The entire world economy is being held hostage to a dynamic in which China links the value of its currency to the value of the dollar in order to prevent the frictional unemployment and related disruptions that would be involved in letting it right. This is created too much unemployment in China, it’s depriving other poor countries of opportunities to grow, it underlies the Giant Pool of Money phenomenon, and it’s clearly unsustainable.

But nobody seems to have any really great ideas for turning this around. Krugman’s column says “behind the scenes [Obama] better be warning the Chinese that they’re playing a dangerous game” and Wolf frames his column as what Obama should have said to Hu, concluding “Did Mr Obama speak so bluntly? Probably not. Should he have? Yes, I think he should.” But I don’t think there’s any really strong case to be made that Chinese leaders are unaware of the problem here. Two different U.S. administrations have made the point, Dominique Strauss-Kahn from the IMF has made the point, Chinese officials are probably capable of reading major FT and NYT columnists on their own, etc. And that’s fine—the real jobs of a Wolf or a Krugman are to lay out the economic issues, not the diplomatic solutions. But the Obama administration and its colleagues in Tokyo and Brussels do need to figure out a way to make the needed rebalancing of global trade flows happen. That means diplomatic and intelligence resources, staff time at high levels, etc.

— In 2009, 42 percent of respondents say that the country is moving in the right direction.

— This figure is higher than in 2008 (38%). Similarly, 29 percent feel that the country is moving in the wrong direction compared to 32 percent in 2008, signaling a check on the trend of declining optimism that had been evident since 2006.

—The main reason for optimism continues to be good security which has been mentioned by an increasing proportion of respondents each year, from 31 percent in 2006 to 44 percent in 2009. More respondents in 2009 also mention reconstruction and rebuilding (36%) and opening of schools for girls (21%) as reasons for optimism than in previous years.

— Insecurity also remains the most important reason for pessimism, cited by 42 percent of respondents. However, the proportion of respondents that highlight insecurity in 2009 has fallen since 2008 when half of respondents (50%) emphasized this factor.

— Insecurity (including attacks, violence and terrorism) is identified as the biggest problem in Afghanistan by over a third of respondents (36%), particularly in the South East (48%), West (44%) and South West (41%). However, concern about other issues such as unemployment (35%), poor economy (20%), corruption (17%), poverty (11%) and education (11%) has increased in 2009 compared to 2008.

I think you can use this data to support a variety of policy conclusion. But it’s striking that the US debate between escalation and scaling-back tends to proceed from a shared assumption that Afghanistan is in a crisis point. But Afghans seem to think things are improving. Note also that corruption, which has been talked about a lot over the past month, rates relatively low on the complaint scale. In terms of unemployment it seems to me that the most helpful thing we can do would be to revise trade policies. Allow the duty free importation of Afghan textiles to the American market. See what it takes to persuade Turkey and India to stop putting such high taxes on Afghan agricultural products.

This kind of thing is very boring to talk about and isn’t amenable to David Brooks writing columns about how the real issue is whether or not Obama is manly enough to demand victory. But it’s really important. Poor labor market conditions make people disgruntled. In stable democracies they vote for opposition parties. In non-stable places they may take up arms.

I'm putting my money into American real estate! (cc photo by chi king)

But why weren’t there enough good, traditional places to invest that money? And by “traditional” I mean people who want to build factories or expand call centers or start up biotech ventures. That is, businesses that provide goods and services to meet demand from consumers and corporations. The supply side of the economy may have been going great guns, but the demand side wasn’t keeping up. This is why some people think it’s better to talk about this phenomenon as an “investment drought.”

Kevin offers an explanation for this that relates to the maldistribution of income in the United States. But isn’t the real issue here that the good investment opportunities were all in China?

That’s what was screwy about the global economy of the 2000s. For each and every one of those years, everyone believed that the short- and medium-term growth prospects in China were better than the prospects in the United States. And yet on net investment funds were flowing from China to the United States. Similarly, Americans had much more consumer goods than Chinese people, yet it was Americans borrowing money to finance present consumption. Borrowing it from China! That’s why Bernanke called it a savings glut.

But in a larger sense, this reflects the failing of the international financial architecture. The IMF wasn’t just created as a stimulus program for the makers of giant puppets—the architects of the postwar economic order thought the globe would be wracked by periodic crises without something to play its role. Nevertheless after the way the IMF handled things in the 1990s, Asian countries resolved to never again rely on the IMF and to instead start stockpiling dollars. But this effort to develop a workaround created a ton of problems. Bypassing the organization turns out to be a poor substitute for actually addressing the problems with it.

Last night at a roundtable for our nations’s elite, that is to say, “bloggers,” Richard Trumka, AFL-CIO President, implied, though did not say outright, that one consequence of the real estate bubble was that manufacturing and other types of businesses were finding it difficult to obtain credit at favorable terms. As I said, this seemed to be the gist of what he was saying though I’m not 100% sure that was his point. So I’m curious! How much was credit being funneled away from all other sectors in the economy?

I’m not sure that’s right. But what I think is pretty clear is that foreign purchase of over-valued real estate-related financial products was intimately tied to the high price of the dollar and the large size of the American trade deficit. All this meant less manufacturing. The alternative to the real estate boom was a cheaper dollar, less construction, fewer imports, more exports, less construction employment and more manufacturing employment.

That said, it is worth learning the lesson of this chart:

Despite what people sometimes say, until the recession hit it’s not actually the case that America was becoming a country where “we don’t make things.” More goods were being made abroad, but more goods were also being made here. Beyond the ups-and-downs of the trade cycle, manufacturing employment is being undermined by increasing productivity in the manufacturing sector. That’s good—more stuff to go around—but it means that the manufacturing share of employment will tend to decline over the long run no matter what happens with the price of the dollar.

The short term fluctuations around the trend are, however, really big. Imports, exports, and currency values matter a lot. A so-called “weak dollar” means manufacturing jobs and an economy brought back into balance.

Subway, Reykjavik, Iceland (my photo, available under cc license)

When I was in Nizhny Novgorod in 1998 when Russia defaulted on its debt, I remember a McDonald’s guy explaining to me that the company tried, when feasible, to make sure that expenses and purchases were happening in the same country. So you buy Russian potatoes with rubles and sell french fries in Russian cities for rubles. Icelandic agriculture isn’t going to be able to work as a McDonald’s supplier (great butter, though) so presumably they were importing tons of stuff and thus exposed to a great deal of currency risk. Perhaps if Iceland joins the EU and adopts the Euro, they’ll get their McDonald’s back.

Meanwhile, I wonder about other fast food outlets. The American fast food chain I went to in Iceland was Subway. Are they still there?

Toonie

A cheaper US dollar is almost certainly in the short-term interests of the United States as it will boost employment and help us get out of the recession. But perhaps more importantly, it’s in the medium-term interests of just about everyone, since it would set the stage for a rebalanced global economy. The problem is that it’s very hard to find any examples out there of “matching” countries whose leaders are excited about the prospect of more-expensive currencies and the enhanced consumption possibilities that would be opened up. For example, the Canadian economy has been a good deal stronger than the American over the past 18-24 months so the Loonie has shot up relative to the Greenback. This means Canadian citizens can afford more goods and services than would otherwise be possible, but it has PM Stephen Harper worried:

Some of the Canadian dollar’s sharp climb is justified by fundamentals but too rapid a rise could damage the country’s economic recovery, Prime Minister Stephen Harper said Tuesday.

“Obviously, it is a concern,” Harper told reporters, noting that Bank of Canada Governor Mark Carney had also worried about volatility in the currency.

He’s not wrong, exactly. Unfortunately with employment looking weak in pretty much every country around the world, no leader anywhere seems to believe that his country can withstand a large short-term increase in value. But eventually the shift has to happen, and I don’t really see what the way out is.

One reason for skepticism is that I’m actually skeptical that a properly implemented set of worldwide carbon border adjustments would actually achieve its intended purpose of boosting American manufacturing. After all, despite all the China hype we do much more trade with developed countries—countries with considerably less carbon-intense economies. Combining data from here and here I present the following chart of leading trade partners:

The EU, Canada, and Japan are in the aggregate much more significant trade partners than China/Mexico/Brazil. And the case for them charging us carbon tariffs seems about as good as the case for us charging the Chinese.

Something I was surprised I didn’t hear more of, but which I think I may take up as my own line on this subject, is that European integration has reached a point where it’s misleading to look at any one country’s balance-of-payments situation in isolation. I assume that there are some American states which, if looked at as individual states, would seem to be in a situation of perpetual imbalance. Washington State, for example, with Microsoft is probably a huge “exporter.” If you look at the Eurozone as a whole, things are perfectly balanced:

Of course at times the Eurozone will be running a surplus and at times a deficit, but looking at that line as a whole nothing whatsoever seems out of order. The next step in the analysis would be to see what happens if you break the United States or China or Japan down into sub-regions and look at their trade balances in isolation. My intuition is that you’d see wild differences from place-to-place comparable to the intra-European differences. But the correct way to look at these four is as two giant markets and two big ones, not as a whole array of medium-sized ones.

“If you look around, you see nothing but jobless people,” said Qari Imam, 30, who sells children’s clothing in the market here. “A lot of people who join the Taliban are jobless, too. If you want to stop the fighting, don’t send us more troops; build us more factories.”

Of course we could build a bunch of factories, but that wouldn’t do any good unless the factories had customers. If I’m reading these slides right then textile products made in Afghanistan are not eligible for duty-free sale in the United States. Changing that rule might encourage some factory-building in Afghanistan. Similarly we see here that some of Afghanistan’s key trade partners have very high tariffs on Afghan agricultural products. Perhaps we could persuade Turkey and India that they don’t need to be charging 50+% taxes on imports of Afghan grapes. India is Afghanistan’s largest export market right now despite those high taxes; changing it would open some additional economic opportunities for people.

The merits of this particular case aside, I think Henry Farrell is right to say that a win for Canada would probably spell big trouble for WTO fans. When foes of trade liberalization are able to make adorable baby seals the face of their cause, it’s hard to oppose them. This makes me wonder why the seal issue is being handled as a trade policy matter in the first place. In other words, why ban the import of seal products rather than simply ban selling seal products? Clearly the EU’s concern here is with the existence of a commercial market for dead seals rather than with the transnational flow of seals per se.

The reasons behind this trend are complicated. But one natural response to it would be to raise taxes on the very rich and use the tax revenue to finance public services. Under that scenario, everyone winds up better off than they were 25 years ago. Absent stepped-up taxation on the rich, changes in the structure of pre-tax income in the United States ensure that many—if not most—Americans see little actual gain from economic growth.

This is worth noting because outside the health care context, many morally admirable policies such as liberal immigration laws and openness to trade have the impact of both boosting overall economic growth and also exacerbating domestic income inequality. They’re also very good for poor people in the third world who want to have jobs in which they do stuff in exchange for money. Responding to growing inequality with ramped-up taxation and ramped-up social services makes these kind of policies more sustainable and serves the general interests of mankind.

Amidst the economic gloom, the Census Bureau reports that the trade deficit is declining:

The U.S. Census Bureau and the U.S. Bureau of Economic Analysis, through the Department of Commerce, announced today that total May exports of $123.3 billion and imports of $149.3 billion resulted in a goods and services deficit of $26.0 billion, down from $28.8 billion in April, revised. May exports were $1.9 billon more than April exports of $121.4 billion. May imports were $0.9 billion less than April imports of $150.2 billion.

Sustainable recovery requires some unwinding of the global trade and financial imbalances, so this counts as good news. Nevertheless, it’s still the case that exports are far below their pre-recession high point. The trade gap is narrowing because imports have collapsed even further and faster. And ultimately we’re going to need not just a smaller trade deficit, but several years of surplus. It’s a reminder that however much additional stimulus in the U.S. may be desirable, even better would be additional stimulus from Japan, China, Germany, and the oil exporters. Those are the places where the world really needs more demand.

Still, he’s right. And neglect of this point is what does give me pause about the talk of a third stimulus. It seems to me that where more stimulus is really needed is in the surplus countries—Japan, China, the oil exporters. Aggregate U.S. demand probably should fall from where it was pre-crisis—it’s the only way to rebalance an unsustainable situation. But that means demand needs to emerge elsewhere.

Good news for cheese lovers as the US and EU reach an accord on the crucial roquefort issue:

The new US administration has now agreed to drop the import duty threat, due to come into force this week, and which would have affected to a lesser degree a range of EU products, from truffles and mineral water to chewing gum. Under the provisional deal, the EU will keep the hormone-treated beef ban, which it claims poses a health threat, but will quadruple imports of non-hormone treated American beef in four years. In a joint statement, the US and EU trade representatives said: “An agreement is in our mutual interest.”

I agree, agreement is in our mutual interest. Good work negotiators.

The normally urbane and mild-mannered Pakistani Foreign Minister, Shah Mahmood Qureshi, was firm and spoke in categorical terms.

Meanwhile, Richard Holbrooke chatted quietly with Admiral Mike Mullen – an act that, whatever the intention, was perceived as rude and contemptuous by those present.

I’m told that this looked really bad in the footage shown on Pakistani television.

Someone recently made the point to me that when thinking about the so-called “Af-Pak” dynamic, it’s important to understand that in Afghanistan most of the population is basically sympathetic to the American mission there. In Pakistan, it’s a very different situation. It’s not as if the bulk of Pakistanis are “against us” in the sense of looking to hijack airliners and crash them into American office buildings, but the United States is generally viewed unsympathetically and our actions in the region are seen as harmful. One thing that could potentially help to turn this around would be for the U.S. to drop our barriers on imports from Pakistan, something that would impact Pakistanis lives in a positive way and not actually “cost” us anything.

Precisely paralleling an argument I had yesterday with a colleague, Jagdash Bagwati makes the case for seeing a linkage between support for free trade and support for the Employee Free Choice Act.

Bagwati’s basic point is that among the competing visions for how you could have a more egalitarian economy is, on the one hand, the idea that we need to sharply restrict imports. On the other hand, though, there’s the idea that we could remain open to trade and let the economy undergo its structural shifts while bringing more widespread unionization to the service sector. It’s not a fact handed down from god that the unionized firms are mostly in the manufacturing sector, it’s just that manufacturing was big during the period of time when U.S. labor law was friendly to union organizing. EFCA could create a new era of organizing-friendly labor law, and an opportunity to shift to an economy that features more decent jobs in the sectors that aren’t import-competing.

Steven Dunaway has a report for the CFR called “Global Imbalances and the Financial Crisis” which, as you can tell from the title, makes the case that global imbalances are key to understanding the crisis. He makes the case that these imbalances have been permitted to grow out of a kind of political laziness and that that trend must stop:

The United States has taken advantage of its position as the primary issuer of reserve assets to finance a growing current account deficit
during the 2000s. East Asian emerging market economies in general, and China in particular, have taken advantage of the second feature of the system. They have resisted upward pressure on their currencies and run large current account surpluses. Japan and Europe have made use of the third feature. Weaknesses in the value of the yen and the euro in the late 1990s and early 2000s contributed to the slow pace and inadequacy of structural reforms in labor and product markets, slowing economic growth and contributing to global imbalances.

I want to focus specifically on his claims about Europe. That Europe needs substantial labor market reforms is one of those things that “everyone knows.” Consequently, a tendency develops to say that substantial labor market reforms are the answer to every problem. So you’re worried about global imbalances? As far as the US and China are concerned, the story is pretty clear—unsustainable American consumption and a badly unbalanced Chinese economy. But what about Europe? Labor market reforms! But note right here that the timing is off. If I were to say “I’m thinking of a trend that came into being in the late-1990s and early 2000s but faded by the middle part of the decade” you wouldn’t say “he’s talking about global imbalances!” The growth of global imbalances doesn’t track the fluctuations of the euro at all.

And look at his own chart on page 15 of the report, which shows that current account surpluses in Europe don’t track the deficit in the United States:

I would further note that running a small current account surplus is exactly what you would expect a wealthy and rapidly aging region to do. Europe is both wealthy and rapidly aging. I’m not sure what else they’re supposed to be doing. Yes, yes, they’re supposed to be undertaking structural labor market reform. But what are they supposed to be doing about global imbalances? They seem to have things just right. It’s America and China that are out of whack.

Delving into the text:

Consumption-fueled growth in the United States fostered economic recoveries in Japan and Europe on the back of higher exports. Particularly in Europe, corporate profits rose. But problems in the structures of these countries’ economies—especially rigidities in product and labor markets—limited investment opportunities. The combination of high corporate savings and sluggish investment led to rising national savings and external surpluses (Figure 4)

Figure 4 is the bottom figure I reproduced above and, as I said, I don’t really know why you would characterize that as “rising . . . external surpluses.” I also have to say that I don’t think this “weak currency —> export-led growth —> reduced pressure for labor market reform” holds up very well to country-by-country analysis. It’s true that “Europe” has a current account surplus, but look at individual countries. These are the top ten current account surpluses in Europe:

– Germany: $254.5 billion
– Switzerland: $72.35 billion
– Norway: $64.07 billion
– Netherlands: $47.31 billion
– Sweden: $37.97 billion
– Austria: $12.03 billion
– Finland: $11.4 billion
– Luxembourg: $4.921 billion
– Denmark: $4.28 billion
– Belgium: $3.3 billion

Now note a couple of things about this list. One is that these aren’t just the top ten current account surpluses in Europe, it’s the only ten current account surpluses in Europe. And of them, two (Norway, Switzerland) aren’t in the European Union at all and a third (Sweden) doesn’t use the euro. More to the point, look who’s not on the list: France. The poster boy for European labor market regulations! Also Spain and Italy. Indeed, this list contains some of the countries with the most flexible labor markets in Europe (Netherlands, Denmark) while leaving out some of the most rigid labor markets. It’s true that Germany has inflexible labor markets and a large current account surplus, but there’s no wider pattern to that effect.

Long story short, there’s a case to be made that greater labor market flexibility in continental Europe would boost growth rates in the large continental economies. And that would be good for the world. But I don’t see any compelling reason to think this is particularly related to global imbalances.

To me, I think the scariest part of the current recession is its inherently global nature. For all the sturm und drang of our domestic political debate, there’s no way for us to get back to economic health without other people reviving their economies and consuming more. Given our massive pre-crash trade deficit, it’s just impossible to see adequate demand coming from the U.S. consumer. It needs to come from the countries that, pre-crash, were running big surpluses. Rich surplus countries like Japan and Germany need to, instead, run at least modest deficits. And a poor high-growth countries like China ought to running big deficits as foreign capital finances its development. That’s the way it’s supposed to work. But instead before the crash capital was basically flowing uphill.

Unfortunately, to do this right means you need actual international coordination of stimulus measures, the subject of my new TAP piece. There was some initial talk of this when it looked like Germany wasn’t going to do any stimulus at all. Then folks got sucked into our congressional debate, and Germany agreed to a modest stimulus. But that’s probably not good enough. They need to do a stimulus that’s really big relative to their GDP, and that needs to be part of a larger global coordination that has all the non-trivial players pulling in the same direction. There’s no precedent for that kind of thing. But the alternatives that there are precedent for—the Long Depression of the late-19th century and the disastrous war that ended the Great Depression—are really terrible.

By Matthew Yglesias

Everyone should read what Paul Krugman has to say about the idea of including “buy American” provisions in the stimulus. It’s not a crazy idea, but it is a bad one. What’s really needed is global policy coordination. Yes, some American stimulus funds will go to production in Canada and China and Europe and Japan. But some Japanese, Chinese, European, and Canadian stimulus will go to production in the United States. The alternative in which we buy American and the Japanese buy Japan and the Europeans buy European is quite a bit worse for everyone.

But this does require actual coordination. We can’t have the US buying American and Chinese and European and Japanese while nobody else buys anything. That’s not good for us and it’s ultimately not going to be good for them either. Indeed, while all countries need to engage in stimulus it seems to me that we actually need bigger stimulus relative to GDP from surplus countries like Japan, China, and German than we ourselves engage in. That means the administration needs to be engaged with the international dimension of the crisis. In bad economic times, the voting pubic tends to turn its attention inwards and lose interest in foreign affairs. But the truth is that in the modern world you can’t separate the economy from international issues. And it’s also true that the “explosions and corpses” aspects of foreign policy attract the most attention, America’s peaceful interactions with Latin America, Europe, and Asia have more impact on the average citizen’s life than do the elections in Iraq.

Via Tyler Cowen, a story about a trade war launched in the waning days of the Bush administration. On its own, this isn’t a very important issue to many people, but it illustrates a serious potential problem with including “Buy American” rules in the stimulus bill—a point to which I’ll eventually return. It seems that the European Union banned “U.S. beef containing hormones” (by which I assume they mean hormone additives, I take it that cows naturally have hormones). This, we felt, violated World Trade Organization rules. And thus entitled us to issue retaliatory tariffs on European products.

The way we do this is normally by slapping fees on imported luxury goods, because those normally aren’t inputs in U.S.-based production and don’t cause undue hardship on poor Americans. Thus, on January 13, U.S. Trade Representative Susan Schwab “imposed a 300 percent duty on Roquefort, in effect closing off the U.S. market.” Roquefort happens to be my favorite cheese. And the roquefort is not alone, the list of newly taxed goods “includes, among other things, French truffles, Irish oatmeal, Italian sparkling water and ‘fatty livers of ducks and geese,’ which apparently is how Washington trade bureaucrats say foie gras.” But the hammer’s come down unusually hard on roquefort:

But the cheese producers and sheep farmers around Roquefort do not see it that way. Only Roquefort got hit with such a high duty that it amounts to a ban, they complain. In their view, this unfairly undermines not only the economy of Roquefort, which depends entirely on cheese, but also the well-being of the 4,500 people who herd special ewes on 2,100 farms producing milk for Roquefort in a carefully defined oval grazing area across the Larzac Plain and up and down nearby hills and valleys.

The details of roquefort’s problem, the key issue is that in a “trade war” like this, everyone loses:

1. The Europeans won’t buy our beef. We’re mad.
2. So we refuse to buy their cheese.
3. This doesn’t help our cattle guys. But it does make me sad, since I love roquefort.
4. And it’s terrible for some French dairy farmers.
5. So maybe they’ll have enough political clout to persuade the Europeans to retaliate by refusing to buy a wider set of our goods.
6. At which point everyone is even more worse off.
7. Bad scene.

It’s a downward spiral of mutual retaliation that makes people on both sides of the Atlantic poorer.

Which brings us to the “buy American” concept. One problem with fiscal stimulus measures is that we don’t have a closed economy. So some of the increase in aggregate demand associated with a fiscal expansion will “leak” outside the borders of the country as the demand is met by imports. Indeed, a small open economy could conceivably reap all the benefits of a global trend toward stimulus without enacting any stimulus measures of its own. In other words, if the United States and Japan and China and Germany and the U.K. and France all enact big stimulus packages, the people of the Netherlands will reap some meaningful benefits even without spending any of their money. Under the circumstances, it’s natural that a big economy like the United States that can’t free ride might enact anti-leakage measure. That, in essence, is the purpose of “buy American” provisions in a stimulus bill. It’s an effort to ensure that the money spent actually goes to help Americans.

On its own terms, this is a perfectly reasonable idea. But European governments wouldn’t take it lying down. As in the case of the beef-cheese trade war, if we act like this they’re going to retaliate with measures aimed at hurting our producers. The we’ll have to think of further measures to hurt their producers. And much the same would apply to Japan and Chinese. This cycle of mutual recriminations will ultimately leave us worse off than we would have been if we’d just let the leakage happen.

What’s needed is a more direct solution to the leakage problem. We need international cooperation to ensure that all the substantial countries are pulling their weight in terms of reviving the global economy. Then we need to accept that, yes, some of our stimulus will leak out, but some foreign stimulus will leak in and it should roughly equal out in the end.