Fixing Global Finance by Martin Wolf

Martin Wolf is an associate editor and economics commentator for the Financial Times and a professor at the University of Nottingham. Fixing Global Finance began as a series of lectures delivered in 2006 at the Paul H. Nitze School of Advanced International Studies. It was published in 2008 but I think the majority of it was written when the stock market was at its 2007 peak. The ideas aren't new -- all of the important points can be found in Ben Bernanke's speeches and writings since 2005 -- but there's a lot of illuminating data and it's an interesting read. What follows is more of a summary than a review.

The subjects of Mr. Wolf's book are the global financial imbalances. America's $800 billion Current Account deficit and emerging economies' giant surpluses are not accidental. They are the result of export-led growth strategies in the developing world and currency market interventions. That America has been on the receiving end of these policies is due to its position as the global borrower of last resort.

The housing market collapse in the United States and the global recession are the results of these global financial imbalances. Martin Wolf has published this book at an appropriate time because some people still seem confused by what happened. President da Silva of Brazil recently blamed "white people with blue eyes" for the global crunch, and China has been pointing its finger at the US. The Chinese explanation is that greedy, stupid Americans who forgot how to save money are consuming all of the world's wealth by buying mansions and BMWs. The US is jeopardizing global stability, and 50 of its investment bankers ruined the world's economy (the only problem with blaming US consumption is that if it was "crowding out" foreign savings, we should see high real interest rates abroad. In fact we see very low real interest rates globally -- China is "crowding in" US consumption, not the other way around).

But those things were not the causes of the housing market collapse and they didn't ruin the global economy. Instead, it was the developing nations' Current Account surpluses that caused the collapse.

Think about this logically. I know that stories about liar loans are easy to understand and make sense, but picture this from China's point of view. China, as we all know, is the fastest growing country in the world. Why would China be sending its money to the US? Is the US a better investment opportunity than China? Of course not. When a nation has the investment opportunities that China has, it should be importing capital as fast as it can to grow. This isn't happening. Something is definitely wrong.

I'm not singling China out of the group; China's case can help us understand what's been going on. China has been running increasingly massive Current Account surpluses since the late 1990s. The world loves tainted milk and poisonous toys, so China exports them in bulk. Normally, when one nation runs such a large surplus, foreign investors buy the local currency and drive up the exchange rate. This makes the local goods less competitive and the surplus shrinks. The developing world has been preventing this from happening. China, Japan, developing Asia, oil-exporting nations, and the C.I.S. countries have been intervening in currency markets to keep their currencies low relative to the Dollar (this is the currency manipulation that politicians on Capitol Hill are constantly bitching about -- although they seem to single out China, who is only part of the problem). So, a manufacturer in China makes a wonderful piece of crap like these glasses, and ships it to Los Angeles County. Someone from Wal-Mart pays for it, and it winds up on a shelf in Framingham, Massachusetts. The Chinese manufacturer takes those Dollars (the Yuan is not an international currency -- this will change) back to China, where the People's Bank buys them from the manufacturer for Yuan (Chinese citizens are not allowed to own foreign assets anyway). The bank then sits on massive foreign currency reserves, and buys more Dollars on the open market to offset foreign investment in China. The Yuan stays weak, Chinese exports stay competitive, and occasionally the People's Bank needs to stockpile more Dollars to keep the Yuan down. Evidence that this is happening is easy to find. Since 2002 the Dollar has been losing value against almost all major currencies. Those nations with currencies that have not appreciated against the Dollar, and have simultaneously run up major foreign currency reserves, are the culprits. Like I said before, these guys are China, Japan, developing Asia, oil-exporting nations, and the C.I.S. countries. The oil-exporting nations were running surpluses thanks to high oil prices, but they're falling now.

How does this affect the US? This is the "global savings glut" that we keep hearing about. An artificially strong US Dollar hurts domestic manufacturing (we had the lowest Current Account deficit in the 4th Quarter of 2008 since 2003 thanks to a falling Dollar). This would result in high unemployment, but the Federal Reserve under President Bush pursued an expansionary monetary policy (interest rates fell to 1%) to create excess demand. This is what is meant by calling the US the "borrower of last resort." This excess demand consumes the surplus coming from Asia. If the Federal Reserve hadn't pursued this policy, it would have stalled the manufacturing sector in Asia and reduced the surpluses. We weren't being malevolent -- it would have also caused higher unemployment in the US. This policy of inflating consumer demand helped create the housing bubble and shrank our savings rate (does anyone want to keep their money in a Bank of America savings account paying 0.20% interest?). I emailed the author of the book, Martin Wolf, and he told me as much. The policies in the developing world are directly related to the housing market bubble in this country.

So what do we do? Well, the worst has already happened. A massive global recession is what intelligent policies may have been able to avoid. But what do we do going forward? If we are to sustain Asia's levels of production, demand there must be primed. It is unlikely that investment can go much higher (it is currently 40%, where investment in the US is 20% of GDP) so domestic consumption and government spending must make up the difference. If China had social safety nets and allowed its citizens to invest abroad, maybe as a nation it wouldn't save 59% of its GDP every year. In his book, Martin Wolf questions whether we need such a liberalized financial system in the first place. Everyone assumes that money should move around the world like free trade, but they're not the same and maybe shouldn't be treated as such.