Thursday, February 24, 2005

That Metastability Thing: A Balance of Financial Terror

Some time ago, I described the situation with regard to the dollar and central bank reserves in terms of metastability, the idea of a position that is both very stable in the short term and also subject to a radical flip triggered by comparatively small events. I think I also linked this up in another post with the idea of a Nash equilibrium, the situation where a small number of actors have arrived at the strategy that minimises their losses relative to each other and therefore have no incentive to change. Econoblogger Brad Setser today links to a column in the FT concurring with this, and also to a rather funnier version of it here.

There's also a good paper on the same theme by Setser. As they point out, "social peace in China is at the expense of political peace in the US": with the monster trade deficit in the US matching the monster trade surplus in China, the currency market intervention is basically keeping Chinese industry running at full capacity and hence, presumably, keeping the streets quiet. In a sense, it's also cushioning the impact of recession in the US by keeping imported consumer goods cheap, but only up to the bang, of course.

Now, I'm mildly sceptical of grand predictions for the Chinese economy; there have been a lot of disappointments back to Lord Macartney, and I really wonder if the social structure can stand the strain of really huge inequality. When we speak of the Chinese economic boom, we mean the boom in the cities of eastern China. The countryside is still full of a majority of peasants so poor they sell their blood to eople who give them AIDS. And the simultaneous dismantling of the communist economy brings up more problems - most of the world thinks a welfare state of some form is needed for a socially stable capitalism. China has dismantled the famous iron rice bowl, but what if anything is replacing it? What about the environmental strain? Or the dodgy banking sector? I mentioned AIDS, and that's a really big problem too; one that's only being addressed now after years of denial.

All these problems look a lot better if the economy is clattering along nicely. Everyone likes having a trade surplus (although, of course, it's impossible for all to have one - like the class where all the kids are above average). High employment growth soaks up the migration from the land, buoyant tax revenues pay for the infrastructure, and the accounts look OK. But, as J.K. Galbraith put it, there's no audit like a recession. The cost of keeping down the renminbi against the dollar is showing up in that the process of intervention is driving rapid growth in the Chinese money supply. It's also helping Chinese banks lend cheaply, and hence making it easier to fund projects that perhaps might be better left. Investment is approaching 45% of Chinese GDP. That's a lot of capacity being built; it's obviously going to be a key problem how it stays utilised. Roubini and Setser point out that maintaining the dollar-renminbi peg at current rates is a proxy for this, as it requires ever-growing exports. Their numbers suggest that, to satisfy this condition, Chinese exports to the US would have to exceed US imports of petroleum within four years, which would take them to 20% of Chinese GDP. I don't know about you, but this sounds to me like a bubble.

Is a hybrid Communist politics/Texan economics polity best placed to handle these social strains if there's a sharp downturn?

This puts another twist in the Nash problem; the longer it goes on, the worse it gets - but this is also an incentive for those with most to lose to keep it going. Setser points out that this means the smaller players become crucial - having not gone as far down the road, they have more to save. And they aren't that small; totting up Taiwan, South Korea, India and Russia's reserves comes to more than China's. Two of these have already shown signs of edging towards the door. Another crucial point emerges with regard to oil. Setser and Roubini state that oil exporters have less of an incentive to not sell dollars because they don't compete with Chinese industry. The other point, of course, is that they have a lot of dollars coming in at the moment - the high oil price makes this a very hot issue. They could well be the first to jump ship.

BTW, read the damn thing. It's only 55 pages. You will be scared. Very scared.

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