Be careful what you wish for on currencies

The rancorous argument about global payment imbalances and the yuan’s valuation is exposing a surprising and dangerous economic illiteracy among policymakers and commentators.

Before pressing China to allow a maxi-revaluation of the yuan, western commentators need to think through the consequences carefully. The idea that devaluing the dollar (and by extension euro and yen) will cause payment imbalances to disappear and boost employment in the West with little or no impact on inflation and living standards is a pipe dream.

MAXI-DEVALUATION

First some notes about terminology. Proponents generally phrase their argument in terms of an appreciation of the yuan (which keeps the focus on the alleged currency manipulators in China). But it could just as easily be recast as a depreciation of the dollar (which is a much more controversial formulation, highlighting the fact that the exchange rate problem reflects U.S. weakness as much as China’s strength).

Since most observers assume bilateral relationships between the dollar and other major currencies would not alter significantly, China is in fact being pressed to permit a balanced depreciation of the dollar, euro, yen and other major currencies.

Finally, we are not talking about small changes but very large ones. Observers have suggested the dollar might be overvalued as much as 25-50 percent. Devaluing it 5 percent is unlikely to cause a substantial adjustment in China’s trade surpluses with the United States and globally and will not remove the political tensions and the root of the crisis.

Only a very large reduction in the dollar’s value over a period of years, in effect a “maxi-devaluation”, could hope to adjust the relative trade performance of the two countries.

ADJUSTMENT WITHOUT INFLATION?

Within the United States and euro zone, the main impact would be to raise the price of tradable goods and services relative to their non-tradable counterparts. Exports would become more competitive while imports would become significantly more expensive. Demand would switch from domestic consumption and imports towards exports and import-competing firms.

Normally, such expenditure-switching adjustments would need to be accompanied by expenditure-reducing tax hikes, spending cuts and interest rate increases to shrink non-tradable industries to expand export and free up resources for import-competing sectors, allowing adjustment without triggering inflation. The combination of expenditure switching and reducing policies is the standard prescription at the heart of an IMF structural adjustment programme in developing countries.

However the recession has already created plenty of slack in U.S. and European manufacturing. Supporters think the United States could achieve a maxi-devaluation, a big rise in exports and a fall in imports without triggering significant inflation or driving the Fed to raise interest rates. Adjustment would be essentially painless.

THE DOLLAR IN YOUR POCKET
 

It is important not to underestimate how big the impact could be. Cheap manufactured imports from China and the rest of Asia, combined with easy credit and rising debt, have been the main engine of rising living standards in the United States and some of the other advanced industrial economies over the last 20 years as real wages have stagnated. If imports become significantly more expensive, households will feel much poorer.

Devaluation supporters often suggest China’s manufacturers might absorb a proportion of the exchange rate change to protect market share, cushioning the blow. Apart from defeating the object of the devaluation, there is no way China’s manufacturers could absorb the full impact of the sort of 25-50 percent maxi-devaluation that would be needed to eliminate the payments imbalance, according to some U.S. economists.

While devaluation’s impact on the cost of manufactured imports might be (slightly) lessened, the biggest impact would be on the cost of raw materials such as crude oil and industrial supplies that trade in global markets.

By boosting the purchasing power of Chinese businesses and households, and their consumption of oil and other raw materials, a maxi-devaluation would drive oil and other commodity prices sharply higher in dollar terms, and cut deeply into real household incomes in the United States.

I have written elsewhere that there is no real, fundamental link between oil prices and changes in the dollar’s trade-weighted value. Correlations are mostly driven by self-fulfilling perceptions. Commodity price changes reflect the relative pricing power of producers and consumers; exchange rates add nothing to the analysis.

But that is only true for relatively moderate changes in the dollar’s value against the euro, yen and other major traded currencies of the sort seen almost continuously for the past 20 years.

In contrast, a maxi-devaluation would lead to a re-pricing of oil and other commodity prices, redistributing real income and consumption away from the United States and Europe to households and firms in China. The United States and Europe are simply too large to devalue their way out of trouble without triggering big shifts in commodity prices.

CENTRE OF GRAVITY SHIFTS

By revaluing the output of China’s businesses and households, maxi-devaluation would also massively increase China’s “weight” in the global economy, accelerating the rapid shift in the centre of gravity in the world economy from the economies of the North Atlantic to East Asia.

Proponents of devaluation (and they are numerous) often portray it as a simple panacea. But maxi-devaluation would trigger a series of wrenching structural shifts in the advanced economies and globally. It might create more jobs in the United States, but all U.S. households would feel noticeably poorer as their real purchasing power is slashed.

It would ram home the fact that U.S. and even European households have been living far beyond their means — enjoying a high standard of living only because of an overvalued currency and the hard work for limited rewards common in China and many other parts of emerging Asia.

Exchange rate realignments are a necessary and inevitable part of the global adjustments that will be necessary in the next few years. In some ways they will make explicit the huge shift that has already been occurring for the past decade, but masked by China’s reserve accumulation and cheap credit in the western world.

But let’s not pretend they will be painless for households and businesses across the United States and Europe. Extra jobs and more exports will be purchased by lower real consumption. Living standards will fall, reflecting the reduced external value of U.S. and European output.

Source: http://blogs.reuters.com/great-debate

Paid to Fail

CAMBRIDGE – In a report just filed with the United States court that is overseeing the bankruptcy of Lehman Brothers, a court-appointed examiner described how Lehman’s executives made deliberate decisions to pursue an aggressive investment strategy, take on greater risks, and substantially increase leverage. Were these decisions the result of hubris and errors in judgment or the product of flawed incentives?

After Bear Stearns and Lehman Brothers melted down, ushering in a worldwide crisis, media reports largely assumed that the wealth of these firms’ executives was wiped out, together with that of the firms they navigated into disaster. This “standard narrative” led commentators to downplay the role of flawed compensation arrangements and the importance of reforming the structures of executive pay.

In our study, “The Wages of Failure: Executive Compensation at Bear Stearns and Lehman Brothers 2000-2008,” we examine this standard narrative and find it to be incorrect.

We piece together the cash flows derived by the firms’ top five executives using data from Securities and Exchange Commission filings. We find that, notwithstanding the 2008 collapse of the firms, the bottom lines of those executives for the period 2000-2008 were positive and substantial.

Most importantly, the firms’ top executives regularly unloaded shares and options, and thus were able to cash out a lot of their equity before the stock price of their firm plummeted. Indeed, the top five executives unloaded more shares during the years prior to their firms’ meltdown than they held when disaster came in 2008. Altogether, during 2000-2008, the top executive teams at Bear Stearns and Lehman cashed out about $1.1 billion and $850 million (in 2009 dollars), respectively.

These payoffs to top executives were further increased by large bonus compensation. During 2000-2007, the top executives’ aggregate bonus compensation reached (in 2009 dollars) $300 million at Bear Stearns and $150 million at Lehman. Of course, the earnings that provided the basis for these bonuses evaporated in 2008. But the firms’ pay arrangements did not contain any “claw-back” provisions that would have enabled the firms to recoup the bonuses that had already been paid.

Combining the figures from equity sales and bonuses, we find that, during 2000-2008, the top five executives at Bear Stearns and Lehman pocketed about $1.4 billion and $1 billion, respectively, or roughly $250 million per executive. These cash proceeds are substantially higher than the value of the holdings that the executives held at the beginning of the period. Thus, while the long-term shareholders in their firms were largely decimated, the executives’ performance-based compensation kept them in positive territory.

The divergence between how top executives and their companies’ shareholders fared raises a serious concern that the aggressive risk-taking at Bear Stearns and Lehman – and other financial firms with similar pay arrangements – could have been the product of flawed incentives. The concern is not that the top executives expected their aggressive risk-taking to lead with certainty to their firms’ failure, but that the executives’ pay arrangements – in particular, their ability to claim large amounts of compensation based on short-term results – induced them to accept excessive levels of risk.

It is important for financial firms – and firms in general – to reform compensation structures to ensure tighter alignment between executive payoffs and long-term results. Executives should not be able to pocket and retain large amounts of bonus compensation even when the performance on which the bonuses are based is subsequently sharply reversed. Similarly, equity incentives should be subject to substantial limitations aimed at preventing executives from placing excessive weight on their firm’s short-term stock price.

Had such compensation structures been in place at Bear Stearns and Lehman, their top executives would not have been able to derive such large amounts of performance-based compensation for managing the firms in the years leading up to their collapse. This would have significantly reduced the executives’ incentives to engage in risk-taking.

Indeed, calls for comprehensive and robust reform of pay structures should not be viewed as mere responses to populist anger. Such reform could do a great deal to improve incentives and prevent the type of excessive risk-taking that firms encouraged in the years preceding the financial crisis – thereby enhancing the value of companies and the wealth of shareholders.

Reforms that redress these destructive incentives should stand as an important lesson and legacy of Bear Stearns, Lehman Brothers, and the crisis they helped to fuel.

Copyright: Project Syndicate, 2010.
www.project-syndicate.org

Roach Rebuffs Krugman Call to Pressure China on Yuan

Stephen Roach .... 'We should take out the baseball bat on Paul Krugman"

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March 19 (Bloomberg) -- Morgan Stanley Asia Chairman Stephen Roach said a “baseball bat” should be taken to economist Paul Krugman over his call for the U.S. to pressure China into allowing the yuan to appreciate.

“We should take out the baseball bat on Paul Krugman -- I mean I think that the advice is completely wrong,” Roach said in an Bloomberg Television interview in Beijing when asked about Krugman’s call, characterized as akin to taking a baseball bat to China. “We’re lashing out at China rather than tending to our own business,” which is raising U.S. savings, Roach said.

“I’m a little surprised at Steve for saying that,” said Krugman, the Princeton University professor and Nobel laureate in economics, in a telephone interview when asked to respond to Roach. “What I said is actually based on pretty careful economic analysis. We have a world economy which is depressed by China artificially keeping its currency undervalued.”

The debate between the two economists echoes verbal clashes between the nations, with Chinese leaders repeatedly saying that their yuan policy isn’t the cause of the U.S. trade gap. American lawmakers have urged the Obama administration to step up pressure on China for keeping its exchange rate unchanged, a stance criticized as providing an unfair advantage.

Yuan Stance

Premier Wen Jiabao’s government has kept the yuan at 6.83 per dollar since mid-2008 to shield exporters from the global recession and a contraction in world trade. It allowed the currency to appreciate 21 percent in the three years before that.

The country has accumulated a record $2.4 trillion of reserves, and $889 billion of U.S. government debt, partly a consequence of its exchange-rate policy.

Global economic growth would be about 1.5 percentage points higher if China stopped restraining the yuan and running trade surpluses, Krugman said at an Economic Policy Institute event in Washington March 12. He said the U.S. may need to get more aggressive in its talks with China, perhaps by treating the exchange-rate as a countervailing duty or other export subsidy.

“I’m a little curious what Steve thinks would happen if the U.S. increased savings” without a stronger yuan, Krugman said today. “Where would the demand” for goods and services come from, he asked. Boosting savings should be done “in the long run,” not now, he also said.

‘Bad Advice’

Krugman is “giving Washington very, very bad advice,” Roach said in a later interview when asked to respond to Krugman’s reaction to his remarks. “I totally reject his idea that savings is bad.”

The U.S. trade deficit is due to a shortfall of savings, and any attempt to address the bilateral gap with China would just cause a shift to another country as Americans kept up their spending, according to Roach. He added that while Krugman and he have been in agreement for years, they are in total disagreement right now.

“What the world needs is a shift in the mix of saving,” Roach said in a further e-mail. While China has a “major surplus saving imbalance,” it’s “highly debatable” whether it’s because of the yuan stance. Efforts to boost Chinese consumer spending will be a more effective way to address the issue, he said.

Roach has since 2007 served as senior representative of New York-based Morgan Stanley to clients, governments, and regulators across Asia. He was previously the investment bank’s chief economist. Before joining Morgan Stanley in 1982, Roach worked at Morgan Guaranty Trust Company and on the research staff of the Federal Reserve Board in Washington. He has a Ph.D. in economics from New York University.

Nobel Prize

Krugman has worked at Princeton University in New Jersey since 2000, previously serving at the Massachusetts Institute of Technology, the International Monetary Fund, and Yale University. He won the Nobel prize for economics in 2008 for his theories on world trade, and earned his doctorate in 1977 from MIT.

Premier Wen said on March 14 in Beijing that “I don’t think the renminbi is undervalued,” using another term for the yuan. “We oppose countries pointing fingers at each other and even forcing a country to appreciate its currency.”

The U.S. trade deficit was $37.3 billion in January. It has shrunk from a record $67.8 billion in August 2006 as American consumers slowed spending amidst the recession. Net exports have contributed to gross domestic product the past two years.

Five senators including Charles Schumer of New York and Lindsey Graham of South Carolina this week introduced legislation to make it easier for the U.S. to declare currency misalignments and take corrective action. The Treasury Department is set to decide next month whether to label China as manipulating its currency.

‘Height of Hypocrisy’

“Isn’t it the height of hypocrisy an American can articulate a particular position in its currency but the Chinese are not allowed to do that,” Roach said today. “Especially since they as a developing economy with an embryonic financial system need a currency anchor probably a lot more than more ’sophisticated economies’ like the United States.”

The U.S. envoy to China this week said that the “recent turbulence” between the world’s largest and third-biggest economies was part of “the natural cycle” and wouldn’t harm long-term ties.

“I am convinced that blue skies are already on the horizon,” Ambassador Jon Huntsman said yesterday in a speech at Tsinghua University in Beijing.

--With assistance from John Liu and Li Yanping in Beijing. Editors: Michael Heath, Michael Dwyer
To contact the reporter on this story: Chris Anstey at canstey@bloomberg.net
To contact the editor responsible for this story: Chris Anstey at canstey@bloomberg.net