|
Peter Morici makes good points.
******
China’s Dragon Does Not Flinch and the Bernanke’s Toothless Dog
by Peter Morici
This week, the big news continues to center around the dollar and the
credit crisis. Secretary Henry Paulson returns from China empty handed
on the dollar-yuan exchange rate, and Federal Reserve Chairman Ben
Bernanke is stunned when an interest rate cut sinks the stock market.
Henry and the Dragon
Paulson continued his Strategic Dialogue with Chinese officials but was
broadly rebuked in his efforts to persuade China to meaningfully
revalue its currency.
(read more)
Since China pegged the yuan against the dollar in 1994, and adopted
a gently sliding peg in 2005, the yuan has become progressively
undervalued against the dollar.
This is evidenced by the ever-widening gap between the demand for yuan
created by foreign purchases of Chinese goods and private foreign
investment in China, and the supply of yuan created by Chinese imports
and private overseas investments. Rather than permit the yuan to rise
and equilibrate demand and supply, as western market economies do, the
Peoples Bank of China has intervened in currency markets, printing and
selling yuan, and buying dollars, euros and other western currencies.
This makes Chinese products artificially inexpensive in the United
States and U.S. products artificially expensive in China.
The magnitude of undervaluation of the yuan is revealed by the growing
level of Chinese net intervention in currency markets, which was $47
billion in 2001 or 19 percent of exports, and is on track to be $450
billion or 45 percent of exports in 2007. Although China has permitted
the yuan to rise about 5.8 percent in the last year, modernization and
rapid productivity growth raise the yuan’s intrinsic value at least 7
and 8 percent each year. The yuan is now 40 to 70 percent undervalued
against the dollar.
Federal Reserve Chairman Ben Bernanke has correctly concluded that
China’s yuan policy provides a subsidy on exports. By the scope of
intervention, this is a 45 percent subsidy. However, the Bush
Administration has rebuked any suggested U.S. policy to offset this
subsidy as protectionist—a profoundly different view than the one it
has adopted on other forms of industry aid offered by China.
The Chinese government is using the yuan peg as an employment policy to
create more jobs for rural workers moving to cities than comparative
advantage and free competition would require in international markets
without these subsidies.
U.S. experiences with intellectual property and other protectionism
teaches China will not relent on mercantilist practices until the
United States is willing to take tangible trade actions to offset their
effects.
Mr. Paulson traveled to China without a stick, and the Chinese dragon did not flinch.
Meanwhile, the United States is amassing a huge overseas debt, which
the Chinese government now wants to convert into equity holdings in the
United States. The U.S. government does not own stock in U.S.
companies, now ironically, it is paving the way for the China’s
sovereign investment fund to do just that.
Ben’s Toothless Dog
Tuesday, the Federal Reserve announced a quarter-point reduction in the
target federal funds rate to 4.25 percent and equity markets gave Ben
Bernanke’s performance a failing grade. Within two hours, the major
stock indexes shed more than two percent of value.
Economists expected only a quarter point cut, because the jobs report
last Friday indicated the U.S. economy continued to expand. Thursday, a
strong retail sales report for November confirmed their confidence but
investors remain skeptical.
Investors are flabbergasted, because the Fed fails to recognize the
country is not suffering from a liquidity crisis—banks can get all the
funds they want from the Federal Reserve Discount Window and the newly
announced Term Auction Facility. Credit markets and the economy are
suffering from a profound crisis of confidence, and the Fed does not
appear to understand or know how to cope.
The subprime meltdown reveals fundamental structural flaws in the U.S.
banking system. The write downs at Citigroup, UBS and others indicate
that bankers have been overvaluing mortgage-backed securities. The
motivation is clear. The compensation awarded bank executives who
create mortgage-backed and other securities is directly related to the
estimated values banks assign these complex and opaque instruments.
The bonuses to bank executives have been paid and are gone, while the
banks’ stockholders find themselves selling off equity to Middle East
investors. Mutual funds, U.S.-state run money market funds for
municipalities, pension funds, and insurance companies that trusted
Citigroup and other banks now hold worthless paper, and the market for
mortgage-backed securities has evaporated.
The whole chain that creates financing for mortgages has been corrupted
from loan officers to banks that bundle loans into securities, to bond
rating agencies like Standard and Poor’s who demand payments from banks
instead of charging investors to evaluate mortgage-backed securities.
All along the chain, executives and smaller folks have been enriched
and now there is no meaningful market for mortgage-backed securities,
except those created by the federally sponsored banks. As Fannie Mae
and others generally don’t do jumbos—loans above $417,000—the cost of
jumbo mortgages has rocketed. No recovery in the housing sector is
possible without resurrecting the jumbo market and the market for
somewhat riskier mortgages.
Evidencing this sad state of affairs, the banks are so suspicious of
each other’s accounting they won’t lend each other money. The Fed can
cut the federal funds rate to zero without effect until this mistrust
abates. It is no surprise that the inter-bank lending rate, Libor, is
now well above the federal funds rate.
Mr. Bernanke keeps pushing the buttons that work in textbook
economics—the federal funds rate, discount window and similar
vehicles—when for some time now those have had little effect on
mortgage rates, and now have dwindling effects on short-term lending
rates, as indicated by the decoupling of the federal funds rate and
Libor.
Central bank monetary policy becomes a toothless dog when the banking
system becomes corrupted and confidence evaporates about the integrity
of principal players in capital markets.
It is high time for Bernanke to address the institutional problems in
U.S. banking that undermine Federal Reserve efforts to effectively
steer the economy: excessive compensation schemes on Wall Street and
throughout the financial system that incentivize the overvaluation of
assets; conflicts of interest in mortgage, commercial and investment
banking; and self dealing at Standard and Poor’s and other bond rating
agencies.
Trackback(0)
 |
TrackBack URI for this entry
Subscribe to this comment's feed