This can occur in two ways. One way is for the nominal exchange rate to rise. In a market in which the central bank does not intervene, the nominal currency would rise automatically as demand for renminbi exceeds demand for dollars. In an intervened market, in response to surging reserves the central bank would simply re-peg at increasingly higher rates (although central banks are often very late when it comes to revaluing their currencies).
If the nominal exchange rate doesn't rise, the resulting net current account inflows should cause excess domestic monetary expansion, which means, ultimately, that domestic prices must rise. This is just another name for inflation. A country that runs large and persistent trade surpluses and a pegged exchange rate should gradually see an erosion of those trade surpluses as rising domestic prices increase the external price of that country's exports.
For the past decade, the rapid growth in Chinese productivity has far exceeded that of its trade partners, and has also far exceeded the growth in domestic wages. The natural result should have been a gradual but strong appreciation of the renminbi. But the level of the renminbi is set by the People's Bank of China, and its total appreciation in the past decade has been much less than the relative growth in productivity – and I am ignoring other factors that should have put even more upward pressure on the currency, like low interest rates, subsidized capital and real estate, and socialized credit risk. As a result China has seen a surge in its trade surplus. As a share of global GDP China's recent trade surpluses (roughly 0.6-0.7% of global GDP) are easily the highest recorded in the last 100 years.
This is all the more striking when you consider that the two previous record holders, the US in the late 1920s (with a trade surplus equal roughly to 0.4% of global GDP) and Japan in the late 1980s (0.5% of global GDP), were relatively much larger economies. The US represented more than 30% of global GDP in the late 1920s, and Japan represented 15% of global GDP in the late 1980s. By contrast China represents only 8% of global GDP today.
The huge resulting current account inflows, reinforced by net capital account inflows as foreign money poured into China to take advantage of cheap assets and subsidized costs, forced an expansion in domestic money supply far beyond the needs of the Chinese economy. Normally, such rapid money growth should have pushed China into an inflationary spiral, which would have then forced a rebalancing of the Chinese economy away from excess reliance on a trade surplus. Remember that rebalancing in China primarily means that household consumption must rise as a share of GDP, and this can occur in both good ways (a surge in consumption) or bad ways (a sharp drop in GDP growth). Spiraling inflation would probably force GDP growth to drop relative to consumption.
Financial repression
But this inflation didn't happen. There have periods of inflation in China in recent years, and even a brief inflationary scare in 2007 and 2008, but on average inflation has been far less than what was needed to revalue the currency sufficiently.
So what happened? Why has inflation been muted – as it has by the way in other countries that followed the so-called Asian growth model, including most importantly Japan in the past several decades?
Two months ago University of Chicago economist, Robert Aliber, came to speak at my central banking seminar at the Guanghua School of Peking University. In a fascinating discussion he explained that in fact there was another possible resolution of the imbalances caused by relatively rapid productivity growth in the tradable goods sector.
He pointed out that if the nominal exchange rate is not allowed to rise, policymakers can still contain inflation by what economists call financial repression, made possible by their control over the banking system in countries where banks completely dominate the financial system. In the Chinese context, financial repression exists because the vast bulk of Chinese savings is in the form of bank deposits, and the deposit rate is set at extremely low levels.
This has the effect of transferring large amounts of income away from net savers, which for the most part consists of Chinese households, and in favor of net users of capital. Net users, of course, consist primarily of large, capital intensive businesses, real estate developers, infrastructure investors and local and central governments, including the People's Bank of China, the largest net borrower of renminbi in China. Net savers are forced into subsidizing net users, in other words.
The consequence is that monetary growth is channeled not into household demand but rather into the production of more goods, and the inflationary impact of monetary expansion is muted. Financial repression is an alternative to currency appreciation or inflation.
The cost of low interest rates
But according to Aliber's model, financial repression has a cost. It leads to overinvestment, asset bubbles, and rising excess capacity. By keeping the cost of capital in China very low – perhaps as much as 5-8% below a rate that would impose a fair distribution of the benefits of economic growth between savers and users of capital – it results in a surge in investment which, allied with large-scale socialization of credit risk, can lead at first to a rapid increase in economically viable investment but ultimately, if left unchecked, results in capital continuing to pour into investment long after its returns are uneconomical.
I think it is pretty clear that during the last few years, and perhaps even longer, we have migrated into a state where the correctly valued costs of Chinese investment in infrastructure, real estate development, manufacturing capacity, and government spending, exceed the economic benefits...
China's financial repression is also at the heart of the imbalance in the Chinese economy. By transferring large amounts of wealth from the household sector to net borrowers (perhaps as much as 5-10% of GDP annually, as I explain in an earlier entry), it creates the large growth differential between national GDP and household income that is at the root of China's very high savings and very low consumption levels.
I should add that if much of this investment is non-economic, as I believe it is, this will exacerbate even further the differential. Why? Because the total economic cost of the investment (which must include the real debt forgiveness implied by excessively low interest rates), and which will be borne over the future as the cost are amortized in the form of debt repayment, exceeds the total economic value of the investment (which must include externalities), which will accrue upfront. This means that we get more investment-driven growth today and less consumption-driven growth tomorrow.
"I want my future husband to be diligent about money," a 27-year-old woman says in an ad being run in free magazines promoting a fixed-rate, three-year note that Japan started selling last week. "Playboys are no good." She's one of five women featured in the page, which says "Men who hold JGBs are popular with women!!"
The ministry commissioned the ads to appeal to citizens for money at a time when record government borrowing threatens to outstrip demand. Prime Minister Naoto Kan, who took office yesterday, said he doesn't have an instant fix to rein in the world's largest public debt.
"Tuesday night's speech from the Oval Office of the White House was written to a 9.8 grade level, said Paul J.J. Payack, president of Global Language Monitor. The Austin, Texas-based company analyzes and catalogues trends in word usage and word choice and their impact on culture.
Though the president used slightly less than four sentences per paragraph, his 19.8 words per sentence "added some difficulty for his target audience," Payack said.
He singled out this sentence from Obama as unfortunate: "That is why just after the rig sank, I assembled a team of our nation's best scientists and engineers to tackle this challenge -- a team led by Dr. Steven Chu, a Nobel Prize-winning physicist and our nation's secretary of energy."
"A little less professorial, less academic and more ordinary," Payack recommended. "That's the type of phraseology that makes you (appear) aloof and out of touch.""
"I don't go tanning anymore because Obama put a 10% tax on tanning," she said. "And I feel like he did that intentionally for us."
Responding to simple economic incentives, the orange-hued TV star has switched to spray tans.
Snooki also offered some praise for Obama's former Republican opponent, Arizona Sen. John McCain. "McCain would never put a 10% tax on tanning because he's pale and he'd probably want to be tan," she said."
A few interesting reads on Israel and Turkey:
and by the way, because everyone is bending over backwards to try and avoid saying this, there IS something deceptively anti-Semitic in Israel's criticism. Why is Israel the target of everyone's opprobrium when by any reasonable metric, they are significantly better than a) any of their neighbors and b) most of the world from a humanitarian perspective? Is this a "departure from expectations" thing - where you only criticize people when they act worse than you expect, and because Israel is a democracy and everywhere else there is a theocracy we ignore the ridiculous humanitarian problems elsewhere? Seriously, let's not forget that the only two countries in history to ever notify residents before attacks are Israel and the US, because they don't want to kill civilians. Helen Thomas' recent remarks are a decent highlight - perhaps people oppose Israel, but most of their solutions involve Jews as well as Israelis, because the media of that entire region equates the two and thus any coexistence necessarily involves Judaism. The UN hasn't listed Israel as the only state of nuclear concern - instead of North Korea or Iran - for reasons that are "opposed to Israel's actions but not to Judaism at all!".
