The Gold Standard  

Dani Rodrik says that banks are losing support of economists in maintaining their grip on the political establishment. He bases his observations on the revision in IMF thinking (published in February 2010) on the utility of capital controls as one more weapon in the policy arsenal of sovereign governments. From here, he reckons that it is a short hop to a global financial transaction tax.

What made finance so lethal in the past was the combination of economists’ ideas with the political power of banks. The bad news is that big banks retain significant political power. The good news is that the intellectual climate has shifted decisively against them. Shorn of support from economists, the financial industry will have a much harder time preventing the fetish of free finance from being tossed into the dustbin of history. [More here]

I am sure he wrote that last sentence visualizing the scene with delight. I certainly would not shed many tears either if it were to happen.

Another academic called for a transaction tax although he admitted that he never thought he would call for one:

One way to chase away this demon is a deeper level of intra-European financial integration, in particular, a Europe-wide Tobin tax on transactions involving government debt. (I never thought I would write this, but I never thought I’d ever see Great Depression 2.0 either). [More here]

Other than that, he thinks that the Greece budget cuts and the demonstrations on the streets of Greece are proof that the European Monetary Union is now putting the finishing touches on political integration. I agree. My European friends told me as much more than a month ago.

The demonstrations and riots in Athens are an indication of the pain that Greece will face in the coming years. A fiscal contraction in a small open economy under fixed exchange rates (i.e. inside the Eurozone) is likely to hurt in the short run.

These draconian measures are also proof that the Eurozone is forcing the very political integration that economists were demanding as a precondition for monetary union (Persaud 2008). [More here]

I.M.F. policies call for it to disclose documents and information on a timely basis, with the deletion only of market-moving information. But under the rules a member country may decide to withhold a report, an organization official said.

China allowed the release of its reports until the monetary fund’s executive board decided in June 2007 that reports should pay more attention to currency policies. China has quietly blocked release of reports on its policies ever since, without providing its specific reasons to the I.M.F. 

A person who has seen copies of the most recent report last summer said that the monetary fund staff concluded the renminbi was “substantially undervalued.”

The monetary fund regards a currency as substantially undervalued if it is more than 20 percent below its fair market value.

More than four-fifths of the I.M.F.’s members allow publication of the agency’s annual staff reports on their economies. Countries blocking release are mostly tightly controlled places like Myanmar, Sudan, Turkmenistan and Saudi Arabia, although Brazil has also not released its reports. [More here from New York Times]

Some blogs gleefully noted that this article could signal an aggressive stance of the US Government on China’s exchange rate policy. I doubt. One person very familiar with China and the IMF said that the article was accurate with respect to the claims it made above. At the same time, he was willing to offer 200:1 odds on the US Treasury calling China a currency manipulator in its forthcoming report on global exchange rate practices. Any takers?

Thanks to the wonderful blog that FT.COM Alphaville is, I came across this recantation by Jim Chanos who now says that he is only shorting the China property sector and not China! He became prominent among China bashers for his comment that China was Dubai * 1000. Jim Rogers, former hedge fund manager and now investing his own money and based out of Singapore, quipped that Jim Chanos did not know China. Funnily, he too thinks that China’s property sector is becoming a bubble. Apologies that this is about two months old. I have not been following it that closely although we have blogged on Jim Chanos’ comments and Tom Friedman’s responses here and here.

Professor Patrick Chovanec has also weighed in on this matter in his blog. For China watchers, his blog is worth bookmarking. He is sceptical of the claims that there is no bubble in China although he has taken care to present the FT article of Geoff Dyer which itself is balanced, if inconclusive.

One should not miss this pithy observation of Jim Chanos:

China has embraced capitalism to keep the socialist elites entrenched while, more lately in the west, we’ve embraced socialism to keep the capitalist elites entrenched. [From here]

As an Indian, I think this is the ‘Ardhanareeswara’ theory of political economy! You need elements of both, eventually, to have a balanced economy.

Moving on from property bubble to the larger issue of whether China has more asset bubbles, noted China bull-turned sceptic-turned bull (if a trifle more balanced now), Stephen Roach has pooh-poohed the notion of Chinese bubbles in property, credit and the notion of an imminent banking crisis. He had written on this for Handelsblatt. But, the English summary is here in FT Alphaville.

While a banking crisis might not be imminent, the question of bank recapitalization might become imminent because China is contemplating cancelling loan guarantees issued by the local governments to their investment companies through whom they had borrowed to fund local infrastructure and related projects. See here and here for some news and commentary on this matter, respectively.

I view this matter rather positively for China for the long-term as China is making the local governments shed the notion of an unlimited backing from the Federal government which, in turn, encourages them to give their own loan guarantees. In turn, that persuades banks to lend to such vehicles indiscriminately. This entire chain of abundant moral hazard might be about to be broken. This is, in that sense, a step towards more risk-aware lending and borrowing.

That said, in the short-term, it is not clear as to what it means for the loans already made. Perhaps, some of them are going to turn bad and that the Central Government does not mind it. Second, it is not clear how the banks would account for the riskiness of the loans already made and hence, how much of capital must they have, on such a risk-adjusted basis. It is my conjecture that there are going to be some significant funding requirements here. We need to wait for reasonable guestimates here.

Based on these developments, it is reasonable to infer that the lending that had taken place in 2009 had exceeded prudential limits. The government is rightly concerned and hence, it is moving to prevent further damage. I agree that it is unlikely to cause systemic damage but it is clear that Chinese banks have some rough ride to encounter, in the near-term. They might emerge stronger and better for it.

Thanks to John Mauldin’s wonderful emails, I came across two pieces of research on Europe. Research by Gavekal was sober, by their standards, considering that the subject matter was Europe. They usually are quite unsparing in their criticism of Euro and the Eurozone. The political economy significance of the single currency project goes unrecognized in most such invective against the Eurozone or the single currency. They invariably focus on the loss of policy freedom and the absence of fiscal union. Most countries knew what they were getting into. So, they must have reckoned with some gains and a crisis is a good way to complete the missing elements in the project.

But, as I wrote earlier, this piece from GaveKal was on whether bond yields in Eurozone account for the risk of break-up adequately. In general, no country’s bond market prices in any risk of a breakup or break-away of their country from the Eurozone, based on their model. Within that broad observation, they find Belgian, Irish and French debt (bonds) to be more expensive than others’.

The second piece of research (’European Union trap’) featured by John Mauldin dealt with the issue of fiscal austerity in a ‘Open Economy National Income Accounting’ framework.  Simply put, if private sector is trying to pay off debt and if the public sector in some of the crisis-affected countries (Spain, Ireland and Greece) too begins to reduce government debt, then growth can only from external surplus. Which means all countries have to depend on exports. That is a lot easier said than done. Alternatively, they need to let private sector run deficits (spend more than they earn). That would increase their indebtedness. This dilemma appears more acute for Spain and Ireland than others.

Of course, if growth is not the primary goal or can be sacrificed for a couple of years or mildly sacrificed but over a longer time-frame, then these countries might be able to pull off the balancing act without having to put the society through a potentially destabilizing economic adjustment programme. In other words, muddle-through is an option.

John Mauldin thinks it is not such a bad idea:

Today I am sitting listening to Ralph Merkle lecture on nanotechnology, part of a 9-day-long series of lectures on how accelerating change in technologies of all types will affect our world. 15-hour days and intense discussions are stretching my brain…I am getting overwhelmed here in California, learning about the future. It is going to be amazing, even if our bonds drop in price. We will live in what may be the most interesting and exciting period of human history. What a contrast between the financial markets and what the scientists continue to amaze us with. It is one of the reasons I think we Muddle Through, in spite of our rather negative economic environment. [See here]

It all started with this URL that  came from a colleague. It was a piece by Stratfor, an American think-tank, on the fiscal deficit problems of Greece.

I read it and my first reaction was that it was interesting to read and it made sense too. I circulated to some friends in Europe, or more precisely, European friends. The replies received from three of them were very illuminating. I am posting them all here. That makes for a very long post. My apologies. But, I am aware that it makes the post long. Yet, I have chosen to do so.

For those of who read only English newspapers to understand what is going on in Europe, these are eye-openers. In their own ways, the three Europeans downplay the notion that Germany has lost out in the single-currency project and that it has only something to lose by ‘bailing out’ Greece. The facts speak otherwise. Germany, as a country that has resolutely and impressively enhanced its productivity since 1995, has benefited from a single European market. Its real effective exchange rate has depreciated despite the appreciation of Euro against other currencies in the world since 1999.

Therefore, hyperventilating English language commentators who gleefully predicted the collapse of the single currency found their arguments losing their key pillars.

Read the second comment by a European friend who says that this is one way to ‘democratically’ obtain political unification rather than a political union. He takes care to emphasize the process rather than the result.

As I said before, read the three responses I got. You would be wiser as I became too, on the topic.

Since the third of the comments ended with Japan, it is what we would turn to in the next post. Make that a second one from now, for we still have unfinished business with Europe

——————————————————–

Thanks for the mail, but I do not share many of the arguments. In fact, talking about a German “born to conquer” mentality is missing much of the point in the current crisis. In a way or another, the current EMU / Greece crisis brings us back to the discussions at the very beginning of the European Economic and Monetary Union, EEMU as the original name was. The blueprint was presented by Jacques Delors in 1988, the times of the Iron Curtain. The European Economic Union had just overcome “Eurosclerosis” and Delors used the momentum to bring forward the old idea of a single currency, basically building up on the Werner plan for monetary union that was withdrawn in 1979 (or so, during the second oil shock).

Right from the beginning, there were two camps: the Italians arguing that “convergence results from monetary union” and the Germans “convergence is the prerequisite for monetary union”. The Germans were pointing to the example of Italy. Although Italy had one currency for decades, the divergence between the poor South and the rich North widened over time. The German (Bundesbank and economic intelligentsia) always stated that the countries with poor fundamentals will suffer if you eternally fix exchange rates. The debate was in full swing when the Iron Curtain fell, and German Chancellor Kohl “sacrificed monetary authority (of the Bundesbank) to obtain the French backing for the Unification” (original comment of the German Bundesbank at that time). My way to look at it is still this old one: the German economy enjoys the largest domestic market and has thus a natural competitive advantage over the rest of Europe. The Single Market and the Single Currency is multiplying this advantage – there is no strategy of “economic combat” or another hidden agenda behind it. the only argument I do accept is that the German Mittelstand (SME entrepreneurs) are so productive that they can compensate for the huge mistakes and obstacles of their own government, such as 43% marginal tax rate for incomes as low as 53,000 Euros per year, very high Value Added Tax, trade union representatives in the board of large companies etc.

Going forward, we have to go back to the discussion of the EEMU (old definition) at introduction that was cut short by German Chancellor Kohl: if convergence is not the result of monetary union, how can you compensate for the divergence in productivity trends? In a way or another, for me Germany has not to bail out Greece, but to give back some of their windfall profits of EMU to the other members.  The German government’s room to do so is limited, due to its own political deficits. Just to keep in mind as an example of Germany’s wrong economic policy: Germany still allows its Bundeslaender (States) to run the Landesbanken, although there is no raison d’être anymore since the creation of the German Bundesbank. The German Landesbanken(s) are generating losses every year, and WestLB gets multi-billion bailouts on a regular basis. Look at the situation of the health care: on average, a German is going to the doctor 18x per year, on average! All the service is free, including the dentist and many more things. They can afford this luxury because they benefit from the EMU.

The risk short term is that Germany is ready to make some concessions on very weak ground, i.e. accepts some form of guarantees for Greece without discussing how to compensate for the divergences in productivity etc.

——————————————————————————————–

Hi Anantha,

I agree that this is a good piece of research. Some remarks:

I don’t think there are examples of monetary unions that have survived history without becoming political unions (the fathers of the monetary union, Schmidt and Giscard first, Kohl and Mitterrand later, might not have explicitly said so, but underneath…that was the idea)

Somehow this dilutes (and confirms the exaggeration of) the emphasis the author puts on the conflict of German interests with the rest of Europe: hey, nowadays we even have a German Pope…and i don’t think that is 100% attributable to the inscrutable ways of the almighty(i.e. some human action is also part of that story…)

A couple of days ago, RGE was mentioning that IMF should do bail-out because they are capable (have history) of imposing conditionality….

The real thing is to see if EU (certainly to a significant extent under the leadership of Germany) will be able to impose serious conditionality: this is what counts and – i think – here i tend to agree with author

So, maybe – without necessarily thinking that it was planned/conspired from the start – this is the way to “democratically” obtain political unification (note: I don’t mention the word union because i emphasize the process rather than the result):

Let them in and party (close to zero spreads at no cost)

Then present the bill…i.e. surrender fiscal sovereignty 10 years after surrendering monetary sovereignty

—————————————-

In my view, this paper tries to dramatize current events with wrong and simplified assumptions. History is not always a Hollywood screenplay.

I agree with the point that “at this moment, European Central Bank liquidity efforts are probably the only thing holding back such a default. But these are a stopgap measure that can hold only until more important economies manage to find their feet.”

Moreover, the statement “letting the chips fall where they may, must be tempting to Berlin”, sounds convincing.

However, the following remarks concerning the text are necessary:

1. Today, neither mountains nor desert or oceans are important trade barriers; it’s the import tax.

2. Nobody wanted war in the 1930s beside Germany and the Soviets. Germany got the Rheinland, Sudetenland, Austria, the Czech Republic, Slovakia and Chamberlain still wanted peace (remember the famous Munich conference in 1938)

3. The funding of the EU is not just Germany’s historic favour/gift to the rest of Europe. A stable, prospering Europe creates the German export markets and it’s in Germany’s own interest. For the same economic reasons the US is protecting trade routes globally, supports failing states and created NAFTA and goes even to war.

4. The Maastricht Treaty bans a concerted EU/ECB bailout for Euro members (not non-euro EU member such as Hungary and Latvia), not a bilateral one. Moreover, the ECB could easily circumvent these rules by buying Greek bonds in the secondary market.

5. A default of Greece would not scuttle the EUR; it would make the currency union more credible.

6. The statement, “the only way out of economic destitution would be for them to leave the eurozone” is nonsense. The Latvian example shows that competitiveness can be achieved by cutting public salaries. Moreover, Greece will never leave the Eurozone. A reintroduction of the Drachma would lead to chaos, not export stimuli.

7. The text doesn’t mention the simplest version of getting rid of debt: a controlled default in the same way as dozens of countries had done this in the past. If a sovereign default is conducted in a proper way, an Argentinean scenario is the exception, not the rule.

8. The debt situation of European countries is serious, but not dramatic. Look at Japan.

Barely had I blogged on the the observations of Prof. Bhagwati on whether the US was right to call for China to revalue the exchange rate here and on the opinion of Prof. Arvind Subramanian on this matter, came an interesting report from the Research folks at Standard Chartered Bank (I am not in a position to share the full report) that showed that ASEAN-India trade had resulted in a greater net positive contribution to the ASEAN region (in other words, India is running a trade deficit with ASEAN) in 2009 than ASEAN’s trade with China. The latter is five times larger than the former. Yet, China ran a smaller deficit than India with ASEAN in 2009. Further, China’s deficit with ASEAN has been shrinking rapidly.

That this happened in 2009 despite China unleashing a massive economic stimulus aimed at fostering domestic demand is significant. Lately, China’s import growth has been outpacing its export growth. Perhaps, the time has come to do a detailed analysis of its import content. It is possible that China is importing more and more raw materials and resources and less of the stuff that ASEAN produces. May be, it has started to produce most of what it used to import from ASEAN countries before.

All of which are a different way of saying that China’s growth is not adding to growth in the region but subtracting from it. At least, that seems to be the case until last year. In other words, as Prof. Arvind Subramanian argued indirectly, yuan exchange rate policy hurts smaller exporting nations than it does the US. At the margin, it should make the option of importing certain goods from ASEAN more attractive for China.

Then, there is the more difficult problem of analysing how much China’s exchange rate policy affects the exports of ASEAN nations to third countries. I exchanged an email with the author of the report in Standard Chartered raising these questions. He replied that some of these questions would be tackled in subsequent research reports. I await them, very keenly.

Banks refuse to learn. We had Mr. Peter Sands of Standard Chartered Bank criticising most regulatory proposals including that of the proposal to separate proprietary trading, floated by Paul Volcker in the US. There were news that Royal Bank of Scotland was setting aside large sum as bonuses although UK Treasury approved the bonus pools. There were various stories of US and other banks helping Greece to hide its debt. Now, they have turned around and perhaps bought Credit Default swaps (insurance against Greek debt default) on Greek debt. Most EU regulators and commentators were not amused. It amounts to insider trading, at some level. We covered the topic here.

Not a surprise, then, UK’s Treasury Minister says the following:

The risk is now that their confidence has not been sufficiently dented; that they have not truly learned their lesson [More here]

Of course, this news item in UK’s Guardian, in my view, is a clever piece of journalism. It is not clear yet that EU governments have decided to block US based banks from participating in EU Governments’ debt auctions. But, Guardian news story makes it out to be.

This column by John Lichfield in ‘Independent’ puts the message across funnily and effectively. That sums up the title of this post.

OK, Daddy, I understand that. It’s very naughty of them. But isn’t this still a case of the banks biting the hand that fed them?

Er, no, son, it’s worse that that. It’s like the banks complaining that governments are naked after taking their clothes. But the markets (i.e. banks) don’t think that way. If they smell blood, they pile in like hyenas after a limping zebra. It’s called a market opportunity. [More here]

 The world has changed. Bankers have not yet noticed it. It is clear that hubris is the cataract in their eyes that prevents them from seeing it. Investors should not be that myopic.

Professor Jagdish Bhagwati is now blogging. It is good news. Even better news is that he seems regular with his comments. They are not sporadic. With Professor Bhagwati, one cannot offer the excuse that one did not understand where he stood and what he stood for.

His latest comment is on China-bashing on exchange rate. Suffice to say that I disagree with the Professor on the undervaluation of the Chinese currency. I may agree with him that it might not do anything to America. But, America is interested in seeing (at least some Americans) what would happen to China if the currency undervaluation vanished. There are costs to China’s exchange rate policy that are borne by other nations. Professor Arvind Subramanian hinted at it in a piece for India’s Business Standard. TGS had commented on it here. But, one has to admit that a systematic study of global costs imposed by China with its exchange rate policy is still missing.

In the meantime, if you wish to follow the latest episode of ’sound and fury signifying nothing’ on China’s exchange rate, you can follow this link. China’s central bank governor hints at flexibility to come and the Premier promises a stable exchange rate in 2010. All interpretations of these statements will be correct. No one knows when China would change its exchange rate policy, by how much and what the new regime would be, etc. Not even Goldman Sachs, I think.

I am not sure what Professor Bhagwati would make of this piece by Gordon Chang. To be clear, Gordon Chang steers clear of exchange rate undervaluation. He simply states that China dependence on US increased in 2009. Its trade surplus with the US was USD226 billion whereas its overall surplus was only USD196 billion! So, Gordon Chang says that US has leverage that it could use and wonders why the US is reluctant. So, do we. Perhaps, the US thinks that its leverage over China is lower than China’s leverage over the US as the creditor to the US.

Lest one thinks that Professor Bhagwati is all wooly-eyed on China, read his comment on the meeting of the Dalai Lama by President Obama. Readers should keep in mind that Professor Bhagwati blogs as an American citizen and not as an Indian, as many might mistakenly assume.

His suggestion to Greece that it should seek IMF and not EU assistance makes eminent sense. But, Greece might have bought time with an austere budget followed by a good bond issue. Greece had a good week, last week. Those who argue that Greece cannot sustain offering an interest rate of 6.25% for its loans are correct in one sense. It is not sustainable. But, they are wrong that Greece might have to indefinitely pay such a rate of interest on its borrowings.

If it could offer credible fiscal austerity packages and implement them, interest rates would come down. Commentators should jog their memory and read up on how Canada shrunk its interest rate spread to the US Treasury in the 1990s.

Between March 2nd and 3rd, FT wrote many pieces painting India in a distinctively positive shade. The highlight was the piece by Martin Wolf. He wants Britain to give up its security council seat to India. Fat chance but a good recommendation, I would say.

David Pilling concludes his piece with the comment that India does not need a smaller State but a better State. Well, no one can quarrel with that. It applies to most countries in the world as much as it does, to India. He begins the article with a positive review of NREGA.  He says that empirical evidence suggests that most of the subsidy under NREGA reaches the intended recipients.

I wish he had given the source of the empirical evidence that he cites. But, considering that most journalists are suspicious of government schemes,  one has to take his statement seriously.

In the print version, this article appeared in the front pages on March 4th in Asia. There were no IFs and BUTs to the story.

Prof. AS deserves our praise for writing a good piece that kills many birds with one stone. It is a good advice to the US.  It does showcase the good things India is doing. It has a lovely dig at the way Indians win tenure in American universities – by digging up dirt on India. It also highlights how – even if only exceptional – Indian politicians could rise above themselves.

Now, we wonder why it is not institutionalized and why the same Yashwant Sinha is not supporting UPA’s fuel price initiatives? Why cannot the BJP, for example ,throw down the gauntlet to the UPA and challenge UPA to fully de-control energy prices with offer of its support both in the Lower House and in the Upper House?