No Mas! New Policies not old mistakes

There appears to be a somewhat interesting controversy afoot in explaining the reason for the emerging markets panic and in establishing a solution for it. The approach of Gavekal would simply like to keep the Ponzi scheme of past years rolling forward. According to that view because the US has the reserve currency the US current account deficit is theoretically unbounded and the US should use its domestic demand to drive global growth stimulating the rest of the world particularly in the developing economies.

Been there. Done that.

Instead, of going back to the old mistakes, we should all be aware that the reason for these ongoing US deficits has been the export targeting of the US market by developing economies wishing to tap US domestic demand. They have done this by keeping their currencies artificially weak and have done this by buying dollars to keep the dollar strong and by investing in the US… when there has been no good reason to do so.

It should be perfectly obvious that with the US unemployment rate having risen, with US consumption outstripping investment  and with the US as a relatively high-wage country around the world there hasn’t really been any reason for firms to invest funds in the US market. Nor were US banks adept at recycling, choosing instead to over-lend in the US housing sector. As a result monies that were invested in the US for the purpose of keeping foreign currencies weak versus the dollar necessarily went hunting for unproductive investments. Because there were far more funds available than there were profitable investments to be funded trouble ensured. Can we be surprised that a crisis developed? Now Gavekal want to do it again.

If your view of the US is a suckling pig that must offer a teat to any developing country that wants one, surely that’s a model for trade to get in trouble.

By now everyone should be aware that Germany has the largest current account surplus in the world and it shows no sign of dissipating it. The US is starting to contract its current account deficit but not because it has improved its competitiveness but because it’s developing its natural resources namely energy. The US nonoil deficit continues to get worse. Gavekal is right about exploitable net demand becoming more scarce.

The Gavekal explanation of the recent market panic is that the Fed sought a weaker dollar with negative real interest rates…this is another example of someone arguing from ‘the facts’ to a convenient –if incorrect- conclusion. Central banks around the world kept interest rates low; inflation was low too. The US was aiming its policy at domestic demand, by far the biggest effect from low rates was on demand at home. There may have been some international fallout but the Fed was definitely not aiming to weaken the dollar. As someone who has worked at the Federal Reserve Bank of New York and in the currency area I can assure you that the Fed does not view itself as the principal architect of US exchange rate policy. It is widely recognized that that option belongs with the US Treasury and when it comes to foreign-exchange matters the Fed has a minor toehold to have some say in the discussion. There can be no doubt the US interest-rate policy was aimed at the domestic economy and at domestic demand with the foreign-exchange aspect viewed as a side effect rather than as a principal policy goal.

The US rarely aims its policy at international matters. But it is a large open economy. Its policies are aimed at its economy but because the economy is ‘open’ there are international repercussions.

Still, it would be far better for the developing economies to balance their growth and to develop their own domestic demand. China is being forced to do it out of necessity. China is the quintessential bull in the china-shop that ran such an aggressive exchange and trade policy that ruined the playing field. China, a developing economy, ran current account surpluses! China sought to get a growing share of global production and, as its GDP grew, the consumption share of GDP in China fell… so much for ‘development.’  China was mercantilist. China kept its wages low and never allowed its exchange rate to matriculate. China broke the exchange rules which call for a surplus country’s exchange rate to rise. And now with the Western economies floundering and so highly in debt, China can no longer expect to gain the export penetration that once fueled its growth and it must turn to domestic demand. It’s a lesson that other smaller developing economies need to learn.

The US central bank’s reserves also need to be pulled and as a share of GDP and in no way should we look for those to expand or to take that expansion is a sign of continued growth or anything good going on in the US economy. In fact these sorts of arguments made by Gavekal given time would almost certainly bring about the antithesis argument criticizing these policies for driving the US into even greater debt and to a larger consumption share of GDP.

Instead, in the time, the US  should be redressing these excesses.

Panics come when markets lose their grip or focus. When the paradigm begins to change in a way that’s inexplicable and when market participants are no longer sure who or what is in control you can get panic selling. Developing economies need to change their models. And change can be destabilizing. They need to balance their growth. They need to develop their own internal demand along with production. The watchword needs to be balance- not more US dependency.

And the US needs to shrink its current account deficit. And, perhaps ominously for the rest of the world, it needs to shrink even the nonoil portion. The US needs to improve the competitiveness of its good sector in order to create jobs. And developing the energy sector alone is not going to do that.

The international paradigm is changing. It should change. It must change. This challenge is bound to create some turmoil. We can hope that at the end of the turmoil we get policies realigned in the right direction rather than backtracking on the progress we’ve made. To continue to make more of the same old problems worse would be a real shame.