The Dragon and the Toothless Dog

This week, the big news continues to center around the dollar and the credit crisis. Secretary Henry Paulson returns from China empty handed on the dollar-yuan exchange rate, and Federal Reserve Chairman Ben Bernanke is stunned when an interest rate cut sinks the stock market.

Henry and the Dragon

Paulson continued his Strategic Dialogue with Chinese officials but was broadly rebuked in his efforts to persuade China to meaningfully revalue its currency.

Since China pegged the yuan against the dollar in 1994, and adopted a gently sliding peg in 2005, the yuan has become progressively undervalued against the dollar.

This is evidenced by the ever-widening gap between the demand for yuan created by foreign purchases of Chinese goods and private foreign investment in China, and the supply of yuan created by Chinese imports and private overseas investments. Rather than permit the yuan to rise and equilibrate demand and supply, as western market economies do, the Peoples Bank of China has intervened in currency markets, printing and selling yuan, and buying dollars, euros and other western currencies. This makes Chinese products artificially inexpensive in the United States and U.S. products artificially expensive in China.

The magnitude of undervaluation of the yuan is revealed by the growing level of Chinese net intervention in currency markets, which was $47 billion in 2001 or 19 percent of exports, and is on track to be $450 billion or 45 percent of exports in 2007. Although China has permitted the yuan to rise about 5.8 percent in the last year, modernization and rapid productivity growth raise the yuan’s intrinsic value at least 7 and 8 percent each year. The yuan is now 40 to 70 percent undervalued against the dollar.

Federal Reserve Chairman Ben Bernanke has correctly concluded that China’s yuan policy provides a subsidy on exports. By the scope of intervention, this is a 45 percent subsidy. However, the Bush Administration has rebuked any suggested U.S. policy to offset this subsidy as protectionist-a profoundly different view than the one it has adopted on other forms of industry aid offered by China.

The Chinese government is using the yuan peg as an employment policy to create more jobs for rural workers moving to cities than comparative advantage and free competition would require in international markets without these subsidies.

U.S. experiences with intellectual property and other protectionism teaches China will not relent on mercantilist practices until the United States is willing to take tangible trade actions to offset their effects.

Mr. Paulson traveled to China without a stick, and the Chinese dragon did not flinch.

Meanwhile, the United States is amassing a huge overseas debt, which the Chinese government now wants to convert into equity holdings in the United States. The U.S. government does not own stock in U.S. companies, now ironically, it is paving the way for the China’s sovereign investment fund to do just that.

Ben’s Toothless Dog

Tuesday, the Federal Reserve announced a quarter-point reduction in the target federal funds rate to 4.25 percent and equity markets gave Ben Bernanke’s performance a failing grade. Within two hours, the major stock indexes shed more than two percent of value.

Economists expected only a quarter point cut, because the jobs report last Friday indicated the U.S. economy continued to expand. Thursday, a strong retail sales report for November confirmed their confidence but investors remain skeptical.

Investors are flabbergasted, because the Fed fails to recognize the country is not suffering from a liquidity crisis-banks can get all the funds they want from the Federal Reserve Discount Window and the newly announced Term Auction Facility. Credit markets and the economy are suffering from a profound crisis of confidence, and the Fed does not appear to understand or know how to cope.

The subprime meltdown reveals fundamental structural flaws in the U.S. banking system. The write downs at Citigroup, UBS and others indicate that bankers have been overvaluing mortgage-backed securities. The motivation is clear. The compensation awarded bank executives who create mortgage-backed and other securities is directly related to the estimated values banks assign these complex and opaque instruments.

The bonuses to bank executives have been paid and are gone, while the banks’ stockholders find themselves selling off equity to Middle East investors. Mutual funds, U.S.-state run money market funds for municipalities, pension funds, and insurance companies that trusted Citigroup and other banks now hold worthless paper, and the market for mortgage-backed securities has evaporated.

The whole chain that creates financing for mortgages has been corrupted from loan officers to banks that bundle loans into securities, to bond rating agencies like Standard and Poor’s who demand payments from banks instead of charging investors to evaluate mortgage-backed securities.

All along the chain, executives and smaller folks have been enriched and now there is no meaningful market for mortgage-backed securities, except those created by the federally sponsored banks. As Fannie Mae and others generally don’t do jumbos-loans above $417,000-the cost of jumbo mortgages has rocketed. No recovery in the housing sector is possible without resurrecting the jumbo market and the market for somewhat riskier mortgages.

Evidencing this sad state of affairs, the banks are so suspicious of each other’s accounting they won’t lend each other money. The Fed can cut the federal funds rate to zero without effect until this mistrust abates. It is no surprise that the inter-bank lending rate, Libor, is now well above the federal funds rate.

Mr. Bernanke keeps pushing the buttons that work in textbook economics-the federal funds rate, discount window and similar vehicles-when for some time now those have had little effect on mortgage rates, and now have dwindling effects on short-term lending rates, as indicated by the decoupling of the federal funds rate and Libor.

Central bank monetary policy becomes a toothless dog when the banking system becomes corrupted and confidence evaporates about the integrity of principal players in capital markets.

It is high time for Bernanke to address the institutional problems in U.S. banking that undermine Federal Reserve efforts to effectively steer the economy: excessive compensation schemes on Wall Street and throughout the financial system that incentivize the overvaluation of assets; conflicts of interest in mortgage, commercial and investment banking; and self dealing at Standard and Poor’s and other bond rating agencies.

The Week Ahead: Forecasts for the Weeks of December 17 and 23

Forecast Prior

December 14
CPI – Nov 0.6% 0.3
CPI – Core 0.2 0.2

Industrial Production – Nov 0.1% -0.5
Capacity Utilization 81.7 81.7

Week of December 17

December 17
Current Account–Q3 -$181.9b -190.8
Net Foreign Purchases – Oct $35.0b 26.4 (line 19 US Treasury TIC Report)

NAHB Market Index 20 19


December 18
Housing Starts – Nov 1.185m 1.229
Building Permits 1.178 1.178

December 20

GDP – Q3 (f) 5.0% 4.9
GDP Deflator 0.9 0.9
PCE 2.7 2.7
PCE Deflator 1.7 1.7
Core Deflator 1.8 1.8

Leading Indicators–Nov -0.2% -0.5

Initial Jobless Claims 335k 333

December 21
Personal Income – Nov 0.5% 0.2
Personal Spending 0.4 0.2
PCE Index 0.6 0.3
Core PCE Index 0.2 0.2
Real Personal Spending -0.2 0.0

Mich Cons Sentiment – Dec (r) 73.5 74.5

Week of December 24

December 27
Durable Goods 0.5% -0.4

Consumer Confidence–Dec 86.8 87.3

December 28
New Home Sales – Nov .726m .728

Help Wanted Index–Nov 23 23

PETER MORICI is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.



PETER MORICI is a professor at the Smith School of Business, University of Maryland School, and the former Chief Economist at the U.S. International Trade Commission.