What would you do if your nest eggs are in a mix of stocks (30%), bonds (65%) and cash (5%)? I still haven’t recovered from the 1996 recession.”
Questions like this are beyond me. But they are useful as a way to force a viewpoint on the likely outcomes here. The first thing to do is not to listen to me. I thought my friend was crazy for diverting her extra income to the stock market in March 2009; she actually timed the market perfectly.
Start from first principles. The official community is behind the current course pretty solidly, despite the market’s profound doubts. The messenger will be shot, not heard. So we have to go with the market’s verdict: it is pricing in negative GDP growth in the euro periphery. That will not be costless for the wider EU, hence the sell-off in the euro. Note: EU leaders are mistaken if they interpret this selloff as a bet against the euro as a currency. It isn’t. Just look at German bunds. Their yields are near an all-time low, and the yield incorporates the market’s viewpoint over currency risk. (Translation: the price of German debt is high because the market believes in the safety of this debt, which coincidentally will be repaid in euros, suggesting that the market is not overly concerned about the euro from an existential viewpoint.)
It will also not be costless for Club Med’s (and Ireland’s) non-euro neighbours. Little wonder the Turkish lira fell 7% in two days earlier this month and has resumed its slide after an intervention. The British pound’s decline is all to do with the trade consequences of the programmed Club Med/Ireland coma. The British government is responding to a phantom if it thinks sterling weakness reflects market disapproval of the fiscal profile. Of course, we’ve been here before, and the details are developed ad nauseum in this blog. It goes back to the Great Depression. One of the Depression’s great ironies (tragedies) was the widespread fear of inflation when deflation was the clear and present danger (h/t Eichengreen 1992). So we shouldn’t be surprised that Paul Krugman is a minority voice in explaining the deflationary dangers at hand today.
But this post is about the positive, not the normative. European currencies are going down. Add to this a whiff of fear in the capital markets, and you get (another) rush for the dollar. Folks like Peter Schiff might liken this to running towards the fire when the alarm goes off, but there are solid reasons for it. The dollar is the global numeraire. You can use it anywhere. In an emergency, you want to be in it. And the greater the emergency, the more liquid form of it the better. Taken to extremes, this means literal cash. It’s the only form of “central bank money” you have access to. (Bank reserves at the Fed are also central bank money, but they’re off-limits to you.) The rest is deposit money and other, higher, forms of money.
So we are going to have a stronger dollar. This feels like “the big postponement” of what we were all really hoping to witness: a shift of US growth into the traded sector. That’s what the whole ‘rebalancing’ thing is about. The US is on the road now to even greater indebtedness to China and other foreign creditors. Let me pause: I am a sino-phile. So whatever you construe from this post (or this blog) one thing it ain’t is China-bashing. But the statement stands: China (and others) are set to accrue more US liabilities. To my way of thinking, this only amplifies the eventual adjustment.
Setting aside my own views, I think I am safe to say that many fear this adjustment will be too big for market processes (and political systems, democratic or otherwise) to handle. We don’t have any good precedents for the upcoming handover in global leadership between the United States and China. The closest historical parallel, at least in modern times, is the baton-pass between Britain and the USA. One approach to the Great Depression blames the interwar travails on the vacuum in leadership created in the middle of that transition.
Britain and the USA shared an affinity of language, culture, etc. This seems less in evidence between the USA and China. There’s a larger point. One can argue that the rise of the United States economy at the turn of the 20th century was intensely destabilising for the global economy. The US was like a clumsy giant, unaware of its global impact and still unresolved over how to manage its own monetary system. China will eventually go through financial crises of its own, indeed it already has, and handled them well. There are reasons to be sanguine. I’ll go through those in a future post about USA/China, as well as my ‘normative’ policy programme. There is no point in fatalism.
Surely the Chinese (and other creditors of the U.S.) must know that at some point the dollar will head strongly in the other direction, and the U.S. debt instruments will lose much of their value. Maybe the gold bugs are correct this time!
Gold might very well be the bridge from the dollar numeraire to the renminbi numeraire.
It seems that before the renminbi could take the dollar’s place, much of what is closed or fixed in the Chinese economy would need to be opened. Is it true that the renminbi can only be freely exchanged if there is no peg?
> Is it true that the renminbi can only be freely exchanged if there is no peg?
IF China were a small, open economy the answer would be, Not at all. HKD is pegged and freely convertible. Danish krona is pegged and freely convertible.
However, since China is a large, open economy, it cannot live with someone else’s monetary policy. The only way to combine some monetary independence with a pegged exchange rate is currency controls. So yes, the renminbi needs to be float if the exchange controls are to be lifted.
But that begs the question: Are exchange controls a bar to international currency status? I’m sceptical (I accept that I’m in the minority here). Was the USD freely convertible under Bretton Woods? (No.)
I’m of a strong opinion that international currency status follows international presence. A ubiquitous currency is ultimately a liquid currency. And this is self-reinforcing. A liquid currency market is an attraction in its own right.