A Real Appreciation for China (Cont'd)

Another day brings more evidence that inflation in China may be taking care of the undervalued renminbi problem (see this previous post).

The Economist:

In adjusting current accounts, what matters is the real exchange rate (which takes account of relative inflation rates at home and abroad). Movements in nominal exchange rates often do not achieve the desired adjustment in real rates because they may be offset by changing domestic prices. For example, the yen’s trade-weighted value is around 150% stronger than it was in 1985. Yet Japan’s current-account surplus remains big because that appreciation has been largely offset by a fall in domestic Japanese wholesale prices, so exporters remain competitive.

An alternative way to lift a real exchange rate is through higher inflation than abroad. To an American buyer, a 5% increase in the yuan price of Chinese exports is the same as a 5% appreciation of the yuan against the dollar.

Fred Bergsten (interviewed by Michael Casey):

The real [inflation-adjusted] renmimbi exchange rate has appreciated against the dollar at an annual rate of about 12% since last June, although considerably less on a trade-weighted basis. The dollar has fallen against most other currencies, so on a trade-weighted basis, the renmimbi has risen less. On the other hand, one has to accept that the Chinese think of this totally in dollar terms. So the dollar exchange rate is a legitimate focus for them, and if you believe that the dollar is going to bounce around and come back over time it will drag the renmimbi back up with it [against those other currencies.]

They have been letting [the real exchange rate] go up an average of 10 to 12% on an annual basis so it’s fair to say that if they would let that continue for another couple of years they would achieve a restoration of underlying equilibrium in the exchange rate. That would take away most, if not all, of the distortions that their persistent interventions have created....

[G]iven China’s history of hyperinflation, it would be far better to adjust via the nominal rate. It has always surprised me that they seem to prefer to do part of it through inflation. And now that they are really worried about inflation, which has become the focal point of their economic policy, this would be the perfect time for them to let the currency adjust. They know the currency is going to adjust over time anyway and it is better to let it happen through the nominal rate. At the same time, it’s an ideal time for us if they make the move now because it will help rebalance our external accounts and help deal with our high unemployment. From the standpoint of both sides there couldn’t be a better time to adjust the nominal exchange rate for the renmimbi.

See also Bergsten's commentary "A Breakthrough on the Renminbi?" at the Peterson Institute's blog.

The Savings Glut, Revisited

In a speech on "Global Imbalances" today in Paris, Ben Bernanke revisited the "savings glut" hypothesis he offered in 2005.  The current account balance (CA) is the difference between investment (I) and net national saving (NS):

 CA = NS-I

A current account deficit occurs when investment is greater than domestic saving - the gap is filled by selling assets to the rest of the world.

Although it is commonplace to criticize deficit countries for low savings - and the savings rate in the US did indeed become very low - Bernanke argued in 2005 that the US current account deficit was driven by foreign savings.  The financial inflows stemming from the foreign "savings glut" drove up the prices of US assets (including bonds, thereby driving down interest rates), and the decline in US savings followed from the resultant increase in wealth.

As a share of GDP, the US current account deficit peaked at just over 6% of GDP in early 2006.

I today's speech, Bernanke cites evidence that there was strong international demand for "safe" US assets, which supports his 2005 hypothesis.

He is careful not to blame the financial inflows for the crisis.  The failure was how the US dealt with them.  This has a parallel to the 1997 Asian financial crisis:

The preferences of foreign investors for highly rated U.S. assets, together with similar preferences by many domestic investors, had a number of implications, including for the relative yields on such assets. Importantly, though, the preference by so many investors for perceived safety created strong incentives for U.S. financial engineers to develop investment products that "transformed" risky loans into highly rated securities. Remarkably, even though a large share of new U.S. mortgages during the housing boom were of weak credit quality, financial engineering resulted in the overwhelming share of private-label mortgage-related securities being rated AAA. The underlying contradiction was, of course, ultimately exposed, at great cost to financial stability and the global economy.

To be clear, these findings are not to be read as assigning responsibility for the breakdown in U.S. financial intermediation to factors outside the United States. Instead, in analogy to the Asian crisis, the primary cause of the breakdown was the poor performance of the financial system and financial regulation in the country receiving the capital inflows, not the inflows themselves. In the case of the United States, sources of poor performance included misaligned incentives in mortgage origination, underwriting, and securitization; risk-management deficiencies among financial institutions; conflicts of interest at credit rating agencies; weaknesses in the capitalization and incentive structures of the government-sponsored enterprises; gaps and weaknesses in the financial regulatory structure; and supervisory failures.

Ouch.  That's harsh, though he could take the Asia analogy one step further - as Simon Johnson does - and acknowledge that the "breakdown" in the US was partly because we have our own form of "crony capitalism" where the financial industry has, to a degree, captured the regulatory and political system.

Bernanke also has an uncomfortable analogy for the surplus countries that are not allowing their currencies to appreciate:

These issues are hardly new. In the late 1920s and early 1930s, the U.S. dollar and French franc were undervalued, with the result that both countries experienced current account surpluses and strong capital inflows. Under the unwritten but long-standing rules of the gold standard, those two countries would have been expected to allow the inflows to feed through to domestic money supplies and prices, leading to real appreciations of their currencies and, with time, to a narrowing of their external surpluses. Instead, the two nations sterilized the effects of these capital inflows on their money supplies, so that their currencies remained persistently undervalued. Under the constraints imposed by the gold standard, these policies in turn increased deflationary pressures and banking-sector strains in deficit countries such as Germany, which were losing gold and foreign deposits. Ultimately, the unwillingness of the United States and France to conduct their domestic policies by the rules of the game, together with structural vulnerabilities in financial systems and in the gold standard itself, helped destabilize the global economic and financial system and bring on the Great Depression. 

In his central banker-ly caution, he refuses to name names, but he's obviously alluding to China's policy of keeping renminbi undervalued. 

Although he has a knack for giving very comprehensive speeches sometimes, there are some important closely-related issues that Bernanke did not touch on this time.  In particular, the demand for US assets was partly due to the fact that the dollar is the most widely-used "reserve currency" (i.e., held in official portfolios).  This periodically generates complaints from the rest of the world (and for the US, its a mixed blessing), but Bernanke did not point to any alternative.  Nor did he suggest that it gives the US any special responsibility (and, personally, I don't believe that it does).  Also, one significant motive for reserve accumulation is self-insurance - countries burned by reliance on inflows of foreign savings decided to build up their own.  An better international insurance mechanism would reduce that need.  In theory, that is part of what the IMF is supposed to provide.

Update: A nice response to the gold standard analogy from Free Exchange.

Who Needs Paris?

Not us lucky denizens of Middletown, CT, according to the National Trust for Historic Places.  At the top of their list of "Most Romantic Main Streets":

Middletown, Connecticut. Middletown’s allure includes an artful Main Street brimming with elegant restaurants, an award-winning local chocolatier, and the romantic Inn at Middletown, offering the best of New England charm.

Not to mention the drama of our collapsing buildings!

The Big Squeeze on Little G

When I introduce the GDP figures to my macroeconomics students, I point out that the federal government accounts for a much smaller portion of the economy than many believe.  Federal government purchases - i.e., the federal part of G in the national income accounts - was 8.3% of GDP in 2010, and more than two-thirds of that was military spending.  The federal nondefense part - all the stuff that we think of as "the federal government" like the FBI, NASA, the State Dept. and so on - was a mere 2.7% of GDP.

One reason that people think that the federal government is larger is that federal spending was $3.7 trillion last year, which would be 26.5% of GDP.  But most of that is transfer payments - money sent to people (and, to a lesser extent, state governments).  Mainly, this is social security and medicare.  In the national income accounts, most transfers end up in the "C" (consumption) component of GDP when the recipients spend the money.

The chart below, from BEA data, illustrates that nondefense federal government purchases are only about 10% of federal spending.

That is, the turquoise pie slice is $396.6 out of $3890.6 billion.

So when zealous congressional republicans say that they are going to cut our "big government" by $100 billion*, the consequences are quite severe because the cuts almost entirely come out of that small slice.  This analysis by the Center on Budget and Policy Priorities provides some of the bloody details, including cuts of 12.7% in Labor, Health and Human Services and Education, 14.5% in Interior and Environment and 26.1% in Transportation and Housing and Urban Development.

*It depends on how you measure it; as the CBPP analysis explains, the "$100 billion" figure is relative to the president's proposal and is for an entire fiscal year (which runs from October through September), while the cuts are for the remainder of fiscal 2011.

The CBPP analysis comes to my attention via the invaluable Ezra Klein.

Update: Paul Krugman has more. 
Update #2: So does Bruce Bartlett.

Real Exchange Rates Under Fixed and Floating Regimes

On Saturday, Paul Krugman posted on a favorite topic of mine (how did he know it was my birthday?) - the interaction between real and nominal exchange rates.  Krugman takes the fact that they are very highly correlated as evidence against the classical view that money is "neutral" (i.e., it does not affect real quantities):

If you have a classical view of the world, you would argue that nominal shocks should affect the nominal, not the real exchange rate: the real exchange rate is a real phenomenon, and money is a veil. Specifically, you’d expect any nominal shock to move the price level by the same amount that they move the exchange rate. 

Moreover, Krugman explains:

Now, a classical economist could (and some did) try to explain away this observation by arguing that what’s going on here is that there are real shocks, and that monetary policy was used to stabilize each country’s price level. But then you run into another problem, highlighted in a classic paper by Mike Mussa (haven’t found the original online, but he summarized the argument here (pdf)). Mussa pointed out that the behavior of both nominal and real exchange rates changed dramatically when the exchange rate regime changed, becoming vastly more volatile with the end of Bretton Woods....

You can, if you’re desperate, try to explain this away by saying that there was some fundamental structural change in the early 1970s, but at that point you’re deep into epicycle territory. And there’s more — for example, Ireland went abruptly from having a stable real exchange rate against the UK to having a stable rate against Germany when it joined the European exchange rate mechanism, etc..

A paper of mine in the October 2010 issue of Economic Inquiry adds to the "and there's more" evidence.  It looks at the US-UK real exchange rate over 1794-2005, during which the nominal exchange rate switches from fixed to floating and back a number of times (5 floating periods and 4 fixed periods).  In this graph of the rolling average of the absolute monthly change, one can see that the real exchange rate is more volatile in floating (shaded) periods than in the adjacent fixed rate periods (the dashed lines denote the periods of government controls around the two world wars).

The biggest change in volatility is after Bretton Woods ends in 1971.  In earlier periods, the differences in real exchange rate behavior between fixed and floating regimes are not as stark, but they are there (there's more evidence in the paper).  That suggests that the classical assumption of money neutrality is invalid (in the short run), but it may have been less so in the 19th century than it is now.

Incidentally, I believe the Mussa paper Krugman is referring to is in the Carnegie-Rochester Conference Series in 1986 (vol. 25) (subscription required).

January Employment Muddle

According to the Bureau of Labor Statistics, there was a significant drop in the unemployment rate, from 9.4% to 9.0%, in January while payrolls increased by a meager 34,000.

The two figures sometimes give conflicting indications because they are drawn from different data: the unemployment rate is calculated from a survey of households, while the payroll number comes from a survey of firms.

The interpretation is further complicated this month by several other factors, including a revised estimate of the population, and the possible impact of unusually severe January weather.  Calculated Risk, the Times' David Leonhardt, the Economist's Greg Ip, John Hilsenrath of the WSJ, and Real Time Economics' round-up of assorted pundits provide some guidance in sorting out the numbers.

Overall, it looks like the news is consistent with a picture of a recovery gaining momentum, but with a long way to go.  Hopefully the February report, which is due on March 4, will give a clearer picture.

Rebalancing Watch

International trade fell sharply during the worst days of 2008-09, and this was reflected in a sharp decline in the US trade deficit.  One of the big questions in the recovery is whether the trade deficit (or, more broadly, the current account deficit) will return to its pre-crisis level.  That is, was the reduction in the deficit temporary, or have we achieved some "rebalancing"?

Friday's advance estimate of GDP provides some encouragement in this regard.  The US economy still has a long way to go, but it is now at least back to its pre-recession level of output.  The trade deficit remains smaller than it was before the recession - it was 3.3% of GDP in the 4th quarter of 2010, versus 4.9% in the last quarter of 2007.

The widening trend that began in mid-2009 appears to have leveled off or reversed.  Menzie Chinn James Hamilton suspects that the decline in the trade deficit in the quarter was tied to the decline in inventory accumulation:

But the fact that a huge negative contribution of inventories coincided with a huge positive contribution of imports does not seem to be a coincidence. There's a clear pattern in the recent data that when one of these makes a positive contribution to GDP growth, the other makes an offsetting negative contribution. Although we often think of inventories as a substitute for production (you could either produce a good or sell it out of inventories), in the current environment inventories seem to act more as a substitute for imports (you could either import the good, or sell it out of inventories).

Nonetheless, it looks like the trade deficit may not headed back to where it was. What happens going forward depends in large part on what happens with the US' trading partners.  Faster growth in the rest of the world should reduce the trade deficit.  We're seeing this in much of the developing world, which is recovering more quickly (indeed many emerging markets now face a danger of inflationary overheating).

At Project Syndicate, Martin Feldstein argues that one of the major surpluses, China's, will come to an end because its astronomical saving rate is headed down:

China’s national saving rate – including household saving and business saving – is now about 45% of its GDP, which is the highest rate in the world. But, looking ahead, the five-year plan will cause the saving rate to decline, as China seeks to increase consumer spending and therefore the standard of living of the average Chinese.

The plan calls for a shift to higher real wages so that household income will rise as a share of GDP. Moreover, state-owned enterprises will be required to pay out a larger portion of their earnings as dividends. And the government will increase its spending on consumption services like health care, education, and housing.

These policies are motivated by domestic considerations, as the Chinese government seeks to raise living standards more rapidly than the moderating growth rate of GDP. Their net effect will be to raise consumption as a share of GDP and to reduce the national saving rate. And with that lower saving rate will come a smaller current-account surplus.

Of course, declining savings only reduces the current account if investment doesn't also fall with it.

Real exchange rates play a role, too, and in this regard, inflation in China is causing its exports to become more expensive, its intervention to hold down the nominal exchange rate notwithstanding.  The Times' Keith Bradsher reports:

Inflation is starting to slow China’s mighty export machine, as buyers from Western multinational companies balk at higher prices and have cut back their planned spring shipments across the Pacific...

Already, the slowdown in American orders has forced some container shipping lines to cancel up to a quarter of their trips to the United States this spring from Hong Kong and other Chinese ports. 

See also this recent post.  Whether it comes by inflation or a movement in nominal exchange rates, a Chinese real appreciation would take some pressure off other developing countries which are shadowing China in holding down their currencies.

3.2

That's a B+ grade point average; its the limit imposed by several western states on the alcohol content on the beer that can be sold in grocery stores; and its the BEA's advance estimate of 4th quarter 2010 real GDP growth.  3.2 is hard to get excited about (though it could be worse).

Real GDP is finally back above its pre-recession (Q4 2007) peak.  However, while growth has accelerated from the 2nd and 3rd quarters, is still not fast enough to close the "output gap" anytime soon.  The red line below is real GDP (quarterly, at annual rates) and the blue line represents what would have happened if the economy continued to grow at 2.5% (roughly the average rate for 2002-07) after the end of 2007.

If real GDP grows at 3.2%, the red line catches up to the blue line in about 10 years.

Consumption grew at a 4.4% pace, and the rate of increase for durable goods purchases was 21.6%.   Exports increased at a rate of 8.5% and imports fell 13.6%, bringing the trade deficit down to 3.3% of GDP.

The main source of disappointment would be investment: nonresidential fixed investment increased at a 4.4% rate.  Since investment is the most volatile component of GDP, one would expect it to grow rapidly during the recovery (just as it shrank rapidly during the recession).  This is particularly true given how well corporate profits are doing. 

The overall investment component shrank at a 22.5% rate, because inventory accumulation slowed dramatically (from a $138.6bn rate in the third quarter to $5.2bn in the fourth). That means that growth is no longer dependent on inventory restocking.  This had a fairly big effect on the overall number - if inventory accumulation had stayed the same, growth would have been 6.9%.  So one could argue that things are perhaps a little better than the headline number suggests.

Government was also a drag on growth as decreases in state and local government and federal defense purchases outweighed a federal non-defense increase.

For the full year 2010, real GDP growth was 2.9% (after falling 2.6% in 2009).  The GDP deflator rose by 1%.

In the first quarter of 2011, disposable income will get a boost from the temporary payroll tax cut agreed to in December, which should help.
 
That's just the first of several estimates - the updated "second estimate" is due Feb. 25.

SOTU

A couple of thoughts on the "State of the Union" -

As an economist, I don't find the rhetoric of "competitiveness" very appealing (see Paul Krugman's classic on this).  International trade is mutually beneficial* - not a zero sum struggle to beat other countries to the "good jobs."  From an economist's point of view, the rapid growth in China is a great story about an dramatic increase in human welfare.  However, while competitiveness rhetoric can be used to justify bad policies like subsidies and tariffs, Obama is employing it to promote policies like investment in infrastructure, basic research and education that are beneficial regardless of what is going on in other countries.  Though it is a mistake to feel threatened by the success of other countries, Obama seems to be exploiting this sentiment to embarrass us into getting our act together, which isn't entirely a bad thing.  He's like our national "Tiger mother."

Unfortunately, President Obama appears to have conceded the rhetorical war on two important fronts: global warming and the budget deficit.

On global warming, which is the most important policy issue we face, the President chose not to even mention it directly.  So much for having "adult conversations" in our politics...  Even if the towel has been thrown in on cap-and-trade, the administration does appear to be trying to confront the problem, sotto voce, in other, less efficient ways.  At least, that is how I interpret the call that 80% of energy should come from "clean sources" by 2035.

As for the deficit, the idea that the government is like a family that needs to "tighten its belt" seems to have won out.  That's simple, intuitive and wrong.  The basic principle of countercyclical fiscal policy - that when households are cutting back, government needs to step in and make up for it with offsetting spending increases or tax cuts - also seems simple and intuitive.  But apparently not enough so.  President Obama is a very good speech-maker, but has proven not to be enough of a great communicator to get the public thinking correctly about this.

It looks like we'll get some "cuts" and "freezes."  These may manage to be a drag on the recovery and damage some important government functions without making much of a dent in the real long run problem because domestic discretionary spending is a fairly small part of the overall budget (as Howard Gleckman says: "that makes Obama the anti-Willie Sutton. He is going whether the money isn’t").  It seems that we're done with counter-cyclical fiscal policy and its all up to the Fed now.  With 14.5 million still unemployed, that is a mistake, and a real shame.  While I hope (and believe) the President is correct in presuming the recovery will continue, it still could benefit from a fiscal push.

See also: Paul Krugman, Mark Thoma and Ezra Klein.

*There are number of possible caveats on that, including that while a country as a whole benefits, some within it are hurt (Stolper-Samuelson theorem) and that a trade deficit can reduce aggregate demand which is bad for employment in the short-run.

Residential Investment vs Construction Payrolls

There's some disagreement out there between those who see the recession as a "reallocation" shock resulting from a change in the composition of output (with the implication that a significant proportion of unemployment is "structural," because workers have the wrong skills and are in the wrong locations), and those who see it as primarily a phenomenon of aggregate demand (AD).  The two stories are not mutually exclusive, but I'm with those who would put more weight on the AD side.  After all, the economy is continually reallocating resources, creating and destroying firms and jobs, and usually manages this without an aggregate downturn; as Brad DeLong puts it:

"Reallocation" occurs when people are pulled out of unemployment or jobs in which their marginal product is low by opportunities in expanding businesses. "Reallocation" does not occur when people lose their jobs and pile up as unemployed. "Reallocation" occurs not in depressions but in booms.

Arguing against the reallocation story, Scott Sumner points out that most of the decline in housing occurred prior to the recession:

Yes, housing output was low in 2009 and unemployment was high.  But is there a causal relationship?  I say no.  Housing starts peaked in January 2006, and then fell steadily for years:
January 2006 — housing starts = 2.303 million, unemployment = 4.7%
April 2008 — housing starts = 1.008 million, unemployment = 4.9%
October 2009 — housing starts = 527,000, unemployment = 10.1%
So housing starts fall by 1.3 million over 27 months, and unemployment hardly changes.  Looks like those construction workers found other jobs...

You can see this in a graph of real residential investment (red), which falls from nearly $800bn to $500bn (in 2005$, at annual rates) from the beginning of 2006 through the end of 2007.  Most of the increase in the unemployment rate (green) occurs later, in 2008 and early 2009.

That seems to suggest that the economy was smoothly managing a significant reallocation of resources out of construction until the end of 2007.  However, while residential investment was falling like a rock in 2006-07, the decline in construction payrolls comes later, and really gets going in 2008-09.

My hunch is that what is going on here is an example of "labor hoarding" - the tendency of firms not to adjust inputs immediately when output changes, because it is costly to do so.  Initially, construction companies may not have been sure whether the decline was temporary or permanent; it may therefore have made sense to keep people on the payroll so that they would be ready to respond if business picked up.

That doesn't validate the reallocation hypothesis, but it is true that there were alot of construction workers among those losing their jobs in 2008 (but there were job losses throughout the economy, not just construction, of course, as an AD decline implies).