Will politicians be able to avert prisoners’ dilemma outcome amid pressures? Currency war debated.

During the last days, attacks on Chinese exchange rate policy (regarding the undervalued Yuan) have become more intense. After the U.S. had ignited the debate by introducing a Currency Bill that would give the U.S. the right to levy import tariffs over Chinese products that are too cheap due to the export subsidy in the form of the undervalued Yuan, other countries were asked to join the debate. Once the Currency Bill has passed Congress and Obama put its signature on it, China can take the case to the WTO. Then, it might take months before the issue is settled, and in the mean time, other countries might have followed the U.S. example, damaging Chinese exporters. Since the chances that the Currency Bill will not be condemned by the WTO are much higher if other countries follow the U.S. example, the EU has strengthened its tone vis-à-vis China to make its exchange rate regime more flexible in practice (currently, it’s only flexible in theory). (Asking the Europeans to introduce an equivalent to the U.S. Currency Bill is perhaps a bit too much.)

But the Chinese are not stupid; they offered Greece a Marshall Plan II whereby China is buying Greek bonds (while saying they strongly believe in the good economic fundamentals of the country and the Euro zone) in return for Greece buying Chinese products. By supporting the weaker countries in the Euro zone, they ensure the strength of the euro, and thereby they retain an investment alternative to the U.S. dollar and an export market. Moreover, it implicitly tells the EU that it should not complain. The EU has gotten one cookie, it should not ask for another one. So now the EU is said to back off when it started complaining about the Yuan weakness.

So this move by the Chinese was very clever, in my opinion. However, do they really have a right to ignore global complaints about the weakness of their currency? IMF studies, and other ones, agree that they Yuan is 20-40% undervalued. If that’s not an unfair export subsidy, what is?

More and more countries seek to devalue their currency by intervention and/or loose monetary policy. Research has provided ample evidence unsterilised intervention is only working when accompanied by a loose monetary policy (and sterilised intervention is actually never working, perhaps only in the short run, and it can even be counterproductive, due to signalling effects). However, it is not always possible to loosen monetary policy. Japan has loosened monetary policy for years and is at or near the zero interest rate bound for years now, without having lifted Japan out of its period of (near) deflation.

Furthermore, it just is a very bad idea to try and weaken your currency, if all your neighbour countries have the same idea. When visitors on the first row of a concert start standing on their toes to have a better view, visitors on the second row have to come up with something better. Maybe jumping does the trick for them. But the ones at the back row really have a problem. This is the outcome of the well-known prisoners’ dilemma: nobody will have an advantage from it (the ones at the first row will start experiencing aching toes after some minutes and will regret their actions).

This is obvious: if each country seeks to lower its currency, flooding the market with liquidity, no country will succeed to lower its currency relative to the other countries. Except, of course, if one country takes such extreme measures that this immediately wipes out the value of its currency. Hyperinflation will prevail. Perhaps it is good – albeit only relatively good – if one country would follow this course, just to set the (bad) example.

Luckily for us Europeans, it is unlikely that the ECB will be the first one setting the bad example; the ECB is farthest from all central banks of the weaker countries to engage in extreme further quantitative easing, although the ECB did admit banks were addicted to their liquidity provisions such that the ECB has seen its exit doors (their path to tighter policy) being blocked.

The big question is, however, how far countries will go. There is a slight chance that central bankers and politicians do not realise the game they are playing is a very nice example of this prisoner’s dilemma. One step in the wrong direction, and the prevailing outcome will not be likened. In the end, every country will be worse off. Political pressure to purposefully devalue currencies, unfortunately, is enormous. I (being an optimist) do not believe central bankers will be so naïve (read: stupig) to underestimate the dangers going “all out” and continue the road (downhill) of extreme QE and currency devaluation.

But perhaps I am just being optimistic, believing in the wisdom of politicians and central bankers. And that is perhaps not so wise.

My personal assets and liabilities

A conference this morning in Amsterdam. Interesting, a lot of macroeconomics, international economics, monetary economics, a lot of men in expensive suits. Still, something else has been playing on my mind. There is something inherently wrong in the idea of economic growth we have. This sounds a bit radical, maybe it is, but I think it is crucial for how we view the world around us.

A side note: we, economists (yes, I consider myself an economist), tend to think the whole world evolves around economics. Maybe I believe this idea is more important than it actually is, but perhaps - especially if you are also wondering what this think we call economic growth actually is - you can agree with me.

Another side note: the gut feeling I have is difficult to put in words, but I'll give it a try...

Let me start with what is going on in the markets and what a very important dilemma is that we are currently facing.

On Tuesday evening, Fed chairman Bernanke said that inflation in the US is below the Fed's target. Since the Fed has the dual mandate of keeping employment at its maximum hurry, as long as it does not hurt its other mandate of price stability, the message of Ben actually implies that the Fed will engage in another round of quantitative easing (QE II) if it sees further dangers to price stability. Hence, more liquidity injections will be advanced by the Fed to prevent deflation. When and in which way the Fed will do this is another uncertainty to which it has not given an answer (not yet at least; tonight Bernanke will give another speech with the topic what the Fed can do to stimulate the economy, speeking about which courses of action are likely and what the accompanying dangers are). However, this is outside the scope of what I'm trying to describe here.

The whole idea of the Fed is that they will provide more liquidity in order to support the economy. This money is very likely to go into assets directly, and this will unavoidably lead to increases in risky asset prices. So will this support the economy? Will this produce economic growth?

There are some conditions that have to be fulfilled, should a monetary stimulus (QE) boost economic growth, and these conditions are quite stringent:

• Liquidity should flow from the banking sector to the real economy. Hence, consumers should receive this liquidity (the banks should be willing to lend, so their prospects for receiving this money back should be sufficiently positive);
• Consumers that receive additional money should be credit constraint. That is, they have to be willing to spend this money, instead of using it to pay off debts;
• The money the central bank seeks to pump into the economy should not be directed to, for example, risky assets or commodities (gold, etc.).

If this happens, money that is created by the central bank does not stay on the balance sheets of commercial banks, but is lended to consumers, who spend this extra money. Consumers would consume, and this increase in demand would be met by additional supply.

However, increased demand for any good will certainly be accompanied by price increases. Retailers must be crazy if they would sell their products for the same price as before, while consumers received "free" money. But most importantly: there is no free lunch!

So the fourth condition for monetary stimulus stimulating growth is that prices should not rise.

Now, assume that the enormous monetary stimulus of the past two years has not created money flows into equity (increasing equity prices) or into safe havens (gold, whose price has soared, and government bonds of countries considered safe, pushing their yields to historically low levels), but consumers would have received this money, would not have consumed even more than before, and supply would have risen simultaneously. Then, we would have been back at the old situation of too much debt accumulation.

It seems that in the past, we have consumed already too much. The problem is not that now there is a lack of aggregate demand, the problem is that in the past there has been excess demand, and this was financed by borrowing, not by an increase in our own production.

So in the end, what it all comes down to, is the following:

Over our lifetime, we should contribute just as much to the economy as we take out of it. We must produce just as much as we consume. In principle (and in the long run), the balance sheet of each person, over a lifetime, should be balanced: assets equal liabilities, and there is no debt nor saving surplus at the end of a person's lifetime. Unfortunately, this is not what has been happening.

So what must be true then, is that we (us, in the West) have borrowed, from foreigners, from future generations, from the world. We are not producing in value terms as much as we are consuming.

In the train yesterday, I overheard a conversation of a woman saying that actually they were working really hard at her company. She works 36 hours a week. I am sure that she is spending more in the other 132 hours of the week than what she truly produces in value terms during the 36-hour work week.

Looking at my own balance sheet, I must admit that I have taken much. My liabilities are composed of: a laptop, a netbook, DVDs, books, a TV, CDs, my phone, the Wii, a not so small student loan, shoes, clothes, etc.. On the other hand, there is just one true asset that I have been accumulating over my lifetime: human capital.

My human capital must be truly enormous if I could have bought with it all that I own. Sure, this is called investing, and I seriously hope that I will add a lot of value to the asset side of my personal balance sheet in the future .

But still: our liabilities are huge.

No news is good news

Finally, a new blog post of mine. The last weeks have been filled with work, study, some volleyball (the preparations for the season were more than great, now let's hope our team can keep this up), and a lot of time spent on the preparations of the General Members Meeting of my volleyball club taking place in two weeks. After that: no longer Ms President of the Board for me. A short, early reflection: it has been a very good experience, but it has been a rough ride as well!

Luckily, during the past few weeks, I had some time to reflect on the economy as well.

Conclusion: nobody knows what is going on anymore! However, very few people are willing to admit this. (What makes even me so sure that nobody knows, and if that is true, I do not even know whether it really is true. Annoying.) And that makes sense. Image what would happen in Ben (Bernanke that is) would say: "Guys, I don't know whether it will help, but let's stuff another huge pile of money into the economy (or in the banks, who do not want the money anyway) and see if tomorrow or next week it can stimuate job growth, housing prices, and thereby economic confidence". Nonsense of course; this will not happen in a million years. At least, I hope it will not.

But let's assume that Ben would say this. The market's logical reaction would be to abandon the USD, and move into safe assets such as gold. The gold price will rocket, perhaps with prices of other safe assets (a more difficult question is which assets will be safe in such an event, perhaps there will not even be one considered safe). The US will face a currency crisis. Banks with substantial assets priced in USD will fail, and this will lead to contagion of other banks, with soon enough really negative consequences for the real economy. In other words: economic disaster.

However, the big question is: why is this scenario so different from what is happening today? As the Fed announced nothing new yesterday; its outlook has not changed and they are still waiting to see in what direction the US economy is heading before they decide whether or not to renew their quantitative easing efforts. Hence, no news.

The same goes for the US housing market. Figures were released on homebuilders' confidence, which remained at the same level as previous month - albeit weakest level in more than a year-. Hence, no news.

Still, market sentiment was positive today. No news is good news? At least the Fed did not announce that the overall economy was getting worse and QEII was required, and also the housing market did not become worse. And this is supposedly good news.

Right.

In some other column, I wrote that this is can be called a bias in human nature. We have seen so much bad news, and perhaps even become immune to bad news. Although bad (or mixed) signals are abound, they are not breaking news anymore. And therefore, it is easy to get optimistic when some good signals show up, which is also what everyone is hoping for.
We even perceive the not-all-too-bad news as good news nowadays. Perhaps not surprisingly, but does it really make sense? The economy is still very unstable.

Market psychology is interesting. Maybe more on this next time.