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A few comments on the news today regarding China.

• What appears common from all news sources is that by 2029/2030, China could eclipse the US as the world’s largest economy. As far as I can tell, this would require China to sustain an 8% growth rate for 20 years, assuming the US will sustain a 3% growth rate over the same period.

Really? I mean - really?

I have no doubt that China could pass the US as the world’s largest economy at some point in the future.  But doing it by sustaining a further 20 years of 8% annual growth? This is the same logic that got us into the housing crisis: assuming linear or consistent growth patterns that appear wildly out of balance with what will probably be a lot more random of a future.

Secondly, what no article did was discuss what this new economy would look like:

• Assuming the US and China had similar size economies, could China sustain a 6-10% current account surplus annually? This would mean in dollar terms a current account surplus annually of $800 million to $1.4 trillion.
• Where would this surplus come from? Japan does not run a current account deficit, neither does Europe on a whole. So that would point to the US, a consistent current account deficit country.
• But the US, while running a current account deficit, has never run a deficit this high. The highest the CA deficit has reached is roughly 6%.
• Current account deficits this high would point to one thing: A currency devaluation. Not just a gradual adjustment, but probably a shock. But a shock would not be good for China, which pegs its currency to the Dollar and relies on the US as one of its largest trading partners.
• A massive US devaluation would boost exports doing three things simultaneously - boosting US growth, decreasing its current account deficit, further increasing US growth, and finally, decreasing Chinese growth by increasing its imports.

All three effects would make it further difficult for China to overtake the US, especially assuming consistent growth under current policy regimes. Consistent growth doesn’t assume a shock, as discussed above. See the last two years as a current example. A faster way for China to overtake the US is to not only grow fast, but let its currency appreciate, as what we’re really discussing is GDP in Dollar terms. Letting its currency appreciate may slow down the export machine, but hopefully it will provide greater per capita wealth across the population.

Click below for the LSE report on the Future of Finance.

Link

As a follow up to my post yesterday on the Laffer Curve and Arthur Laffer’s defense of tax cuts spurring the economy, here is Paul Krugman today saying the same thing.

Look, three weeks ago, we couldn’t pass unemployment benefits (basic economic assistance) because it was a budget buster. Today,  Alan Greenspan thinks tax cuts will not pay for themselves. Yet the lobbying for tax cuts for the top 2% goes on.

C’mon. Enough is enough.

Ben Bernanke said the following in South Carolina:

“In particular, in the household sector, growth in real consumer spending seems likely to pick up in coming quarters from its recent modest pace, supported by gains in income and improving credit conditions.”

Let’s put this in perspective:

• We have roughly 15,000,000 unemployed people in the United States.
• To return to true level of structural unemployment, we need to create roughly 8-9 million jobs at a minimum.
• The average full time salary for full time workers is approximately $39,000.
• Thus, GDP must increase by $39,000 * 9,000,000 = $350 Billion

What could cause this? Based on Bernanke’s comment, one of two conditions could occur:

• Credit conditions could occur, allowing consumers to borrow against half of current savings ~ $707 billion and spend that entire amount within the United States (no imports).
• Income could increase by wages and salaries increasing by 6%, even though they have been unchanged since 2007 and real wages have remained flat for the last decade.

Unfortunately, I see it being incredibly difficult for either to occur rapidly without some sort of external boost.

I’m still blown away by Arthur Laffer and others espousing the benefits of tax cuts.  Here is discussing the benefits of the Reagan tax cuts, courtesy of the Wall St Journal:

“In 1981, Ronald Reagan—with bipartisan support—began the first phase in a series of tax cuts passed under the Economic Recovery Tax Act (ERTA), whereby the bulk of the tax cuts didn’t take effect until Jan. 1, 1983. Reagan’s delayed tax cuts were the mirror image of President Barack Obama’s delayed tax rate increases. For 1981 and 1982 people deferred so much economic activity that real GDP was basically flat (i.e., no growth), and the unemployment rate rose to well over 10%.

But at the tax boundary of Jan. 1, 1983 the economy took off like a rocket, with average real growth reaching 7.5% in 1983 and 5.5% in 1984. It has always amazed me how tax cuts don’t work until they take effect. Mr. Obama’s experience with deferred tax rate increases will be the reverse. The economy will collapse in 2011.”

Fair enough, but aren’t we forgetting Paul Volcker and his “War on Inflation”?

Look at fed funds rates during 1981, 1982 and 1983. We go from 19% in 1981 to 8.51% in 1983.

And CPI? We go from 10.3% in 1981 and 6.2% in 1982 to 3.2% in 1983.

So, I mean - C’mon.

But here are my two favorite responses to this:

• From Capital Gains and Games
• And Alan Greenspan from this Sunday’s Meet the Press:

“MR. GREGORY:  You don’t agree with Republican leaders who say tax cuts pay for themselves?

MR. GREENSPAN:  They do not. ”

So, let’s focus on job creating government policy that will get the economy going, without breaking the bank.

• Right now, required reserves at the Federal Reserve stand at ~$64 billion
• Excess reserves stand at slightly over $1 trillion, roughly equal to 7% of average GDP over the 2007-2009

In the Winter of 2008, the Federal Reserve faced a difficult decision:

• The overnight funds rate on reserves, the base rate the Fed controls, was set at 1%, but the traded rate was 0.14%. So, as predicted, the Fed slashed its rate by 0.75 points and starting paying interest on excess reserves.
• Today, the Fed pays interest on excess reserves equal to its targeted funds rate 0.25%. However, the effective rate trades between 0.10% and 0.2% according to market data from the FT, pointing to continued slack in the system.

What to do:

• GDP for 2007 was barely over $14 trillion. In 2009, it was $14.1 trillion. Assuming the US grows at 3% per year, mid-2010 GDP would have been roughly over $15.1 trillion. The difference between potential output and current GDP is the amount of money parked at the Federal Reserve, earning 0.25%.
• Stopping the payment on excess reserves could be a boost to growth of the economy. Banks will have to find a home for this money. However, faced with the uncertainty of the current economy, and an economy facing deflation, banks may simply continue to keep those reserves parked at the Fed.
• The only major use of this income in the short term, would be a new round of stimulus. Highly controversial, yet effective according to a new paper by Mark Zandi of Moody’s and Alan Blinder of Princeton. Consumers are saving more, 6.2% of their disposable income, equal to ~$700 billion. This is roughly $450 billion more than during normal times. Fair to say, this money is being parked at the Fed in the form of excess reserves.
• Suspending interest payments on excess reserves would almost certainly bring the effective rate to zero. Using the Taylor Rule, the difference between 0.1 and 0.0 would add 0.2% increase in GDP given current CPI - not much.
• Yet, cash earning zero would have to find a home. Maybe then it would be possible to fund a second stimulus. Ideas for this stimulus would be as follows:

1. Replacing all municipal buses and taxi cabs with clean burning natural gas buses and taxis made in the USA.  This would have a significant impact for both the natural gas industry as well as domestic manufacturing.
2. Expanding high speed rail for both passenger and freight transport (moving more post and parcel service onto high speed rail). Key links would be Chicago to Detroit and the East Coast as well as continued east coast service from Boston all the way thru Charlotte and Atlanta.
3. Increasing port capacity for greater exporting ability in Houston, New Orleans, Virginia Beach, Philly, New York and the entire West Coast.
4. Increasing rail capacity in the Midwest to make manufacturing easier (and cheaper) to move to the coastal parts of the country.

To be sure, the investments outlined above would be 2-5 years in duration, shifting the excess reserves to the right on the yield curve where the current 10 year treasury yield stands at 2.91%. But infrastructure investments are incredibly productive. All of these outlined above would for sure produce more than 2.91% over ten years in returns. It’s a bet worth making and funding worth investing.

• Mark Zandi of Moody’s and Alan Blinder of Princeton give an interview with Ezra Klein of the Washington Post on their new paper analyzing the effects of the Stimulus, TARP and other Federal Government efforts. Link
• Hank Paulson writes about the need for housing reform. Link
• Alan Greenspan has lunch with the Financial Times. Link

Four data points (from the Market Data section of the Financial Times) start the discussion:

1. Today, the US Dollar to Euro exchange rate is ~$1.29.
2. The one year (longest published out) Dollar Spot Forward is ~$1.29 as well
3. The ~ 1 Year US Treasury Yield is 2,99
4. The 10 Year Yield on a German bond is 2.75

Multiplying (1+.0299)^10 * 1.29 Divided by (1.0275)^10 = $1.32 to the Euro, suggesting the Euro is long term undervalued.

However, what about the following other Euro countries? Here are the following ten year yield and percentages of Euro Currency 2009 GDP:

• Austria - 3.13 (3%)
• Belgium - 3.36 (4%)
• Finland - 2.93 (2%)
• France  - 3.03 (22%)
• Germany - 2.75 (27%)
• Greece - 10.53 (3%)
• Ireland - 5.42 (2%)
• Italy - 3.99 (17%)
• Netherlands 2.94 (6%)
• Portugal 5.52 (2%)
• Spain 4.28 (12%)

By averaging the ten year yield based on the gdp of all Eurozone countries, we find the Eurozone 10 year yield is 3.57%

Multiplying (1+.0299)^10 * 1.29 Divided by (1.0357)^10 = $1.22 to the Euro, suggesting the Euro is long term overvalued. Adjusting this calculation for % of Public Debt to GDP, the value of the Euro drops to $1.21 to the Euro

What is the explanation?

Countries in crisis (such as Portugal, Spain, Greece and even Italy) have taken advantage of Eurozone financing for government financing. This purchasing has negated the need to tap domestic and foreign capital markets for purchases. This lack of foreign exchange has created a void for deciphering where the euro is truly in demand. This is further evidenced by an officer of BBVA’s notorious quote earlier this summer.

What this essentially means is that current account surplus countries such as Germany are forced to help out current account deficit countries such as Greece and Ireland. Yet the Eurozone has a current account deficit. If Germany and German banks are bailing out Greece and Ireland, countries such as China are only buying German bonds. This makes German sovereign bonds the “on the margin” security denominated in Euros sold and traded in foreign currency and not just in Euros.

The “marginally available” security is probably the major explanation why the Dollar Spot is valued closer to the Covered Interest Parity Calculation using the German 10 Year Bond than the composite of European Bonds.

The Austerity Debate, hosted by the Financial Times is definitely mandatory reading.

Within the Austerity Debate is a piece by Ken Rogoff, co-author of This Time is Different, which is also a must read.

Paul Krugman responds to Ken Rogoff’s piece here. That too is worth a read.

Martin Wolf, Economics Editor for the Financial Times, poses many questions on his Wolf Exchange.

I was particularly interested in Mr Wolf’s question on Current Account Deficits. I, like many others, responded to Mr. Wolf’s question. Here is Martin’s response, mentioning me, posted in his Exchange:

Current Account Deficits, I think, is one of the most important topics in economics. Therefore, here is my cleaned up version of his response.

Click on this link to view the response: avoiding-a-financial-shock-with-sustained-current-account-deficits. As I see it, the key is real productivity increases. In the long run, inflation and deflation won’t get you there. Would love to hear your thoughts.