## Saturday, December 11, 2004

There has not been an article on this blog focusing on economy yet, I think.

The American "twin deficits" have become a popular topic - especially on the currency markets. Every time a new journalist learns something about the basic flows of money in the economy, he or she writes an article. This article is read by other journalists who write their own articles, and so forth. Consequently, there are thousands of articles about the American deficits and all of them look alike.

Don't get me wrong: I think that the US trade gap shows that something is not quite right. It's great that the Americans like almost all other nations in the world, and they buy all of their products - but they're just doing too much of it and others are doing too little of it! :-) The British empire in the 19th century was not only a superpower, but also the world's biggest creditor. (Note that it did not help them too much to remain the number one superpower either.) The budget deficit is also kind of wrong - although this one is more likely to shrink if the economy works well. After 1999, I did not believe for a single minute that the US budget surplus would be a permanent state of affairs and one should "plan how to spend it" - in other words, I believed that it should have been spent to compensate a part of the debt from the previous years and the following years. Yes, of course that I would have also supported tax cuts, but they should come together with cuts in spending.

Although the deficits are not right, my feeling is that some not-terribly-deep ideas are repeated too many times. Also, some unfounded rumors - such as the statement "China is reducing its US dollar reserves" - appear all the time - this one has been officially denied. So let me propose a provoking alternative description of the situation.

The sino-dollar zone

The USA effectively have a monetary union with China because the Chinese government pegs their yuan to the US dollar. The monthly trade gap of the Sino-American union is roughly 40 billion dollars: 50 billion of the US gap and 10 billion of the Chinese surplus: these two numbers also include the internal trade between China and the USA. The deficit is roughly 25 dollars per capita; obviously, the Chinese citizens are treated as people with all of their human rights!

Let me call the monetary union "USAC" - which stands for The United States of America and China. ;-) It's a disconnected country with 50 states on one continent and another, large independent state on another continent which is run by a Communist Party. It has two capitals and nearly 1.6 billion people.

Those 25 dollars of the monthly trade gap per a citizen of USAC is a lot, but it is not so much if compared to other countries. For example, Australia's October trade gap was nearly 2 billion US dollars, which is 100 dollars per capita.

United Kingdom's October trade gap was 8 billion USD, which is 130 USD per capita. Note that even if I split USAC to America and China, the US gap will be "just" 170 USD per capita (about 6 dollars a day) - it's not so terribly different from the UK, and you may explain the difference by a better ability of the USA to grow. The more space & population growth a country has, the more you should expect that it will attract investments to support its growth. It's of course incorrect to imagine that the only sustainable configuration is when all trade deficits vanish.

Why I talk about America and China together? Because every time the dollar loses a cent, the yuan loses, too - which makes China even more competitive. Most people don't appreciate the fact that the depreciating dollar has also depreciated the yuan.

Imagine that yuan becomes a floating currency. Free market is always great, but will it be enough to restore balance in the global trade? I am not so sure. Even if China's currency would double, China would remain an excellent source of cheap labor simply because the salary per hour is just 10% of the salary in America, for example.

(Some people say that the yuan is only undervalued by 40 percent - I don't believe it. The correction would start with 40 percent, but it would continue.)

Although a floating Chinese currency is eventually desirable, it may be inappropriate to make this change in the period when many people believe exaggerated ideas about China which is so "hot".

Such a transition should be done in a predictable environment. By "predictable", I mean predictable by the policymakers, not so much predictable by the speculators! I actually think that China itself should first demand more - e.g. higher taxes - from all the foreign (and domestic) companies that come there and the government should actually do more for their people! They're giving their capital - which is the work of the Chinese people - too cheaply. It probably sounds ridiculous if a pro-free-market advocate like I complains about the Chinese communist government that it is not sufficiently socialist on the economic issues, but well, this is what I do. :-)

When the situation in China is sufficiently cooled down so that the average expectation for the yuan motion is zero, it should become a freely floating currency. Floating the currency in the environment of high expectations helps primarily the speculators who buy the currency in time, but that's probably not the goal.

The budget deficits after 2000 appeared because the US economy slowed down, and the deficits in 2003 and 2004 were affected by things like the war in Iraq. With an improved economy and improving situation in Iraq (hopefully), it may be expected that the budget deficit will decrease in 2005.

What about the trade gap? It is not right to assume that the healthier economy will reduce it too much. A growing economy means that the demand is strong, and the imports are strong as well. However it seems clear that the trade gap is large especially because it's still easy for the Americans to borrow money. As the interest rates grow - and hopefully there won't be anything that stops Greenspan to raise the basic interest rate to 3.5 - 4.0 % next year - they will reduce the consumption paid from the loans. This will naturally limit the trade gap. Higher interest rates may attract more investments, and the currency exchange rates may move closer to those when the US interest rates were high in the late 1990s - although this time, they necessarily won't be that high.

I am skeptical about the eurozone growth next year, and my estimate is 0% while the new members of the EU will have a moderately positive growth. The main reasons why the growth in the eurozone will not be positive are:
• the jobs are gonna be moved to the Eastern Europe, and because most of the new countries will already be seen as comparably expensive, given the reduced quality of the workforce there, the jobs will be moved even more to the East. This will undermine the Western European job market and the domestic demand
• the hedging contracts will evaporate throughout 2005 and the European exporters will see, without too much of the rosy glasses of hedging, what it means to be producing with a currency overvalued by 20-40 percent; we claim that a sustainable EUR/USD rate that allows growth everywhere is about \$1.10 per euro
• the inflexibility of the oversocialized European economy will take its toll
• moreover, some new pressures suppressing the growth - such as the Kyoto protocol that will take effect in February - will start to act

OK, let me finish with a judgement about the unbalanced situation on the market. It is mostly a fault of the small interest rates in the U.S. - in this sense, I apologize to Mr. Maestro - it is Alan Greenspan's fault. The very small interest rates have discouraged Americans from saving; the discouraged saving also reduces the intent to export; the small rates encourage them to borrow money and import. All these things support the semi-rational idea that the dollar should fall, and the dollar fall clearly does not solve anything. Americans still buy the same things and pay more for it; the foreign exporters get less for their exports, which makes them less able to import from America. The real inbalance is elsewhere, and the interest rates are a major reason.

There are lots of hedging funds and currency speculators around. These disgusting parasites are small replicas of George Soros who have decided to earn money simply by making bets that the dollar or something else will drop - and so far, the theory that this is the ultimate free lunch has worked for them. There should be no free lunches like that because a free lunch is something that makes economy inefficient - a free lunch is a socialist concept. The hedging pseudo-businessmen are not doing anything useful, and they receive a lot of money for this "work". Instead, they should be cleaning the toilets, for example, to be more useful for the society. They should be awarded for their excellent "work" they have done so far: for example, the Fed should raise the rates more than expected. The dollar would then recover much more rapidly than otherwise, and these stinky anti-dollar hedged bastards - which are worse than loop quantum gravity - should drown in their own blood, much like amoebas in a petri dish after we added acid. ;-)

The market should become much less predictable for the speculators - they should be much less able to predict the outcome. Because they're often able to predict, many people with poor moral standards become speculators, and many speculators around is certainly not good for the society as a whole. You know, in socialist Czechoslovakia, we used to have a lot of "wechselmen" who were buying the German mark from the German tourists for 10 crowns and selling it to the Czechs for 20 crowns while the communists claimed that the German mark was equal to 4 crowns (except that you could not buy it - but 4 crowns is what the Germans got in the bank). These people became pretty rich; in some sense, they were already building the market economy within socialism. That does not change anything about my opinion that these people are immoral, useless, and despicable, and the hedge funds are analogous.

My guess is that America can happily grow with up to 5 percent interest rates. It was only the period after the internet bubble burst when the people were so discouraged that they needed a smaller interest rate. Today, the USA should be able to return to the high interest rates. Greenspan has warned everyone sufficiently many times, and the next thing he should do is to act.

1. I don't see the relevance of measuring debt per capita. The real danger of debt is that your credit gets cut off, like Argentina a few years ago. In the case of the US this probably hasn't happened yet because it would cause serious problems for the global economy (in particular for our creditors in east Asia whose economies and bank solvencies are now dependent on our debt). Your credit doesn't depend so much on your population but on your GDP. Thus adding China doesn't really do much good, especially since China has been promising to gradually decouple. Rumors about China dumping dollars with no substantiation propogate throughout the world overnight because people expect this decoupling any time now.

But I agree, by this measure the UK and Australia have equally serious problems. The trade debt has always gone away during a recession, but globalization has apparently destroyed this mechanism. The dangerous position of the UK and Australia doesn't imply that the US is safe, but that the English speaking world will sink or swim together. But a mild winter could let the US off the hook for now.

2. Sure, not surprisingly I agree with the dependence of the problems on the ratio with the GDP, and so forth.

On the other hand, I don't believe that the English speaking world is approaching a catastrophe of the Argentinian proportions, and I can't quite imagine a sudden coordinated attack of the creditors against the USA or even the whole English-speaking world.

3. The problem with economics is that there are "hidden variables" which are not included in these sorts of discussions. I.E, it is impossible to measure utility curves, even if you record ALL the data from a real economy. This is what makes Economics an art form.

Now that we have cleared that up, fundamentally the success of the American economy will be how it overcomes mistakes by its leaders as whoever runs the country will make mistakes. I quote:
"It is better to be wrong and do something than to be right and do nothing."

George Bush is a decision maker. Now will he make the "right decisions"? Well any decision in economics is the wrong decision in the long run, due to a lack of data. Only markets can decide. The real criteria is will his decisions lead to a critical collapse for America. Using your analogue with the UK, this will not happen due to economics but due to politics and grand alliances.

Now George Bush could be a liability as for the first time in my life, the French and Germans are without doubt leaning towards China! Almost certainly, the French and Germans are aiding China militarily and technologically. I believe that Nato is finished! This means for the next 20-30 years Global instability until China gets on its feet.
It shall be interesting times!!!

An amateur mathematician

4. Hey Zelah!

Thanks for your interesting notes. I agree that economics is a kind of art, due to the impossibility to learn any complete set of relevant data exactly.

George Bush is not the person who decides about the whole US economy. Most of the economy works without any interventions - America is a rather typical free market.

The USA is a military superpower, and as a European, I would be very unhappy if Europe started to move away from the USA as its key ally. On the other hand Europe, a military dwarf, should become stronger. It's painful that the US soldiers are still so necessary in so many places of the world! I am mostly grateful to the US troops - and the US taxpayer who pays them (well, this includes me haha) - for their presence.

I don't know what sort of military collaboration of Europe and China you're talking about. China is as far - literally as well as metaphorically - from Europe as it is from the US. Could you be more specific? It could be rather interesting.

Best
Lubos

5. Hi. I cannot prove my thesis I must admit, but I have circumstantial evidence.

1. The French and Chinese Military have been training together on an increasing basis like in March and September 2004.

2. Europe (Mainly France and Germany) are building a Global Positioning System (Galileo). France and Germany wants this to be shared with China. America wanted Europe to deny China access to Galileo if there is a crisis but France and Germany have refused so far. America has retaliated that she will destroy Galileo rather than allow China access.

3. France has been requesting a lifting of the Arms embargo to China recently. Now as anyone who has followed the recent UN scandals will know, this effectively means that France has already made illegal arms sales to China.

4. Gerhard Schroeder has made it clear that Germany supports China's "One Country" policy towards Taiwan. This is just when Taiwan is about to have elections...
Perfect timing for China! Now it has just been announced that Taiwan's opposition, which supports reunification, has just won...

5. China will overtake America as Germany's major export market in 5 years!

6. Finally, I believe that America's Cultural conservatism, which you as a Czech national would understand, is not understood in Europe. (So little do the Czech people support the Iraq war, the ruling conservative government can only send 100 POLICE to Iraq! Although it is reliant on America counterbalancing the Franco-German Axis in Europe!)

This is my evidence that an enviable split between Europe and America has occured. America has a strong military, but is a net debtor and if Asian countries like China felt they could rely on Europe (admittedly a bit if!!!) they could dump the dollar and replace it with the Euro!

An amateur Mathematician

6. Hey Zelah,
I think that you are confused about many things.

The Czech Republic has had a left-wing, social democratic government since 1998. Not sure what conservative government you're talking about. It just happens that the social democratic governments may support Bush's military plans - much like Tony Blair - is it so shocking?

Yes, the Czech Republic was not terribly excited about the war and only offered a few policemen and the chemical unit that was not really used too much. The conservative, pro-free-market president Vaclav Klaus, who is otherwise a supporter of Bush, is never enthusiastic about any war, so the Czech Republic's attitude to the war was "neutral", so to say. ;-)

I don't think that it is necessary to reply to your conspiratory speculations about the European-Chinese plans against the USA; I expected something more serious. Europe is doing various things, and Chirac may have been Arafat's friend etc. ;-), but globally, be sure that Europe is not so infinitely different from America, and China is pretty far from the Euroatlantic reference frame of the world.

All the best
Lubos

7. Lubos,

You are really out of the loop if you think that "Europe is essential the same as America".I think your thought processes must be like this.
America is essentially a liberal country. France-Germany are essentially liberal contries.

This may have true before 9/11, but it not true of America anymore! Read the Patriot Act! Even America conservatives complain about this!

The only thing in common between America and France-Germany is that they are both democracies! This does not count much in foreign affairs! What matters to Europe is America foreign policy terms viz-a-viz China!

Finally, what "conspiracies theories" have I portrayed? All the points I made are FACTS! No conspiracy theories were portrayed! All I did was extrapolate from the obvious massive decline of the dollar to a reasonable proposition that Asian countries could decide to switch to the Euro! Already many countries are diversifying!

An Amateur Mathematician

8. Dear Zelah,
the Patriot act has been a very reasonable answer to the incrased threats.

America definitely remains a free country.

Best
Lubos

9. One day China and India will become just as "expensive" as America, Western Europe, and Japan today.

For many years after World War 2, West Germany and Japan were "cheap labor" countries. For West Germany it took around 10 to 15 years to become an "expensive" country, while Japan took around 25 to 30 years. South Korea seems to have taken around 15 to 20 years to become "expensive", once it became a genuine democracy in the 1980's. It would not be too surprising if China and/or India becomes "expensive" by the time it's 2020.

The obvious scenarios I can think of where the American dollar would lose it's world reserve currency status, would be if there's an episode of hyperinflation in America (ie. 200%+ inflation per annum) and/or China backs it's Yuan currency with gold. Ever since Richard Nixon took the American dollar off the gold standard, almost every currency has become fiat and is backed by nothing. What determines the value of a fiat currency is it's supply and demand on the international financial markets. It seems like politicians really dislike gold with a passion, since it limits how much they can manipulate their monetary systems for political purposes. Printing up money is a lot easier than digging up more gold out of the ground.

10. Hi Lubos,

the Patriot act is a reasonable answer?
Have you actually read it? I think it's very dangerous...
By the way, I think it's a little bit funny to watch an anti-left
euro-american and an apparently europhobic american argue about the relationship of Germany/France (the center of old Europe :)) and China.

An "old" european

11. 1. The trade deficit does not matter very much as long as foreigners keep investing in the US private sector (i.e., the productive sector). Unfortunately, it seems that for the first time, the foreign investment in the US private sector is shrinking, most of the inflow is buying up US debt. The commonest is US treasuries, and China has diversified into buying US home-mortgage debt.

2. The budget deficit is very much decideable by President Bush and the Congress. Since it is all in control of the Republican Party, there is not the excuse of previous times of divided government (e.g., during the Reagan-Bush years, when Congress was Democratic). It is not a rumor that foreign countries are slowly diversifying their reserve currency holdings, holding fewer dollars as a percentage of their portfolios. The dollar is falling in relative value in response to the US deficits. The problem is that should these trends continue, the US government will have to raise interest rates to fund its deficit. This will slow down the US economy.

3. Markets have a tendency to overreact, a.k.a. panic. One cannot rule out some event that would cause something like the October 19, 1987 stock market crash.

4.I believe, this year, China overtook the US as the largest recepient of foreign direct investment (and in absolute, not relative terms).

The US economy has great size and strength. Provided its government stops abusing it, it will recover.

12. See, e.g., what Morgan-Stanley's economist, Stephen Roach, has to say on the subject. He is, to put it mildly, a lot less sanguine.

But then, when one's company and their clients have hundreds of millions of dollars on the line, one does tend to be a little less flippant about the downside risks.

13. Physicsists on economics is almost as odd as economists on physics, only more entertaining.

Lubos, you claim to believe in markets, but your distain for speculators shows that you don't appreciate their function.

You know, in socialist Czechoslovakia, we used to have a lot of "wechselmen" who were buying the German mark from the German tourists for 10 crowns and selling it to the Czechs for 20 crowns while the communists claimed that the German mark was equal to 4 crowns (except that you could not buy it - but 4 crowns is what the Germans got in the bank).The wechselmen were illegally exploiting the Czech governments attempt to overchage Germans for Crowns permitting Czechs to obtain Marks - providing an illegal service but one valuable to both Germans and Czech individuals. Those like George Soros, who obey the laws, are providing a legal service, and a valuable one. By identifying overvalued currencies they are maintaining a proper valuation in the markets, an absolutely essential element for a free market. If they bet correctly, they make a lot of money. If they bet incorrectly, they will lose a lot, but their activity helps make markets possible.

Your later post about people short selling Coca Cola is an amusing example. Their enterprise is almost certainly foolhardy, since Coca Cola earnings are doing OK, and unless somebody discovers that Coke causes AIDS, are likely to remain so. In that event, the short sellers will lose their shirts, providing a nice profit for Coke shareholders (He who sells what isn't hisn, must buy it back or go to prison.)

...these stinky anti-dollar hedged bastards - which are worse than loop quantum gravity - should drown in their own blood, much like amoebas in a petri dish after we added acid. ;-)Have you considered anger management therapy?

14. Dear imperialist pig,

I am not arresting them - I am just saying that the people like George Soros are mostly parasites.

You know, capitalism is a system that naturally makes things efficient, and the efficient invisible hand of the market is what I believe - as opposed to admiring anything that anyone else is doing. Self-regulation of the market by business is an important thing, but it can be done with 10% of those George's Soroses compared to the current number. In other words, 90% of them are parasites.

Moreover, Soros is moreover a socialist pig, and if you were really a capitalist pig, you would definitely agree with me that he's a jerk.

Best
Lubos

15. The whole idea of a market economy is that the market determines the "right" number of speculators, not the government and most assuredly not highly opinionated physicists. George Soros is a very clever fellow and a capitalist rather than a socialist, but I don't know whether or not he's a jerk. He certainly seems pretty charming on television. He makes his money by exposing swindles, which can be unpopular because the swindled don't like to learn it - but he's not the swindler - the swindlers are the Suhartos and Bushs of the world.

16. Dear imperialist,

you're not getting the main point about Soros - which is that he would not have earned a single million if governments did not exist.

This whole industry of bets and speculations about the currencies is about guessing whether the government or the central bank will enter the game and support this currency or another currency, whether it will raise the interest rates or not, and the main moves in the currency rates always reflect something that the governments says. Just watch the forex market for one day.

Without the governments, there would be a very little room for such speculations. So in this sense the reason why Soroses and similar guys can exist is the same like for the wechselmen in Czechoslovakia where the regime decided to pretend that 1 crown was 5 times more valuable than it actually was. In both cases, the speculators benefit from the overly existence of the government regulation.

The stories about exposing swindles are ridiculous - it's just about exposing and inventing whatever is useful for Soros et al. to make profit. I don't believe that your nickname reflects your political opinions if you prefer Soros over Bush.

Best
Lubos

17. Lubos - you're not getting the main point about Soros - which is that he would not have earned a single million if governments did not exist.Absolutely. But my point is that markets have frictions, and if I may make a physical analogy, metastable states develop due to government mismanagement or corruption. Speculators are a kind of catalyst, permitting these metastable states to decay.

A good example is the present US current account deficit. At present, the US consumes about 6% more than it produces. Historically this would be a catastrophiclly unstable state for an ordinary economy. But the US, by virtue of its extraordinary military power and huge economy, and the status of the dollar as the worlds reserve currency, has a very large potential barrier against collapse of the dollar. Japan and China have too much to lose to want to trigger the decay. If the imbalance continues, though, decay it will, and the later the decay, the more catastrophic it is likely to be.

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