This recent report from Telegraph of China's worry that the US is going to inflate away its debt:
Richard Fisher, president of the Dallas Federal Reserve Bank, said: "Senior officials of the Chinese government grilled me about whether or not we are going to monetise the actions of our legislature."
"I must have been asked about that a hundred times in China. I was asked at every single meeting about our purchases of Treasuries. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States," he told the Wall Street Journal.
His recent trip to the Far East appears to have been a stark reminder that Asia's "Confucian" culture of right action does not look kindly on the insouciant policy of printing money by Anglo-Saxons.
Fortune's impression about China: the massive, massive infrastructure build-out, the biggest in the history of humanity.
The fast growing Chinese economy posts many challenges to the world. One of such is pollution. In 2002 during his visit to Baylor University, I asked Robert Fogel, the Nobel-winning Chicago economic historian, about his view on China's pollution problem. His answer was startlingly simple ---Just compare today's China to Chicago in the early 20th century: Chicago back then was a fast growing dirty butcher town and transportation hub, and now look at what Chicago has become.
The message conveyed in Fogel's simple answer is two fold: 1) for poor countries, the concern over economic development naturally dominates the concern over environment; 2) Chinese will have the greatest incentives to cure their pollution problem once they realize this can't go on forever. For this matter, I always think China will come out as the world leader in energy efficiency innovation. Why? China faces the gravest energy challenges so the greatest pressure to innovate and break through in energy-saving technology. What will push such innovation to happen faster is crisis. Yes, I do think China needs (and possibly will have) multiple mini energy crises to make this pressure even greater. But I am optimistic.
An excellent panel discussion on What's Next for the American economy, with Joseph Stiglitz of Columbia University, Meredith Whitney of Meredith Whitney Advisory Group, Oliver Sarkozy of Carlyle Group, Jack Welch, former General Electric CEO and Austan Goolsbee of White House Senior Economic Adviser.
In this short YouTube video, Milton Friedman explains why the US has been so attractive to investors worldwide in the past; and under what condition such appeal may disappear.
I also made a chart a couple of months ago summarizing China's recent effort starting to use its own currency, Renminbi, in international trade and signed numerous currency swap agreements with a bunch of countries. And China and Brazil are in a similar talk recently.
I don't think for these actions China aims to replace the dollar. What Chinese government really worries about is their huge dollar-denominated asset holdings (70% of nearly $2 trillion foreign reserves) may lose value big time if the dollar drops precipitously in the future.
(click to enlarge)
With economic recovery around the corner, the US should stop its money printing machine. "Ignore it at your own peril"---the US may well be on its path to destroy its economy and its reputation among countries. Watch this classic Friedman 1980 video on inflation, "Inflation is just like alcoholsim. In both cases, when you start drinking, or you start printing too much money, the good effect comes first, and the bad effects only come later. That's why in both cases, there is a strong temptation to overdo it: to drink too much and to print too much money..."
Government and politicians have a tendency to use inflation to get out of their debt problem. Call it "debt monetization". Here is a great chart from Casey's Chart.
(click to enlarge)
"The costs of things as measured by the consumer price index have risen twentyfold since the Federal Reserve Act of 1913. This act empowered the central bank to create and control a new currency for the United States, the Federal Reserve Note. Over this same period, the federal deficit soared from $2 billion to over $11 trillion. Coincidence? We think not.
After President Nixon cut the dollar’s ties to gold, funding the whims of government was no longer burdened by the need for higher taxes. Now any gaps in the budget can be filled by simply printing more dollars. And as you can see, the politicians didn’t hesitate to meet the challenge. Price levels and federal debt have risen hand-in-hand ever since.
The hidden tax of inflation has been stealing people’s buying power for nearly a century, but the opportunity to profit from it only comes about once every generation…"
Exhibit 1 (all graphs are taken from Freeman's NBER working paper) shows country's share of global college enrollment.
In 2006, the US accounts for 12% of total college enrollment globally. But watch how China and India, the two most populous countries, how their college enrollments have soared over the years. China's college enrollments rose from 1.7 million in 1980 to 23.4 million in 2006, or 16.5% of the world total.
A lot of college graduates from developing countries, seeking better opportunities, came to the United States. The chart below shows you the major source countries of international students in the US.
In the 2006-07 period, among 580K international students in the US, 2/3 are from Asia; 85% from developing countries: with India supplying the most, nearly 15%; China 12%; South Korea 10%. And nearly half (45%) of international students came to the US to pursue graduate degrees.
A lot of international students went to science & engineering (S&E) field. In 2005, 50.9% of PhD degrees in S&E were granted to foreign-born international students. If we just look at engineering, the number was at startling 69% (I believe the number is about the same in economics).
Focus on China: The number of students who came to the US to study and eventually got their PhD degrees in natural sciences has been rising sharply, especially after 1990s. (see graph below; the following graphs were taken from another NBER research by Bound, Turner & Walsh)
Meanwhile fewer and fewer US-born college graduates went to pursue PhD degrees. This is especially true in life sciences and physical sciences. I am not quite sure how this happened: it could be due to the education problem in US high school system; it could also be higher pay in other sectors, such as financials and investment banking.
But I suspect the surge of foreign PhDs in the US was largely a supply story. Why? The graph below looks at the correlation between the number of Bachelor degree holders and the PhD degrees granted in the US to foreign students. As you can see, there is an obviously strong positive correlation between the two.
Also, we have witnessed a cross-board surge of international students, almost in every field, not only in the science and engineering field.
Now we come to the policy delibrations.
With more and more PhD degrees granted to international students, foreign-born researchers and academics are sure to play a more and more important role in US higher education and research in coming years. A policy question naturally rises as to how to retain these foreign researchers. And what changes in US immigration policy should be in place to acheive the goal?
A very interesting interview (with a lot of humor) of Dr. Marc Faber on the prospect of hyperinflation in the US.
He links inflation to pregnancy, "a little bit pregnant is as good as 100% pregnant". A hilarious analogy! But he did raise a very intriguing question ---why do economists unanimously think deflation is worse than inflation?
Normally, rising yield curve signals economic recovery is well ahead. But the recent surge reflects probably much more of the market's concern over government budget deficits and its ability to finance it. Either the government reins in spending, or the market will demand a higher interest rate as reflected in the rising yields of long-term government bonds.
Of course, government can always print money. So the alternative way of interpreting the current surge in the yield curve could be that the market is very nervous about higher inflation in the future so investors will demand the same real return on government bonds (nominal interest rate minus inflation).
(click to enlarge; source: calculatedrisk)
Also, with rising yield of 10-y treasury, the Fed's effort in stimulating housing market through purchasing mortgage-backed securities will become less effective as the 30-year mortgage rates are closely tied to 10y treasury yields.
One such consensus is we need a regulator to look after the risks our financial system is taking as a whole. And what we need is not MORE regulation, but SMART regulation.
Watch this piece from David Wessel at Wall Street Journal:
John Taylor at Stanford writes on Financial Times the recent downgrade of British sovereign debt is a wake-up call for America. He analyzes how the projected budget deficits of Obama Administration could lead to double digit inflation and sharp depreciation of the dollar, just like 1970s.
Standard and Poor's decision to downgrade its outlook for British sovereign debt from "stable" to "negative" should be a wake-up call for the US Congress and administration. Let us hope they wake up.
Under President Barack Obama's budget plan, the federal debt is exploding. To be precise, it is rising – and will continue to rise – much faster than gross domestic product, a measure of America's ability to service it. The federal debt was equivalent to 41 per cent of GDP at the end of 2008; the Congressional Budget Office projects it will increase to 82 per cent of GDP in 10 years. With no change in policy, it could hit 100 per cent of GDP in just another five years.
"A government debt burden of that [100 per cent] level, if sustained, would in Standard & Poor's view be incompatible with a triple A rating," as the risk rating agency stated last week.
I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis. To understand the size of the risk, take a look at the numbers that Standard and Poor's considers. The deficit in 2019 is expected by the CBO to be $1,200bn (€859bn, £754bn). Income tax revenues are expected to be about $2,000bn that year, so a permanent 60 per cent across-the-board tax increase would be required to balance the budget. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP?
Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. But it would not be that smooth – probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.
The fact that the Federal Reserve is now buying longer-term Treasuries in an effort to keep Treasury yields low adds credibility to this scary story, because it suggests that the debt will be monetized. That the Fed may have a difficult task reducing its own ballooning balance sheet to prevent inflation increases the risks considerably. And 100 per cent inflation would, of course, mean a 100 per cent depreciation of the dollar. Americans would have to pay $2.80 for a euro; the Japanese could buy a dollar for Y50; and gold would be $2,000 per ounce. This is not a forecast, because policy can change; rather it is an indication of how much systemic risk the government is now creating.
Why might Washington sleep through this wake-up call? You can already hear the excuses.
"We have an unprecedented financial crisis and we must run unprecedented deficits." While there is debate about whether a large deficit today provides economic stimulus, there is no economic theory or evidence that shows that deficits in five or 10 years will help to get us out of this recession. Such thinking is irresponsible. If you believe deficits are good in bad times, then the responsible policy is to try to balance the budget in good times. The CBO projects that the economy will be back to delivering on its potential growth by 2014. A responsible budget would lay out proposals for balancing the budget by then rather than aim for trillion-dollar deficits.
"But we will cut the deficit in half." CBO analysts project that the deficit will be the same in 2019 as the administration estimates for 2010, a zero per cent cut.
"We inherited this mess." The debt was 41 per cent of GDP at the end of 1988, President Ronald Reagan's last year in office, the same as at the end of 2008, President George W. Bush's last year in office. If one thinks policies from Reagan to Bush were mistakes does it make any sense to double down on those mistakes, as with the 80 per cent debt-to-GDP level projected when Mr Obama leaves office?
The time for such excuses is over. They paint a picture of a government that is not working, one that creates risks rather than reduces them. Good government should be a nonpartisan issue. I have written that government actions and interventions in the past several years caused, prolonged and worsened the financial crisis. The problem is that policy is getting worse not better. Top government officials, including the heads of the US Treasury, the Fed, the Federal Deposit Insurance Corporation and the Securities and Exchange Commission are calling for the creation of a powerful systemic risk regulator to reign in systemic risk in the private sector. But their government is now the most serious source of systemic risk.
The good news is that it is not too late. There is time to wake up, to make a mid-course correction, to get back on track. Many blame the rating agencies for not telling us about systemic risks in the private sector that lead to this crisis. Let us not ignore them when they try to tell us about the risks in the government sector that will lead to the next one.
The writer, a professor of economics at Stanford and a senior fellow at the Hoover Institution, is the author of 'Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis'
(added on 5/30/2009): there is also a nice CNBC interview of John Taylor on the inflation worry:
Ed. Glaeser at Harvard writes "India is a nation where private citizens, both rich and poor, do amazing things despite tremendous failures of the public sector".
Kiplinger rolled out their picks for the ten best cities in America of 2009. Most of them are either college towns or places with a lot of government jobs or new alternative industries.
I always imagine myself settling down in a college town. Among the college towns in the pick: Austin is really nice and I have been there many times before; Madison, Wisconsin is very vibrant but a little bit cold for me, and I have been there once in 2003. I will visit Charlottesville, VA and Releigh, NC this summer. I have high hope for the Releigh-Durham-Chapel Hill Research Triangle area. I will soon find out.
Bonds beat stocks in the last 40 years, from Feb. 1969 to Feb. 2009. If you sold stocks right before the dot com bubble, your return on bonds is even greater: almost 4 times of stock returns.
Watch this nice debate on investing in stocks vs. bonds between Robert Arnott and Jeremy Siegel.
Arnott is the guru in quant investing, and he also sits on the editorial board of Financial Analyst Journal and Journal of Portfolio Management; Siegel is a finance professor at Wharton School, University of Pennsylvania.
A nice presentation from Richard Suttmeier, an expert on Chinese Science & Technology and innovation, on whether China is becoming a scientific superpower.
The US dollar often moves in the opposite direction with the market during this crisis, i.e., when stock market is down, dollar is up. But Peter Schiff noted something has changed ---we may have dollar, stocks and bonds decline at the same time. And he thinks inflation is coming.
The observation can be summarized in the graph below:
One source of such recovery is consumption. But given that consumption is unlikely to have a quick rebound in this recession, they conclude that even economic recovery is possible, it will be slow and shallow.
A very nice (and funny) video on the evolution of the federal debt (different from national debt, which includes debts from the states and private debt). According to the video, Obama administration will be increasing the federal debt at "174 mph", almost tripling the speed of Bush Administration. No wonder Bill Gross is worrying about the US government may lose AAA rating.
Arguments for deflation or inflation is not to worry: >excessive capacity and output gap; >debt deleveraging; >rising unemployment;
Arguments for inflation (some are my own arguments): >the Fed put too much money into the system, once economy recovers, the excess liquidity is hard to reverse and money velocity will snap back very quickly; >the Fed is getting out of its normal monetary policy areas and widely engaged in credit expansions. This may comprise the Fed's independence and the Fed may face pressure from the Congress not to raise rates giving rising unemployment rate, which is forecast to surpass 10%; >the temptation of using inflation to erode debt (or monetizing debt); >a divergence may appear: a slow gradual recovery in the economy (stagnation), and sharp rising of commodities prices, including oil (partly pushed up by vast energy needs in the faster growing emerging markets, especially China), leading to the 70s-like "stagflation".
Stimulating economy without concern over long-term fiscal budget won't go long forever. This even applies to the US, which has retained its AAA rating on government debt since WWI. Report from Reuters:
Bill Gross, manager of the world's biggest bond fund, warned on Thursday the United States will eventually lose its top AAA credit rating, a fear that had already spooked financial markets on Thursday and could keep the dollar, stocks and bonds under heavy selling pressure.
The United States will face a downgrade in "at least three to four years, if that, but the market will recognize the problems before the rating services -- just like it did today," Gross told Reuters.
Gross, the co-chief investment officer of Pacific Investment Management Co. and manager of the Pimco Total Return Fund, which has $154 billion in assets, earlier had told Reuters via email that market declines on Thursday were due to investor fears that the United States is "going the way of the UK -- losing AAA rating which affects all financial assets and the dollar."
Standard & Poor's on Thursday lowered its outlook on Britain to "negative" from "stable," threatening the nation's top AAA rating. Britain faces a one in three chance of a ratings cut as debt approaches 100 percent of gross domestic product.
Foreign direct investment inflows into China declined 21 % y-o-y during January-April. The $6 billion FDI inflow for the month of April translated into a decrease of 23 % y-o-y. Although the contraction from the start of the year appears dramatic, it actually represents a return to more typical levels. FDI inflows were massive in 2008, reaching $108 billion for the year. In the first four months of this year, investments are actually beating the same period in 2007.
More tellingly, the number of projects under implementation has declined each year over the past four years. On the other hand, the average size of a project was growing until the start of this year. Nominally, foreign investment in China is relatively small, representing a mere 7 % of total investment annually. Hong Kong is the largest provider of FDI (about 46 %), and its relative contribution has increased sharply as other countries (including tax havens) have pulled back from investment in China. Combined EU and US investments represent less than of 10 % of total foreign investment at the moment.
An interesting analysis from Economist Magazine on the reliability of China's growth data. What I took away from reading this piece is data massaging did exist, but the situation has been improved over the years. The recent official GDP growth number is unlikely to have overstated China's real growth. Maybe a little bit.
Is China overstating its true rate of growth?
PART of the recent optimism in world markets rests on the belief that China's fiscal-stimulus package is boosting its economy and that GDP growth could come close to the government's target of 8% this year. Some economists, however, suspect that the figures overstate the economy's true growth rate and that Beijing would report 8% regardless of the truth. Is China cheating?
Economists have long doubted the credibility of Chinese data and it is widely accepted that GDP growth was overstated during the previous two downturns. In 1998-99, during the Asian financial crisis, China's GDP grew by an average of 7.7%, according to official figures. However, using alternative measures of activity, such as energy production, air travel and imports, Thomas Rawski of the University of Pittsburgh calculated that the growth rate was at best 2%. Other economists reckon that Mr Rawski was too pessimistic. Arthur Kroeber of Dragonomics, a research firm in Beijing, estimates GDP growth was around 5% in 1998-99, for example. The top chart, plotting the official growth rate against estimates by Dragonomics, clearly suggests that some massaging of the government statistics may have gone on. The biggest adjustment seems to have been made in 1989, the year of political protests in Tiananmen Square. Officially, GDP grew by over 4%; Dragonomics reckons it actually declined by 1.5%.
China's growth in the first quarter of this year has led some to conclude that the government is up to the same old tricks. According to official figures, GDP was 6.1% higher than a year earlier. Yet electricity production in the first quarter was 4% lower than it had been a year earlier; in comparison, production grew by 16% in the year to the first quarter of 2008. In the past, GDP and electricity output have moved broadly together, although it is not a one-to-one relationship (see bottom chart). But the gap between the two lines is now wider than it has ever been. Given that power statistics are less likely to have been tampered with than politically sensitive GDP figures, is this evidence that the latter have been fiddled?
Probably not. Paul Cavey, an economist at Macquarie Securities, argues that the discrepancy is explained by the fact that energy-guzzling heavy industries, such as steel and aluminium, bore the brunt of the slowdown last year. Mr Cavey calculates that the metals industry accounted for 40% of the growth in electricity consumption in 2001-07, but only 16% of the increase in industrial production. Steel output fell by more than 10% in the year to the fourth quarter, so it is hardly surprising that energy use dropped.
Distrust of the GDP numbers has prompted Capital Economics, a research firm based in London, to create its own proxy of economic activity, which includes electricity output, domestic freight volumes, cargo traffic at ports, passenger transport and floor area under construction. It suggests that GDP growth slowed to only 4% in the year to the first quarter. However, it tracks mostly industrial activity, and thus excludes two-fifths of the economy, most notably services, which are growing faster.
Then there are government tax revenues. These have fallen by 10% over the past year, compared with a surge of 35% in early 2008, suggesting that incomes and output have tumbled. But Stephen Green, an economist at Standard Chartered, says that revenues were inflated in early 2008 by a sharp rise in taxes from the boom in land sales, which has since subsided. Another possible distortion is that local officials may be hiding tax revenue to make their finances appear worse, in order to get more money from Beijing to finance infrastructure projects.
Overall, Dragonomics's Mr Kroeber thinks that GDP growth in the year to the first quarter of 2009 was not significantly overstated. One reason why others are more suspicious is the fact that the National Bureau of Statistics (NBS) does not publish quarterly GDP figures as developed economies do; its year-on-year changes give it more scope to smooth growth rates (for example, output probably did stall over the past two quarters). To be fair, many developing countries do this as well. One reason is that seasonal adjustment is tricky in such countries where the shift from agriculture to industry changes the pattern of seasonality over time, says Mr Kroeber.
And for all today's misgivings, Beijing's growth estimates consistently proved to be too low until recently. One of the quirks of Chinese data has long been that the provinces reported higher numbers than the central government did—a phenomenon that was put down to the fact that local officials inflated growth rates in order to get promoted. Yet the NBS GDP figures have almost always been revised upwards. For example, growth in 2007 was first reported as 11.4%, but in January it was marked up to 13%.
The NBS has improved its data-gathering methods in recent years, by extending its coverage of services, for example. This month Beijing also introduced new penalties for officials who falsify statistics. But the real test is whether the government itself is prepared to publish politically embarrassing bad news. There are encouraging signs that it is becoming more open. On May 14th an essay on the NBS website by Xu Xianchun, the bureau's deputy director, was surprisingly frank about some of the flaws in Chinese statistics. Mr Xu admitted, for example, that the retail-sales numbers include some purchases by companies and the government, which should not be counted as consumption. He estimated that consumer spending in the first quarter grew by 9%, compared with the 15% increase reported for retail sales.
Andy Rothman, an economist at CLSA, a regional broker, believes that Chinese statistics are much more trustworthy than they used to be. This is partly because there are alternative numbers to go on; CLSA, for example, produces its own purchasing-managers' index. There are also more private-sector economists keeping tabs on China than there were a decade ago. The more eyes there are on China, and the more crucial its economic performance becomes for the rest of the world, the harder it is for officials to tamper with the speedometer.
Rosenberg says the 25-year consumer credit expansion has come to an end and expect more frugality and don't expect any quick rebound of American consumption, which accounts for 70% of the US economy and 17% of the world economy.
Interview of Hans Rosling, one of the founders of gapminder.org, on the rise of China. And he asks people not to ignore the speed and the magnitude of China's unprecedented rising.
(sidenote: the interview should've taken at a better place)
There has been a lot of talk that the rebound of the commodities signal the coming economic recovery. But I was intrigued by this Bloomberg report that China may have been strategically piling up a lot of commodities at very cheap price as a result of the collapse of the commodities across the board.
If that is the case, or assuming majority of these commodity imports are just for hoarding purpose, is the world economic recovery just a mirage? An interesting question worth more research.
Interview of William Poole and Brandeis' Catherine Mann on why a 6% inflation, as advocated by some economists, will do more harm than good.
Adding to the discussion, I think moving to a higher inflation 'target' may also destroy the Fed's hard-won reputation against inflation in Volcker era.
Monetizing debt looks seductive, but I hope the Fed will not go there.
Credit cards have long been a very good deal for people who pay their bills on time and in full. Even as card companies imposed punitive fees and penalties on those late with their payments, the best customers racked up cash-back rewards, frequent-flier miles and other perks in recent years.
Now Congress is moving to limit the penalties on riskier borrowers, who have become a prime source of billions of dollars in fee revenue for the industry. And to make up for lost income, the card companies are going after those people with sterling credit.
Banks are expected to look at reviving annual fees, curtailing cash-back and other rewards programs and charging interest immediately on a purchase instead of allowing a grace period of weeks, according to bank officials and trade groups.
The author at IMF attributed the reason to the fact that Asian countries specialize too much in advanced manufacturing. This is in sharp contrast to China, which specializes in low-end manufacturing.
I call China's ability to weather this financial storm, "the Walmart Effect", where during economic recession, the demand for necessity goods tends to decline less than the demand for durable and (or) luxury goods.
NYT's economics reporter, who had written many pieces on subprime mortgages and the "liar loans", told a vivid personal story of how he foolishly got into a mortgage he couldn't afford and ruined his personal finance.
Talking about tax increase is taboo in America. But the current sharp rise of budget deficits and government spending will, sooner or later, make tax increase inevitable. My sense is that not only the top earners will see a tax hike, but the tax increase will be much broader than what Obama Administration had promised.
First watch this interesting debate between dollar bull and bear.
Now I will explain why I think dollar will be going down.
First I show you a graph between market volatility index (VIX) and the Dollar, in recent 3 years. The dollar shown in the graph is the dollar index, weighted by the US trade share with its major trading partners.
(click to enlarge)
It's easy to see that before August/September '08, the two lines did not move together, and actually they often moved in the opposite direction. But right after Lehman's fall (as circled in blue), market volatility spiked up, going all the way to above 80, and the dollar rose along with it. The reason is that risk-averse investors moved their assets and investments from overseas back to the country. With huge capital flowing back in, the dollar had a huge appreciation. Dollar benefited from risk-aversion and served a safe-haven during the time of panic.
Recently, with equity market up almost 40% and a lot of talk about "green shoots", market confidence came back, and the volatility came down. The Dollar just broke below its 200-day moving average (see below graph for a closer relationship between the two in recent months).
My sense is that the Dollar will continue to go down. What you might see is a diverging performance: dollar going down against the commodities currencies, such as Aussie and Canadian Dollar; but going up against Euro, where the economy is weaker and the European Central Bank lags behind in economic stimulation.
(click to enlarge)
In the long term, the single most important factor in determining the Dollar's direction is the Fed's monetary policy and US business cycle. This idea came originally from Robert Mundell, the Nobel laureate and the "father of the Euro".
Below I show you the historical relationship between short term interest rate (in red) and the Dollar (in blue). The short term interest rate is measured by the yield of 3-month treasury bills, which closely matches the Fed funds rate.
(click to enlarge; source: St. Louis Fed)
The history goes back to 1973, where the data is last available. As you can see, the two lines roughly move in tandem with each other, with interest rate leading for the dollar for a few quarters (or even longer).
Of course, the real life is much more complicated, so is the Dollar. There are a few notable exceptions: one was after the 1973 recession, then there was 1982 recession, and lastly the most recent recession.
In the 1973 and 1982 recessions, dollar went up even when the interest went down. This was probably because the relative interest rate between the US and other developed countries was still quite large.
While the recent divergence was obviously the panic trade: the Dollar serving as safe-haven. And this is also the main reason why I predict the US dollar will go down once the economy starts to recover.
In reforming executive pay, two things need to be resolved:
1. How to properly award competent CEOs while discouraging them to take too much risk that may bring down the whole system; 2. How to align short-term gain with long-term health of the firm.
Most of the current discussion simply focuses on capping executive pay without addressing the above two incentive problems.
Some interesting graphs to share:
a. The long swing of Wall Street Pay
(source: WSJ)
b. A similar graph linking deregulation with pay in financial sector:
Nouriel Roubini, a.k.a. "Dr. Doom", predicts that US dollar will be replaced by Chinese Yuan within a decade or even sooner, as the world reserve currency. His bold prediction is based on the observation of the history that when British pound was replaced by US Dollar as reserve currency, Britain was a debtor nation. In his view, a creditor nation is the ultimate natural candidate for reserve currency. He obviously has China in mind.
I can only say Roubini's prediction is too bold to be validated by history. Back in 1980s, there were also frequent talks that Japanese Yen will replace the Dollar as reserve currency because Japan ran huge trade surplus with the US, just like China today. Everybody knows what really happened. Nothing happened ---the US is still the most powerful economy in the world and US Dollar still remains the world reserve currency.
According to the research by Berkeley economic historian Barry Eichengreen, it took US Dollar almost half century to eventually replace British pound as reserve currency, even American economy surpassed Britain economy long before WWII: in early 1910s. The lesson is no country will give up its reserve currency status easily.
And bear in mind China is still a relatively poor country. The most optimistic case is China will surpass the US in total GDP somewhere around 2025, and it will take another 40-50 years afterwards for China to challenge the US on the next reserve currency.
some excerpts of Eichengreen's paper:
This paper provides an historical perspective on reserve currency competition and on the prospects of the dollar as an international currency. It questions the conventional wisdom that competition for reserve-currency status is a winner-take-all game, showing that several currencies have often shared this role in the past and arguing that innovations in financial markets make it even more likely that they will do so in the future. It suggests that the dollar and the euro are likely to share this position for the foreseeable future.
Everyone’s favorite heir to the throne, China, will have to solve some very serious problems before its currency begins to become attractive as a repository for other countries’ foreign exchange reserves. Removing capital controls is the least of its problems, in my view. Its financial markets are not very liquid or transparent; indeed, most of the institutional infrastructure needed for Shanghai to become a true international financial center will take decades to install. The security of property rights is uncertain, and making investors feel secure will ultimately require a transition to democracy, the creation of credible political checks and balances, and the development of a creditor class with political sway. While the renminbi is everyone’s favorite candidate for the new reserve currency champion four or five decades from now, such hopes are, in my opinion, still highly premature.
I admit letting the US dominate money printing is not the best arrangement in the international monetary system. Some change may come earlier than anybody would anticipate. I certainly hope the US government does not squander the trust by the world.
Now I attach Roubini's premature prediction (source: NYT):
The Almighty Renminbi?
By NOURIEL ROUBINI
THE 19th century was dominated by the British Empire, the 20th century by the United States. We may now be entering the Asian century, dominated by a rising China and its currency. While the dollar's status as the major reserve currency will not vanish overnight, we can no longer take it for granted. Sooner than we think, the dollar may be challenged by other currencies, most likely the Chinese renminbi. This would have serious costs for America, as our ability to finance our budget and trade deficits cheaply would disappear.
Traditionally, empires that hold the global reserve currency are also net foreign creditors and net lenders. The British Empire declined — and the pound lost its status as the main global reserve currency — when Britain became a net debtor and a net borrower in World War II. Today, the United States is in a similar position. It is running huge budget and trade deficits, and is relying on the kindness of restless foreign creditors who are starting to feel uneasy about accumulating even more dollar assets. The resulting downfall of the dollar may be only a matter of time.
But what could replace it? The British pound, the Japanese yen and the Swiss franc remain minor reserve currencies, as those countries are not major powers. Gold is still a barbaric relic whose value rises only when inflation is high. The euro is hobbled by concerns about the long-term viability of the European Monetary Union. That leaves the renminbi.
China is a creditor country with large current account surpluses, a small budget deficit, much lower public debt as a share of G.D.P. than the United States, and solid growth. And it is already taking steps toward challenging the supremacy of the dollar. Beijing has called for a new international reserve currency in the form of the International Monetary Fund's special drawing rights (a basket of dollars, euros, pounds and yen). China will soon want to see its own currency included in the basket, as well as the renminbi used as a means of payment in bilateral trade.
At the moment, though, the renminbi is far from ready to achieve reserve currency status. China would first have to ease restrictions on money entering and leaving the country, make its currency fully convertible for such transactions, continue its domestic financial reforms and make its bond markets more liquid. It would take a long time for the renminbi to become a reserve currency, but it could happen. China has already flexed its muscle by setting up currency swaps with several countries (including Argentina, Belarus and Indonesia) and by letting institutions in Hong Kong issue bonds denominated in renminbi, a first step toward creating a deep domestic and international market for its currency.
If China and other countries were to diversify their reserve holdings away from the dollar — and they eventually will — the United States would suffer. We have reaped significant financial benefits from having the dollar as the reserve currency. In particular, the strong market for the dollar allows Americans to borrow at better rates. We have thus been able to finance larger deficits for longer and at lower interest rates, as foreign demand has kept Treasury yields low. We have been able to issue debt in our own currency rather than a foreign one, thus shifting the losses of a fall in the value of the dollar to our creditors. Having commodities priced in dollars has also meant that a fall in the dollar's value doesn't lead to a rise in the price of imports.
Now, imagine a world in which China could borrow and lend internationally in its own currency. The renminbi, rather than the dollar, could eventually become a means of payment in trade and a unit of account in pricing imports and exports, as well as a store of value for wealth by international investors. Americans would pay the price. We would have to shell out more for imported goods, and interest rates on both private and public debt would rise. The higher private cost of borrowing could lead to weaker consumption and investment, and slower growth.
This decline of the dollar might take more than a decade, but it could happen even sooner if we do not get our financial house in order. The United States must rein in spending and borrowing, and pursue growth that is not based on asset and credit bubbles. For the last two decades America has been spending more than its income, increasing its foreign liabilities and amassing debts that have become unsustainable. A system where the dollar was the major global currency allowed us to prolong reckless borrowing.
Now that the dollar's position is no longer so secure, we need to shift our priorities. This will entail investing in our crumbling infrastructure, alternative and renewable resources and productive human capital — rather than in unnecessary housing and toxic financial innovation. This will be the only way to slow down the decline of the dollar, and sustain our influence in global affairs.
Nouriel Roubini is a professor of economics at the New York University Stern School of Business and the chairman of an economic consulting firm.
(added on May 15, 2009): Bloomberg also reports Roubini's worry about the Dollar.
Being as provocative as it is, the history of stock market shows big bear market often ends with overshoot on the downside (another way of saying mean-reverting). We haven't seen that, not yet.
Plus, with recent market rally of nearly 40%, the market no longer looks cheap.
It is said that copper has a PhD degree in economics because of its remarkable reputation to predict economic recovery. This was the case during the last recession, so are we going to see the same thing happening this time around?
China is the largest consumer of copper---with China's "green shoots" greener than anywhere in the world, we can only hope the economic recovery is indeed around the corner. That being said, expect more robust growth in emerging markets and only anemic recovery in the US.
US Dollar has been depreciating again in recent weeks as risk appetite comes back to the market. At the same time, gold price has been steadily rising (see chart below).
(click to enlarge)
What determines the price of gold? I tend to think two things matter most: $ and inflation. Of course, $ and inflation are interconnected. Higher inflation tends to correlate with lower $ value. I call the negative correlation between US dollar and gold the first order in determining gold price.
The second order factor is risk appetite. It can be measured by market volatility, for example, VIX. As discussed previously, gold is attractive to investors for various reasons. During panic time, gold, same as US dollar, is often treated as investment safe haven. So no wonder gold and the Dollar often move in the same direction. This is evident in the graph above, from mid January to early March this year.
Of course, in the short run, gold price may be complicated by many other things. One such thing is liquidity. In the summer of 2007 and 2008, during the height of the market panic, gold, for a brief period, dropped sharply with the rise of market volatility. This was because a lot of institutional investors were force to sell in order to meet margin calls: They had to sell their gold holding to raise cash.
Finally, I share with you a graph of the dollar and gold with longer history, dating back to early 90s.
This week is the graduation week all cross the country. Graduating in 2009 is not fun: with unemployment rate rising to 8.9% and surely going to get worse in coming quarters, the job is harder to find than ever. Even you find a job, your wage/salary is likely to be much lower than in good times. And according to the research by Yale economist Lisa Kahn, this initial gap in salary tends to persist over many years to come.
The graph below shows that when unemployment rate is at 7.1%, the initial salary offer is more than 10% lower than when the unemployment rate is at 5.3%. When the unemployment rate is at 9.6%, the initial offer, on average, is more than 30% lower than in good times.
Worse yet, the gap does not dissapear and it tends to perist for a long period of time. As shown in the graph, even after 15 years, the gap is still at 10% for people hired when unemployment rate is at historically high level. Call it "the curse of class of 2009".
WSJ reports how some banks battled with the government and managed to force government to make concessions and lower the capital requirement.
Here are some interesting excerpts:
At times, frustrations boiled over. Negotiations with Wells Fargo, where Chairman Richard Kovacevich had publicly derided the stress tests as "asinine," were particularly heated, according to people familiar with the matter. Government officials worried San Francisco-based Wells might file a lawsuit contesting the Fed's findings.
... Wells Fargo's capital hole shrank to $13.7 billion, according to people familiar with the matter. Before adjusting for first-quarter results and other factors, the figure was $17.3 billion, according to a federal document.
... Citigroup's capital shortfall was initially pegged at roughly $35 billion, according to people familiar with the matter. The ultimate number was $5.5 billion. Executives persuaded the Fed to include the future capital-boosting impacts of pending transactions.
... Bank of America's final gap was $33.9 billion, down from an earlier estimate of more than $50 billion, according to a person familiar with the negotiations.
And government used tier 1 capital ratio instead of TCE ratio to measure capital adequacy.
![[Chart]](http://s.wsj.net/public/resources/images/P1-AP851_STRESS_NS_20090508232418.gif)
