Old Economics: Still Good Economics

Despite the bad rap given to traditional economic models in the aftermath of the global financial crisis, economic theory and economic history together still best point the way to understanding the rhetoric surrounding U.S. deficits, the role of the dollar in trade, and the Chinese trade surplus. Today's New York Times Op Ed page contains two related articles by Ferguson and Schularick ("The Great Wallop") and by Paul Krugman that discuss some of the issues.

First, there is no doubt that the biggest contribution that the U.S. can make to global welfare is to get our fiscal house in order over some reasonable time horizon and secondly, to reform financial system regulation to choke off future systemic crises before they become lethal.

However, it is equally fair to say that the behavior of the Chinese in managing the RMB exchange rate vis-a-vis the dollar is deleterious to the world economy, especially Third World countries with large volume of potential exportables and to the U.S. adjustment to its twin deficits. We all know from economic history that this "beggar thy neighbor" policy of artificial devaluation results in a diminished volume of world trade and large welfare losses to the world economy. The Chinese government is doing this to protect their global export engine, which is rational only in the very short-term.

There is some occasional rhetoric about "replacing" the dollar as the primary instrument of world trade. However, the dollar enjoys this primacy not because of a popularity poll but because there is a large, low risk, highly liquid market in short-term Treasury bills. What about purchasing power risk associated with higher U.S. inflation? Right now, the Federal Reserve governors have almost been unanimous in saying that significant inflation is not a risk given all the slack in capacity utilization and in the labor market. Even if it were a prospect, interest rates would adjust to compensate the holders for this risk. So far, so good.

What about the using the euro or the yen as alternative reserve currencies? Despite the growth of the Euro capital markets, they remain fragmented and nowhere as deep and liquid as dollar markets. Since reserve holders cannot hold the euro directly but rather hold euro-denominated securities, one has to look at a potential issuer of euro-denominated, government debt with large outstandings. As Richard N. Cooper of the Peterson Institute points out, the largest issuer of euro-denominated government securities is the government of Italy, with $1.8 trillion in outstandings. It's highly unlikely that the world will place its confidence in the reliability and transparency of Italian monetary and fiscal policies in order to switch to the euro through this issuer. The government of Germany is a possibility, but only $266 billion of their outstandings are in short-term maturities, which is inadequate to finance world trade and reserve movements. The yen has significant outstandings ($7.9 trillion in government debt) and $2.3 trillion in short-term maturities, but the near-zero rates and the long-term fiscal issues cast a pall over using this issuer as the bulwark for global trade and finance. As Cooper notes, "none of the other leading currencies in the world today is ready to replace the U.S. dollar in its international role." The reasons are based on fundamental market economics, which are still the optic through which currency traders view the world, however fancy their trading instruments.

I won't go into the idea of using SDR's for trade and private settlements. It makes for nice conversation in the halls of the European Parliament, IMF, BIS, and World Bank, but it's not an idea whose time will likely come in the near future.

Global trading partners are really inter-dependent. We don't call the shots because of our fiscal and economic issues, and neither do the Chinese because of their unsustainable policy to grow exports at the expense of domestic consumption in a fifteen year orgy of subsidized export growth. Everyone has to adjust, and the biggest traders will have to adjust more.

President Obama's trip to Asia puts him at the top of Presidential travellers measured in mileage. It's hard to imagine the Chinese taking anything he says seriously. By all means, let us get our domestic fiscal and foreign policy houses in order and focus the agenda on jobs and economic growth. The markets would really take notice.