The titillating and terrifying collapse of the dollar. Again.

This post was originally published at China Financial Markets.

By Michael Pettis

Foreign perceptions about the Chinese economy are far more volatile than the economy itself, and are spread across a fantastic array of forecasts. On one extreme there are still many who hold the view that overwhelmingly dominated the consensus just four of five years ago, with a book by Martin Jacques,When China Rules the World, titillating or terrifying many with a subtitle that promised the end of the Western world and the birth of a new global order. Although few within this camp still believe in their earlier forecasts of 8-9 percent annual growth for another one or two decades, many among them still think China will manage to double its GDP in ten to twelve years.

On the other extreme are those who expect the economy to collapse well before the end of the decade. Although he himself does not expect an economic collapse but rather a political one, among the deeply pessimistic is George Washington University’s David Shambaugh, who published an article in the Wall Street Journal last year about “The Coming Chinese Crackup”. His article set off an intense debate among China watchers that still continues and indeed has been made more intense by a number of recent measures that seem aimed at limiting economic discussion and analysis.

Shambaugh warns that Beijing’s policies, aimed at staving off imminent political collapse, are instead “bringing it closer to a breaking point.” This seemed to mark a sharp change from his earlier views, all the more noteworthy given that his credentials as a knowledgeable and sympathetic observer of China had been reinforced just two months earlier when the prestigious China Foreign Affairs University, “the only institution of higher learning under the guidance of the Ministry of Foreign Affairs”, according to its website, named him the second-most influential China expert in the United States.

While political whispering and gossip about political instability have undoubtedly surged during the past year, I have no ability to judge China’s complex power struggle and its mysterious political maneuverings. No one I know, even the most plugged-in of my friends and former students, seems to have much sense of the political direction in which we are going, and the only thing with which everyone agrees is that they are all a lot less certain than they used to be.

In my opinion, however, there is no question that the days of rapid growth, which powered the inexorable economic rise on which Jacques relies for the future described in his book, are well and truly over. There is no way that growth won’t drop to below 2-3% well before the end of this decade, although if it manages the adjustment well and doesn’t put off too much longer an intelligent plant to resolve its debt burden, Beijing could keep the annual growth in household income from dropping much below 5% during this period.

This doesn’t mean that I think China is likely to experience an economic or financial crisis, let alone political collapse, however, although historical precedents make it very clear that as a country’s balance sheet becomes increasingly fragile, it takes a smaller and smaller adverse shock to set off a financial unraveling. There is nonetheless absolutely no question in my mind that its GDP growth rate will continue to drop sharply – either by 1-2 percentage points a year, or a lot more steeply after two or three years in which it maintains growth rates above 6 percent.

But titillation and terror continue in various forms. For many analysts who don’t understand why continued rapid slowdown is inevitable and why, therefore, it makes sense to tone down some of the rhetoric, recent statements made by Zhou Xiaochuan, Governor of the People’s Bank of China (PBoC), set off some very loud alarm bells. In his statement on April 16 to the IMF’s International Monetary and Financial Committee meeting in Washington, D.C., the head of China’s central bank closed with two sentences that caught the eyes of a number of analysts:

Starting from this April, China has released foreign exchange reserve data denominated in the SDR in addition to the USD. We will also explore issuing SDR-denominated bonds in the domestic market.

A concurrent release by the central bank on the PBoC website emphasized the first of these two statements: “starting from April 2016, the People’s Bank of China is releasing foreign exchange reserve data denominated in the SDR, in addition to the USD currently used.”

A little bit of context is in order here. Every month the PBoC announces the value of its foreign currency reserves in renminbi and in US dollars. Beginning in April, it plans also to announce the value of the PBoC’s reserves in Special Drawing Rights (SDRs).

The PBoC correctly points out that because the SDR is necessarily less volatile than any of the constituent currencies – US dollar, euro, the Japanese yen, pound sterling, and, in October of this year, the renminbi – using the SDR “would help reduce valuation changes caused by frequent and volatile fluctuations of major currencies.” We saw how this works Sunday, in an article in the South China Morning Post that opened with this:

China’s foreign exchange reserves rose, albeit marginally, for a second consecutive month in April, indicating easing in capital outflows, according to data released by the People’s Bank of China on Saturday. The US$7.1 billion rise beat the market forecast of a drop and took outstanding forex reserves to US$3.22 trillion at the end of last month. In March, the reserves rose US$10.2 billion, ending a five-month decline.

At the bottom of the article, the SCMP gave us the SDR figures released by the PBoC:

In terms of SDR, the country’s foreign exchange reserves were 2.27 trillion at the end of last month, down from 2.28 trillion at the end of March.

A $7.1 billion increase in reserves when quoted in US dollars turned into a SDR 0.1 decrease when quoted in SDRs. The dollar declined against most major currencies in April and this weakness showed up in the form of an increase in the dollar value of the PBoC’s non-dollar reserves. Because the US dollar share of PBoC reserves is around 1.5 times its share of SDR, this same weakness showed up in the form of a decline in the SDR value.

Aside from reducing volatility, the PBoC also claims that using the SDR to report foreign exchange reserve data will help “provide a more objective measurement of the overall value of the reserve”. Here the PBoC is mistaken; there is no additional information in the new number. Indeed anyone who preferred to keep track of the SDR value of PBoC reserves could have done so all along simply by converting each monthly US dollar value into SDRs – or euros, yen, sterling, or any other currency for that matter – at the then-prevailing exchange rate. There is no special trick here.

Undermining dollar hegemony

It was the last sentence in the PBoC release that raised eyebrows among many analysts, and this is where the titillation and terror come in. Reporting the value of foreign exchange reserves in SDRs, according to the PBoC release, “would also help enhance the role of the SDR as a unit of account.”

Why is the PBoC so concerned about enhancing the role of the SDR, an “international reserve asset” that until now has had little practical use and into which the renminbi has only recently entered? Shortly after the release, an article in the South China Morning Post provided one possible answer. It warned that the PBoC’s use of the SDR was aimed at achieving Beijing’s “longstanding strategic aim of dethroning the US dollar in the international monetary system.” According to the article “Beijing‘s renewed passion for the awkwardly phrased reserve asset is all part of its strategic goal – led by the central bank’s veteran governor Zhou Xiaochuan – to end the US dollar’s hegemony; the world’s second-largest economy wants to forge a new global financial order.”

In an article for MarketWatch, David Marsh, managing director of a London-based research company called Official Monetary and Financial Institutions Forum, explained in greater, slightly fawning, detail why this latest move is all part of a grander, carefully-thought-out strategy:

China’s utterances over the years on the International Monetary Fund’s special drawing rights confirm the Beijing authorities’ reputation for long-term thinking as well their ability to create riddles on what the goals actually are. The mystery is starting to look little less obscure. The world’s second-largest economy is embarking, pragmatically but steadily, toward enshrining a multicurrency reserve system at the heart of the world’s financial order.

Although it accepts that many years will elapse before the dollar can be dethroned from its No. 1 role, Beijing favors a “4 plus 1” system: the euro, sterling, yen, and yuan coexisting with the dollar. These are the five constituents of the SDR, which the yuan formally enters in October, following a U.S. Treasury-endorsed IMF decision in November. As part of this thinking, China for some years has been showing less interest in purchasing U.S. Treasurys — a trend that is likely to continue.

Beijing has upgraded the role of the IMF’s composite currency unit by starting to publish its foreign reserves total (the world’s biggest) in SDRs in addition to its long-standing practice of publishing them in dollars.

Marsh, like many other analysts who have repeated the popular but confused story about the rise of the renminbi and the decline of the US dollar, has probably misunderstood the way reserve currencies work within the global balance of payments. Whatever some people in Beijing might think about enshrining a multicurrency reserve system, in fact Beijing’s economic policies in the past two decades have done the opposite. They have systematically enhanced the reserve role of the US dollar. Had Beijing done otherwise, it would either have undermined China’s economic development or it would have created significantly higher domestic political pressures in the past two decades.

This is truer now than ever. Regardless of the stated intentions of certain political figures, Chine’s economic adjustment requires that Beijing continue supporting the dollar’s reserve-currency role. A reduced role for the US dollar would actually make China’s already difficult economic rebalancing costlier than ever.

As an aside there is of course no question that US dollars account for most central bank reserves, and have for seven decades, in spite of occasional periods in which many believed its role would be significantly reduced as another currency rose to take on a much greater presence – for example the D-mark was seen as a potential rival in the 1970s and 1980s, the yen in the 1980s and early 1990s, and the yen in fact widely expected to supplant the dollar altogether by the beginning of the last decade, and even the ruble in the 1950s. Nomura’s Stuart Oakley explained the current breakdown three years ago:

According to IMF data there is currently approximately $11 trillion of foreign exchange reserves sitting in the coffers of the world’s central banks. $6 trillion of this is referred to as “allocated reserves” where the currency composition is known. Most of the remaining $4-5 trillion “unallocated reserves” are owned by China who choose not to divulge the currency composition of their foreign loot. 

We know roughly 62 percent of “allocated reserves” are held in U.S. dollars, 23 percent in euros, 4 percent in yen, 4 percent in sterling with the Swiss franc, the Aussie and Canadian dollars making up the tiny remaining balance.

I will get back to this later, but I want to follow up on one of the other points Marsh made in his piece. He claimed that it was no coincidence that only a few days before his Washington statement, Zhou Xiaochuan had been in Paris: “The French capital is the traditional venue for plans (mainly fruitless) to unseat the dollar. These date back to the maneuverings of Jacques Rueff, the legendary pre-World War II French economist, and the ill-fated 1960s rebellion against the greenback’s exorbitant privilege.”

In fact the whole theory of the exorbitant privilege – first articulated by Valery Giscard D’Estaing, later France’s president, and referring to the tremendous economic benefits that the US supposedly receives because of the primacy of the US dollar among reserve currencies – came out of very special post-War circumstances. In the late 1940s, as the US ran trade surpluses with war-torn Europe, the Bretton Woods institutions were unable to recycle enough dollars to Europe to allow it to pay for consumption as well as fund the necessary rebuilding of infrastructure and manufacturing. The notorious “dollar shortage” was so severe that it threatened to derail any hope of European and Japanese economic recovery.

The large US dollar grants provided by the US under the Marshall Plan partially resolved the problem, but even this wasn’t enough. By the 1950s, as Cold War tensions rose, in order to rebuild European economies the US permitted protectionist policies in Europe without retaliating, so that its allies could reduce their current account deficits and eventually convert them into surpluses.[1] This would permit European employment to rise quickly enough that the concurrent increase in savings could fund faster increases in domestic investment.

No more dollar shortage

The exorbitant privilege, in other words, seemed only a privilege when the global dollar shortage meant that European investment was constrained by its inability to fund investment with a credible reserve currency. Although those days are long gone, they have not gone with an equivalent change in perception. Most Europeans are still opposed to allowing the benefits the US presumably obtains from its exorbitant privilege. What makes European intellectual obtuseness extraordinary is that while American politicians have vocally criticized predatory Chinese trade behavior for years, European policy has been far more predatory, and it is only the US “exorbitant privilege” that has permitted recent European policies, especially in Germany, to be among the most irresponsible in modern history.

The story by now is well-known. After first devastating peripheral Europe, German wage policies that caused a sharp contraction in domestic German demand have driven Europe’s current account from rough balance just a few years ago into the largest surplus ever recorded. The US has been remarkably polite about European policies, at least in public, and it wasn’t until last month that the US Treasury formally placed Germany, along with China and Japan, on a new currency watch-list. Putting Germany on this list was an action described as “provocative” by the Financial Times, and in contrast the US Treasury offered “what reads like cautious praise for Chinese authorities” – correctly so, in my opinion.

Conspiracy theorists are certain that there is some nefarious benefit that the US receives, along with the prestige, of controlling the world’s reserve currency, in spite of what should be obviously contrary evidence. While we all understand the reasons why countries engage in currency war, we are unable to understand that currency war is nothing more than the actions of a country determined to reduce its own share of “exorbitant privilege”, and force it onto the rest of the world, which in practice usually means the US. In the end the confusion over exorbitant privilege is simply part of the larger confusion that among other things drives continental machinations against the dollar and “Anglo-Saxon” financial hegemony.

For example French and other European right-wing opponents of the euro, like members of France’s Front National, fulminate against the US and oppose overt American support for the European Union and the euro as part of a long-term US strategy to emasculate Europe. Supporters of the euro, however, are no less insistent that its current failures are caused largely by covert Anglo-Saxon opposition, generated by the fear that a unified Europe will be a threat to US power, or that the success of the euro will undermine the dollar’s reserve currency role.

This confusion is so deep that participants at last year’s World Credit Rating Forum, a conference organized by Chinese rating agency Dagong Credit rating, were able to witness a remarkable speech by Dominique de Villepin, former Prime Minister of France who, in his opening address, proposed an alliance between France and China which together would form a partnership that would overturn US and British financial domination and the hegemony of the dollar. Rather than the stirring call to arms he might have planned, his speech came off as incredibly patronizing, at least to some of the younger Chinese attending. Later that week two of my students who had attended the conference, knowing that I am half-French and enjoying the very informal atmosphere I try to maintain in my seminar, teasingly related de Villepin’s speech to their classmates after which, turning to me, they expressed with grinning gratitude their appreciation that France was determined to lead poor China to great things.

But, that aside, is the reserve status of the US dollar part of US financial hegemony, and is it in China’s interest to replace it with the SDR, or even with the renminbi? Here is where the confusion lies deepest. The reserve status of the US dollar was and is necessary to China’s growth, and in fact Chinese actions in the past three decades have done more to enshrine it than anything the US has done. In fact, the US has tried, without success, to undermine its exorbitant privilege.

In fact the dollar presumably received a body blow eight years ago, delivered once again by Governor Zhou, but after which its share of total reserves actually seems to have climbed. After the first, American, leg of the global crisis in 2008 Zhou wrote a famous essay in March 2009 for the PBoC website in which he asked “what kind of international reserve currency do we need to secure global financial stability and facilitate world economic growth?”

His answer to the question he posed was careful enough to satisfy the requirements of both diplomacy and central bank obscurity, but it was widely interpreted, in spite of Zhou’s refusal to take the bait, as a fierce assault on US dollar hegemony, one that spelled the rapid demise of the American “exorbitant privilege”. The implications of Zhou’s question seemed obvious to many.

They believed that the US economy had been felled by a knockout financial crisis that was merely the first step in an inexorable US decline, one which would soon see the eclipse of old financial centers like New York and London by more vibrant stock exchanges in Shanghai, Sao Paolo, and Moscow. They also believed that the European economy was essentially sound and would sail through the crisis, with an ever more solid euro. As the indignant chairman of one of Spain’s largest banks bitterly proclaimed some time in late 2008, European banks had been conservative, prudent and level-headed, in spite of the derision heaped upon them by American and British banks, and that was why Spanish banks were in such great shape, and why the European financial system would remain largely unaffected by what was wholly an American crisis.

What can history teach us?

As part of this consensus very few analysts in China or abroad expected that Chinese GDP growth would drop below 9 percent, at least not until the end of the decade, and it was widely accepted that GDP growth could not drop below 8 percent because 8 percent was believed to be the minimum needed to stabilize unemployment. Beijing would never allow growth, these analysts said, to drop below that number. Among foreign analysts – albeit much less so among the Chinese – the capabilities of Chinese policymakers were held in such astonishingly high esteem that it seemed unnecessary to distinguish between what Beijing wanted to happen and what actually would happen.

The same optimism was applied to the stated desire of many in China that the renminbi take its place as one of the major global currencies. The data that showed the rapid increase in the share of global trade denominated in renminbi said to the optimists nothing about the very low base against which growth was measured, or about the obvious speculative interest in holding an appreciating currency, and everything about its inexorable rise, which pointed indirectly but powerfully, the consensus had it, to the equally inexorable decline of the US dollar to secondary status.

Not everyone agreed with the consensus, however, and in fact it seems that most economists with a background in economic and financial history in fact disagreed strongly. In my Peking University (PKU) classes I have always insisted on the importance of placing economic and financial events in historical context and of understanding the structure of balance sheets and financial sector incentives in analyzing the evolution of financial markets and economies. From 2008 to 2010 the extremely bright students who made up my central bank seminar used both to predict the inevitability of economic rebalancing.

Also around this time I published an article that argued that because global financial crises tended always to increase the liquidity premium and make more valuable the liquidity advantage global financial centers had over local stock markets, contrary to consensus I expected New York and London to take market share from local stock markets. A few months later in another article I argued that not only would the US dollar not fade away as a reserve currency, but that for similar reasons we should expect its use “actually to increase, not decline, as investors and exporters increasingly move out of less liquid currencies and into the most liquid.”[2]

In retrospect history seems to have been the better guide than the consensus. While it is too early to say for sure, the Shanghai, Sao Paolo and Moscow stock exchanges don’t seem to have taken market share from the old global financial centers and in fact seem likely to lose it as local markets have seized up and in some cases required significant government intervention. What’s more, rather than see its role diminish rapidly, as was widely expected in 2008-09, the dollar’s share of total currency reserves has grown, according to the IMF, by more than 3 percentage points since then, to over 64%.

My PKU seminar was also always extremely skeptical of claims that emerging markets had decoupled from the West and would become self-perpetuating engines for growth. In fact it seemed clear that the sub-prime crisis was simply the trigger for a disruptive global adjustment to years of misguided monetary policy and balance of payment distortions. Excess liquidity had been created by all of the major central banks, and this had supported the imbalances that led to what must inevitably be a global crisis.

The sub-prime crisis, in other words, was not the problem. It was simply the trigger for a global crisis caused by ferocious growth in central bank liquidity, which forced or accommodated significant distortions in the global balance of payments that could only be temporarily resolved by soaring debt.

That is why my students and I were convinced almost from the beginning that the global financial crisis would occur in three stages. The first stage was the American crisis, which would be brutal but from which the US would recover fairly quickly. The second stage would be the crisis in Europe based on the unsustainable institutional foundations of the euro, and it would probably run until sovereign debt was forgiven and the strictures created by the euro were resolved. The third stage would be the emerging market stage, set off by the collapse in commodity prices as China’s economy slowed. In early 2012 I wrote in one of my newsletters that industrial metal prices would drop by more than 50% within three years and iron, then trading above $190 a ton, would soon test $50 – as China was forced into rebalancing. This seems almost inevitable as part of the necessary Chinese adjustment.

Returning to Governor Zhou’s statement in April to the IMF, like his 2009 essay, will the new PBoC policy to report the SDR value, along with the US dollar value, of its foreign exchange reserves increase the visibility and viability of the SDR, and if so, will it in any way undermine the use of the US dollar as a dominant reserve currency as it is slowly replaced by the SDR or the renminbi? The answer is that while it may increase the visibility of the SDR, it will in no way increase its viability. More importantly, it will have not undermine the dollar as the global reserve currency nor will it support the rise of the renminbi.

The effects of reserve currency status

It turns out that improving the visibility of the SDR will not make it more widely used as a reserve currency. Central banks can only buy SDR if the IMF or an acceptable sovereign credit wishes to issue bonds denominated in SDR, and they will only want to do so in more than token amounts if they can hedge by buying the constituent currencies. This they will not be able to do.

Regardless of excited complaints about the “exorbitant privilege” the US government enjoys from the US dollar’s hegemonic status, in fact the US absorbs very little economic benefit and a huge economic cost when foreign central banks stockpile US dollar reserves, and no other country is willing to absorb this cost. That is why whatever happens to the SDR, the US dollar will continue to be the dominant reserve currency for the next several decades unless the US government itself decides to prevent or limit the ability of foreign central to accumulate reserves in US dollars (and sooner or later – and the sooner, the better economically for the US – Washington will do so because the economic cost to the US far exceeds the political benefits).

Whatever happens to the SDR, the renminbi will not become an important reserve currency at any time over the next few decades. While many in Beijing may not understand the costs to the issuing country associated with significant foreign purchases of its currency for central bank reserves, they nonetheless exist and are significant. In spite of explicit policies to increase renminbi holdings among foreign central banks – much ballyhooed but of limited value – Beijing’s overall economic policies implicitly make this impossible. If foreign central banks acquire significant amounts of renminbi denominated bonds, China’s economic rebalancing will become far more difficult because either Beijing’s debt burden will grow even faster than it currently is growing, or its unemployment will be higher.

This would happen anyway if the US were to decide to limit foreign central bank purchases of US bonds, perhaps by imposing cross-border taxes. If it were to do so the US economy will grow more quickly in the subsequent years, while the global economy, and especially countries that historically depend on trade surpluses to generate growth, will grow less quickly. In fact countries like China have put into place policies that require a hegemonic reserve role for the US dollar for many more years for them to be successful.

To see why these seemingly counter-intuitive statements are in fact logically necessary we only have to go through the balance of payments exercise. The SDR is a constructed currency, and no issuer will be willing to issue unlimited amounts of bonds denominated in SDRs unless it can hedge them by buying the constituent currencies. But if a central bank buys an SDR-denominated bond issued by the IMF, and the IMF hedges it by buying the requisite amount of bonds in dollars, euros, yen, sterling, and, soon enough, renminbi, this is no different than if the original central bank simply bought the requisite amount of bonds in dollars, euros, yen, sterling, and renminbi. Put differently, as I wrote in response to Governor Zhou’s 2009 essay, if the PBoC wants SDRs, it can easily get the equivalent by buying the constituent currencies according to the formula set out by the IMF.

But this isn’t the end of the story. Historically, neither Europe nor Japan, and certainly not China, have been willing to permit foreigners to purchase significant amounts of government bonds for reserve purposes. When the PBoC tried to accumulate yen three years ago, for example, rather than welcome the friendly Chinese gesture granting the Bank of Japan some of the exorbitant privilege enjoyed by the Fed, the Japanese government demanded that the PBoC stop buying. The reason is because PBoC buying would force up the value of the yen by just enough to reduce Japan’s current account surplus by an amount exactly equal to PBoC purchases. This, after all, is the way the balance of payments works: it must balance.

What is more, because the current account surplus is by definition equal to the excess of Japanese savings over Japanese investment, the gap would have to narrow by an amount exactly equal to PBoC purchases. Here is where the exorbitant privilege collapses. If Japan needs foreign capital because it has many productive investments at home that it cannot finance for lack of access to savings, it would welcome Chinese purchases. PBoC purchases of yen bonds would indirectly cause productive Japanese investment to rise by exactly the amount of the PBoC purchase, and because the current account surplus is equal to the excess of savings over investment, the reduction in Japan’s current account surplus would occur in the form of higher productive investment at home. Both China and Japan would be better off in that case.

But like other advanced economies Japan does not need foreign capital to fund productive domestic investment projects. These can easily be funded anyway. In that case PBoC purchases of yen bonds must cause Japanese savings to decline, so that its current account surplus can decline (if the gap between savings and investment must decline, and investment does not rise, then savings must decline). There are only two ways Japanese savings can decline: first, the Japanese debt burden can rise, which Tokyo clearly doesn’t want, and second, Japanese unemployment can rise, which Tokyo even more clearly doesn’t want.

There is no way, in short, that Japan can benefit from PBoC purchases of its yen bonds, which is why Japan has always opposed substantial purchases by foreign central banks. It is why European countries also strongly opposed the same thing before the euro was created, and it is why China restricts foreign inflows, except in the past year when it has been overwhelmed by capital outflows. The US and, to a lesser extent, the UK, are the only countries that permit unlimited purchases of their government bonds by foreign central banks, but the calculus is no different.

It turns out that foreign investment is only good for an economy if it brings needed technological or managerial innovation, or if the recipient country has productive investment needs that cannot otherwise be funded. If neither of these two conditions hold, foreign investment must always lead either to a higher debt burden or to higher unemployment. Put differently, foreign investment must result in some combination of only three things: higher productive investment, a higher debt burden, or higher unemployment, and if it does not cause a rise in productive investment, it must cause one of the other two.

The two conditions under which foreign investment is positive for the economy – i.e. it leads to higher productive investment – are conditions that characterize developing economies only, and not advanced countries like Japan and the US. These conditions also do not characterize developing countries that have forced up their domestic savings rates to levels that exceed domestic investment, like China.

The case of Australia

The confusion that arises from a failure to understand this affects a whole series of policies around the world. Recently, for example, Canberra blocked the acquisition by a Chinese buyer of the S. Kidman & Co estate, “the largest private land holding in Australia”. This land holding was “approximately 1.3 per cent of Australia’s total land area, and 2.5 per cent of Australia’s agricultural land”, and it was blocked on the grounds that it was not in the national interest, according to the April 29 statement to the media on the subject by Scott Morrison, the Australian Treasurer.

Morrison did not provide much greater detail on the reasons for blocking the acquisition, but he assured the press that Canberra welcomes foreign investment. “Foreign investment has underpinned the development of our nation,” he wrote, “and we must continue to attract the strong inflows of foreign capital that our economy requires. Without foreign capital and investment, Australia’s output, employment and standard of living would all be lower.”

I think it used to be true that foreign capital was necessary to increase Australian output, but it is much less true today. In fact I would argue that foreign investment is only likely to be positive for Australian growth under specific conditions, and these do not apply to the Kidman transaction.

Australians are clearly concerned about the political implications of a major acquisition of Australian assets by foreigners, and although this was not a formal part of the reason for blocking it, there is no question that the nationality of this particular foreign entity mattered. Some people argue that in evaluating large foreign purchases Canberra should not distinguish between a Chinese buyer and, say, an English buyer, and that to the extent it does this can only reflect hidden assumptions about racial or ethnic superiority.

This is nonsense, of course. Whether rightly or wrongly, Australians are more opposed to foreign government involvement in domestic politics than to involvement by foreign private individuals (and of course any major economic player is inevitably also a political player). Differences in their recent histories, political cultures, the primacy of rule of law, and so on, have convinced Australians, probably with reason, that the behavior of a private buyer from England is less likely to be driven by his government’s foreign policy objectives than the behavior of a Chinese buyer.

Having said that, however, it is also worth pointing out that a major acquisition of Australian land by a foreigner does not necessarily mean greater foreign leverage in domestic politics. It might mean greater Australian leverage on the foreigner. The buyer, after all, is held partly hostage to his property, and it is worth remembering that American, British and French businesses with significant commercial interests in Germany in the 1930s tended to be far likely to support accommodation with Nazi policies than businesses that were not exposed commercially to Germany. The effect isn’t symmetrical, however, and I suspect that this is more likely to be true in countries in which the government is above the law – German businesses with significant commercial interests in the US, Britain and France, for example, were probably much less likely to support Berlin’s accommodation of American, British or French policies than vice versa.

While they may understand the politics, the economics of the transaction are probably not what most Australians assume. The Chinese purchase of the Kidman estate impacts the Australian economy primarily through its impact on the Australian balance of payments. The net amount of capital flowing from China to Australia will cause a reduction in the Australian current account surplus (or an increase in its deficit) with China in the period in which it occurs. This net amount is equal to the purchase price, less the amount financed within Australia, plus or minus other capital flows between the two countries set off by the purchase – for example it would increase if Chinese ownership of the Kidman estate causes other Chinese entities to increase their investments in China.

If there is a consequent net increase in productive Australian investment, there will be a boost to Australian GDP generated by either a reduction in Australian unemployment or an increase in Australian wages. If not, either Australian GDP growth will remain unchanged and its debt burden will rise, boosting consumption and so strengthening Australia’s non-tradable sector in line with a weaker tradable goods sector, or GDP growth will decline because of an increase in Australian unemployment. In the former case it would be because the Chinese purchase increased the amount of capital within Australia that had to be invested, and this capital caused real estate and equity prices to rise, thereby setting off a wealth effect.

The key is whether or not the Chinese purchase of the Kidman land results in an equivalent boost in productive Australian investment. It is not at all obvious that it will. If the Chinese investors bring with them novel management techniques and new technologies that are unfamiliar to Australians and that cause the Kidman estate to be far more productive than it otherwise would, and if these new management techniques and technology then spread through Australia, raising productivity everywhere, then the benefits the foreign investment would bring to Australia outweigh the costs.

It is hard to imagine that this will be the case, however. Whoever owns the Kidman estate is likely to maximize the land’s productive value no more than any Australian owner would, given current technologies. In that case for advanced countries like Australia, foreign investment is only useful to the extent that it provides the competitive fillip to keep Australian businesses at the forefront of innovation. In a global economy of weak demand, however, countries export capital to advanced economies not to make the recipient country more competitive but rather to generate foreign demand for its exports.

So how does Australia benefit from the Chinese purchase of the Kidman estate? If the Chinese buyer significantly overpays for the asset (which might be the case if Chinese capital outflows are being driven by political or financial uncertainty at home), the Australian seller of course benefits by getting more than the asset is worth.

If the Chinese buyer brings in new managerial or technological innovations that increase the productive use of the Kidman estate, Australia benefits by the amount of the additional productivity generated over future years. And finally if the Chinese investment funds a productive investment within Australia that had been on hold because of an Australian inability to raise the necessary capital, which seems quite unlikely, Australia benefits by an increase in productive investment that otherwise would not have happened, and this increase would cause unemployment to drop (or wages to rise) as Australians are able to consume the resulting increase in national output.

Otherwise there is a cost to Australia which emerges from its the impact on the balance of payments. The net capital inflow must cause Australian investment to rise or savings to drop. If it does not cause investment to rise, it must cause savings to drop, and of course that means either the Australian debt burden must rise or else unemployment will.

The geopolitics of trade deficits

Doesn’t the same happen to the US? Yes, it does. Like all rich countries, the US has no problem funding productive domestic investments that it wishes to fund, and so foreign capital inflows cannot cause productive domestic investment to rise. Therefore as is the case with other countries with credible currencies, they must cause domestic savings to fall, and the only way this can happen is with a rise in the debt burden or a rise in unemployment. This is exactly what happened in the periods both before the 2008 crisis (debt rose) and after (unemployment rose).

I should add that while the US doesn’t benefit economically, it might benefit politically. During the Cold War, the US may have drawn tremendous foreign policy advantages from allowing US demand to stabilize foreign markets and reduce foreign unemployment.

It is not clear to me however that even this political benefit is any longer very substantial, but this is the only rational explanation for why the US has not, like other countries with credible currencies, discouraged foreign central banks from acquiring US dollar reserves. After Bretton Woods, it was considered vitally important that the global trade and capital regime be stabilized if the war-torn countries were to benefit from economic recovery, and because the US was the only country that could stabilize the global trade and capital regime, and because it felt that it had to do so to protect its allies from the kind of economic instability that might drive them away from the US and even into the arms of the USSR, the US took on that role.

Should the US continue playing this role? In my opinion if the economic costs do not already significantly exceed the political benefits, it is only a question of time that they begin to do so. This is the great irony of the global financial crisis. While China, Russia, and France lead the charge to strip the US of its exorbitant privilege, and the US and it’s allies resist, in fact each side should take the opposite position, especially if they wanted to benefit most from beggar-thy-neighbor policies. If the US were to take steps to prevent foreigners from accumulating US assets, the result would be a sharp contraction in international trade. The US current account deficit would fall as a direct function of the reduction in net capital inflows, and as it did so, US unemployment would fall and GDP growth rise.

At the same time the European and Chinese current account surpluses would fall exactly in line with their ability to export capital, and they would be forced to choose either to lend capital to capital-poor developing countries, forcing them into substantial current account deficits that would make repayment highly unlikely, or to suffer the consequences of a collapse in their surpluses, which almost certainly would cause both soaring debt and surging unemployment. If Europe and China were prevented from handing exorbitant privilege to the US, their economies would suffer terribly.

This is the great irony of the global financial crisis. China, Russia, and France want to lead the charge to strip the US of its exorbitant privilege, and the US resists. And yet if the US were to take steps to prevent foreigners from accumulating US assets, the result would be a sharp contraction in international trade. Surplus countries, like Europe and China, would be devastated, but the US current account deficit would fall with the reduction in net capital inflows. As it did, by definition the excess of US investment over US savings would have to contract. Because US investment wouldn’t fall, and in fact would most likely rise, US savings would automatically rise as lower US unemployment caused GDP to grow faster than the rise in consumption.

But what about the extremely low savings rates in the US. Don’t they prove, as Yale University’s Stephen Roach has often pointed out, that the US is savings-deficient and relies on Chinese and European savings to fund US investment, or at least the US fiscal deficit, because the US consumes beyond its means?

What the candidates won’t tell the American people is that the trade deficit and the pressures it places on hard-pressed middle-class workers stem from problems made at home. In fact, the real reason the US has such a massive multilateral trade deficit is that Americans don’t save.

This is one of the most fundamental errors that arise from a failure to understand the balance of payments mechanisms. As I explained four years ago in an article for Foreign Policy, “it may be correct to say that the role of the dollar allows Americans to consume beyond their means, but it is just as correct, and probably more so, to say that foreign accumulations of dollars force Americans to consume beyond their means.” As counter-intuitive as it may seem at first, the US does not need foreign capital because the US savings rate is low. The US savings rate is low because it must counterbalance foreign capital inflows, and this is true out of arithmetical necessity, as I showed in a May, 2014 blog entry.

It must happen because, to repeat what I have said earlier, if foreign exports of capital to the US increase, by definition so must the excess of US investment over US savings. Because there are no productive investments in the US that investors want to make but cannot because of the unavailability of capital, increased net capital exports to the US do not cause investment to rise. In that case they must cause savings to fall, and they do so either because of the wealth effect or because of the increase in the current account deficit driven by the increase in the capital account surplus (often as capital inflows drive up the value of the currency).

During boom times the obvious mechanism by which they cause a fall in savings has been seen a number of times throughout modern history, including most famously in the US and peripheral Europe before the 2008-09 crisis, in the US and Germany before the 1929 crisis and before the 1873 crisis. As foreign savings pour into the economy, they flow into asset markets, driving up prices, especially in real estate and the stock markets. As household owners of these assets see their wealth rise, they experience a wealth effect that results in a subsequent increase in consumption – usually funded by rising debt as incomes do not rise, or rise more slowly than wealth. The increase in consumption creates new jobs that replace the jobs lost as workers producing tradable goods are displaced by the rise in the current account deficit.

During depressed periods, which usually follow the boom times described above, as excessive debt levels and declining asset prices eliminate the wealth-effect impact on consumption, the decline in consumption forces layoffs and unemployment rises. Rising unemployment, of course, reduces savings as worker income drops to zero but worker consumption declines by less.

The idea proposed by Roach and many others that the US needs foreign capital to balance its low savings rate, in other words, or that this low savings rate is itself the consequence of spendthrift habits of American households, flies in the face of logic and the balance of payments mechanisms. It is simply not true.

What of the benefits?

But what about all of the benefits to the US associated with exorbitant privilege that are so widely known and cited? It turns out that it isn’t easy to list these benefits because for all the conviction that they are substantial, few analysts can identify them except very vaguely. The main benefits seem to include:

• It lowers US government borrowing costs. An otherwise excellent 2009 survey by McKinsey claims that “the United States can raise capital more cheaply due to large purchases of US Treasury securities by foreign governments and government agencies.” As Nomura’s Stuart Oakley put it in 2013, “Who wouldn’t want cheap access to world capital markets that reserve currency status brings? Not to mention cheaper transaction costs on international trade.” This seems reasonable at first: more demand for government bonds after all should drive prices up. But because foreign purchases also automatically increase the supply of US dollar debt, either directly or indirectly, when rising unemployment causes a larger US fiscal deficit. Were this not so we would have absurdly to conclude that driving up a country’s current account deficit, the obverse of its capital account surplus, would automatically lower its borrowing cost.
• It allows Americans to consume beyond their means. This extraordinarily bumbling interpretation implies that American current account deficits force other countries unwillingly to run current account surpluses, and not the reverse. Any country with a credible currency will “consume beyond its means” whenever foreign central banks try to stockpile its currency. And yet most countries refuse the privilege, often indignantly, as unfairly forcing up its currency, and so forcing it to “consume beyond its means”.
• Outstanding currency notes provide seignorage benefits. Currency notes are effectively interest-free loans to the issuing government. The value of his benefit, however, is tiny, almost negligible, and anyway has nothing to do with reserve status. Any credible currency can enjoy seignorage benefits, and with the creation of the Euro 500 note in 2002 we saw a significant shift in seignorage benefits from the USD 100 note, implying that these benefits come mainly from those who are trying to hide their wealth. This is why rather than celebrate, Brussels has just announced that it will eliminate this “benefit” by discontinuing issuance.
•  The US sells economic insurance. As the US intermediates low-risk high-quality inflows into riskier outflows during times of stability, it effectively earns a risk premium for which it pays out during periods of instability. This creates real value both for the US and for countries that choose to buy this “insurance”. As Barry Eichengreen, author of Exorbitant Privilege explains, “the US has a built-in insurance policy. Whenever something goes wrong in the world – whether in the US or abroad – and incomes go down, the dollar goes up. So that insulates the US against the worst effects.” Eichengreen is right, but to the extent that he is, it does not depend on the reserve currency status of the US dollar. Any country whose economy is perceived as a safe haven in times of trouble, for example Japan, Germany and Switzerland, receives such inflows during market disruptions. But in recent year this has not been perceived as a benefit. Just over two years ago Japan’s Prime Minister Shinzo Abe was determined to protect Japan from this “benefit”, arguing that “If it goes on like this, the yen will inevitably strengthen. It’s vital to resist this” according toan article in the Wall Street Journal.

Japan’s determination not to allow other countries to force it into accepting exorbitant privilege was not fully appreciated by other countries, including China. Two months after the Wall Street Journal article was published, Bloomberg published the following:

China doesn’t approve of excessively loose monetary policies by other nations, according to a senior government adviser who wrote a book with Li Keqiang, the country’s incoming premier.

“We have already taken a position on this before and China doesn’t approve of some countries’ overly accommodative monetary policy,” Li Yining, 82, a Peking University professor and delegate to China’s top advisory body, said at a briefing in Beijing today when asked about Japan’s recent easing. “This is an act of transferring the crisis to others.”

The remarks may reflect official displeasure over the yen’s depreciation amid Japanese Prime Minister Shinzo Abe’s campaign for more monetary easing to fight deflation. China is “fully prepared” for a currency war should one happen, central bank Deputy Governor Yi Gang said March 1, according to the official Xinhua News Agency.

The US should lead a reconvening of the world’s economic policymakers in a global conference to restructure the global capital and trade regime, so that countries looking to kick-start or goose domestic growth cannot do so at the cost of US unemployment or rising US debt levels. Enshrining SDR is is a start. If central banks were allowed only to accumulate SDRs, the US would be forced to absorb just under 42 percent of these distortions, as opposed to the roughly two-thirds it currently must absorb. Europe would be forced to absorb almost 31 percent and China, Japan and the UK between 6 percent and 11 percent.

But even this is too much. It would be far better, as Keynes unsuccessfully proposed during the Bretton Woods conference, that countries that try to force domestic demand deficiencies caused by domestic policy distortions onto their trading partners, rather than resolve them domestically, were prevented from behaving irresponsibly. It is surprising that Washington has not yet taken the lead in attempting to restructure the international trade and capital regime so as to limit reserve accumulation in US dollars. The logic, however, is inexorable. It is only a matter of time before it does so. The only question is how much economic pain and domestic unemployment is it willing to accept before it decides to move.

 

 

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[1] In one of the flights I took last year I was able to watch a documentary about the Nixon tapes. In one conversation, one of his aides frets about protectionist European measures that are hurting US businesses, and discusses retaliating to pressure Europe into withdrawing the measures. Another aide interrupts and warns that retaliation would undermine European support for certain Cod War positions, after which Nixon immediately puts an end to all talk of pressuring Europe to remove its protectionist policies. This was a pretty constant refrain from the 1950s onwards, and continues to inform policy today – TPP for example.

[2] Both articles were South China Morning Post columns, the first “Financial capitals unlikely to lose their clout”, November 3, 2008, and the second “Reserve currencies rarely change,” May 25, 2009