from Follow the Money

Is Steven Pearlstein right?

January 1, 2007

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Steven Pearlstein’s column “Public debt, private wealth” argues that surge in demand for US financial assets from emerging economies – and overwhelmingly from the governments of emerging economies, not private investors -- be they Asian central banks or oil investment funds – has had a profound impact on the distribution of wealth in the US.    I agree.

Greenwich CT is partying (Goldman too) this weekend. Detroit, Michigan is not.   At least not in the same way.

Pearlstein writes:

These countries know that if they were to try to exchange all those dollars for their own currencies, it would drive down the value of the dollar -- and with it, demand by American consumers for all the things they sell. Rather than accept slower growth and higher unemployment, they have decided to keep their currencies loosely pegged to the dollar by investing those trade-surplus dollars in U.S. assets.

One obvious effect of this decision is to drive up demand for U.S. stocks, bonds and real estate, which foreigners have purchased either directly or through such intermediaries as hedge and private-equity funds. Their money was a significant factor in the tech and telecom bubbles of the 1990s, the current bubble in corporate takeovers and commercial real estate, and the just-ended bubble in residential real estate. Indirectly, it also helps explain why stock prices are at or near all-time records.

….  So what does this have to do with income inequality? Quite a bit, actually.

We've known for a long time that increased trade with low-wage countries depresses wages of workers who produce goods and services now imported. A trade deficit equal to 7 percent of economic output obviously magnifies that effect.

But as the trade deficit is depressing wages at the bottom, it is now boosting incomes at the top by significantly inflating the value of stocks, bonds and real estate -- assets whose ownership is concentrated heavily in the hands of high-income people. By buying and selling these assets, and borrowing against them, these people have been transforming their paper wealth into spendable (and measurable) income at a record pace.

Finally, let's remember that all this buying, selling and monetizing of assets has created lots of fat fees for handling these transactions or serving as financial intermediaries. Those fees, in turn, translate into eye-popping bonuses for Wall Street investment bankers, hedge fund managers and partners in private-equity firms.

The last few years have been very good for those who manufacture financial assets for sale to Asian central banks and oil investment funds.   But central bank demand  also ripples through the financial system.   When the PBoC buys an Agency bond from a US pension fund, that pension fund has to look for another investment – perhaps something like Felix’s beloved 200 bp and no-real-risk if you are patient CPDOs.  US financial firms now manufacture both the kind of assets that the PBoC and its ilk want – and slightly high yielding assets for US investors who want a bit more than safe bonds now offer.

The past few years haven’t been so good for those manufacturing goods, whether for sale in the US or abroad.   There is lots of competition from places like China – and for that matter places like Japan.  US automobile production looks set to shrink absolutely: the rise in Japanese production in the US won’t offset the fall in production by the formerly Big-3.  Morgan Stanley estimates 2007 US vehicle production will be about 1 million units less than in 2002-05.

I don’t want to over state things.   Not all US manufacturers compete with China – and not all U.S. manufacturers are hurting right now.  US exports have done well recently – particularly, I suspect, in sectors where US firms employ US labor to compete with European firms who use European labor.   Think aircraft.   Airbus has made its share of mistakes recently (A380 wiring ...), but Boeing finds life a lot easier with the euro at 1.3 than with the euro at 0.9.    

Toyota has done its share of things right recently (hybrids and the like), but it also is helped by a 115-120 yen …

It is also true that relatively few workers in the US are employed making things.  Most workers are in the service sector.  Many argue that the available of low-costs goods helps US workers generally– their wages from their work go further because manufactured goods cost so little.  Real wages can go up if nominal wages rise and prices are constant – or if nominal wages are constant and prices fall. 

However, looking only at falling prices for manufactures seems too narrow.  The available data suggests that median real wage growth hasn’t been all that impressive through out the economy – not just in the manufacturing sector.  See Janet Yellen’s graphs (Via the superb Menzie Chinn of Econbrowser).  Median wages are pretty flat; real compensation growth has lagged productivity growth.    

Service workers certainly benefit from low priced Chinese goods – at least to the extent that they aren’t competing in the labor market with workers released from the manufacturing sector.   But median workers also buy things like oil and houses – and their prices have gone up faster than most wages.  Looking just those areas where China has lowered prices without also looking at those areas where China has raised prices seems a bit unfair.    The American people aren’t all wrong (Hat tip, the New Economist and Drezner) – they aren’t feeling richer or more secure right now. 

China here is a metaphor for a host of countries that are selling goods cheap while buying US financial assets dear as a result of government policies.  

Of course, workers aren’t released from manufacturing just because of Chinese competition – rising productivity plays a role.   Look at agriculture.  Western and central Kansas haven’t been depopulated by Chinese competition; they have been depopulated by bigger tractors and better combines.   

But even with rising productivity, more folks would be employed in manufacturing if the US was exporting 17% of GDP and importing 17% of GDP – or exporting 15% of GDP and importing 15% of GDP – rather than exporting 11% of GDP and importing 17% of GDP.

China’s integration – and again China is shorthand for a host of countries with lots of underemployed people -- into the global economy was bound to be disruptive.  But I have a nagging feeling that a large fraction of the current disruption reflects not just China’s integration into the global economy, but the integration China’s integration into the global economy at what increasingly looks like an signicantly undervalued exchange rate.   

There is some disagreement on that point, I know.  But to my mind, any oil importer with a 10% of GDP current account surplus when its own economy is booming and oil is above $60 has a very undervalued exchange rate.  

China will exports about $1 trillion worth of goods in 2006.  Its exports are heading into 2007 with 30% pace of growth.    Think about that.    If that pace of growth is sustained, the increase in China’s exports in 2007 will top China’s total exports in 2001. 

Which brings me back to Pearlstein’s column.  There is little doubt that Chinese demand for US financial assets far exceeds Chinese demand for US goods.  

We don’t (yet) have great data on Chinese purchases of US debt for the past year.  But we do have good data for the year from June 2004 to June 2005.  During that period China bought about $185b of US debt, and roughly $50b in US goods.  I doubt the basic pattern changed significantly in the last 18 months. 

It isn’t hard to figure out why the past few years have been for those who manufacture debt than those who manufacture goods.   Over time, the US economy has become increasingly specializes in the production and sale of financial assets to the PBoC -- and a few other big accounts.

The data on China is better than the data on the major oil exporters.  But the same basic point holds.  The big oil exporters don’t buy many US goods.  Boeings, sure.  But not much else.    But they must buy a lot of US debt, albeit in ways that don’t register cleanly in the US data.  

Pearlstein notes surge in demand for financial assets has had a profound impact on the distribution of income and wealth in the US.    And these changes haven’t been – at least to my mind –simply the product of market forces.    

The oil exporters haven’t distributed the recent surge in oil revenues to their people and let their people decide how much to spend and how much to save – or allowed their populations to decide what kind of financial assets to hold.     No, they have budgeted for oil at say $30 or $35 (that’s changing) and put the difference between the budget price and the actual price on deposit with the central bank – or given it to the state oil fund.   The Saudi fiscal surplus was $70b in 2006 – almost half of the government’s oil revenues.  Most of that was put on deposit with SAMA – and used to buy debt securities.  Norway added $50b to its government pension fund.  Abu Dhabi and Kuwait had the capacity to add almost as much.   Russia’s reserves rose by over $100b – even drawing on its reserves to repay $24b of Paris Club debt. 

In these countries, the government saves, and the central bank or oil fund decides what kinds of assets to hold.

China is a bit different.  China’s government, unlike the oil exporters, doesn’t run a huge fiscal surplus -- though in the national accounts lots of government invested is financed by government savings.   China’s savings surplus comes from the household and business sector.   And, a by product of its peg, the PBoC ends up managing the chunk of private Chinese savings that is invested abroad.   If you look at the increase in China’s external assets recently, the lion’s share of the increase has come from the buildup of the PBoC’s reserves. 

Sure, the state banks and some state insurance and pension funds are adding to their holdings of external debt as well.  But it pretty clear most of the banks would prefer to sell their dollars to the PBoC and hold RMB if they had a chance.    While this demand technically comes from China’s private sector, it is still coming from the state controlled sector.

No matter.   The net result is the same.   Tons of demand for financial assets.   And more demand for dollar assets than one might reasonably expect, relative to say euro assets, because of various dollar peg and quasi dollar pegs. 

That most directly impacts the market for high quality assets.   

But its impact isn’t limited their.  Why can private equity funds, whether in the US or Europe, raise funds so easily in the leveraged loan market? (See Figure 17 in the IMF’s latest market update, with another hat tip to Dr. Chinn)   The fact that the international banking system is flush with deposits from central banks has something to do with it.  The BIS reports that monetary authorities deposits rose by 85b in the first ½ of 2006, a $170 annual pace.  Cheap credit for private equity firms helps support equity market valuations generally. 

Central banks aren’t big players in the more exotic bits of the corporate credit market.  I doubt the PBoC owns any CPDOs (yet).   But by bidding up the price (and bringing the yield down) of more conventional assets, emerging market central banks demand has contributed to a host of innovations – as other institutions are forced to search for yield.   That also supports the leveraged loan market.

Hell, some big oil exporters likely play both sides of the private equity game – the ruling family/ the country’s oil investment fund invests in a private equity shop, and the private equity firm effectively borrows – through the international banking system – from the central bank as well. 

I could go on and on.  

The key point is simple:  China and others emerging market governments haven’t just subsidized the consumers of their goods.  They also have subsidized those manufacturing financial assets -- the have-mores of the global economy.  

Wall Street should have lifted a glass to the PBoC as they toasted the new year.  The City should have toasted the Bank of Russia and a host of other oil state central banks …   Call it financial capitalism, 21st century style.

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