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Emerald Group Publishing Limited
Copyright © 2011, Emerald Group Publishing Limited
Article Type: Editorial From: International Journal of Managerial Finance, Volume 7, Issue 1
By all press accounts, the recently concluded economic conference of the leaders of the world’s largest economies, the G20, was not a success, even by the modest standards that apply to such events. Usually in the face of fundamental disagreement the parties issue a document that is vague enough that all participants can sign it without committing to anything concrete. This case, however, was more extreme: there was no serious attempt to disguise the fact that we are just not all singing out of the same hymnbook.
The issue has to do with “imbalances”, as they have come to be called, in the world economy: several of the largest countries have been running trade surpluses and thereby accumulating foreign-denominated assets. Of these, Germany and especially China are the most important. Other countries, principally the United States, have been doing the opposite. Calling these differences imbalances creates the presumption that they constitute a problem requiring political intervention. It is far from obvious that this is the case – there is nothing wrong with individuals borrowing from and lending to each other; why is it different for nations? Throughout the nineteenth century the United States was a heavy net borrower from Europe. There was more money to be made building railroads in the United States than in expanding the railroad network in Europe, so European wealth-holders invested in United States capital goods and securities. By general agreement this “imbalance” did no harm on either side of the Atlantic. Is it different now?
The discussion has focused on two countries, the United States and China. As everyone knows, the United States is a large net importer from China. To a considerable extent this state of affairs reflects a deliberate Chinese policy of undervaluing the yuan. Doing so enables Chinese manufacturers to undersell both United States manufacturers and exporters to the United States in other countries. For the same reason United States exporters have difficulty competing in the Chinese markets. As a result of the export surpluses, the Chinese have accumulated about two trillion dollars worth of United States Treasury bonds.
Focusing on just the trade between the United States and China while ignoring the trade between each of these and third countries distorts the picture to some extent: although China has an export surplus against the United States, it is a large importer from other countries, notably Australia. Even the most extreme proponents of “balance” in international trade do not assert that it should hold pairwise among all countries in the world. Rather, the argument is that for each country deficits against one country should be offset by surpluses against another, so that the net balance for each country is near zero. However, the validity of even this weaker reading of balance is questionable, as just noted.
A major goal of United States policy is to persuade the Chinese to allow the yuan to appreciate. Doing so would decrease or eliminate China’s export surplus against the rest of the world. The resulting increase in United States exports would, it is asserted, enable the United States to recover from the recession of the past several years. The fact that the major exporters, China and Germany, have in fact emerged from the recession to a greater extent than the United States appears to give some support to the argument.
A striking feature of this goal of United States policy is the asymmetric roles it assigns to the United States and China. We are talking about the relative price of two currencies. Obviously it does not matter whether we talk about the dollar price of the yuan or the yuan price of the dollar. Yet, despite this symmetry, the desired policy presumes that the burden is on China to bring about the desired change. The presumption that it is up to the Chinese alone to determine the price of the yuan against the dollar is in part a holdover from the Bretton Woods international monetary system, put in place following the Second World War. When the Bretton Woods system was set up all the major powers in the world except the United States had as their first priority rebuilding from the war. Given the destruction suffered by all the major allied powers other than the United States, leadership of the capitalist world by the United States was inevitable, and the Bretton Woods system reflected this state of affairs.
At Bretton Woods there was general agreement that going back to the gold standard, which had prevailed prior to the First World War but had lost ground in the interwar period, was not the way to go. How then to regulate the relative values of national currencies? The chosen solution was to have the United States dollar replace gold in the world monetary system. Countries other than the United States would control the prices of their currencies against the United States dollar. The United States, as provider of the reserve currency, had no parallel obligation, although in principle it would have been possible for the United States unilaterally to alter the exchange rate of the dollar against any other national currency, or all of them. The current situation with China directly reflects this situation.
As the world recovered from the destruction of the Second World War the special position of the United States gradually eroded. The defeated powers in the Second World War – Germany, Japan and Italy – transformed their economies to the point where per capita GDP in these countries is comparable to that in the United States. The former developing countries of Asia, especially China and India, are now major players in the world economy.
Throughout the postwar period the United States imported more than it exported in most years. For the most part this pattern in the balance of trade was not perceived as a major problem in the United States. It was, after all, the opposite side of the coin from the ongoing capital flow, which reflected the fact that wealth-holders around the world wished to hold United States Treasury bonds in preference to the assets of any other country, as a result of the United States’ perceived economic and political stability. The way to accumulate United States assets is to run an export surplus and use the proceeds to buy United States securities, and this is what many countries did.
In recent years there have been signs that the willingness of wealth-holders to accumulate United States assets has its limits. Partly this is a consequence of the increasing magnitude of United States trade deficits in the past several years, and it also doubtless reflects the fact that foreign investors have taken large losses on United States mortgage-backed securities. Recent drops in the United States dollar against other currencies, including the yen, the euro and the Australian dollar suggest that the era in which the United States dollar occupied a privileged position among world currencies may be nearly over.
In any case, the presumption carried over from the Bretton Woods system that it is up to China to regulate the value of its currency against the United States dollar is now one of form more than substance. There are measures the United States could take to reverse the situation. Most drastically, it would be possible to subsidize exports or impose tariffs on imports. The United States has opposed such protectionist measures throughout the postwar period on the grounds that other countries would retaliate, resulting in loss of the benefits of international trade. During the Great Depression of the 1930s protectionist policies were implemented by most of the major trading countries, and many students of that period believe that these policies were major contributors to the length and severity of the Great Depression. United States policymakers have reiterated their opposition to measures that might trigger a currency war.
Part of the friction at the recent G20 conference is due to the fact that, while expressing opposition to competitive devaluations, the United States has taken actions that, in the eyes of some, amount to the same thing. On this view the United States is seen as guilty of the same behavior that it criticizes when China does it. Monetary policy has been used much more aggressively in the United States by the Federal Reserve System to combat the recession than has been the case anywhere else in the world. Short-term interest rates are essentially zero in the United States, and interest rates on 20-year Treasury bonds are below 4 percent. The idea is to encourage consumption, investment in plant and equipment and especially to promote a recovery in real estate values. Other countries have taken similar actions, but have been much less aggressive, so interest rates in Europe in particular are much closer to normal levels. In the last several weeks the Federal Reserve announced a new round of “quantitative easing”, the current euphemism for easy monetary policy. The goal of the current round of quantitative easing is to decrease long-term interest rates from the current already very low levels.
Widening of the spread on interest rates between United States and European interest rates gives investors an incentive to hold euro-denominated assets in preference to dollar-denominated assets. This eventually results in drops in the value of the dollar against the Euro and other currencies as investors sell dollar-denominated assets, convert the proceeds to Euros or other currencies and buy securities in those currencies. Thus even though the United States interest rate policy is directed primarily at the domestic economy, the critics see it as amounting to a back-door devaluation of the United States dollar. Thus the United States is viewed as no less culpable than China in risking provocation of a currency war.
What is most striking about the discussions surrounding the G20 conference is the unquestioning acceptance by virtually all participants of Keynesian and mercantilist ideas. Exports are good because they generate income, thereby stimulating demand and raising GDP. Devaluing the currency is good because it encourages exports. Therefore it is in the interest of each country to keep its currency value low relative to the others. But if all countries take actions to this end, the outcome is bad, so the essential point is to induce each country to sacrifice its immediate interest for the welfare of all countries.
To economists, every link in this chain is, at best, open to serious question (except the last; there is little doubt that a currency war would make all countries worse off). A majority of economists, although perhaps not an overwhelming majority, regard Keynesian ideas as unintelligible, at least in the simple form that they take in the present context. The most important book ever written in economics, Adam Smith’s Wealth of Nations, was devoted in large measure to criticizing the mercantilist ideas that dominated discussion in the eighteenth century, as they do now. Economists, but apparently not many others, find Smith’s eloquent discussion, besides being entertaining, to be completely persuasive.
Specifically, it is far from clear that the decision on the part of the Chinese to accumulation trillions of dollars of United States Treasury bonds is in their interest, nor that their doing so is antithetical to United States interests. If the Chinese accumulate United States bonds forever, they are in effect giving goods to the United States for free. No problem there for the United States. Therefore at some point they will stop running surpluses and will draw down their assets. Doing so, which is the opposite of what they are doing now, will decrease the value of the dollar relative to the yuan, implying major portfolio losses on Chinese holdings of United States debt. This is substantially the same outcome the United States is trying to achieve now. Why then is it so important to make the change now rather than some time in the future, which is what will happen if nothing is done now?
It is true that such changes generally go more smoothly and are less extreme when they are implemented early rather than when they are conducted under duress at the last moment, but this is surely a second-order effect. These considerations suggest that the sturm und drang of international economic conferences such as that, which has just terminated is overdone. Such affairs are generally not very important, and it seems as if the respective publics understand this.
How does all of this bear on the work of financial managers? First, the fact that interest rates are much lower in the United States than in the rest of the world has obvious relevance for financial managers, particularly those associated with large firms that have ready access to worldwide capital markets. Many large United States firms are taking the opportunity to lock in funding for the next decade or so by issuing long-term bonds. It is true that non-United States corporations who are considering borrowing in United States capital markets have the additional problem of currency risk to ponder. Hedging currency risk effectively converts the borrowing from United States dollars into units of the home currency, thereby negating the benefit of the interest rate differential. The alternative is to take on the risk of a rise of the United States dollar against other currencies. If one thinks that the United States dollar is likely to continue to drop against other currencies, as the preceding considerations suggest, then a manager might be willing to put the funding in place now without a hedge.
Another point comes close to contradicting that just made: an unusually high degree of uncertainty now prevails about virtually every important aspect of the economic and political environment. This is true worldwide, but particularly so in the United States. As a result of the recent election we do not even know whether the Democrats or the Republicans are in the driver’s seat, not to mention the fact that what either of these parties represents is more vague than usual. Taxes, currency issues, recovery from the recession, recapitalization of the financial system are all big question marks. Corporate managers invariably react to such situations by postponing major decisions until they can form a clearer view of the future. Thus in the United States banks are conservative about making loans, while corporations are reluctant to commit to new employment. Managers worldwide face a similar situation, although perhaps to a lesser degree. It is hard to tell how long this situation will last, but until it is reversed it is likely that financial managers will persist with a wait-and-see attitude.
Stephen F. LeRoyUniversity of California, Santa Barbara, CA, USA