrenching sequence of events—in lost jobs, postponed retirement, reduced wealth, delayed medication, lower confidence.

making nice to foreigners

An article in the Washington Post makes a point that should be obvious, but wasn't to me. The falling value of the US dollar makes life easier for companies that have goods to sell foreigners (Harley Davidson Motor Cycles, I hope). It also makes more expensive the million things Americans buy from abroad. And it helps US tourism; visiting here becomes the thing for foreigners to do. Just as predictably it encourages European and other overseas buyers to pick up pieces of us -- our real estate, our companies; farms, factories, and franchises. Here's the citation: What Can They Buy? A Good Bit of Us., by Moisés Naím (Washington Post, Sunday, April 27, 2008; Page B04). The author says,

U.S. companies have rarely been so cheap. Five years ago, a German or Spanish company that coveted a U.S. competitor worth $500 million needed almost 550 million euros to purchase it. Today, it would take just 319 million euros. The U.S. marketplace will be altered by an infusion of new foreign competitors that will manufacture their own products in the United States. These firms will use their new American base both to export to the world -- including their own European markets -- and to serve the U.S. market from inside its borders.

Such a transatlantic shift will inevitably, ignite a political firestorm on both sides of the Atlantic. [But] it will be impossible for U.S. politicians to stop the Euroinvasion, and European politicians will prove equally helpless in preventing their companies from moving to the United States. While blocking a few large investments by foreign government-owned funds in U.S. ports, defense industries and oil companies may be possible, preventing thousands of private companies from investing in the United States is not. Although difficult economic times always create political opportunities for demagogues and populists, the United States is far from ready to repeal capitalism. And stopping the Euroinvasion will require nothing short of that.

An article from Agence France Presse adds a bit of spice to this thought. Although much of the foreign investment in the US is coming from individuals and private corporations, much is also coming from large financial concerns, among them the huge sovereign wealth funds that governments have set up to manage their budget surpluses. The article says these surpluses are large and growing. Here's the head and lede:
Sovereign wealth funds hit 3.5 trillion dlrs in 2007: US firm.

Sovereign wealth funds have mushroomed 24 percent annually over the past three years to hold a total of 3.5 trillion dollars in 2007, a US economic firm said Monday.

Global Insight said that projected on that annual growth pace, sovereign wealth funds (SWFs) would surpass the entire current economic output of the United States by 2015, and the European Union by 2016.

As always, there's concern that these government-run funds will be used for political not just economic purposes. Of course the unbelievably large US deficit makes this country vulnerable to blackmail by other governments simply because we rely so greatly on them to help cover our debt through purchase of US Treasuries and the like. The potentially inimical actions of sovereign wealth funds adds spice to the paranoiac mix. It's not just the uncomfortable feeling one gets on realizing that -- more and more -- foreigners "own" us; it's also the risk that they'll let it be known that they will do some destabilizing action, like a sudden shift in investment that puts thousands of Americans out of work, unless the US government takes a position that agrees with theirs (reduces or eliminates US subsidies for farm products for example).

Along with these two somewhat scary stories comes one of a type that's becoming increasingly familiar. The price of the energy we use is likely to continue to rise. As Al Jolson said "You ain't seen nutt'n yet." From the Financial Times: Opec says oil could hit $200, by Carola Hoyos in London. The article says that oil continues to cost more partly because the US dollar is worth less and less. But, as we all know, the price is also manipulated by suppliers. There's no free market for oil. The wonderful discipline of oil producing nations enables them to screw the rest of the world if they wish, and apparently they do. There's nothing new about this state of affairs. For a long time we've been living in paranoia over the havoc that OPEC could wreak in the US economy. In fact our carefully maintained good relations with Saudi Arabia might be something of a bellwether for our life a world of cheap dollars where foreigners buy up America. I mean to say the huge diplomatic, commercial, and political efforts to stay on the good side of the Saudi ruling family may be a useful learning experience as we find ourselves required to make nice to many others who could do us harm.

Addendum:The Washington Post has an excellent article on the global escalation of food prices: The New Economics of Hunger, A brutal convergence of events has hit an unprepared global market, and grain prices are sky high. The world's poor suffer most. For the 1 billion people living on less than a dollar a day, the world's worst food crisis in a generation is a matter of survival. By Anthony Faiola, Washington Post Staff Writer, Sunday, April 27, 2008; Page A01

The article makes it plain that nations are interdependent and there's no policy that is purely domestic. We no long live in a world where any nation can act unilaterally to protect its citizens. For example, a country that fears the consequences of rising grain prices may wish to stockpile grain, but this stockpiling makes prices rise higher and faster and consequences are bad for all. Similarly, fears of dwindling supplies may cause grain producing nations to control exports. That action reduces world supply of course, driving prices higher, even within the nation that's trying to control exports. (And resorting to price controls to prevent price rises can destabilize the country's financial markets with further unfortunate consequences.)

It's another indication, for me, that the US habit of acting unilaterally has had its day. We're still the dominant world power, but our ability to influence affairs with selfish arrogance is growing weaker and weaker.

Pearlstein on burst bubbles

I've written before about how low interest rates have fueled consumption in the US and how, in turn, this consumption has helped countries that export to the US, notably the oil producing nations and China. I've been a little fuzzy about one aspect of this bilateral binge. The cycle of accelerating indebtedness and import frenzy has been accompanied by the purchase of huge chunks of US debt by foreigners (among them the oil producers and China). But with low interest rates these investors in American debt might have sought to put their money elsewhere, where it would earn a greater return.

Why have foreigners continued to invest in US debt when there has been more money to be made through investments elsewhere at higher return?

To some extent they put money into the US financial markets because that enabled Americans to continue buying from them. To some extent because the huge imbalance of trade between the US and other nations resulted in huge stores of US dollars that needed, one way or another, to be repatriated. To some extent since the US dollar is the defacto medium of exchange across the globe and, because of that, all nations have an interest in preventing its collapse. (A collapse that would probably result from failure of foreign nations to finance US deficits and its those foreigners financing US deficits enabled the US to keep interest rates low.)

But to some extent the put their money into the US financial markets because they see the US mainly as a customer for their output (whether oil or t-shirts). They see themselves as producers more than as investors. Their dollar hoards are more of a problem for them than an opportunity. Yes, they represent wealth, but -- such is their abundance -- these hoards need to be carefully managed to insure that the main business -- production -- continues to grow.

All this is long preamble to a link to a current article by Steven Pearlstein. He writes today about how the habit we Americans have of living beyond our means is a main source of the financial crisis we have created and the world now suffers from. In doing so he draws attention to the phenomenon I've just drawn attention to. I urge you to read the article.

Its upshot is what many have already said, global prosperity cannot be sustained simply by the huge amounts of over-consumption we've seen in the US over recent years. There has to be an international rebalancing. He says we Americans have been living way beyond our means, consuming more than we produce and investing more than we save. Other nations, such as China and Saudi Arabia have been willing to finance our trade deficit on easy terms because it allows them to peg their currencies to the dollar in a way that generated higher job creation and economic growth in their home markets. This mutually advantageous imbalance in trade and investment flows has created a huge supply of cheap dollar-denominated credit that virtually invited the bankers and brokers and rating agencies and private-equity firms in U.S. markets to throw caution to the wind and make ill-advised lending and investing decisions.

Some excerpts:

If this is the case -- if the story of the credit bubble and its bursting is more fundamentally about macroeconomic imbalances than microeconomic failures -- that has very different implications for where we go from here.

For what it means is that things won't be "fixed" simply by having the financial sector write off its losses and bad loans and promise to do a better job next time with risk management. Rather, it will require a reduction in the overall standard of living in the United States so that the country as a whole begins to live within its means.

What does that mean exactly?

In practical terms, it means that households will have to reduce consumption, increase savings and stop piling up credit card debt or using home equity as an ATM.

It means that the federal government stops running huge operating deficits by raising taxes or dramatically cutting national security and entitlement spending.

Such a broad reduction in wealth and living standards will take many forms. It will come in the form of higher unemployment and stagnant wages and falling income, which take statistical form in slower or even negative economic growth. It will come in the form of inflation and its first cousin, a lower value for the dollar. And it will manifest itself in lower values for pension funds, 401(k) accounts, university endowments and house prices.

You don't have to have a PhD in economics to see that this adjustment is underway. But it would be folly to assume that it is anywhere near completion. After all, it took many years for our collective standard of living to get out so far out of whack, and it's highly unlikely that we are somehow going to reverse things in a couple of quarters. And the bubbles in commodities and commercial real estate are still to pop.

What Pearstein doesn't say, because it's not his subject, is that the producing nations whose exports we have been consuming are becoming disenchanted with the US market and the US dominance in world finance. China is diversifying its manufacturing, finding a growing number of customers outside the US, and, by the growing prosperity of its citizens, making its own internal markets. Saudi Arabia and the other oil producers are finding other markets as well, notably within the newly-emerging economic powerhouse countries -- that is China, India, much of South-East Asia, and, eventually within Latin America as well. Along with this the decline in value of the US dollar is encouraging money men to think of international finance in terms of a market basket of currencies, including notably the euro as well as the dollar. The evolutionary impulse of these two shifts will reinforce the changes that Pearlstein predicts.

whither China?

Newspapers are reporting that China's currency has appreciated against the US dollar to the highest point since 1994. This pleases US policy makers who maintain that the Yuan has been artificially low.

As the Yuan rises in value, Chinese exports become more costly to Americans. Americans who spend a lot of time in Wal-Mart and Target have benefited from the cheap Yuan. They'll regret the appreciation of the currency. American producers consider the cheap Yuan to be unfair competition. American politicians dislike the unequal trade balance that has resulted, as exports from America to China represent only a tiny offset to the enormous volume of American imports from China.*

Things are much more complicated than that.

China has been constrained from letting the Yuan rise in value because its factories provide employment to millions of its citizens. The nation set a fixed ratio of the Yuan to the dollar at least partly in order to stimulate exports and thus provide jobs to those who were barely surviving on subsistence agriculture. Chinese factories produced cheap clothing and other low-wage goods, Americans bought this output, and the Chinese economy grew at a rapid rate.

China sees that there are limits to this policy and has more recently begun to diversify its manufacturing. It has been purchasing high-tech production equipment and improving educational opportunities so that it can develop a better-trained workforce and produce more sophisticated goods and services.

It has been induced to make this change partly because its currency manipulation has stimulated inflation and partly because middle class Chinese people need better investment opportunities: it does not make sense for them to continue to invest in low-end manufacturing.

Chinese policy makers also realize that as Chinese people gain wealth (or at least reasonable incomes) from exports, their desire to consume high-end goods and services increases. The Chinese government would prefer to meet this need from within China rather than by way of imports.

Inflation is a world-wide concern. The price of oil continues to rise and now rises in the price of food are causing great concern. China has to worry about the rising price of rice as much as do its Asian neighbors. There's great risk that people who can't afford food will rebel against their governments.

Echoing many financial experts, a blogger says China should be more aggressive in revaluing its currency:

China's PMI Numbers Are Too Strong, by Michael Pettis.

Extracts:

China should have begun the appreciation of [its currency] much earlier than it did and it should have appreciated more aggressively. Unfortunately, perhaps because of the excess global liquidity of the past few years and especially of the past few months, China is now caught in a monetary trap in which the high trade surplus forces the central bank to buy large amounts of foreign exchange, which of course causes very rapid domestic money expansion. This money expansion feeds directly into excessively high levels of investment, which force up industrial production and so causes the trade surplus to rise or remain high. It will be extremely difficult for China to get out of this trap.

As China’s labor force, especially in the wealthy south and southeast, move out of low value-added assembly and into higher quality manufacturing and service jobs, companies that rely on cheap, unsophisticated labor will necessarily find conditions more difficult and may even go out of business.

Policies aimed at creating a higher quality manufacturing and service base in places like Guangdong are succeeding. As long as overall exports continue to grow it is hard to see how the rising RMB** has caused trouble for Chinese exporters in general.

In China, appreciation will not reduce inflationary pressures through the price impact on imported goods. It can only really reduce inflation if it reduces the amount of foreign exchange the central bank has to buy every month, and so reduce the growth of the domestic money supply. As long as China’s money supply keeps expanding at such a fast pace, it will be impossible to bring inflation down, and as long as the central bank is forced to purchase very high levels of foreign exchange every month, China’s money supply will keep growing too quickly. The recent appreciation has done nothing to slow the trade surplus but it may have increased speculative inflows, so it actually causes an even further increase in the money supply.

Chinese policy makers say this analysis overstates their ability to revalue the Yuan. There is a limit to how quickly the country can replace low-level manufacturing with manufacturing that requires a more educated workforce. Moving too fast could cause economic chaos world-wide.

The US and other western governments don't substantially disagree, but see it as in their interest to keep the pressure on China.

Coincidentally, the global concern with inflation and the rising price of food comes as China is attempting to show the best side of itself with the coming Olympic games. Its difficulty in answering critics of its civil rights policies in general and in particular of its policies toward Tibet is only one of many concerns connected with this aim to look good.

China thus has lots of reasons to allow its currency to continue to appreciate.

One final complication, however, is the expected recession in the US and (to a lesser extent) around the globe. That event will cause American imports to decline and the decline in imports from China will provide counter-pressure against appreciation of the Yuan. The logic is thus: appreciation increases the price of exports and reduces the expansion of the Chinese money supply through purchase of dollars. US recession reduces the volume of exports and this makes it less necessary to purchase dollars. The result is less need to purchase dollars and consequently less inflationary pressure on the economy.

If China succeeds in controlling the rise in prices of oil and food imports, the recession in the US and slowed growth throughout the world may give Chinese policy makers greater flexibility in transforming the country's industrial infrastructure from low-end toward high-end manufacturing. If they do get this flexibility and use it wisely, expected benefits should flow over from China to the global marketplace. That is to say, all of us stand to benefit from Chinese modernization. However, these benefits will not be evenly distributed (whenever are benefits evenly distributed?) and, in the long run, while the US may be able to increase exports to China, it will not be easy for Americans to make a transition from prosperity based on expanding consumption (driven by low interest rates and manifested substantially in an abundance of cheap imports from China) to one in which interest rates are more rational (i.e., higher) and prosperity is achieved by growth in production as much as by growth in consumption. Along the way, as I've said, there's a good chance that the US will lose its status as preeminent financial power.

One last quote. Here is the head of the IMF on the Chinese economic situation. Note that he mentions social inequality, energy efficiency, and social services as areas that the Chinese government should address in addition to more purely economic and financial ones. He doesn't say so outright, but it's implicit that carbon emissions and other forms of pollution are and should be a major concern. It's not his place to add that China needs to address the corruption of its political regime. Although China has immensely talented and well-educated bureaucrats and policy makers, Party hacks block needed economic, social, and political reforms, and -- to some extent -- permeate the government from top to bottom. And the Chinese judicial system is unable to insure due process either for the Chinese people or those who do business with them.

Statement by IMF Managing Director Dominique Strauss-Kahn at the Conclusion of his Visit to China.

Extract

The Chinese government is confronting several macroeconomic policy challenges, including preventing inflation—largely the result of food price increases in recent months—from becoming entrenched, and rebalancing growth away from heavy reliance on exports and investment toward consumption. Addressing social inequalities and improving energy efficiency are also priorities.

We agreed that continued tight monetary policy will be important in containing investment growth and inflationary pressures. The government's emphasis on reorienting the budget toward improving social services—including health and education programs—can also help both to reduce disparities and rebalance growth. In addition, we also see the government's focus on financial sector reforms as key for achieving these goals. On exchange rate policy, we welcome the authorities' objective of allowing greater flexibility over time. However, we encourage a faster pace of appreciation that would be helpful for addressing China's key economic challenges and would also contribute to preserving global economic stability.

-----------
* The BEA reports that the Chinese trade surplus with the US was $20 billion in January and a little less in February. $20 billion is more than a quarter of the total January deficit in US import/export of goods.
**RMB: The renminbi (literally "people's currency") is the currency of the mainland of the People's Republic of China whose principal unit is the yuan. (Wikipedia)

a time for committed and credible American leadership

In last Sunday's Outlook Section, a Washington Post columnist made some of the same arguments about international finance which I made in a recent post (a process of mutual understanding). The article is No Cushion Against Hubris, by Jim Hoagland. Here are a few extracts:

"The first panacea for a mismanaged nation is inflation of the currency; the second is war." -- Ernest Hemingway, Esquire magazine, September 1935

There is still time to covet and honor the American greenback as the strongest link of stability in the international financial system. [But] the "golden moment" that enveloped the global economy for most of this decade is fading -- at least psychologically if not materially -- as we reach the end of an era of hubris in global affairs.

[The moment is fading] not just because President Bush will leave the White House next year, although that will help. The brash Texan has personified the global zeitgeist of his time: one of audacity curdling into hubris. He was elected to pursue a powerful nation's impulses and ambitions to be stronger and richer than any country in history, and he and his compatriots have pursued those dreams into the ditch.

However necessary and skillfully managed, the rescue efforts [of the Federal Reserve] add devastating new pressure on the dollar's value as a traded currency (which then affects oil and other commodity prices) and on rising U.S. inflation rates. They also eat into the fixed-income investments of many retirees. Like so much that has happened on Bush's watch, the bill for today's maneuvers will come due after he has gone.

It is hard to see how the world's global trading and financial systems can be fixed or even rebalanced without committed and credible American leadership based on realism and not hubris. But it is even harder to see that leadership coming forth unless the United States can first put its own house in order.

Hoagland doesn't say so directly, but it's implicit in his argument that we're at risk of destroying the status of the dollar as the world's standard currency. This de-facto standard has given Americans the ability to set internal monetary policy without considering international repercussions. As this site points out:

Today over half of all dollar notes in circulation are held outside the borders of the US. Almost half of US Treasury securities are owned by foreigners, mainly held as reserves by foreign central banks. The dollar is the main currency in international capital flows, as well as the currency of invoice for commodities and for many manufactured goods and services. All countries that trade directly with the US invoice both imports and exports in US dollars. . . . The US can issue dollar-denominated claims to the rest of the world which may never have to be redeemed so long as it maintains the domestic purchasing power of the dollar. While this gives the US a unique advantage in terms of borrowing in its own currency, the existence of a safe reserve asset is a great convenience to other countries. Only a serious loss of confidence in the dollar could depose it as the primary medium of international exchange, such as might be due to a prolonged major inflation in the US.

It's the "loss of confidence" in the dollar that's now becoming a realistic possibility and the failure of Americans to recognize this fact is part of the hubris that Hoagland warns against.

a process of mutual understanding

It's been quite a while since I wrote a post here on financial matters. In fact, though the US is in the midst of a meltdown and on the cusp of recession, there hasn't been much change in the global situation. It's simply becoming more clear that there are serious problems which are not being addressed. The oil-producing states are more than ever awash in US dollars, but haven't shown inclination to redirect their investment of these dollars in the economies of third-world developing nations. The developing nations haven't reformed themselves enough, in fact, to give the oil-rich nations much inclination to invest in them. The newly-rich nations on whom Americans rely for cheap imports and off-shore contract services -- China and India -- haven't been able to lessen their dependence on export of goods and services to the US. The US hasn't reduced its dependence on foreigners to cover its deficits. And the old industrial nations of Europe continue to suffer from low productivity growth.

It seems obvious that concerted international action is needed to make the changes necessary to bring international imbalances into a new dynamic equilibrium in which the US has greater household savings, reduced importation of oil, and stable export growth; in which China has lower household savings and is finally able to cease artificially enhancing the value of its currency; in which Japan solves its interest-rate problems; in which Europe reduces its government-funded social entitlements; and of course in which economic growth in the third-world is sustained by investments by oil producers. But there's little effort being made, that I can see, toward coordinated action to achieve this obvious set of goals.

A Bloomberg reporter named Rich Miller has put together a neat summary of financial difficulties facing Americans at the moment: Recession in U.S. Sows Slower Growth, Weaker Dollar. It's too compact to lend itself to summarizing, so just click and read.

Notice that it almost entirely ignores the global implications of US policy. Difficult though our domestic situation may be, it's made that much more difficult by the interconnectedness of the world's economies. There's great risk in policy decisions which ignore this fact of life.

The biggest of these risks is also one of the least likely, at least in the short run. That is the abandonment of the US dollar as the defacto international standard monetary unit. The existence of this defacto standard permits the US Federal Reserve to undermine the value of the dollar by reducing interest rates and helping to rescue the failing financial system. Foreigners -- the oil producers, export giants, and our partners in the Euro-area -- are all hurt by this devaluation. They see this unilateral action as arrogant and selfish, but -- at least this time around -- there's not much they can do about it.

It's a open question what lesson they will learn from it. If they follow the lead of the US and they too behave defensively, protectively, and selfishly, all will lose. They understand this, but circumstances may make it impossible, or maybe just imprudent, for them to act collectively to solve mutual problems. When one economic entity fosters its own economy at the expense of others, its international partners -- all the world's other economic entities -- come under pressure to do the same.

Isn't this what happened when the US adopted protectionism in the 1920s and didn't the world economy then fall apart in the 1930s? I'm not saying the current situation has much in common with that one, but the same sequence of unilaterality could now be disastrous as it was then.

A book review in the New Yorker calls attention to the need for global ethics. It's germane since world financial polices are a major aspect of these ethics. The book is The Open Road: The Global Journey of the Fourteenth Dalai Lama by Pico Iyer. Here are extracts from the review:

In his public appearances before English-speaking audiences, he prefers to speak of “global ethics” rather than of the abstruse Buddhist concept of Nirvana. Doubtless he doesn’t want to put off the largely secular middle-class Americans in weekend casuals who crowd Central Park to listen to him, but, as Iyer points out, this is also a reaffirmation of a Buddhist philosophical vision in which all existence is deeply interconnected. Indeed, this notion may be why the Dalai Lama was early to grasp the existential and political challenges of globalized human existence, decades before they were underlined by the disasters of climate change.

“For the first time in history,” Hannah Arendt wrote in 1957, “all peoples on earth have a common present. . . . Every country has become the almost immediate neighbor of every other country, and every man feels the shock of events which take place at the other end of the globe.” Arendt feared that this new “unity of the world” would be a largely negative phenomenon if it wasn’t accompanied by the “renunciation, not of one’s own tradition and national past, but of the binding authority and universal validity which tradition and past have always claimed.” . . . .

As China grows unassailable, it is easy to become pessimistic about Tibet, and to imagine its spiritual leader becoming increasingly prey to fatalism. The Dalai Lama’s retreat from the exclusivist claims of ancestral religion and the nation-state can seem the reflex of someone who, since he first copied out his predecessor’s prophecy, has helplessly watched his country’s landmarks disappear. The bracing virtue of Iyer’s thoughtful essay, however, is that it allows us to imagine the Dalai Lama as something of an intellectual and spiritual adventurer, exploring fresh sources of individual identity and belonging in the newly united world.

Certainly, Arendt’s “solidarity of mankind,” enforced by capitalism and technology, has become, as she observed, “an unbearable burden,” provoking “political apathy, isolationist nationalism, or desperate rebellion against all powers that be.” There are few things that Tibetans lashing out at the Chinese presence in Lhasa today fear more than absorption into the ruthless new economy and culture of China. Iyer’s book makes it plausible that the boy from the Tibetan backwoods may be outlining, in his own frequently Forrest Gumpish way, “a process of mutual understanding and progressing self-clarification on a gigantic scale” — the process that Arendt believed necessary for halting the “tremendous increase in mutual hatred and a somewhat universal irritability of everybody against everybody else.” It is hard to see the Dalai Lama bringing about mutual understanding in the world at large when he has failed to bring it about between China and Tibet. Such, however, are the advantages of being a simple Buddhist monk that he is less likely—indeed, less able—than most politicians to compromise his noble ends with dubious means, even as he, following the Buddha’s deathbed exhortation, diligently strives on.

{Photo source: The New Yorker}

Vietnam through Hayden's eyes

I recommend an article called The Old Revolutionaries of Vietnam by Tom Hayden (from the March 10, 2008 issue of The Nation). People my age remember Hayden for his SDS presidency and the Port Huron Statement, his arrest at the 1968 Chicago convention, his political work in California and, most of all, his opposition to the war in Vietnam. We also remember that he likes to be in front of cameras and is attracted to Hollywood celebritydom. He divorced his first wife to marry Jane Fonda and when they divorced he married another actress. Reading his bio in wikipedia, I found that he's done some admirable low-profile political work which belies the publicity-hound image you might get of him from the many headlines in which his name has appeared over the decades.

The article is short and relatively free of bombast. It shows Hayden's nostalgia for the ideals of the 1960s and his current opposition to our culture's superficiality and the growing inequality of haves and have-nots. It also shows the difficulty he has in coming to terms with the quick-growth economic policies of the current socialist government in Hanoi. He says, "far be it from me to question the desire of Vietnamese to share our globalized consumer culture like everyone else," but it's obvious that's not the outcome he would have wanted.

He tells of secular Santa Clauses and Christmas carols in Hanoi's shopping district and quotes a young Vietnamese blogger: "I have only one dream is buy one of brand new Harley-Davidson, now I waiting for Harley-Davidson deal to open in Saigon. I need a Fatboy."

Much of the article is given over to reminiscences with Vietnamese members of the old guard whom he sought out on a visit to Hanoi last Christmas. They, like he, are saddened by the younger generation's loss of revolutionary fervor, its wholesale adoption of American values, and its growing passion for material possessions.

One says, "Look carefully now at the peace we have, painful, bitter, and sad. And look who won the war. To win, martyrs had sacrificed their lives in order that others might survive. Not a new phenomenon, true. But those still living to know that the kindest, most worthy people have all fallen away, or even been tortured, humiliated before being killed, or buried and wiped away by the machinery of war, then this beautiful landscape of calm and peace is an appalling paradox." Another says, "The government is trying to reduce poverty, but it's already a reality. The rich are getting richer because they have the means. And the poor don't. We are better off materially, but not mentally, ethically."

In the end, he resists the temptation to bludgeon the reader with the old-timers vs. youngsters dichotomy. Here are the closing paragraphs:

Finally, there was a visit to my oldest friend, Do Xuan Oanh, who first greeted me at Hanoi's airport on a December day forty-two years before. He went through a "bitter period" after retirement, someone told me, but was feeling better, having recently translated into English an edition of Vietnamese women's poetry. He lived alone, his wife having died after many years of illness, his three sons all abroad. As I remembered him, Oanh loved America in unique ways. For example, after learning English from the BBC, he translated Huckleberry Finn into Vietnamese, a massive challenge. A musician, he could sing many American protest songs. A romantic, he wept easily and became close to many Americans.

Now, in a carload of old revolutionaries, I traveled along a narrow cement path past houses, until we came to the gate of Oanh's home of fifty years. He was standing in the door, a thin shadow of the Oanh I remembered. Taking my hand, he led me into a windowless room where a couch and piano were the most prominent fixtures. There were alcoves for painting and a kitchen. We sat and looked at each other. He held my hand on his knee, while the others sat in a quiet circle. It was more a last visit than a time to renew an old conversation.

"Do you want some booze?" Oanh asked with a low chuckle, pointing to a half-bottle of Jim Beam. I deferred, worried what might happen after a few drinks. My wife said Oanh seemed fit and energetic for an 85-year-old. She asked if he would play the piano, and he performed an original piece in a classic European style. He gave me a copy of the song, signed to his "precious friend," and a small carving of a beautiful Vietnamese woman carrying a student briefcase, which he said reminded him of his wife "before the revolution." He repeated the phrase, then relaxed. Gradually, the others began to reminisce about the old days. I wondered if we would ever meet again. I remembered an e-mail from Oanh's son in San Francisco: "I believe God assigned my father and myself to serve the American people." His son would come for a visit in the summer, Oanh said.

We walked back along the dark path to the street filled with motorbikes and strolling couples out for a coffee. Oanh looked at me intently, pointing a finger for emphasis. "Nothing can be predicted," were his last words before we said goodbye.

Hayden has his own website and he blogs on Huffington Post. Noting that he was a community organizer in Newark, New Jersey, in the mid-1960s, at the same time Leroi Jones (Amiri Baraka) was there, I did a Google search and turned up a fascinating bit of history. This comes from Alan Ginsburg's description of his FBI file:

Ginsberg said that some of the papers in his file come from related customs and Treasury Department investigative bureaus. His file crisscrosses those of other writers. "They include Leroi Jones, who was the victim of much more attack than people understand and, in that context, his anger is understandable," Ginsberg said. "Most people don't realize what he and other black literati have been through, assuming that all past injustices have been redressed or somehow disappeared out of mind. The waste remains, the waste remains and kills. The section on Tom Hayden in Newark intersects with Jones, since Jones was influenced by an FBI misinformation campaign to denounce Hayden as an [FBI] agent and drive him out of Newark.

{Source: Allen Ginsberg's FBI file from Herbert Mitgang, Dangerous dossiers : exposing the secret war against America's greatest authors (New York : D.I. Fine, 1988)}

Addendum: Leroi Jones comes up in a post on this blog a few months back: two women. I was given his book, Blues People, as a Christmas present and have half a thought to do a blog post on him one day.

economics 101

I keep a blog called Science and Reason in my aggregator. It's by Charles Daney, a science writer. That's something I wanted to be when I was high school age. He writes about cosmology, genetics, mathematics, and -- this week -- he's got an interesting post on economics: Economics 101, Science and Reason. It's not about free markets, free enterprise, and freedom of trade -- which are pretty empty terms after all -- but about manipulations that aim to create maximimum financial return. A kind of Machiavelli for markets.

It's short. Go there and read it.

One point he makes connects with my recent research. He says people who want to sell stuff often turn to governments to gain protection from competition, obtain subsidies to help them invade new markets, and the like.

I see this prefigured in the operation of medieval cartels and monopolies. Back then both church and state enacted strict laws prohibiting unfair trading practices, and then both church and state gave themselves dispensation to set up their own cartels and monopolies. The papal monopoly in alum is a good example. Alum was used in dying fabric and tanning hides and alum ore wasn't common. When discovered in papal territories, the papal curiat set up a monopoly to exploit the find, excusing itself from its own fair-trade rules by earmarking profits to a war-chest for fighting infidels. It leagued with bankers, merchants, and mining specialists to insure maximum returns -- the most important alliance being with the powerful Medici clan of Florence. Together the papacy and the Medici systematically eliminated competition. The used military force to suppress production in competing mines within Italy. They prohibited importation from sources outside Italy (Turkey being the only significant one) by threats of ecclesiastical censure. They made exclusive deals for distribution of their product within Europe obtaining guaranteed sales from the distributors and promises of non-competition. Having done all this they reaped the rewards of their labors. And, when alum ore was discovered in England, their superior discipline and the efficiency of their organization became apparent as the Stuart Court bumbled its attempt to set up a competing monopoly of its own.

{Making alum from alum ore. source: De Re Metallica, by Georg Agricola, 1541}

Robert B. Ekelund provides a concise description of these events.

sovereign wealth funds and US sovereignty

The papers are reporting on a new Saudi sovereign wealth fund. I've written about these funds once before. They are established by dollar-rich nations to permit hedge-fund style investing in the world's financial markets. They are important because, until now, these states have relied exclusively on government agencies such as central banks to invest their surplus dollars and these agencies have traditionally made conservative purchases, mostly purchases of US Treasury Securities. This meant that money Americans spend on such things as imported oil is returned to the United States to help pay the interest on our national debt. Without these investments it's safe to say the US would not have been able to keep interest rates low while also increasing national productivity and, in sum, maintaining an economy that grows faster than that of other highly-industrialized nations. These two charts graphically demonstrate US reliance on purchase of Treasury investments by central banks and other foreign sources.

{Click to view full size. Source: Who Do We Owe and How Much?. }

The number and extent of the sovereign wealth funds is large and growing. Their total assets, shown below, are estimated at about $2.5 trillion. They are expected to grow to $12 trillion in the next eight years.

Click to view full size. Source: Sovereign Wealth Funds - A Controversial New Power in Global Markets.}

The move from central bank investment in the US national debt toward SWF investments in all kinds of financial instruments destabilizes a precarious balance in global finance. As foreign government shift investments away from US Treasuries, there's a risk that the value of the dollar will plummet. It's dropped already as a result of the housing crisis and foreigners' nervousness about the extent of their holdings of US investments (in addition to other factors of course).

As the International Monetary Fund has repeatedly said, a gradual and orderly decline in the value of the dollar will actually increase global financial stability, since low interest rates in the US have kept the value of the dollar artificially high. So the risk is a dramatic plunge in value. The IMF would like to see a gradual shift from dollar-denominated investments to toward investment in developing nations (coupled, necessarily, with reductions in the US national debt, strengthening of the Euro economies, a shift in China away from internal investment, and in general reform of corrupt regimes in developing countries).

The value of the dollar would plummet, producing a huge international depression, if foreigners made a precipitous decision to move investments to other economies than the US. Since the depression would be global, foreign investors can be expected to do their best to avoid that scenario. They have to balance their risks however.

The risk hangs on a matter not just of rational decision-making in dollar-rich countries but also a matter of faith: faith in the ability of the US to work its way out of the current financial crisis and establish policies that insure -- as much as can be -- orderly and predictable economic growth. So far, the dollar-rich nations have kept this faith. If they were to lose it, one or more of them might pull investments out of the US despite the risk of global depression. Their motivation would be the same as that of investors in an overheated stock market whose fears of recession cause them to do panic selling of their holdings. If a crash is seen as inevitable, those who sell first end up better off, during the ensuing depression, than those who sell only after the value of stocks has gone way down.

The news about SWFs and their investment policies actually has an optimistic aspect in this respect. There's no evidence of a decline in faith in the US economy. Instead what's happening, so far, is SWF investment mainly in the US. They are buying stocks and bonds, but also real estate, and -- I guess it shouldn't come as a surprise -- they are buying up US businesses, particularly within the depressed financial sector.

The Telegraph (UK) explains:

Merrill Lynch set to take $5bn from Singapore, by Angela Monaghan, Dec 22, 2007.

excerpts:

Merrill Lynch is set to become the latest global investment bank to receive a capital injection from an Asian government fund. Temasek's investment in Merrill would make it the fourth bank to receive a foreign state bail-out from cash-rich developing economies to stem their escalating sub-prime problems, a further sign of the shift in power to the Far East and Middle East. China's sovereign wealth fund - China Investment Corp (CIC) - has injected $5bn to shore up Morgan Stanley's capital position in return for equity units that will convert into as much as 9.9pc of Morgan Stanley stock. Abu Dhabi's sovereign wealth fund invested $7.5bn in Citigroup last month while last week GIC, an investment arm of the Singapore government, and an undisclosed Middle Eastern investor injected Sfr13bn (£5.6bn) into Swiss bank UBS.

It seems strange to welcome purchase of US assets by foreign governments. Doesn't it compromise US sovereignty? This has been a major concern, but -- when you think about it: (a) the US doesn't have much choice and (b) the US is already so much dependent on foreign investment that the task for the US government is to regulate these inflows of investment to keep the risk of lost sovereignty to a minimum.

By risk of lost sovereignty I mean such things as the ability of one or more foreign governments to, in effect, blackmail the US into bending its policies to suit the foreign governments. An example might occur if dollar-rich Russia took a huge stake in, say, American Express, and then threatened to sell unless the US aligned with Russia on some issue involving Iran, Iraq, or Afghanistan.

one more voice for fixing US ag policy

In today's WaPo, George Will's column addresses the farm subsidy fiasco. He points out something that's relevant to the discussion of biofuels: price supports foster overproduction. His focus is entirely domestic and aimed at eliminating welfarestate-ism, but others point out that agricultural protectionism in the US prevents poor nations from hoping to compete in world agricultural markets -- with government subsidies, US prices are always too low. Will says:

Fifty-seven percent of farms receive no payments and two-thirds of those that do receive less than $10,000. The largest 8 percent of farms receive 58 percent of the payments. Farms with revenue of $250,000 or more receive payments averaging $70,000. Lugar wants to redirect the flow of federal funds from subsidizing favored crops to rural development, because fewer than 14 percent of residents in rural areas work on farms.

Under the continuing New Deal approach, five commodities -- corn, soybeans, cotton, rice and wheat -- got about 90 percent of last year's $19 billion in subsidies. This is a perverse incentive for overproduction of the five, which depresses prices, which triggers federal supports.

Here's the citation:

The Farmer to Fix Farm Policy
By George F. Will
Thursday, July 12, 2007; Page A23

government-directed investment funds

I haven't written on global finance in a while. Some recent news accounts led me to take another stab at understanding the subject.

So, first off, some basic facts:

(1) Foreign individuals, institutions, and governments own a huge and rapidly growing quantity of US assets. This is dramatically shown in a graph of the US current account balance showing how many more goods and services* people in the US buy from foreigners than they sell to them. This goods and services deficit is covered by purchases of US Treasury Securities and other US investments by foreigners.

{Click to enlarge. My source: http://i17.photobucket.com/}

(2) Other advanced industrial nations need to sell their assets to foreigners but their negative account balances are much smaller. A table in the CIA World Factbook shows that the advanced industrial nation with the next largest negative balance (UK) has a negative balance a good deal less than one percent of the US negative balance (about $58 trillion vs about $862 trillion).
(3) The countries with the largest positive balances are China, Japan, Russia, Saudi Arabia, and (a bit of a surprise) Germany. Though large, the combined surpluses of China, Japan, Russia, and Saudi Arabia are only equal to 65% of the US deficit. The other countries with large positive balances are for the most part oil producers, like Saudi Arabia, or industrial nations in Europe, like Germany.
(4) There's a risk that individuals, institutions, and central bankers in countries with large postive balances will disrupt the US economy by deciding not to fund the US negative balance. This risk is said to be negligible because the disaster that would result would greatly injure the economies of those countries.

That said, there's a new set of fears:

Although individuals and institutions in the countries with the largest positive balances have bought a whole variety of US assets -- stocks, bonds, and real estate as well as Treasury Securities, the central banks of these countries have tended to use their surplus cash to make extremely conservative investments, mostly purchases of US Treasury Securities. This situation is rapidly changing as the central banks are setting up Sovereign Wealth Funds which they use to invest in stocks, bonds, and real estate. This graph gives some idea of the size of SWFs.

{My source: http://goldseek.com/}

The first fear is that the SWFs will increasingly put their investments outside the US. This fear stems from the slow down in the US economy, particularly in contrast to other advanced industrial economies. On the whole, the US slow down is good news since it means the economy is gradually retreating from overheating (as represented by the melt-down in housing). The fear arises as the US economy is seen to lag and investments elsewhere become more attractive. This lag can be seen in this graph showing the gap between the gross domestic product of the US compared with the rest of the world.

{My source: http://www.ers.usda.gov/}

The second fear is that a country such as China or Russia could use its SWF to interfere in the internal affairs of the US. Think of the way the US likes to put pressure on Japan to prevent Japanese automakers from destroying the US auto industry.

A recent blog entry on the Financial Times web site points discusses the growth of SWFs and points to some of the potential outfall of this growth: Sovereign wealth funds and the $2,500bn question

Extracts:

Sovereign wealth funds are rapidly becoming a huge force in global markets and economies, as the world is seeing in China's move to kick off its own SWF with a $3bn investment in the IPO of private equity group Blackstone. But equally compelling issues lie ahead in the nature and operation of these often opaque investment vehicles, says the FT.

Driven by trade surpluses unequalled as a percentage of the global economy since the beginning of the 20th century, official reserves held by some governments are now astronomically high, amid mounting pressure to earn better returns by putting the money with specialised investment agencies.

How and where this massive – and often secretively managed – pool of funds is deployed will be one of the big investment themes of coming years.

The IMF warned recently of the risks arising from the fact that public sector institutions such as SWFs are now large players in world financial markets.

A column in the Washinton Post gives a more acute presentation of risks:

The Next Globalization Backlash
Wait Till the Kremlin Starts Buying Our Stocks
By Sebastian Mallaby

Mallaby says SWFs are large and growing. Financial reserves held by central banks has more than trebbled over the past five years. This money is finding its way into SWFs. To take one example, the SWF of the United Arab Emirates is estimated at a trillion dollars. SWFs are virtually inevitable. The countries that set them up first, years ago, have profited greatly. A recent book** declares that governments would be irresponsible if they did not set them up.

Here's his statement of the fear:

Chunks of corporate America could be bought by Beijing's government -- or, for that matter, by the Kremlin. Given the Chinese and Russian tendency to treat corporations as tools of government policy, you don't have to be paranoid to ask whether these would be purely commercial holdings.

But the final straw may be that even the least threatening form of investment -- the purchase of publicly traded equities -- will not escape controversy. This is because of that second upheaval: the advent in the United States of something approaching shareholder democracy. As Alan Murray writes in his new book, " Revolt in the Boardroom," companies are no longer controlled by all-powerful CEOs. Instead, chief executives increasingly live in fear of activist shareholders and directors. Bosses from Harry Stonecipher of Boeing to Carly Fiorina of Hewlett-Packard have been ejected from the corporate suite in a manner that would not have been conceivable a generation earlier.

What if the Chinese are seen to have a hand in the firing of some future Fiorina? The more shareholders exercise power, the surer the backlash against governments that buy up chunks of the stock market.

======
Notes
*Actually not just goods and services, but also income from US investments abroad and net unilateral current transfers (such as foreign aid).
**This book is forthcoming from a UK publisher: Sovereign Wealth Management; see the chapter by Larry Summers, former US Secretary of the Treasury, Opportunities in an era of large and growing official wealth.