Brad DeLong's Semi-Daily Journal: A Weblog

Knowing nothing about these issues, I post this paragraph from a Morgan Stanley report to get your response:

"...deficits aren't inflationary unless monetary policy overtly accommodates them. But there may be a subtle and insidious pressure to boost inflation — to erode the value of hard-to-keep long-term promises such as those embedded in corporate and private pensions, Social Security, and Medicare."

The original: http://www.morganstanley.com/about/gsb/index.html

There was a stock which had, for the first time ever, gone south of 100. I told a Sales to recommend it to his clients. He did to one of his biggest, but the client told him, "I'm very interested buying above 100, not at all below."

I tell that story because I think Higgins and Kiltgaard are wrong that foreign investors will require a weaker dollar as compensation to add to their already large stock of dollar assets. If the dollar weakens, foreign investors are likely to become net sellers rather than net buyers.

Alan Krueger of Princeton has made similar comments about inflating our way out of debt. The prospect would be more than just sad. We ould be breaking faith with a generation of retirees, who contributed faithfully to this country through their working years.

"If the dollar weakens, foreign investors are likely to become net sellers rather than net buyers."

Yes, but will central banks act as investors? How important is it for central banks to protect against making the dollar weaker against their currencies? I wonder. How important is a stable dollar to Japan?

The notion of inflating away government obligations is about as old as coinage, but is not inevitable. If fact, unless I have been misunderstanding all the talk about "central bank credibility" (didn't a Nobel just get handed out on this subject), confidence that the central bank has inflation well under control and intends to keep in that way makes it difficult for a central bank to inflate away government obligations. That is not to say the central bank can't mop up a lot of sovereign debt, just that doing so won't reduce the value of that debt.

I think Andrew has identified a very likely pattern among foreign investors. Currency losses raise the apparent risk of holding an asset, making the asset less desirable. Currency risk was there all the time, but some investors notice it only when it bites them. Think about the Nasdaq bubble.

Andrew Boucher and KHarris,

Though I agree with you, I am wondering about the mixed motives of central banks in protecting currencies. Does the Bank of Japan have any limit to the amount of American debt it will hold? How amply can the Bank of Japan protect the value of the dollar against the Yen?

http://www.nytimes.com/2004/11/04/business/worldbusiness/04volkswagen.html

Volkswagen Averts Strike by German Workers
By MARK LANDLER

FRANKFURT - Volkswagen averted the first full-scale strike in its history on Wednesday, offering its factory workers a seven-year job guarantee in return for a 28-month freeze in wages.

The agreement, which came after a marathon bargaining session, achieves two equally important objectives for Volkswagen: it will reduce labor costs nearly one-third by 2011 and it will preserve labor harmony at a company that is a German industrial icon.

Volkswagen's union, IG Metall, had staged warning strikes at several factories to press for a pay increase of 4 percent. But even as it threatened broader disruption, the union later gave up this demand - accepting a face-saving compromise that it must now try to sell to its members.

In a largely symbolic gesture, Volkswagen will make a one-time payment of 1,000 euros to the 103,000 workers covered by the contract. The company also pledged to invest in six plants in western Germany, which workers fear are in danger of losing production to lower-cost factories in the Czech Republic, Slovakia and other Central European countries.

"We achieved our goal of securing jobs, not just for today but for the future," Hartmut Meine, the chief negotiator of IG Metall, said to reporters in Hanover, where the talks were held.

Volkswagen said the agreement freed it from a labor contract that provided higher pay rates than those at any other German carmaker and imposed rigid rules on overtime and the hiring of new employees.

"From now on, new employees will work on the same level as our competitors," said Dirk Grosse-Leege, a spokesman for Volkswagen. "We never asked as much from workers as in this round of negotiations."

Volkswagen's face-off with the union was closely watched here as a test of whether German auto workers - and VW employees in particular - could maintain their privileged position as the best-paid, best-treated workers in an increasingly competitive global industry.

Other carmakers, including DaimlerChrysler and the Opel division of General Motors, have demanded concessions on wages and work rules, as they struggle to reduce labor costs. G.M. said recently it would reduce its European work force by 12,000 jobs, most of them in Germany. In the Volkswagen negotiations, however, Germany's long tradition of worker-management consensus prevailed over the union's protests and the company's not-so-veiled threats of job cuts.

"The fact that they did reach an agreement, given the complexity of the issues and the hardness of the positions, shows a remarkable ability to work together," said Michael Fichter, an expert in labor relations at the Free University of Berlin. "It is an example of the social partnership culture."

Hi, Anne.

Trichet took a poke today at "Asian nations" which could afford to allow thier currencies to appareciate. The point, it seems, is that in stabilizing their currencies against the dollar, while the dollar slips against the euro, European firms end up in the crosshairs. Japan, meanwhile, is partly motivated to stabilize the yen against the dollar because the yuan is pegged to the dollar. Japan has trouble enough with China without having to put up with an appreciation of the yen against the yuan. The crux here seems to be Asian currencies, but not in the way we have come to habitually think of Asian currencies. It is not dollar/yuan and dollar/yen, pure and simple. There is a strong yuan/yen undercurrent. Kick in Trichet's comment, and the euro is part of the equation.

If China allows the yuan to appreciate, it may not have to buy as many dollars (but I'm not entire convinced - more below), and may relieve Japan of the need to intervene, as well. In fact, there is little direct evidence of BoJ intervention since March.

The problem is that China, if it opens the door halfway, may find it has to buy more dollars, not fewer. There is little joy in speculating against a pegged currency that is well managed. A "flexible" currency can prove far more expensive to manage than a pegged one, as speculators grow hopeful.

Some of my colleagues have speculated that China's recent rate hike, and hints of more, are preparation for greater yuan flexibility. I have my doubts. China does not need higher rates ahead of a change in fx regime, when the best guess is that there would be upward pressure on the yuan without higher rates. I suspect the rate hike was aimed at reducing investment growth, just as Chinese officials have said. Power shortages, for instance, have been blamed on too rapid demand growth (hardly controversial), with slower growth outside the electricity generation industry intended to allow the electric industry to catch up.

If I'm right, efforts to slow growth still leave China with higher rates, so a yuan that is more prone to appreciate than was already the case. A touchy situation, which might involve a pick-up in dollar buying as China approaches greater fx flexibility.

Wow, I spell bad.

http://www.nytimes.com/2004/11/04/business/04place.html

The Dollar's Long-Term Direction: Down
By EDUARDO PORTER and ELIZABETH BECKER

...

Economists who speak of the current account deficit often quote the economist Herb Stein: "If something cannot go on forever, it will stop.''

So what will it take for the brakes to be applied? Barry Eichengreen, a professor of economics at the University of California, Berkeley, argues that Asian policy makers are going to force a change. He contents that as they move away from their present export-led growth strategies, which require cheap currencies, to focus monetary policy on managing internal demand, Asian governments will support the dollar less, buy fewer Treasury bonds and shift some of their foreign reserves to other currencies, like euros.

Indeed, China's decision to raise interest rates last week put upward pressure on the yuan and indicated a willingness to take market-based measures to cool its galloping economy.

"Asian policy is changing," Mr. Eichengreen said. "The end is growing increasingly near."

Hi KHarris,

Your comments as always as superb. Your writing crystal clear. Spelling, who notices? Now to put the mix of ideas together...

Should have written "hoo notices?"

http://www.nytimes.com/2004/11/04/business/04place.html

The situation, some suggested, is analogous to the problems faced by Ronald Reagan early in his second term, when the United States, despite robust growth, suffered from an expensive dollar, weak exports and big deficits.

In 1986, the administration negotiated the Plaza Agreement with six other major industrial powers, helping pave the way to a manageable, if sometimes rocky, 40 percent decline in the value of the dollar.

"We have to do something similar to get the value of the dollar down and not wait for a market adjustment which could be more damaging to the economy," said Robert E. Scott, of the liberal Economic Policy Institute in Washington.

The strategy worked for Mr. Reagan because he also pushed through a couple of tax increases that helped narrow the budget gap. Economists are not very confident, however, that a second Bush administration would be prepared to do something similar.

That could leave the economy vulnerable to a more painful adjustment, with the dollar falling rapidly and interest rates rising fast. The result would almost certainly lead to a recession and perhaps a collapse in the real estate market.

"There is a real possibility,'' Catherine Mann, an economist at the Institute for International Economics, wrote in a study earlier this year, "that the entanglements created by this co-dependency cannot be undone by anything short of a global economic crisis."

Found this at Prudent Bear and got a laugh. I think we all need a laugh at this point. Or, strong drink?

http://www.prudentbear.com/archive_comm_article.asp?category=Guest+Commentary&content_idx=37375

How low would the dollar need to drop against the yen to make production in the US more attractive? And are there Japanese companies which keep production in Japan out of an obligation to keep a worker employed and not out of a profit motive? Toyota already produces a significant amount of North American sales in North America--I think I read about 60%--so what kind of incentive is needed to move the rest here over the medium term (say 10 years)?

It would help my understanding of this if anybody here could offer a good estimate of purchasing power parity for the yen and euro. A recent Big Mac thing has it as 90 Y/D and 1.06 D/E but I'd be interested in something more accurate since I don't really see what makes production in Japan or Europe so attractive after the relatively recent dollar drop. In fact, many articles I read about Europe including the one Anne posted suggest they already aren't very competitive at all.

I would not be at all surprised to see a Bush tax reform packaged that generated a significant tax increase -- but it would be on labor income not capital income. What comes first to Bush is class welfare and if it happens to benefit the economy that is also ok.

The drop in the dollar is underway because the US is not an attractive market to foreign investors. The only question is how long the Asian central banks will continue to support the
dollar. At some point -- I do not know when-- their support will vanish.

Get a load of those job figures. Apparently lots of rebuilding going on in the Southeast, lots of preparation for holiday retail sales, and the usual seasonal wiggle-wobbles in the education sector. The factory data, however, are dreadful. Jobs down, hours down, diffusion index still well below even. This is consistent with the flat showing from industrial production the past couple of months and the softening in ISM factory data.

Do we still think the factory sector leads?

But isn't foreign central banks willingness to hold dollars measured only against their willingness to hold anything else? What else would you buy, if not dollar-denominated assets?

The US market is less attractive now than it was on November 1st, because of the fiscal policy risks. And it is less attractive than it was several years ago. But is it less attractive, relative to its rivals? Japanese markets are still not as investor-friendly as the US. European markets are smaller and fragmented, European growth is slower, and many European governments' finances are also in trouble. Nowhere else offers the same combination of volume, transparency, liquidity, and potential for growth.

There can only be stampede to the exits if there are other places to go.

SNSterling

Guessing at a reasonable value for the dollar is tricky, because we have little sense of where personal saving may be 12 or 24 or 36 months from now, nor can we tell much about fiscal policy. Will the federal deficit continue to grow faster than the economy? Will personal saving be as low? Then, a 20 to 30% loss in value for the dollar against the Euro and Yen seems reasonable.

Central banks have rules for investing reserves, many of which argue for holding US$ denominated assets. Not all those rules, however, argue for holding US$ assets. The US holds a declining share of world output (not the case in the 1990s, but true now, I believe). Reserves are massively skewed toward US$ assets, relative to the US share of world output, or world trade. The US current account deficit is deeply tangled up in international reserve holdings, but that is not necessarily an argument for holding more dollar assets. Finally, we should remember that it is not necessary for foreign investors to sell US$ assets in order to put the dollar and US financial markets under pressure. Foreigners are now lending us the $1.5 bln or so needed every day to service our overseas obligations. If they simply cut back on lending to us, we're in trouble.

In addition, the rules intended to limit risk in central bank reserve holdings are weighed against policy objectives. My guess is that, while the "volume, transparency, liquidity" argument allows foreign central bankers to sleep at night, those with the largest US$ reserves know in their central banker hearts that their reserve portfolios are already at risk from too many US$ holdings. They are breaking the rules in order to serve trade policy objectives. If the policy objectives change, or if the risk of supporting those policy objectives becomes too great, central bank US$ asset accumulation will slow.

KHarris

Agreed. Japan has a significant government budget deficit and short term interest rates that are minimal, still there has been deflation and quite sluggish growth since May 1998. So, the Bank of Japan is supporting the dollar against the Yen to foster export growth. A 20% increase in value of Yen must seem quite threatening.

The dollar, in 1985, began a steep decline against European and Japanese currencies; a decline by agreement with the finance ministries of the major economies. The decline lasted to 1991 and came to about 40%, and contributed to serious economic difficulties in Japan and several European economies. I wonder whether such an agreed decline could be brokered today.

What should also be noted is the absence of inflation brought by the steep decline in dollar value. The Federal Reserve was able to adjust interest rates to prevent inflation and keep a fair growth rate to the mild recession of 1990-1991. Neither the tax increases of the Reagan Administration nor the brief stock market crash in 1987 led to recession. Proper monetary and fiscal policies, if we have them, can control the growth of internal and external deficits and allow a benign curreny adjustment. The need is for proper economic policy; there is the worry.

Sometime back there was news that China was deploying/transferring reserve dollars as capital for the weak state banks. If so (and if I haven't misunderstood it), how does this affect the accounting for China's reserves?

If we see a "gently falling dollar", as the Nov. 3 Buttonwood column suggests, we'd see rising import costs, inflation, and higher interest rates as foreigners cut back on lending to us. We'd also have sharp falls in asset prices as foreign investors pull out of dollar-denominated equities. The hike in interest rates would halt house-price appreciation for years, if not lead into actual prices declines.

But at the same time, American labor has been competing unsuccessfully both with foreign labor (abroad and the illegal fraction at home) and with cheap capital. How else to explain the continued rises in productivity, when set against the dismal employment numbers of the last three years? A decline in the dollar would necessarily make domestic labor cheaper relative to capital, and thus spur employment. The 90s showed that very high employment has lots of add-on benefits for consumption and social well-being. It would not be entirely bad...

KHarris and SNSterling

- Barry Eichengreen, a professor of economics at the University of California, Berkeley, argues that Asian policy makers are going to force a change. He contends that as they move away from their present export-led growth strategies, which require cheap currencies, to focus monetary policy on managing internal demand, Asian governments will support the dollar less, buy fewer Treasury bonds and shift some of their foreign reserves to other currencies, like euros. -

The question is, when will China and India decide that domestic demand can drive their rapidly developing economies? We may be close to this time. Should currency traders sense a lack of support for the dollar, we could have a dramatic decline.

For me it would be a good thing to see housing prices decline and manufactured goods (imported) prices go up. Our economy is unbalanced right now and needs to adjust to a more sustainable and equitable mode.

I like Eichengreen, but don't read him enough.

The problem I see is that Eichengreen (as Anne relates) predicates on economic view on guessing what policy makers will do. Figuring out what an economy will do is hard enough. Policy making is a small-group exercise. Figuring out what a small group of people will do is not economics. Then, you have to allow for the economy to respond to the unknowable decisions of a small group.

It makes sense that, as incomes rise, consumption will rise, too. That doesn't require a policy decision, so I have pretty good confidence that China and India will continue to consume and import more as they grow wealthier. I'm not sure we can be confident that policy makers will foster, rather than inhibit, such a shift, unless they tell us they will. Policy making in China and India have improved greatly. We can only hope that improvement continues.

KHarris

Agreed. There is no compelling reason for an immanent change in policy by either China or India. China by the way is rather annoyed just now at the possibility that textile import quotas might be retained this coming year. A change in value of the Yuan will come with a price wrought of hard bargaining.

paulo at November 5, 2004 10:33 AM posted:

"Sometime back there was news that China was deploying/transferring reserve dollars as capital for the weak state banks. If so (and if I haven't misunderstood it), how does this affect the accounting for China's reserves?"

Actually I never understood how they were going to implement that. The banks in the PRC have large liabilities unmatched by they assets, due to the fact that an estimated 50% of their loans are hopelessly bad. However, those liabilities are denominated in the local currency (RMB): how are the banks supposed to make use of foreign currency reserves to balance them, especially considering that the RMB is not convertible in capital account?

Also, kharris posted at November 4, 2004 05:18 PM:

"It is not dollar/yuan and dollar/yen, pure and simple. There is a strong yuan/yen undercurrent. Kick in Trichet's comment, and the euro is part of the equation."

But note that China does not have a current account deficit with Japan as it does with the US: instead, it has a deficit ($59.4b of exports vs $74.2b of imports) and the same is true for ASEAN countries (30.9 / 47.3), Korea (20.1 / 43.1) Russia (6.0 / 9.7) and other commodities exporters such as Brazil. Overall, China's trade is not very far from balanced (exports: $438.4b, imports: $412.8b). The real problem is the dollar, not the RMB...

"The problem is that China, if it opens the door halfway, may find it has to buy more dollars, not fewer. There is little joy in speculating against a pegged currency that is well managed. A 'flexible' currency can prove far more expensive to manage than a pegged one, as speculators grow hopeful."

Absolutely! And I believe they realize that very well, which is why, so far, they have resisted calls for half-baked measures such as one-off reappreciation of their currency. The best alternative to a closed capital account would be fully floating rates; on the other hand, the fragility of their banking system is probably going to force a postponement of that arrangement for several years to come.

Enzo

Enzo

There is every reason to think the dollar is being sold by currency traders. The trading has little risk. The Treasury has no reason to defend against an orderly decline in the value of the dollar, since the decline will help ease the balance of payments deficit. We should have international investments to protect against what may be years of a weak dollar. The dollar was weak from 1985 to 1991, another such time frame seems in an early stage. We need to discuss low cost practical investments to protect against the weakening dollar.

A practical question from a non-economist who finds this discussion intriguing:

If foreign central banks do stop buying US treasuries, and the predictable crisis ensues, will a US investor be better off in cash (presumably not long-term bonds), or stock, or hard assets?

"If foreign central banks do stop buying US treasuries, and the predictable crisis ensues, will a US investor be better off in cash (presumably not long-term bonds), or stock, or hard assets?"

Why not simply hold the Europe Stock Index against a possible continuing weakness in the dollar? Waiting for a crisis, would seem a foolish strategy. Europe Stock Index valuations are reasonable, so why not use a serious investment and expect an orderly currency market with a gradually weakening dollar. Should the dollar not weaken, you hold a fine set of companies.