from Follow the Money

Will the good cop (Hank Paulson) get results …

September 13, 2006

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Hank Paulson delivered his big speech on “the international economic system” today.    It was mostly about China.   That is not a surprise.  He is going to China next week.

It makes sense too.   The relationship between the US – and increasingly Europe – and China is the crucible that is forging the architecture of the international economic system.   Both the trading system and the financial system.

Some read Paulson’s speech as tough on China.  The NYT:

But he used unusually forceful language in saying that China has kept the value of its currency artificially low relative to the dollar. A growing number of economic analysts say China’s exchange-rate policies are distorting trade in its favor, making other nations’ goods cost more than they should in China while giving its own exports a price advantage in foreign markets. ….

“Maintaining and relying on an overly rigid exchange rate and outdated administrative controls increases the risk of boom-and-bust cycles,” Mr. Paulson said. “Also, to be underestimated only at China’s own peril, is the fact that their currency exchange rate is increasingly being viewed by their critics as a symbol of unfair competition.”

Some read it as soft on China.   Or at least soft on the currency issue.   The FT:

“The speech implicitly downgrades the importance of the Chinese exchange rate as a stand-alone issue, setting it instead as part of a necessary shift towards more market-based economic management.” 

I read it as cleverly trying to be both.

Paulson wants to remain the good cop – the old friend -- that China wants to deal with.  But he also wanted to remind the Chinese that there is a bad cop lurking around the corner.  

Paulson kept his language on the hot issue – the value of the RMB – rather muted.   No doubt, the “private message” will be a bit stronger.  I would certainly hope the Treasury has taken note that the RMB has depreciated in real terms this year even as China’s current account surplus has soared.

Paulson wasn’t just playing up domestic objections to increase his bargaining leverage.   The domestic pressure here is real.   And as China moves into auto parts (here too) and the US economy slows, it will only get stronger. 

Paulson is right to say:

“I was struck by the fact that some of the anti-trade sentiment manifesting itself outside our nation is turning into anti-China sentiment as more people in nations around the world are viewing China as a symbol embodying both the real and imagined downsides of global competition.” 

Paulson no doubt hopes – like all good cops – that China rewards his attempt to take a tiny bit of heat off the currency issue by doing a bit more.   I do too.

Otherwise, politics may end up setting the limits of the “cheap goods for over-priced IOUs” trade that defines our current brand of “globalization.” 

Paulson started his speech with a strong defense of globalization.  That shouldn't surprise anyone. Defending globalization has been a large part of the traditional remit of the Treasury secretary.  And it no doubt resonates with Paulson’s own experience.  He is among globalization’s winners.

But it was rather surprising that Paulson’s speech didn’t explicitly allude to any risks from the rising financial imbalances that have been associated with the current form of globalization.  After all there is no intrinsic reason why globalization implies that emerging economies should be financing the world’s advanced economies.   Yet that is what is happening now, on an unprecedented scale.  According to the IMF’s capital markets report, gross outflows from emerging economies topped a trillion dollars in 2005 – and the majority of those outflows came from central banks and oil investment funds, not private citizens.   

The net flow of capital out of the emerging world – total outflows net of private inflows – from the emerging world topped $500b in 2005, and it will be far larger in 2006.

Paulson’s speech sets him up as the Administration’s point person on all international economic issues, trade as well as finance – and as the administration’s leading China hand.     Fair enough.   He really is a China hand.  And the State and Defense departments are rather bogged down in the Middle East.   

I liked the fact that Paulson avoided the Bush Administration’s usual rhetorical style.  That plays better in Peoria than in Peking, so to speak (And yes, I do know that Peking is an achronistic spelling).    I liked that Paulson emphasized that the US would not gain if China's economy slows.   The US wants China to change the way it grows, not to stop growing.  And I liked Paulson’s recognition that “all nations need to search for ways to moderate income disparities and help those who lose their jobs to international competition.”

That doesn’t mean that I liked all aspects of Paulson’s speech.

The policies that Paulson mentioned to “moderate income disparities” and “help those who lose their jobs” were rather stale and thin.  “First-rate education” won’t help a 50 year old auto parts worker  …  

Paulson didn’t include “reducing the US fiscal deficit” and raising the US saving rate in his list of the United States own responsibilities as a stake-holder in the global financial system.

Technically, I don’t think “China’s astonishingly high savings rate” is only because China’s households face so many uncertainties.   The World Bank has convinced me that much of the recent surge in Chinese savings stems from a surge in business savings.  Household savings are high, but no higher than say in India.   But Chinese firms "save" so much that they have less need to borrow from Chinese households than Indian firms, so China has a current account surplus while India's doesn't.

And I was a bit concerned that Paulson may be putting a bit too much emphasis on domestic capital market reform and opening up China’s domestic banking markets to foreign competition and too little emphasis on currency reform.  He called on China to “modernize its financial sector” (code for letting Citi and other US financial institutions buy majority shares in Chinese banks, among other things) and to open up its capital account.  I would have dropped the call for capital account liberalization – as it makes it more difficult, not less difficult, For China to manage RMB appreciation.

More generally, letting US financial instituions operate Chinese banks won’t do much (if anything) to address the concerns of American auto parts workers.   Auto workers  are not going to retrained to provide financial services in China.  More generally, US banks do not generally plan to staff their Chinese operations with American workers.   "Financial modernization" may help the US financial sector's bottom line – but it may not do much to help moderate income disparities in the US.   The banking industry is not among those who have lost out – in aggregate – from new competition from China.

Above all, though, I was struck by the irony of the United States – and particularly the Bush Administration – emphasizing how important it is that all countries like up to their international responsibilities.   That was how Paulson framed US demands for economic reform -- China needs to live up to its global responsibilities.  And Paulson noted:

“Global economic leadership also brings with it responsibilities that go beyond the economic area, including international laws and conventions “ …

Wasn’t the Bush Administration elected, in part, to make sure that the United States own policies – including its economic policies -- weren’t subject to any global tests?

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