Streetwise Professor

June 5, 2009

No Laughing Matter

Filed under: Economics,Energy,Financial crisis,Politics — The Professor @ 1:31 pm

Treasury Secretary Timothy Geithner’s trip to China drew guffaws—yes, laughter—when he tried to say with a straight face that the US was committed to a strong dollar policy.      (The Wall Street Journal tried to put a more favorable gloss on it, saying that the audience at Beijing University “tittered” at Geithner’s statement.   FT Alphaville (linked above) called it “loud laughter.”)     Guffaws are warranted.   The credibility of this statement is indeed risible, even though it is no laughing matter.   Every major policy initiative points in the exact opposite direction.  

Angela Merkel isn’t laughing.   She’s spitting mad, apparently sharing the same concern as Geithner’s China audience.   She delivered a broadside against the aggressive quantitative easing by the US Fed, the Bank of England, and (to a lesser degree) the European Central Bank.  

Even one of the authors of that policy, Ben Bernanke has suggested (in testimony before Congress) that American deficits are too large and could threaten price stability.

Commodity prices could well be the harbinger of an incipient inflation, and provide a money-where-your-mouth-is verdict on the credibility of Geithner’s pronouncement.   Fundamentals in the developed economies—the US, Europe, and Japan—remain horrid.   Yet copper has breached $5000 for the first time in months and oil neared $70 before selling off on 3 June on additional signs of fundamental weakness, a building of crude stocks of about 2 million barrels when a bigger than 1 million draw was widely forecast.  

So where is the demand coming from?   China is widely identified as the source.   Moreover, the rally in world equity markets in past weeks has been driven in part by a belief that the Chinese economy is strong and will experience decent growth for the remainder of the year.        Forecasts of 8 percent growth are widespread.

I am very skeptical about the realism of such forecasts, and similarly skeptical about the official statistics on the purported growth in Chinese manufacturing.   Here’s the reason for my skepticism.   Every major export-oriented economy is in deep trouble: Japan has experienced a double-digit decline in GDP; South Korea is sputtering; Germany is one of Europe’s weakest economies.   China is an export driven economy.   Domestic consumption accounts for only about 35 percent of Chinese GDP.   As the FT Alphaville post (by Izabella Kaminska) states: “trade has been a key engine for China’s rapid economic growth in the past few years, but a slump in global demand has caused a fall in Chinese exports since November of last year.             Exports in April fell 22.6 percent from a year earlier, compared with a fall of 17.1 percent in March and 25.7 percent in February.”   So, (a) China is a trade dominated economy, and its remarkable growth in recent years has been driven by exports; (b) its exports have declined dramatically; (c) other trade-oriented economies have experienced declines in GDP bigger than those experienced by less-export dependent economies; but (d) China is growing, or going to grow, far more than virtually any other economy in the world.   Huh?   How is that possible?   (Not to mention the other anecdotal evidence, such as the layoff of 20 million migrant workers, and the closure of numerous factories in the (former?) boom areas of coastal China.)   It all doesn’t add up.

What does make sense is that China is indeed buying commodities, but as an inflation/dollar hedge, rather than to feed a resurgent manufacturing sector.   Given its massive investments in dollar-denominated securities, dollar inflation is in fact no laughing matter to China, and it makes perfect sense to substitute out of such assets into commodities.   This makes sense not just for Chinese, but for others holding dollar-denominated assets, and the assets denominated in currencies of other countries/regions with central banks which are engaged in aggressive quantitative easing.  

I find it very hard, therefore, to credit the commodity rally to strengthening real fundamentals.   Other data support this.   The differential between nominal yields on Treasuries and yields on inflation protected Treasuries (TIPS) are widening, indicating increased inflation expectations.   But, importantly, TIPS yields themselves are not rising.   That is, real interest rates are not rising, as would be expected as the real economy strengthens.    This is important, and has gone largely unremarked.  Indeed, some advocates of quantitative easing and expansionary fiscal policies, such as Martin Wolf, actually view the decline in TIPS yields as a favorable sign.  Wolf says this means that government spending and borrowing is not crowding out private investment.  Another way of putting this is that there is little demand for private investment.  Hardly the sign of an impending recovery, that.  

Like James Hamilton, I believe that the main puzzle is why nominal yields haven’t risen  more relative to TIPS; the monetary expansion and the spurt in commodity prices both would suggest a bigger increase in inflationary expectations than the nominal-TIPS yield differential reflects.   Moribund commodity consumption (as indicated by continued high and at times rising stocks), flat-to-declining real interest rates, rising nominal rates, and spurting prices commodity prices say stagflation to me—not recovery.     And that’s not funny.  

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  1. Reasons why China may continue growing at a respectable clip:

    1) Exports are down, but so are imports (energy prices down, and much of what China manufactures is actually just the assembly of imported components).
    Also, there are opinions that China’s export-dependency is much over-estimated.
    2) Much of what China exports is lower-tech and cheaper (compared with Germany, Japan), and as such probably more inelastic to foreign consumers.
    3) Similarly, domestic consumption was suppressed and as such can now expand quite easily to soak up what would earlier have been exported, since the Chinese middle class is now wealthy enough to afford things like fridges, cheaper cars, etc.
    3) Had much bigger prior momentum.
    4) Most importantly its banking system is fundamentally healthy (pretty ironic since a few years ago the pundits were predicting it would be the Chinese who’d sink under a tide of bad loans) and credit flows have even increased, though admittedly a significant share of it is phantom.
    5) It’s stimulus measures. Though no doubt far from optimally allocated, the returns to it are still very high since China is a developing country, and negative consequences are relayed to the far future.
    6) I think China’s acquisition of energy and mineral assets is not only an inflation/dollar hedge, but a long-term strategic decision – I suspect they realize the implications of depleting energy resources much better than amongst Western policymakers.

    Comment by Sublime Oblivion — June 5, 2009 @ 4:25 pm

  2. I don’t think that a recovery in China’s massive build out boom is the source of the commodity rise as much as the flight to inflation havens. Sorry, but, China has got to be hurting with the American consumer on life supports. I’m not saying that they aren’t buying copper/oil reserves on the cheap, but, not enough to drive prices in this recession this high.

    The 10 year T note has risen sharply implying, and, hey, correct me if I’m wrong that big time inflation is coming. That ought to kill off any alleged housing recovery real fast.

    We have an unholy alliance going on here with the Feds ginning the data in my opinion and their JPM/GS cronies keeping the S&P from collaping by buying before every market close recently. Rumor has it that oil tankers are sitting with stored oil surpluses while Goldman Sachs plays their oil futures games with out TARP money of course.

    It’s an Alice-in-Wonderland world since the Messiah took office and I’m getting too old to figure it out anymore.

    Comment by penny — June 5, 2009 @ 8:42 pm

  3. Penny said: “Rumor has it that oil tankers are sitting with stored oil surpluses while Goldman Sachs plays their oil futures games with out TARP money of course”.

    It’s disgusting, – this futures trading and speculation. Big players have ability to insert themselves between producers and consumers and collect tax. It’s just another link in the chain producers – wholesalers/distributors – consumers.
    Speculators – those who do not use commodities – should not be allowed to trade commodities futures.
    Majority of them on the Wall Street are democ Rats anyway. Democ Rats bitch about low wages in hotels and restaurants, but all they do is parasitic services like litigation and futures trading.
    These parasitic services are added to our GDP, and it looks huge. In reality, we produce a lot of parasitic services that are not making the country richer. It’s just redistribution of wealth from the society to the Rats.

    Comment by Michael Vilkin — June 5, 2009 @ 9:41 pm

  4. Professor said:
    “Like James Hamilton, I believe that the main puzzle is why nominal yields haven’t risen more relative to TIPS; the monetary expansion and the spurt in commodity prices both would suggest a bigger increase in inflationary expectations than the nominal-TIPS yield differential reflects.”

    Dear Professor, I agree with your logic. Inflationary expectations are high. Real yields will be low or negative. But there is a lot of bank reserves just sitting there. And, as you know, any firm, including banks, has to minimize losses. At a time when everyone is scared to invest in anything, the only game in town is to invest in government paper. High demand causes prices up and yields down, even though real yields might turn out to be negative. Looks like the banks believe that normal banking business will bring even more losses than investing in government paper.

    Comment by Michael Vilkin — June 5, 2009 @ 9:55 pm

  5. “Rumor has it that oil tankers are sitting with stored oil surpluses while Goldman Sachs plays their oil futures games with out TARP money of course.”

    Ooops, meant with our TARP money, big difference.

    Comment by penny — June 5, 2009 @ 10:14 pm

  6. What the US is doing here is sacrificing its credibility to get out of recession. I think this has been possible because it has been more fiscally responsible than most countries (those in Europe, Asian and even China) thus far. So, the dollar was the safe haven currency and investors in many countries have a vested interest in a strong dollar. That is why Bernanke could get away with quantitative easing thus far. Imagine what would have happened if Brazil tried such a thing – the country would have gone bankrupt in a week. Like we have been saying for the past several months, it is only a matter of time before the chinese and the europeans find a better alternative. Well, thanks to the global recession that hasn’t been such an easy thing to do. Looks like commodities are the alternative the chinese have come up with. But it is worrisome enough to Bernanke that they are very proactively looking for alternate assets instead of getting their trust abused by the US gov. I think we can get away with it this time. But, this is going to have huge costs even after a recovery.

    Comment by Surya — June 7, 2009 @ 9:45 am

  7. The US was fiscally responsible? What?

    It was running sizable budget deficits throughout the (phantom) boom of the Bush administration. The BRICs and stakeholder Europe all had moderate to sizable surpluses, IIRC.

    I completely agree with the credibility issue.

    Comment by Sublime Oblivion — June 8, 2009 @ 3:48 pm

  8. The US was fiscally responsible? What? – I didn’t say that. I used the comparative “more”. I guess most european countries are running deficits that are a higher proportion of their GDPs.

    Comment by Surya — June 8, 2009 @ 6:12 pm

  9. Certainly not now. The imminent US budget deficit of 13% of GDP is only observed in Europe in total wrecks like Ireland.

    And not during the Bush Administration either – I’m pretty sure that even then the deficits of most European countries were less. I recall that the likes of China, Russia and Germany had moderate to big surpluses.

    Comment by Sublime Oblivion — June 9, 2009 @ 4:00 pm

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