Wednesday, 1 October 2014

Golden Rule - Alan Greenspan on Chinese Gold Buying - Foreign Affairs

Not the usual goldbug crowd, but former Fed Chairman Alan Greenspan writing in the influential Foreign Affairs
Whilst the gold price is currently weak, the facts of continued central bank ownership of gold and recent accumulation, in particular by China, continue to intrigue  
If China were to convert a relatively modest part of its $4 trillion foreign exchange reserves into gold, the country’s currency could take on unexpected strength in today’s international financial system.
If the dollar or any other fiat currency were universally acceptable at all times, central banks would see no need to hold any gold. The fact that they do indicates that such currencies are not a universal substitute.  
What is not really discussed is why China would seek a stronger currency at a time we are seeing competitive global currency devaluations, with Japan and the Eurozone following the US to QE and
weaker currencies, potentially stoking imported inflation in economies which some consider demographically deflationary.

We have seen China follow a mercantilist model of growth, devaluing their currency by building enormous US$ reserves, reducing inflationary pressures within China, politically critical, but at a cost to household wealth and consumption within China.
It is conceivable that the next phase of growth is to direct the productive capacities inwards to drive Chinese consumption.
In this case a stronger currency could be a driver of purchasing power, imports become cheaper. Dollar reserve building can then slow or reverse without unleashing inflation across food and energy and other import cost drivers which would threaten the ruling party if widespread discontent was seen amongst the newly urbanised poor.
The Chinese then need to internationalise their currency, wide ranging agreements are being put in place, undertaking trade in their own currency.
Could political pressures, Hong Kong protests for example, spark a new drive to enrich Chinese consumers through a stronger currency and mark a revaluation of all other currencies against China's?

Michael Pettis' discussions of the US$ based global trading system are very significant and well worth reading in full  HERE and HERE

Chinese revaluation could drive two things.

  • Firstly unleash consumer demand in China, artificially suppressed by the "excessive savings" of US Dollar hoarding to suppress the Chinese currency. 
  • Secondly avoid protectionist measures in the US. Indeed devaluation of the US$, Euro and Yen against the Renminbi could drive global exports and growth. This could address the key global imbalances at the heart of the 2008 crisis.
This may come at a time when the US becomes increasingly isolationist and no longer sees the benefit of the "exhorbitant privelege" of the US dollar but instead sees the negative aspects of the "Triffin dilemma".

It seems to me then purely a matter of logic that as the world grows, as there is convergence in income disparities between rich and poor countries, and as more countries choose to join the global trading system, at some point the two lines – the higher line representing a declining share of total benefits, whose slope is likely to be slightly positive tending towards flat, and the lower line, representing rising costs, whose slope is steeply positive and becoming more so – must cross, after which point the costs exceed the benefits.
I would argue that we have probably already passed that point, and that the US would be better off today by significantly modifying the way it participates in the global trading system. The longer it waits to do so, the riskier it will be, and either the more debt or the more unemployment it will have to accept. Among other things, the US must address the role of the US dollar as the world’s reserve currency and the way this role forces the US into absorbing volatility and shortfalls in demand that originate abroad. 
China’s extraordinarily high savings rate is almost wholly explained by the transfer mechanisms that subsidized rapid growth over the past two decades, leaving Chinese households with the lowest share of GDP in the world, and perhaps the lowest ever recorded for a large economy. Arithmetic, not to mention historical precedents, can easily explain why these transfers, which during this century amounted to as much as 5-8 percent of GDP annually, would drive down the household consumption share of GDP by driving down the household income share, and of course high savings are simply the obverse of low consumption.
When the world is suffering from insufficient demand, however, clearly the problem we face today, income inequality and excess savings are the problem, not the solution. There may be plenty of good investment that are not being funded in the US, but the reason they suffer from lack of funding, unlike in the 19th Century, is not because capital is to scarce or too expensive. Capital is actually too plentiful, and this shows up in the speculative flows that have driven global stock and bond markets to unreasonable levels. It is weak demand or political gridlock that prevents productive investments from being made.
In a world with few constraints on trade or capital flows, if you try to raise domestic consumption by raising household income – for example by raising wages – your contribution to global demand will indeed rise, but your export competitiveness will decline, and so you may retain a smaller share of that greater amount.  In a globalized world, without a globally coordinated no-cheating boost in spending, beggar-they-neighbor policies may be systemically crazy but they are individually rational.
Americans become increasingly aware that when foreign central banks amass hoards of dollars and prevent others, including the Fed, from reciprocating, they aren’t doing the US any favors (and if they were, why are they so determined to prevent other central banks, including the Fed, from returning the favor?). Their purchases are aimed at boosting domestic employment, and unless productive investments in the US are unfunded because of a savings shortage (which is all but impossible to believe), their purchases must result either in an increase in US debt or an increase in US unemployment. This may sound surprising to many people, including, shockingly enough, to many economists, but is actually quite easy to prove, either by using balance of payments arithmetic or by looking at the historical precedents.
Second, it seems to me that the US is becoming increasingly isolationist, largely because it is increasingly uncertain that the benefits to the US of a US-dominated world order still exceed the costs. When the US comprised a much larger share of the “globalized” part of the world, it retained a greater share of the benefits of a stable trading environment and it cost less to maintain that environment. As the US becomes a declining share of the globalized world, the costs of imposing stability (and I have no illusions that this is done for charity) rise, and its share of the benefits decline. It is only a matter of arithmetic that at some point the costs will exceed the benefits. 

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