Guest Editorial: The Currency War

February 21, 2011

What’s Behind the Currency War?

By Professor Dr. Antony P. Mueller

In September 2010, a short time before the international financial summit of the Group of Twenty (G20) took place in South Korea, Brazilian finance minister Guido Mantega declared that the world is experiencing a “currency war” where “devaluing currencies artificially is a global strategy.”

Dr. Antony P. Mueller is a professor of economics at the graduate business school of the University of Caxias-do-Sul (UCS) in Brazil. He is an adjunct scholar of the Ludwig von Mises Institute and president and founder of The Continental Economics Institute.

Dr. Antony P. Mueller is a professor of economics at the graduate business school of the University of Caxias-do-Sul (UCS) in Brazil. He is an adjunct scholar of the Ludwig von Mises Institute and president and founder of The Continental Economics Institute.

By announcing the outbreak of a “currency war,” Mantega wanted to draw attention to the problems caused by the ongoing exchange-rate manipulations that governments put in place in order to gain economic advantages. In this sense, “currency war” denotes the conflict among nations that arises from the deliberate manipulation of the exchange rate in order to gain international competitiveness by way of currency devaluation.

Competitive Devaluation

Calling competitive devaluation a “war” may seem like a gross exaggeration. Yet in terms of its potential of destruction, the current global financial conflict may well rank at a level similar to that of a real war.

In a wider historical perspective, the current currency war is the latest conflict in a series of acute crises of the modern international monetary system. In a world of national monetary regimes based on fiat money without physical anchors, domestic monetary instability automatically transforms into exchange-rate instability. As before, the current crisis of the international economic order is mainly the result of monetary fragilities coming from the unsound national monetary systems and reckless domestic monetary and fiscal policies.

The immediate cause of the currency war entering an acute stage is the policy of massive quantitative easing practiced by the US central bank. Whatever the original intention of this policy may have been, the consequences of the Fed’s measures include monetary expansion, low interest rates, and a weaker US dollar. With dollar interest rates approaching the “zero bound,” the United States is joining Japan in the effort to stimulate a sluggish economy with massive monetary impulses.

Until recently, the currency war was contained as a kind of financial cold war. The conflict entered its hot phase as a result of the expansive monetary policies that were put in place in the wake of the financial-market crisis that began in 2007. In defiance of the fact that the financial crisis itself was the result of the extremely expansive monetary policies in the years before, many central banks have now accelerated monetary expansion in the vain attempt to cure the disease with the same measures that had caused it in the first place.

Easy Money and International Financial Flows

What has emerged in the global financial arena over the past couple of years is the interplay among easy money, low interest rates, international trade imbalances, financial flows, and exchange-rate manipulations. The failure of attempts to cure overindebtedness with more debt, and to stimulate weak economies by giving them interest rates as low as possible, provokes a repetitive pattern of bubble and crash where each phase ends in a higher level of government debt.

A global search for higher yields has been going on not unlike what happened in the late 1960s and 1970s, when the United States inflated and the countries that had linked their exchange rates to the US dollar suffered from imported inflation. Nowadays, the formal dollar-based fixed-exchange-rate system no longer exists. It has been replaced by a system that sometimes is called “Bretton Woods II”: a series of countries, particularly in Asia this time, have pegged their exchange rates (albeit without a formal agreement) to the US dollar.

If a country wants to slow down the appreciation of its exchange rate that comes as a consequence of the financial inflows from abroad, it must intervene in the foreign-exchange markets and monetize at least a part of the foreign exchange. This way, the monetary authorities will automatically increase the domestic money stock. Additionally, under this system relatively poor countries feel forced not only to buy the debt issued by the relatively wealthy countries like the United States but also to buy these bonds at their current extremely low yields.

Under current conditions, the monetary expansion gets globalized and invades even those countries that wish to practice restrictive monetary policy. Relatively high levels of the interest rate improve the restrictive currency’s attractiveness. Thus, more and more monetary expansion happens on a global scale, which in turn provides the fuel for the next great wave of international financial flows.

The weaker countries, which compete with each other on the basis of low prices, are getting pushed to the side; it was just a matter of time until more and more governments would begin to intervene in the foreign-exchange markets by buying up foreign currencies in order to try to prevent their exchange rates from appreciating too much, too fast.

Yet using the exchange rate as a tool in order to gain economic advantage or avert damage for the domestic economy is inherently at variance with a sound global monetary order, because one country’s devaluation automatically implies the revaluation of another country’s currency and thus the advantage that one tries to obtain will be achieved by putting a burden on other countries.

Escalation

By recycling the monetary equivalent of the trade surplus into the financial markets around the globe, monetary authorities in surplus countries form a symbiosis with trade-deficit countries in fabricating a worldwide monetary expansion of extreme proportions.

The paradoxical, or rather perverse, features of the current state of affairs were highlighted a short time ago when in January 2011 the monetary authorities of Turkey decided to lower the policy interest rates so as to make the inflow of foreign funds less attractive, despite a booming Turkish economy that shows plenty characteristics of a bubble.

Exchange-rate policies produce the usual spiral of interventionism: the de facto consequences tend to diverge from the original intentions, prompting further rounds of doomed interventions. This interventionist escalation is not only limited to an incessant repetition of the same failed policies, but the errors committed in one policy area also affect other parts of the economy. Thus, it is only a matter of time until errors of monetary policy lead to fiscal fiascos, and exchange-rate interventions lead to trade conflicts.

At first sight, exchange-rate intervention may appear tolerable as the legitimate pursuit of national self-interest. But exchange-rate policies are intrinsically matters that tend to stir transnational controversies. When a country’s exchange rate policy collides with the interests of the trading partners, the tit-for-tat of mutual retaliation automatically tends to lead to an escalation of the conflict. Once the process of competitive devaluation has started, a devaluation by one country invites other countries to devaluate their exchange rates as well. As a consequence, the international monetary order will eventually disintegrate, and sooner or later the conflict will go beyond currency issues and affect a wide spectrum of economic and political relations.

Therefore, because of the unsound monetary system, a peaceful international political system also is constantly at risk. Monetary conflicts provoke political confrontations. Besides the immediate costs of exchange-rate conflicts that come from the damage to international trade and investment, and thereby to the international division of labor, harm will also be done to confidence and trust in the international political arena.

The dispute about exchange rates is the consequence of contradictory tensions that are innate to the modern monetary system. In this respect the currency war is an expression of the defects that characterize an unsound and destructive financial system. The outbreak of the currency war is a symptom of a deeply flawed international monetary order.

Brazil

When Brazil’s finance minister repeated his warnings in January 2011 and said that “the currency war is turning into a trade war,” Mantega sent a signal to the world that the escalation of the trade war had started. Because of the massive inflow of money from abroad, the Brazilian currency had sharply appreciated and the Brazilian economy was losing competitiveness.

In order to reduce the impact on is domestic economy, Brazil had been intervening in the foreign-exchange markets, diminishing the degree of currency appreciation. In doing so, the monetary authorities had to buy foreign currencies, mainly US dollars, in exchange for its domestic money.

By pursuing such a policy over the past couple of years, Brazil has increased its foreign-exchange reserves from around 50 billion to 300 billion US dollars. Yet even despite these foreign-exchange interventions, the Brazilian currency appreciated drastically against the US dollar and other currencies.

By various estimates, Brazilian foreign trade suffers from an exchange-rate overvaluation of around 40 percent. As a consequence, Brazil’s current account balance, which was still at surplus in 2007, has plunged into a deficit of 47.5 billion US dollars in 2010. At the same time when an artificial boom is taking place as the result of massive monetary expansion, the Brazilian economy suffers from creeping deindustrialization.

Part of the explosion of Brazil’s current-account deficit can be explained by weak demand from its trading partners, which have plunged into a prolonged recession. Yet beyond this circumstance, there has been another causal chain at work: the inflow of funds from abroad that boosts the exchange rate provides the grounds for an exorbitant increase of the country’s monetary base.

The combination of ample liquidity at home, weak demand from some trading partners abroad, and a strong exchange-rate appreciation provides the basis for an extreme import expansion that vastly exceeds exports. Unlike a country such as Germany, for example, whose industry is pretty resilient against currency appreciation, Brazil resembles in this respect the countries of the Southern periphery of the eurozone in its incapacity to cope effectively with an overvalued currency.

When, in January 2011, a new government took power in Brazil, the newly-elected president, Dilma Rousseff, declared in her inauguration speech that she will protect Brazil “from unfair competition and from the indiscriminate flow of speculative capital.” Guido Mantega, the former and new Brazilian finance minister, did not hesitate to join in when he asserted that the government has an “infinite” number of interventionist tools at its disposal with which to protect national interests. Mantega said that the government is ready to use taxation and trade measures in order to stop the deterioration of Brazil’s trade balance.

China

The countries that form the favored group that gets targeted by international financial flows in search of higher yields compete among themselves in order to prevent their currencies from appreciating too much, and as a group these countries compete against China in their efforts to maintain a competitive exchange rate.

China’s position forms part of a long causal chain, which includes low interest rates and monetary expansion in the United States, that fuels higher import demand. Given that China drastically devalued its exchange rate as early as in the 1980s, this country was at the forefront of gaining advantage of America’s import surge; China grabbed the golden opportunity to turn itself into the major exporter to the United States.

In order to maintain its currency at its undervalued level, the Chinese monetary authorities must buy up the excess of foreign exchange that accumulates from its trade surplus, preferably by buying US treasury notes and bonds. In this way, China became America’s main creditor. Over the past decade, China increased its foreign exchange position from a meager $165 billion in 2000 to an amount that was approaching $3 trillion at the end of 2010.

From the 1980s up to the early 1990s, China devalued its currency from less than 2 Yuan to the US dollar to an exchange rate of 9 Yuan against the US dollar. And despite its huge trade surpluses, China has only slightly revalued the Yuan ever since, establishing the current exchange rate at 6.56 Yuan per US dollar.

Over the past decade, China has become the major financier of the US budget deficit. Together with other monies flowing in from abroad, the US government was relieved from the need to cut spending. The inflow of foreign capital also allowed the US government to pay lower interest rates for its debt than it would have if only domestic supply of savings were available. Foreign imports put pressure on the price level, and the US central bank could continue monetary expansion without an immediate effect on the price-inflation rate.

If China wants to hold its competitive position through an undervalued currency, the Chinese monetary authorities must continue their policy of intervention in the foreign-exchange markets. As a consequence of buying dollars from its exporters, the domestic money supply in China continues to rise, throwing additional fuel on a domestic boom that is already in full swing.

Even more so than their Brazilian counterparts, China’s political-decision makers have failed to exert moderation or restraint when it comes to interventionist measures. As long as China’s leadership presumes that it gains from exchange-rate manipulation, its currency interventions will go on.

Global Financial Fragilities

Since the abandonment of the gold standard, the global financial system has been in disarray. All the international monetary arrangements that have been established since then have ended in crisis and finally collapsed. For almost a hundred years now, one interventionist scheme has been established and then soon fallen to pieces.

When the monetary and fiscal decision makers in the United States and Europe discarded all restraints against intervention in the wake of the financial market crisis, socialist and interventionist governments around the globe felt vindicated. They had long been convinced that only through state control could financial stability be obtained. Due to the policies adopted by Western countries in their futile attempt to overcome the financial-market crisis, the leaders of the so-called emerging economies have become even more unscrupulous interventionists.

Political leaders around the globe have shed the little that was left of support for free markets and set the controls for a way back on the road to serfdom. It is mainly due to ignorance that the modern monetary system gets labelled as a laissez-faire or free market system. In fact not only the basic “commodity” of this scheme, i.e., fiat money, but also its price and quantity are largely determined by political institutions such as central banks.

It is more than absurd when, in the face of crises and conflicts, more government intervention gets called upon: it was state intervention in the first place that laid the groundwork for the trouble to appear.

So-called “speculative” international capital flows already happened decades ago. What has changed since then is the amount of hot money and the speed with which it floats around the world. It would be wrong to describe these financial movements as an expression of free markets. The fact, for instance, that in 2010 daily transactions on the international currency market have reached a volume of four trillion US dollars is the result of unhampered fiat-money expansion and massive state intervention in the foreign-exchange markets.

The increase in the global money supply that has been going on for many years finds its complement in a global asset boom. The inflation of money drives up the price of precious metals, natural resources, and food. Once more, the world experiences a period of fake prosperity not much different from the real-estate bubble, and many other episodes, that led to previous financial crises.

Conclusion

The political endeavours to gain competitive advantages through exchange-rate devaluation sows mistrust among nations; and the ensuing regime uncertainties frustrate the business community. Over time the conflict over exchange rates tends to destroy the global division of labor.

Once again, the international monetary system is on the brink of a breakdown. As in the past, the main reason behind the current conflict is extreme monetary expansion. Unsound monetary systems produce turmoil not just at home but also in the international arena. Excessive monetary expansion, which is the cause of domestic malinvestment, is also the root of economic distortions at a global level.

Without a fundamental change of the monetary system itself, without a return to sound money, the international monetary system will remain in a state of permanent fragility — ever oscillating between the abyss of deflationary depression and the fake escape of hyperinflation. This is the fate of the world when nations implement fiat monetary systems and put them under political authority.

© 2011, Dr. Antony P. Mueller.


China-Bashing contaminates 2010 United States midterm elections

October 8, 2010

China is emerging as a common adversary in midterm U.S. election campaigns, as candidates from both parties seize on anxieties about China’s growing economic power to attack each other on trade policies, outsourcing, and the deficit.

 

French political cartoon from the late 1890s. A pie represents "Chine" (French for China) and is being divided between caricatures of Queen Victoria of the United Kingdom, William II of Germany (who is squabbling with Queen Victoria over a borderland piece, whilst thrusting a knife into the pie to signify aggressive German intentions), Nicholas II of Russia, who is eyeing a particular piece, the French Marianne (who is diplomatically shown as not participating in the carving, and is depicted as close to Nicholas II, as a reminder of the Franco-Russian Alliance), and the Meiji Emperor of Japan, carefully contemplating which pieces to take. A stereotypical Qing official throws up his hands to try and stop them, but is powerless. It is meant to be a figurative representation of the Imperialist tendencies of these nations towards China during the decade.

French political cartoon from the late 1890s. A pie represents "Chine" (French for China) and is being divided between caricatures of Queen Victoria of the United Kingdom, William II of Germany (who is squabbling with Queen Victoria over a borderland piece, whilst thrusting a knife into the pie to signify aggressive German intentions), Nicholas II of Russia, who is eyeing a particular piece, the French Marianne (who is diplomatically shown as not participating in the carving, and is depicted as close to Nicholas II, as a reminder of the Franco-Russian Alliance), and the Meiji Emperor of Japan, carefully contemplating which pieces to take. A stereotypical Qing official throws up his hands to try and stop them, but is powerless. It is meant to be a figurative representation of the Imperialist tendencies of these nations towards China during the decade.

 

With U.S. economic revival still slow, trade policy looms as a an issue in midterm races, The Wall Street Journal reports.

***

China-Bashing Gains Bipartisan Support

By Naftali Bendavid, The Wall Street Journal, October 8, 2010

China is emerging as a bogeyman this campaign season, with candidates across the American political spectrum seizing on anxieties about the country’s growing economic might to pummel each other on trade, outsourcing and the deficit.

In television ads, China is framed as an ominous foreign influence in a time of economic anxiety, often accompanied by red flags and communist-style stars and sometimes by Asian-sounding music. Democrats say Republicans support tax breaks that reward companies for moving jobs to China; Republicans blame Democrats for a federal budget deficit they say forces the U.S. to borrow money from China.

“Candidates are looking to speak in a visceral way to the fears and concerns of voters about jobs,” said Lawrence Jacobs, a political scientist at the University of Minnesota. “Bashing China is safe.”

The heated rhetoric puts the White House in a bind. Administration officials often don’t mind Congress putting pressure on China, and Treasury Secretary Timothy Geithner himself in a speech Wednesday offered a blunt critique of Beijing’s currency policy. But officials also worry that a confrontational approach could backfire.

Both nations may feel compelled by public opinion to engage in “an escalation of rhetoric that is going to be difficult to manage” after the election, said Charles Freeman, chairman of China studies at the Center for Strategic and International Studies in Washington.

Wang Baodong, a spokesman for Beijing’s embassy in Washington, criticized candidates’ use of his country in campaign messages. “China is committed to promoting strong bilateral trade and economic cooperation, which brings about enormous benefit to the welfare of our two peoples,” Mr. Wang said. “So making China an issue in the elections or in any other forms is irrelevant and wrong-targeted.”

Mark Schauer, a Michigan Democrat facing a tough re-election fight, has aired an ad against his Republican rival saying, “Tim Walberg made it way too easy for companies to outsource our jobs to China.” Mr. Walberg said the ad was misleading and that he considered American products superior to Chinese ones.

In Ohio, Democratic Senate candidate Lee Fisher has focused on GOP opponent Rob Portman’s stint as a House member and as U.S. trade representative under President George W. Bush. “Congressman Rob Portman knows how to grow the economy—in China,” said a recent Fisher ad.

The Portman campaign rejected these assertions, saying Mr. Portman fought to increase exports and was the first U.S. trade representative to take China to court and win.

Republicans, for their part, cited China in their recently released “Pledge to America.” “We now borrow 41 cents of every dollar we spend, much of it from foreign countries, including China, and leave the bill to our kids and grandkids,” it said, as it attacked Democrats for “unparalleled recklessness with taxpayer dollars.”

Warnings of foreign influence have often been a feature of U.S. elections, especially in times of economic insecurity. And there is little reason to believe the latest ads will have a long-term effect on U.S.-China relations. or on the fate of anti-China legislation, which has struggled in Congress.But with China on the rise, warnings about it seem to have a special resonance this campaign season. The House, with GOP support, passed a bill in September to penalize Beijing’s foreign-exchange practices. A few days earlier, Democrats unsuccessfully pushed a measure to end corporate tax deductions for expenses related to shifting jobs overseas.

Meanwhile, in West Virginia, an ad by Republican Spike Maynard against Rep. Nick Rahall featured Asian music and Chinese flags. It cited a Texas wind farm that reportedly planned to apply for federal stimulus funds while obtaining its windmills from China. “It’s on our jeans, even our children’s toys: ‘Made in China,’ ” the narrator said.

Democrats said the windmill project would have materials manufactured in the U.S. and that the operator hadn’t applied for stimulus funds.

A similar back-and-forth is unfolding in Virginia, where an ad by Republican State Sen. Robert Hurt accuses Rep. Tom Perriello (D., Va.) of voting to give tax breaks to foreign companies “creating jobs in China.”

That’s a reference to a portion of the stimulus package that gives tax breaks for green jobs. The Perriello campaign said Mr. Hurt’s pledge not to raise taxes means he’d oppose closing tax loopholes for companies that move jobs overseas.

About the author: Naftali Bendavid covers Congress and politics for The Wall Street Journal. Before coming to the Journal, he covered the White House and the Justice Department for the Chicago Tribune. Bendavid also spent five years as deputy Washington bureau chief for the Tribune, overseeing its coverage of government and politics. Bendavid has covered such stories as the impeachment of Bill Clinton, the Al Gore presidential campaign, the September 11, 2001 terrorist attacks and the Supreme Court confirmation of Sonia Sotomayor.

Reprinted with kindly permission of The Wall Street Journal.


U.S. Recession Longest Since World War II

September 21, 2010

The U.S. recession lasted eighteen months and was the longest since World War II, according to the National Bureau of Economic Research, which announced yesterday that the recession ended in June 2009.

Read full story.


Capitalism Still the Only Game in Town

January 13, 2010

Alex J. Pollock says volatility is key to capitalism’s success as an economic system.

“A Business Week article in 1979 proclaimed ‘The Death of Equities.’  A few years later, a vast, long-running bull market in stocks began. In 1997, the Financial Times similarly announced ‘The Death of Gold.’

Our current decade, needless to say, has brought a giant bull market in the shining metal, ‘barbarous relic’ though it was claimed to be.

With the financial crisis of 2007-09, we were treated to announcements of ‘The Death of Capitalism.’ This is just as hopeless a prediction as the other two were. The bull market in capitalism also will return, because it will continue to be unmatched at creating economic well-being for ordinary people on the trend–but it will not do so without its inevitable cycles of booms and busts.

The future of capitalism, which is better thought of as economies based on enterprise, market competition and uncertainty, is robust on the trend line, but volatile, as always. People who think capitalism is about equilibrium, who value above all stability and theorise that markets will create it, are shocked by this volatility. This is to miss the essence of the matter.”

Read full story.


OECD revises World Economic Outlook forecast upward

June 24, 2009

The Organization for Economic Cooperation and Development (OECD) today revised its World Economic Outlook forecast upward for the first time since 2007, indicating that the global economic slide may be approaching a bottom.

The group revised its estimates for 2009 upward, projecting a contraction of 4.1 percent rather than the 4.3 percent it projected before, and also projected slight growth in 2010, whereas before it had projected none.

Here is the text of the OECD report.

The new OECD report coincides with meetings of the U.S. Federal Reserve’s Open Market Committee today in Washington.

A blog entry in the Wall Street Journal says the focus of the Fed’s meetings will be interest rates, how to word its statement on the economy, and the Fed’s asset purchase plan.

Read full story.


U.S. treasury secretary Geithner urges combined U.S.-China efforts to boost global economy

June 1, 2009
 

United States Secretary of the Treasury Timothy Geithner

United States Secretary of the Treasury Timothy Geithner

Timothy Geithner, in his first visit to China as U.S. Treasury Secretary, presented a plan for the United States and China to work together to rebuild the global economy and restore growth.

In a speech today at Peking University, Geithner stressed that there is much that both the United States and China need to do to rebalance the world economy. He called for China to make its currency more flexible in exchange for fiscal reforms in the United States. He also said China would need to diversify its economy beyond relying so heavily on exports for growth, and that the United States, in return, would focus on mitigating its ballooning deficit to protect massive Chinese investments in U.S. government debt.

Chinese media focused on Geithner’s implication that China should play a more significant role in global economic policymaking. China Daily says the primary goal of Geithner’s trip, which has included meetings with several leading Chinese economic policymakers, has been to reaffirm China’s faith in U.S. dollar-backed assets and still fears that U.S. budget deficit and loose monetary policy will prompt inflation, undermining Chinese holdings of both the U.S. dollar and U.S. Treasury bonds.

Below is the text of Timothy Geithner’s speech.

***

The United States and China, Cooperating for Recovery and Growth

 Treasury Secretary Timothy F. Geithner

Speech at Peking University – Beijing, China
June 1st, 2009

 It is a pleasure to be back in China and to join you here today at this great university. 

I first came to China, and to Peking University, in the summer of 1981 as a college student studying Mandarin. I was here with a small group of graduate and undergraduate students from across the United States. I returned the next summer to Beijing Normal University. 

We studied reasonably hard, and had the privilege of working with many talented professors, some of whom are here today. As we explored this city and traveled through Eastern China, we had the chance not just to understand more about your history and your aspirations, but also to begin to see the United States through your eyes. 

Over the decades since, we have seen the beginnings of one of the most extraordinary economic transformations in history. China is thriving.  Economic reform has brought exceptionally rapid and sustained growth in incomes. China’s emergence as a major economic force more fully integrated into the world economy has brought substantial benefits to the United States and to economies around the world.  

In recognition of our mutual interest in a positive, cooperative, and comprehensive relationship, President Hu Jintao and President Obama agreed in April to establish the Strategic and Economic Dialogue. Secretary Clinton and I will host Vice Premier Wang and State Councilor Dai in Washington this summer for our first meeting.  I have the privilege of beginning the economic discussions with a series of meetings in Beijing today and tomorrow. 

These meetings will give us a chance to discuss the risks and challenges on the economic front, to examine some of the longer term challenges we both face in laying the foundation for a more balanced and sustainable recovery, and to explore our common interest in international financial reform.

Current Challenges and Risks

 The world economy is going through the most challenging economic and financial stress in generations. 

 The International Monetary Fund predicts that the world economy will shrink this year for the first time in more than six decades. The collapse of world trade is likely to be the worst since the end of World War II. The lost output, compared to the world economy’s potential growth in a normal year, could be between three and four trillion dollars.

In the face of this challenge, China and the United States are working together to help shape a strong global strategy to contain the crisis and to lay the foundation for recovery. And these efforts, the combined effect of forceful policy actions here in China, in the United States, and in other major economies, have helped slow the pace of deterioration in growth, repair the financial system, and improve confidence. 

In fact, what distinguishes the current crisis is not just its global scale and its acute severity, but the size and speed of the global response.

At the G-20 Leaders meeting in London in April, we agreed on an unprecedented program of coordinated policy actions to support growth, to stabilize and repair the financial system, to restore the flow of credit essential for trade and investment, to mobilize financial resources for emerging market economies through the international financial institutions, and to keep markets open for trade and investment. 

That historic accord on a strategy for recovery was made possible in part by the policy actions already begun in China and the United States. 

China moved quickly as the crisis intensified with a very forceful program of investments and financial measures to strengthen domestic demand.

In the United States, in the first weeks of the new Administration, we put in place a comprehensive program of tax incentives and investments ¨C the largest peace time recovery effort since World War II – to help arrest the sharp fall in private demand. Alongside these fiscal measures, we acted to ease the housing crisis. And we have put in place a series of initiatives to bring more capital into the banking system and to restart the credit markets.  

These actions have been reinforced by similar actions in countries around the world. 

In contrast to the global crisis of the 1930s and to the major economic crises of the postwar period, the leaders of the world acted together. They acted quickly. They  took steps to provide assistance to the most vulnerable economies, even as they faced exceptional financial needs at home. They worked to keep their markets open, rather than retreating into self-defeating measures of discrimination and protection. 

And they have committed to make sure this program of initiatives is sustained until the foundation for recovery is firmly established, a commitment the IMF will monitor closely, and that we will be able to evaluate together when the G-20 Leaders meet again in the United States this fall. 

We are starting to see some initial signs of improvement. The global recession seems to be losing force. In the United States, the pace of decline in economic activity has slowed. Households are saving more, but consumer confidence has improved, and spending is starting to recover. House prices are falling at a slower pace and the inventory of unsold homes has come down significantly. Orders for goods and services are somewhat stronger. The pace of deterioration in the labor market has slowed, and new claims for unemployment insurance have started to come down a bit. 

The financial system is starting to heal. The clarity and disclosure provided by our capital assessment of major U.S. banks has helped improve market confidence in them, making it possible for banks that needed capital to raise it from private investors and to borrow without guarantees. The securities markets, including the asset backed securities markets that essentially stopped functioning late last year, have started to come back. The cost of credit has fallen substantially for businesses and for families as spreads and risk premia have narrowed.    

These are important signs of stability, and assurance that we will succeed in averting financial collapse and global deflation, but they represent only the first steps in laying the foundation for recovery. The process of repair and adjustment is going to take time. 

China, despite your own manifest challenges as a developing country, you are in an enviably strong position. But in most economies, the recession is still powerful and dangerous. Business and households in the United States, as in many countries, are still experiencing the most challenging economic and financial pressures in decades. 

The plant closures, and company restructurings that the recession is causing are painful, and this process is not yet over. The fallout from these events has been brutally indiscriminant, affecting those with little or no responsibility for the events that now buffet them, as well as on some who played key roles in bringing about our troubles.

The extent of the damage to financial systems entails significant risk that the supply of credit will be constrained for some time. The constraints on banks in many major economies will make it hard for them to compensate fully for the damage done to the basic machinery of the securitization markets, including the loss of confidence in credit ratings. After a long period where financial institutions took on too much risk, we still face the possibility that  banks and investors may take too little risk, even as the underlying economic conditions start to improve. 

And, after a long period of falling saving and substantial growth in household borrowing relative to GDP, consumer spending in the United States will be restrained for some time relative to what is typically the case in recoveries. 

 These are necessary adjustments. They will entail a longer, slower process of recovery, with a very different pattern of future growth across countries than we have seen in the past several recoveries. 

Laying the Foundation for Future Growth

 As we address this immediate financial and economic crisis, it is important that we also lay the foundations for more balanced, sustained growth of the global economy once this recovery is firmly established. 

A successful transition to a more balanced and stable global economy will require very substantial changes to economic policy and financial regulation around the world. But some of the most important of those changes will have to come in the United States and China. How successful we are in Washington and Beijing will be critically important to the economic fortunes of the rest of the world. The effectiveness of U.S. policies will depend in part on China’s, and the effectiveness of yours on ours. 

Although the United States and China start from very different positions, many of our domestic challenges are similar. In the United States, we are working to reform our health care system, to improve the quality of education, to rebuild our infrastructure, and to improve energy efficiency. These reforms are essential to boosting the productive capacity of our economy. These challenges are at the center of your reform priorities, too. 

We are both working to reform our financial systems. In the United States, our challenge is to create a more stable and more resilient financial system, with stronger protections for consumer and investors.  As we work to strengthen and redesign regulation to achieve these objectives, our challenge is to preserve the core strengths of our financial system, which are its exceptional capacity to adapt and innovate and to channel capital for investment in new technologies and innovative companies. You have the benefit of being able to learn from our shortcomings, which have proved so damaging in the present crisis, as well as from our strengths.  

Our common challenge is to recognize that a more balanced and sustainable global recovery will require changes in the composition of growth in our two economies. Because of this, our policies have to be directed at very different outcomes. 

In the United States, saving rates will have to increase, and the purchases of U.S. consumers cannot be as dominant a driver of growth as they have been in the past. 

In China, as your leadership has recognized, growth that is sustainable growth will require a very substantial shift from external to domestic demand, from an investment and export intensive driven growth, to growth led by consumption. Strengthening domestic demand will also strengthen China’s ability to weather fluctuations in global supply and demand.

If we are successful on these respective paths, public and private saving in the United States will increase as recovery strengthens, and as this happens, our current account deficit will come down. And in China, domestic demand will rise at a faster rate than overall GDP, led by a gradual shift to higher rates of consumption.  

Globally, recovery will have come more from a shift by high saving economies to stronger domestic demand and less from the American consumer. 

The policy framework for a successful transition to this outcome is starting to take shape.

In the United States, we are putting in place the foundations for restoring fiscal sustainability. 

The President in his initial budget to Congress made it clear that, as soon as recovery is firmly established, we are going to have to bring our fiscal deficit down to a level that is sustainable over the medium term. This will mean bringing the imbalance between our fiscal resources and expenditures down to the point – roughly three percent of GDP – where the overall level of public debt to GDP is definitively on a downward path.  The temporary investments and tax incentives we put in place in the Recovery Act to strengthen private demand will have to expire, discretionary spending will have to fall back to a more modest level relative to GDP, and we will have to be very disciplined in limiting future commitments through the reintroduction of budget disciplines, such as pay-as-you go rules.

The President also looks forward to working with Congress to further reduce our long-run fiscal deficit.

And, critical to our long-term fiscal health, we have to put in place comprehensive health care reform that will bring down the growth in health care costs, costs that are the principal driver of our long run fiscal deficit. 

The President has also proposed steps to encourage private saving, including through automatic enrollment in retirement savings accounts. 

Alongside these fiscal actions, we have designed our policies to address the financial crisis to carefully minimize risk to the taxpayer and to allow for an orderly exit or unwinding as soon as conditions permit. Across the various financial facilities put in place by the Treasury, the Federal Reserve, and the FDIC, we have been careful to set the economic terms at a level so that demand for these facilities will fade as conditions normalize and risk premia recede.  Banks have a strong incentive to replace public capital with private capital as soon as conditions permit. 

Let me be clear – the United States is committed to a strong and stable international financial system. The Obama Administration fully recognizes that the United States has a special responsibility to play in this regard, and we fully appreciate that exercising this special responsibility begins at home. As we recover from this unprecedented crisis, we will cut our fiscal deficit, we will eliminate the extraordinary governmental support that we have put in place to overcome the crisis, we will continue to preserve the openness of our economy, and we will resolutely maintain the policy framework necessary for durable and lasting sustained non-inflationary growth.

In China, the challenge is fundamentally different, and at least as complex. 

Critical to the success of your efforts to shift future growth to domestic demand are measures to raise household incomes and to reduce the need that households feel to save large amounts for precautionary reasons or to pay for major expenditures like education.  This involves strengthening the social safety net with health care reform and more complete public retirement systems, enacting financial reforms to help expand access to credit for households, and providing products that allow households to insure against risk.  These efforts can be funded through the increased collection of dividends from state-owned enterprises.

The structure of the Chinese economy will shift as domestic demand grows in importance, with a larger service sector, more emphasis on light industry, and less emphasis on heavy, capital intensive export and import-competing industries.  The resulting growth will generate greater employment, and be less energy-intensive than the current structure of Chinese industry. Allowing the market, interest rates, and other prices to function to encourage the shift in production will be particularly important.

An important part of this strategy is the government’s commitment to continue progress toward a more flexible exchange rate regime.  Greater exchange rate flexibility will help reinforce the shift in the composition of growth, encourage resource shifts to support domestic demand, and provide greater ability for monetary policy to achieve sustained growth with low inflation in the future. 

International Financial Reform

 These are some of the most important domestic economic challenge we face, and these issues will be at the core of our agenda for economic cooperation. 

But I think it is important to underscore that we also have a very strong interest in working together to strengthen the framework for international economic and financial cooperation.  

Let me highlight three important areas.

At the G-20 Leaders meeting, we committed to a series of actions to help reform and strengthen the international financial architecture.

As part of this, we agreed to put in place a stronger framework of standards for supervision and regulation of the financial system.  We expanded and strengthened the Financial Stability Forum, now renamed the Financial Stability Board.  China and other major emerging economies are now full participants, alongside the major financial centers, in this critical institution for cooperation.  We will have the chance together to help redesign global standards for capital requirements, stronger oversight of global markets like derivatives, better tools for resolving future financial crises, and measures to reduce the opportunities for regulatory arbitrage. 

We also committed to an ambitious program of reform of the IMF and other international financial institutions.  Our common objective is to reform the governance of these institutions to make them more representative of the shifting balance of economic and financial activity in the world, to strengthen their capacity to prevent future crisis, with stronger surveillance of macroeconomic, exchange rate, and financial policies, and to equip them with a stronger financial capacity to respond to future crises. We also committed to mobilize $500 billion in additional finance through the enlargement and membership expansion of the IMF’s New Arrangements to Borrow in order to provide an insurance policy for the global financial system.

As part of this process of reform, the United States will fully support having China play a role in the principal cooperative arrangements that help shape the international system, a role that is commensurate with China’s importance in the global economy.

I believe that a greater role for China is necessary for China, for the effectiveness of the international financial institutions themselves, and for the world economy. 

China is already too important to the global economy not to have a full seat at the international table, helping to define the policies that are critical to the effective functioning of the international financial system.

Second, we must cooperate to assure that the global trade and investment environment remains open, and that opportunities continue to expand.  As economies have become more open and more closely integrated, global economic growth has been stronger and more broad-based, bringing increasing numbers out of poverty, and turning developing nations into major emerging markets.    The global commitment to trade liberalization and increasingly open investment played a critical role in this process ¨C in the industrialized world, in East Asia, and, since 1978, in China.  As we go through the severe stresses of this crisis, we must not turn our backs on open trade and investment – for ourselves and for those who have yet to experience the fruits of growth and development. The United States, China, and the other members of the G20 have committed to not resort to protectionist measures by raising trade and investment barriers and to work toward a successful conclusion to the Doha Development Round. 

And third, one of the most critical long-term challenges that we both face is climate change.  Individually and collectively, there is an urgent need to ensure that each and every country takes meaningful action to deal with this threat.  Reducing land and forest degradation, conserving energy, and using clean technology are important objectives that complement both our efforts to achieve a new, sustainable pattern of growth and our goal of reducing greenhouse gas emissions. China and the United States already are working closely through the Strategic and Economic Dialogue in areas such as clean transportation, clean and efficient production of electricity, and the reduction of air and water pollution.  We must continue these efforts for the sake of our natio ns and the planet.

Conclusion

In the last few years the frequency, intensity, and importance of U.S.-China economic engagements have multiplied.  The U.S.-China Strategic and Economic Dialogue that President Obama and President Hu initiated in April is the next stage in that process.  I look forward to welcoming Vice Premier Wang, State Councilor Dai and their colleagues to Washington to participate in the first meeting of the U.S.-China Strategic and Economic Dialogue.

 Our engagement should be conducted with mutual respect for the traditions, values, and interests of China and the United States. We will make a joint effort in a concerted way “同心协力”.  We should understand that we each have a very strong stake in the health and the success of each other’s economy. 

China and the United States individually, and together, are so important in the global economy and financial system that what we do has a direct impact on the stability and strength of the international economic system.  Other nations have a legitimate interest in our policies and the ways in which we work together, and we each have an obligation to ensure that our policies and actions promote the health and stability of the global economy and financial system.

We come together because we have shared interests and responsibilities.  We also have our own national interests.   I will be a strong advocate for U.S. interests, just as I expect my counterparts to represent China.  China has benefited hugely from open trade and investment, and the ability to greatly increase its exports to the rest of the world.  In turn, we expect increased opportunities to export to and invest in the Chinese economy.   

We want China to succeed and prosper.  Chinese growth and expanding Chinese demand is a tremendous opportunity for U.S. firms and workers, just as it is in China and the rest of the world. 

Global problems will not be solved without U.S.-China cooperation.  That goes for the entire range of issues that face our world from economic recovery and financial repair to climate change and energy policy.

I look forward to working with you cooperatively, and in a spirit of mutual respect.


Germany’s Recession

May 15, 2009

The Financial Times reports Germany’s economy shrank at a record pace during the first three months of 2008, shrinking at a faster rate than analysts had predicted and confirming that Germany is among the European countries hardest hit by the crisis.

The New York Times reports the economy of the eurozone as a whole shrank 2.5 percent during the same period.