Samuel Rines - August 13, 2015
It all feels a little too familiar, and, without care, the Fed could fall into the Greenspan Trap—again.
- China lets yuan fall further, fuels fears of 'currency war' SHANGHAI | By Pete Sweeney and Lu Jianxin
- China’s currency devaluation - Patrick McGee in Hong Kong
- Currency war? How China devaluation may impact Fed - Matthew J. Belvedere
- China's Devaluation of Yuan Slams U.S. Stocks - by Reuters
- China's devaluation raises currency war fear as Greece strikes deal - Reuters
In the late 20th century and the first decade of the 21st, Alan Greenspan led a Fed that—in retrospect—kept monetary policy loose for an exceedingly long period of time. Inflation was tame, and wage pressures were nonexistent due to the acceleration of global competition for jobs, and the relocation of American manufacturing jobs to China. Seeing none of the typical indicators of an overheated economy, low interest rates seemed a reasonable means to spur job creation and spark some wage inflation.
The end result was a housing bubble. And housing created the type of low or noncontestable jobs that were impossible to find in other sectors of the economy. Housing construction jobs were easy transitions from the manufacturing floor, and they could not be taken offshore easily—they were China proof. But the housing bubble burst in spectacular fashion. The inflation—excepting home prices—never materialized, and Greenspan is given credit (blame) for building the housing bubble.
Today, China is creating complications for the Fed again. Its surprise move to devalue the Yuan will have a profound effect on the global economy. Deflationary pressures will be exported to countries who import Chinese goods, which in turn will affect monetary policy decisions in those countries. The U.S. economy and the Fed are not immune to these forces, and deflationary pressures could give the Fed pause as it moves toward lifting interest rates off zero. It all feels a little too familiar, and, without care, the Fed could fall into the Greenspan Trap—again.
There are reasons to be skeptical of the People’s Bank of China (PBoC)’s timing. The “one-off” reset of the Yuan was certainly an unexpected move. But the critical aspect of the move was the shift in the mechanism for setting the fix (the target value of the Yuan against the Dollar). Instead of being set unilaterally by the PBoC and allowed to move very little, the Yuan will now be, in part, set by market forces—a move the International Monetary Fund has been calling for ahead of China’s possible inclusion as a reserve currency. The resetting of the Yuan’s value has only just begun.
If the Yuan drifts lower over an extended period of time, advanced economies will feel steady deflationary pressure through commodity and import channels. China will become incrementally more competitive with other emerging nations, and will cause those countries’ central banks to rethink their near-term monetary policies—not to mention the developed world. For the United States, it means deflationary pressures from the Middle Kingdom will last for a long-time—not dissimilar from the long, slow off-shoring of manufacturing that kept wages and inflation in check in the Greenspan Era.
This time the U.S. economy has steadily created jobs, but inflation and wage growth have disappointed. Greenspan’s low rates were a result of the terrorist attacks of 9/11. His Fed faced a trickle of jobs and a competitive threat to the vestige of American manufacturing. The Fed has already kept rates low for a long time, drawing criticism and even threats of congressional oversight. Now, China, instead of taking jobs, is moving toward a market mechanism to determine exchange rates (and probably wanted to get ahead of a Fed rate hike).
Despite the differences in circumstances, there similarities bear watching. China is tempting the Fed to delaying lifting-off for as long as it likes. Deflationary pressures from China will persist as long as the Yuan is under pressure and the Dollar is rising—regardless of what the Fed chooses to do, there will be deflation.
Even before the Yuan began its revaluation, the Fed was up against significant policy headwinds from other large trading partners—Europe and Japan are both undergoing large-scale easing. China is only playing catch-up with its currency moves. It was only natural for China to join the fray, and the Yuan has depreciated far less than the Euro or Yen did last year. Regardless of the high visibility of the devaluation of the Yuan, it should be thought of in a much broader context of a global race to the bottom.
The current Fed should heed the lesson of history or risk repeating it—the risks appeared benign and nonexistent until they malignant and obvious. While low inflation can be used as an excuse to push out a lift-off, it should not be. China has exported disinflation to trading partners before. The mechanism is different this time, but the deflationary pressures are the same. Yes, the Greenspan Trap is tempting but should be resisted. Otherwise, history repeats and the United States will eventually find another subprime somewhere.
Christopher Whalen - August 14, 2015
The signs are quite telling.
China’s surprise decision to stop supporting its currency marks the latest move in the dangerous game of competitive currency devaluations that has been underway since the 2008 financial crisis. All of the major industrial nations have been forced to use zero interest rates and currency depreciation as a response to weak growth and deflation in commodity prices. But there is no positive outcome possible in a zero-sum process of competitive currency devaluations.
The immediate cause of the move by Beijing is political and illustrates the concerns of China’s leaders that a slowing economy will result in social instability. But it is important to recognize that the bubble in real estate and financial assets that resulted in the 2008 market crash was fueled by capital inflows to the United States and Europe from China, which sought to recycle its vast trade surplus with the west by investing in financial and real assets. The fact that this surplus was funded via the creation of trillions of dollars in debt only made the situation more unstable.
With the collapse of the West’s appetite for Chinese exports, Beijing has gone through several attempts to “rebalance” its economy to focus on internal demand rather than exports. As we noted earlier in The National Interest (The False Hope of Chinese Economic Rebalancing), the loss of export markets in the West has put the Chinese economy into a deflationary tailspin that is impacting the entire world economy. Falling prices for oil, copper and other key industrial commodities, and the related decrease in economic activity, are a direct result of the financial deflation since 2008.
Dr. David Woo of Merrill Lynch believes that the move by China to weaken its currency is just the start of a series of efforts by Beijing’s communist rulers to avoid an economic crisis. Financial bubbles in the housing sector as well as stocks have forced the government to take action to prevent these speculative anomalies from collapsing. But with the export sector weak—in part due to the Chinese currency being effectively pegged to a strong dollar—and few practical alternatives to support employment and the growth of consumption, China’s authoritarian rulers face their greatest fear: namely economic stagnation.
James Rickards, author of Currency Wars and one of America’s most astute observers of China, believes that the endgame in this latest chapter of beggar thy neighbor could be a global economic crisis:
After a truce in the currency wars between China and the U.S., China has broken the peace with its shock devaluation over the course of August 11-12. Investors should expect further devaluation, not only from China, but all of the emerging markets and developed economies such as Canada and Australia. The dynamic is clear - currency wars have no logical conclusion except for systemic reform or systemic collapse. Right now, the latter seems more likely. Until then, the war will go on.
For months financial markets have been fixated by the idea that tiny Greece might need to exit the European Union and devalue its currency. Now seeing China do so is a shock for markets and policy makers alike. Not only does it call into question the image of solidity and growth in China, but it also begs the question as to whether seven years of low interest rate policies in the United States and EU have done anything more than temporarily slow the relentless advance of deflation. Was the growth in China (and other nations) over the past ten or twenty years an illusion, funded with debt incurred by the western nations? Do the bubbles in housing and financial assets in China represent a crisis in the making, a final climactic event before an inevitable adjustment to reality?
It is difficult for western observers to appreciate that the claims of economic growth made by China’s rulers have never been believable—this because political stability is the dominant consideration. Even experienced China hands with great resources in the region fall into the cognitive illusion of thinking that the economy of China is comparable to the market economies of the west. But with all that said, the reaction in foreign financial markets to China’s devaluation is probably overblown.
Just a few weeks ago, China Beige Book, one of the best sources of information on the country available in the west, stated in a report entitled China’s Economy is Recovering:
China released second-quarter statistics Wednesday that showed the economy growing at 7%, the same real rate as the first quarter but with stronger nominal growth. That result, higher than expected and coming just after a stock-market panic, surprised some commentators and even aroused suspicion that the government cooked the numbers for political reasons. While official data is indeed unreliable, our firm's latest research confirms that the Chinese economy is improving after several disappointing quarters-just not for the reasons given by Beijing.
Leland Miller, President of China Beige Book (CBB), believes that western audiences are not interpreting the moves by China correctly. For the past year, China has actually been supporting the currency against mounting forces for a devaluation. China’s currency has strengthened significantly against the euro and Japanese yen because Beijing has effectively pegged it to the surging dollar. In this situation, a 10 percent devaluation would be justified simply to restore parity with other non-dollar currencies. “This is not the start of a currency war, at least not yet,” argues Miller. “This is more a case of tweaking around the edges by a regime that tries to avoid market volatility but has seen its currency appreciate substantially in the past year.”
So the good news, if you believe Miller and the experts at CBB, is that China is not deliberately try to start a global currency war. The bad news, however, is that the forces of global deflation have not been calmed by the zero interest rate policies of the major central banks. Indeed, as we have discussed in The National Interest (The Fed’s Day of Reckoning Nears) low interest rates may now be accelerating global deflation by taking badly needed income out of the hands of consumers and savers in all of the global economies.
Looking at continued weakness in oil prices, for example, it is pretty clear that both supply and demand for energy remain anemic. In fact, the Russian ruble, which is a surrogate for oil prices, actually fell more than the Chinese currency this past week. With the dollar appreciating against most global currencies, the outlook for commodity prices and global economic activity generally seems muted at best.
If the Fed actually follows through with its intention to raise interest rates in the future, the United States could become the economic version of a black hole sun in space, sucking in capital from other nations as the dollar appreciates. In the event, China and other nations which have effectively pegged their currencies to the dollar may be forced to adjust further, giving additional support to the notion that we are in fact in a global currency war.