It is ironic that the dollar has strengthened rather than weakened over the last year.

· The sub-prime mortgage crisis originated in the United States;

· The crisis has severely undermined the credibility of American financial institutions – both in the narrower sense that leading investment banks have now disappeared and in the broader sense that American modes of corporate governance have lost value as role models (rating agencies, accounting systems, executive compensation, and so on)

· The response in Washington has included further acceleration in the already-rising national debt plus an expansion of the US money supply and reduction in policy interest rates that, though appropriate, are unprecedented.

Under normal conditions, any country on the receiving end of three such bullet-points would see its currency go down in flames. Yet the dollar has appreciated.

 

The explanation is not a mystery. The world’s investors have in two years gone from inordinately low perceptions of (and aversion to) risk and illiquidity, to inordinately higher perceptions of (and aversion to) risk and illiquidity. Virtually all assets other than US Treasury bills look risky and illiquid. That there has been a flight to quality is not surprising. What is perhaps surprising is that US Treasury bills continue to be perceived as the safest of safe havens and the US dollar continues to be the preferred international currency. The flight to the dollar shows up in both the strength of the dollar and the low level of US interest rates. For those of us who warned that the unsustainable current account deficit could eventually lead to a decline in the international role of the dollar at the hands of the euro… that day is not today.

 

The most noteworthy flows into the dollar and into US treasury securities have for some years been coming in the form of purchases by foreign central banks. The People’s Bank of China reached $ 2 trillion in international reserves at the end of 2008 (actually 1.95 trillion), which it continues to hold predominantly in dollars. Other central banks among Asian exporters of manufactures and Gulf exporters of oil have been behaving similarly.     China’s leaders are beginning to worry that the debt is growing too large, and President Obama recently had to reassure them about the safety of US Treasury securities.  The American public is increasingly being made aware that the United States has grown dependent on the Chinese for its funding, that our interest rates will go up if they stop buying our treasury bills.  

     There is another irony, however. Even while the US has grown increasingly dependent on holdings of dollars by the People’s Bank of China, US politicians maintain their demands that the People’s Bank of China abandon its purchases of dollars. They don’t usually phrase it this way, because the logical contradiction would be too glaring. Instead the US policy has been, and apparently still is, that China should allow its currency to appreciate. But it is elementary economics that PBoC purchases of dollars over the last six years are the force that has prevented the Renminbi from appreciating. The American insistence that the RMB appreciate is an insistence that the PBoC should stop buying dollars.   Be careful what you wish for !

 

(The accompanying cartoon captures the idea… except that, as Shang-Jin Wei points out, the sign should really say “Float the Yuan” instead of “Fix the Yuan.”   And in fact the danger is that the dragon will at our request stop flooding us with liquidity.)

 

[Source: KAL’s cartoon From The Economist print edition - Aug 9th 2007 - Illustration by Kevin Kallaugher

http://media.economist.com/images/20070811/D3207WW0.jpg]

 

     The authorities in Beijing have in various ways taken some steps in the direction that Americans have demanded, allowing the RMB to appreciate against the dollar. I have written in the past on the details of what exchange rate policy the Chinese have actually followed over the last four years, and I plan to update that analysis in a successor post in two days.

 

     My position on what policy the Chinese should follow regarding the Renminbi has been roughly in the middle of a contentious range of commentators over the last few years:

 On the one hand, I have argued:

(i) that it is foolish for American politicians to place so much emphasis on this issue in our bilateral relations

(ii) that it is dangerous to ignore the flip-side implications for funding of US deficits, and

(iii) that it is unwise to use language such as “unfair manipulation” or “violation of international rules.”

On the other hand, I have argued that an appreciation was both

(i) in the interest of China, for a number of reasons, and

(ii) in the interest of the world, to help address the global imbalances problem.

 

The balance of arguments has now shifted. Overheating is no longer the problem for the Chinese economy that it was as recently as a year ago, having been pushed aside by an abrupt fall in exports. Global imbalances are no longer the most important problem for the world macroeconomy, having been supplanted by the inadequacy of demand. If American politicians are still inclined to make demands on China, it would be more logical to ask for increased fiscal stimulus. Given that China often reacts adversely to foreign pressure, however, perhaps it is just as well that American politicians have been asking for the wrong thing.

 

  

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It is hard to remember now, but mineral and agricultural commodities were considered passé less than ten years ago. Anyone who talked about sectors where the product was as clunky and mundane as copper, corn, and crude petroleum, was considered behind the times. In Alan Greenspan’s phrase, GDP had gotten “lighter;” the economy was becoming weightless, “dematerializing.” Agriculture and mining no longer constituted a large share of the New Economy, and did not matter much in an age dominated by ethereal digital communication, evanescent dotcoms, and externally outsourced services. The Economist magazine in a 1999 cover story forecast that oil might be headed for a price of $5 a barrel.

Since then, of course, we have seen tremendous increases in the prices of most mineral and agricultural commodities, many of them hitting records in nominal and even real terms (see graph). Oil is now well above $100 a barrel, and gold has just crossed the $1000 an ounce line.

The question is why.

There could well be merit to many of the explanations that have been offered for the rise in the price of oil. One is the “peak oil hypothesis,” and another is geopolitical uncertainty in Russia, Nigeria, Venezuela and – above all – the Gulf. Corn prices have been impacted by American subsidies for biofuel. And other special microeconomic factors are relevant in other specific sectors. But it cannot be a coincidence that mineral and agricultural prices have risen virtually across the board. Some macroeconomic explanation is called for.

The popular explanation since 2004 has been rapid growth in the world economy. The strongest growth has of course been coming from China and other recently minted manufacturing powerhouses in Asia, but the expansion has been unusually broad-based – including up to last year the United States and even a reinvigorated Europe. So growth has pushed up demand for energy, minerals, farm products, and other industrial inputs, right?

This reigning explanation now looks suspect. Since last summer the US economy has slowed down noticeably, and is probably entering a recession. Despite talk of decoupling, it is clear that other countries are also slowing down at least to some extent. In its most recent forecast, the IMF World Economic Outlook revised downward the growth rate for virtually every region, including China. The overall global growth rate for 2008 has been marked down by 1.1% (from 5.2 % in July 2007, just before the sub-prime mortgage crisis hit, to 4.1 % as of January 29, 2008). And prospects continue to deteriorate. Yet commodity prices have found their second wind over precisely this period! Up some 25% or more since August 2007, by a number of indices. So much for the growth explanation.

How to explain commodity prices up while the economy turns down? I will offer my answer in my next posting, tomorrow.