Monday, February 28, 2011

The last grownup.

Each time Ben Bernanke testifies before Congress, his job gets more difficult. Firmly ensconced between a rock and a hard place, Bernanke must defend the drastic measures he is taking as Chairman of the Federal Reserve Bank to support the economic recovery, all the while denying any extreme concerns that he might have, lest his words spook the bond markets and exacerbate the problems that are his to tackle.

But the extreme nature of current Fed actions—the quantitative easing strategy that essentially constitutes printing money to buy long-term bonds in an effort both to reduce long-term rates and flood the economy with liquidity—betray the depth of Bernanke’s concern. Looking back at a his seminal speech in 2002—when Bernanke laid out the extraordinary steps available to some future Fed chairman that would assure that Japan-style deflation could never happen here—one can read the full array of strategies Bernanke has now employed. However circumspect and positive he tries to be in his public commentary, his are the actions of one who believes the risks of falling back into recession, and ultimately into a deflationary spiral, are real indeed.

And he is not alone. The recently released minutes of the late January meeting of the Federal Reserve Bank Board of Governors indicate unanimous support for continuing the Fed’s QE2 strategy. Buried in the elliptical government-speak of the staff reports is the list of contingencies that the Fed Governors fear may yet drag the U.S. economy down into a deflationary spiral: Deepening financial market disarray in Europe; layoffs by stressed state and local governments; downside risks in housing prices; reversal of improving consumer sentiment; and slow job growth. And since that meeting, turmoil in the Middle East has spiked oil prices upward.

Congress, on the other hand, has largely moved on from the 2008 crisis. While Bernanke continues to warn of the risks of moving too quickly or too soon to reduce federal deficits, his words by and large are falling on deaf ears. Bernanke, a Republican Fed Chairman appointed by a Republican President, is now widely derided by new House leaders and their supporters who are in thrall of the Austrian school of economics that rejects both Keynesian theorists on the left and Monetarists on the right.

Harsher still have been the attacks from the international community. In the early months of the financial crisis, the Fed emerged as the world’s central bank, providing liquidity for U.S. and foreign banks alike to stem systemic failure. However, as the fear and panic receded into memory, protests escalated as the Fed expanded its efforts late last year. Bernanke, foreign leaders complained, was seeking to drive down the value of the dollar. He was seeking to build U.S. exports at the expense of other nations. He was seeking to export inflation and poverty.

Most shrill in its criticism was China, whose leaders and media decried Bernanke’s efforts and demanded that the Fed renounce its policies and strengthen the dollar. Yet, for all of those nations there was something far greater at stake, something that seemed to have been lost in all the noise: All of those nations—and none more so than China— depend on the strength and resilience of the United States economy for their own economic growth, and they have much to lose should the U.S. recovery fail. Instead of cries of indignation, some degree of introspection and patience should have been warranted from those foreign leaders as they consider what the future might hold should Bernanke fail.

But patience and introspection are commodities in short supply these days. Few in the United States seem to recall the turmoil in late 2008, when Hank Paulson begged Congress to act to save the financial system. Few seem to recall how the voices across the political spectrum and commentariat fell silent in the face of real and palpable fear of broad based economic collapse. The cavalier protests that Bernanke confronts these days are evidence of how quickly success in forestalling a greater crisis has engendered collective amnesia regarding that national near-death experience.

And the arrogant retorts from China strikes a similar cord. Despite the recent fanfare of China’s economy surpassing Japan in size, it remains a relatively poor country—on a per capita basis it is barely in the top 100 nations, sitting at 93 between Bosnia and El Savador according to IMF data. And the depth of China’s dependence on the U.S. consumer was laid bare following the 2008 collapse, as factories shut down and protesters quickly turned on the Communist regime, quieted only by an immediate and massive public works program.

Nowhere in the public declarations of Chinese leaders is the acknowledgement, the appreciation or the humility that might come with the recognition that without open access to the U.S. market, China has no path to becoming Japan, and the Communist Party will be hard pressed to keep its hold on power. Chinese leaders are quick to point to the excesses of U.S. consumerismtoo much debt and too little savingsignoring the paradox of their own dependence on that consumer excess.

Nowhere too is there any recognition of the unsustainability of the status quo. While the global financial collapse was precipitated by a housing asset bubble problems across the financial sector, it masked an accelerating problem at the center of the U.S. economy—the continuing erosion of the manufacturing sector that, for all the talk of the migration to a service economy, remains essential to sustaining the U.S. middle class wealth.

In the wake of the 2008 financial collapse, the U.S. manufacturing sector was in freefall, illustrated here in Federal Reserve data. The long run decline of the U.S. manufacturing economy was not news. The percent of the workforce employed in manufacturing declined steadily by decade—from 24% in 1970 to 21% in 1980 to 17% in 1990 to 14% in 2000—and this decline contributed directly to the lack of real wage growth for the middle quintile of the U.S. workforce over the past three decades.

However, despite these percentage declines, the actual number of workers employed in manufacturing was remarkably stable, declining only slightly from 19.2 million to 18.5 million from 1970 to 2000. In contrast, since 2000 manufacturing employment plummeted, as approximately 6 million jobs were lost by 2009, a decline of 33%.

The difference was China. Since 1970, U.S. manufacturers faced global competition from Germany and Japan to Singapore and Korea. Worker productivity steadily increased, as did manufacturing quality. Nonetheless, while the U.S. had negative trade balances with those countries that built their own economies through access to the U.S. market, by and large those trade balances remained manageable.

Trade with China has been another story, however. With a deep labor pool of very low cost labor and abundant capital provided through trade surpluses, the Chinese economy has grown steadily and driven manufacturing costs toward zero. Over the course of the past decade, trade with China eroded the U.S. manufacturing base. As illustrated here, as 6 million jobs were lost over the past decade, U.S. manufacturing income declined by 17% in real terms and imported Chinese goods grew in value from 6% to 20% of U.S. manufacturing income.

Perhaps most notable in this graph is the increase in the Chinese share of the total U.S. manufacturing trade deficit, which grew to 45%, or more than doubling, over the decade. For other countries that rely on free access to the U.S. market for their own economic development, this essentially meant that China, a relative new-comer to free trade, was rapidly squeezing out the rest of the world in the most important global market.

Central to China’s economic development strategy has been to peg the value of the renminbi to the dollar, and to carefully manage changes over time. Since the beginning of the Fed’s quantitative easing, the dollar has declined in value against the currency of the U.S.’s major trading partners, while the Chinese government has continued to resist pressure to open its currency to market forces.

Slowly, international opposition to Benanke’s policy has moderated, as other nations—Brazil most recently—have come to recognize that Bernanke’s fight is not with them, but with a Chinese regime whose predatory trade and currency policies will ultimately decimate their manufacturing sectors just as it has the U.S. And like Bernanke, they are beginning to realize that the future stability of their own economies depend on his success.

Last week, as oil prices moved over $100 and the Case-Shiller housing index turned downward, the hint of fear began to emerge that we are not out of the woods. But Benanke should not expect to see greater support for his efforts in Washington, as the 2012 election season is upon us. That’s just the way it is. Surely Ben Bernanke must know by now that if he succeeds there will be no acclaim or garlands, even as he understands that if he fails the consequences will be devastating.

Tuesday, February 08, 2011

Why now?

As we watch history unfold, the events that swirl around us are interrelated in ways we never could have imagined a generation ago. And so it is that events in Tunisia and Egypt can be seen as interconnected stories emerging from a single tableau.

For all of the stories wired in from Cairo of the yearning for freedom in Tahrir Square, the question of Why Now? is rarely addressed. Surely the predations of the state visited upon Arab populations by autocrats and secret police from Morocco to the Gulf are not news—at least not to the citizenry of those countries. Yet as blogs and bylines and televised reports reach us, their central narrative remains the yearning for freedom and dignity.

But Why Now?

In Tunisia, it was Mohammed Bouazizi, a food vendor in the city of Sidi Bouzid, who, after years of taunting and abuse by the police, immolated himself in rage and frustration, and ignited the storm that subsequently erupted. But it was the price of food that had changed Mohammed Bouazizi’s world, for the beatings were a regular feature of his life. And so too in Egypt, it is the price of basic foodstuffs—that consume as much as half of a typical family’s income—rather than the denial of basic rights that marks a material change in peoples lives.

Over the second half of 2010, basic food commodity prices have skyrocketed, with wheat and sugar prices up over 90% in six months. While many have pointed to supply and demand factors—ranging from growing demand in China to floods in Australia that threaten future wheat supplies—the fact is that commodity price inflation has not been limited to food.

If there is a simple answer to Why Now, it may be that the answer is less Hosni Mubarak than Ben Bernanke. In normal economic times, broad-based commodity price inflation would increase during periods of strong economic growth. But these are not normal economic times.

In the wake of the economic meltdown of 2008, it has become clear that the recovery of the world economy depends on successful return to growth in the United States. For all of the talk of decoupling Europe from the U.S., in the wake of the global collapse the U.S. Federal Reserve emerged as the de facto central bank of the E.U. And for all the talk of China rising, the collapse of U.S. consumer spending wrecked havoc on China in a matter of months, leading to widespread civil unrest and forcing the Communist regime to spend an amount equal to 20% of its foreign exchange reserves on a stimulus program to weather the storm.

By the middle of last year, Bernanke and the Fed broadened their efforts to push liquidity (read: money) into the system to forestall a recessionary "double-dip" and accelerate domestic job creation. This effort, known by the moniker Quantitative Easing, or QE2, basically entailed printing money and buying long-term Treasury bonds.

The response of the global markets to QE2 was an immediate understanding that the Fed's intention was to push down the value of the dollar to ease trade pressures and stimulate domestic growth, even as the Fed was counting on international investment to continue to fund U.S. deficit spending. In a massive game of chicken with the Chinese—and others whose national development strategies have been nothing less than dumping cheap goods into the hands of U.S. consumers—Bernanke was counting on international dependence on the U.S. dollar as the reserve currency to assure adequate continued flow of funds in the U.S., even as the dollar traded down in value.

To date, for all the complaining, from China to the Fox commentariat, Bernanke has thus far succeeded. International holdings of U.S. Treasuries have continued to grow in the face of a weakening dollar, the U.S. stock market has boomed and the economic recovery has been sustained. Even some vocal critics of quantitative easing have softened their views, such as Kansas City Fed President Thomas Hoenig, who recently suggested that the Fed would likely consider extending the program.

But if QE2 has been provoked little adverse reaction domestically, a more concrete impact of QE2 has been felt in Tunisia, Egypt and across the Middle East, where basic food price inflation has skyrocketed.

Despite all the talk about supply and demand factors pushing up food commodity prices, the recent price surge reflects the wave of speculative money flowing into commodities and gold, seeking protection against a declining U.S. dollar. As illustrated in this graph, since the implementation of QE2 in mid-2010, wheat and sugar prices—those foodstuffs most closely linked to Mohammed Bouazizi’s livelihood—have gone through the roof. While rising commodity prices have minimal impact on domestic U.S. inflation, it has a dramatic impact in less developed countries.

In Iran, fear of food riots made international news in December, as the Ahmadinejad regime sought to cut subsidies for fuel and food as commodity prices rose and further strained the national budget. And in Egypt, subsidy regimes that sought to provide low cost bread, oil, and sugar have provided little protection to the wide swath of the population—40% of whom live on less than $2.00 per day—as the price of food reportedly grew by 30% in the last six months of 2010, and the black market price of flour was 100 times the official subsidized price.

Food prices are not new as an instigating factor in popular uprisings, dating at least back to the American and French revolutions, and the price of bread can bring more people to the streets than the noblest of words. The ultimate indignity and humiliation heaped upon Mohammed Bouazizi was not the beatings that he grew to accept, but rather—faced with forces beyond his control— it was his inability to provide for his family, to fulfill that most basic responsibility.

For that humiliation, Hosni Mubarak may fall, like Tunisian President Ben Ali before him. But the story is not just about them. It also about the interconnection of the world in ways that we rarely think about, about how policies in Washington might affect traders in Zurich and, in turn, the life of Mohammed Bouazizi on a street in Sidi Bouzid. As we watch history unfold, and imagine what the next chapter might entail, the interdependence of our world should be neither ignored nor forgotten.