Sunday, April 25, 2010

Chinese exchange rate flexibility would affect the US

Published in The Tennessean, April 25, 2010

Chinese exchange rate flexibility would affect the US

by Richard J. Grant

Why did Treasury Secretary Timothy Geithner decide to delay a regularly scheduled report on international monetary policies? Apparently the report accused China of being a “currency manipulator.”

Such accusations do not make for easy relations, but they are made to achieve a purpose. Speaking before a congressional committee, Federal Reserve Chairman Ben Bernanke claimed that the yuan is “undervalued” and hinted that the Chinese do this deliberately in order to promote exports. He suggested that the Chinese should allow more flexibility in their exchange rate to “address inflation and bubbles within their own economy.”

Whatever faults the Chinese might have in their economic policies, accusations of currency manipulation are misleading. Most of the time since 1997, China has had a fixed exchange rate policy. Although from 2005 to mid-2008 the yuan was allowed gradually to appreciate, since July of 2008 it has been pegged at about 6.83 yuan per dollar.

As a policy choice, a fixed exchange rate is quite respectable. For the quarter century following World War II, the international monetary system was built on fixed exchange rates. Most currencies were fixed to the US dollar, which was fixed to gold.

That system ended for much the same reasons that could cause the yuan soon to float against the dollar. Many countries inflate their currencies for domestic political gain. By inflating the currency, short-term interest rates can be held down during politically important time periods. Also, inflation of the money supply weakens the currency relative to other currencies thereby giving a temporary advantage to domestic export industries, albeit at the expense of domestic importers.

This can lead to periods during which several countries are trying to compete by weakening their currencies. But this is a race to the bottom in which the "loser" appears to have the strongest currency.

Of course, any country that plays this game will have a weak currency compared to the values of real goods. Inflated currencies can appear strong only when compared to currencies that are weaker.

The postwar Bretton Woods monetary system of fixed exchange rates eventually broke down, not because other countries were inflating (though many were), but because the United States inflated the quantity of dollars beyond the value of its gold reserves. In other words, our monetary authorities failed to keep the dollar sufficiently backed by gold; and as a result, foreign central banks began to redeem large amounts of dollars for bullion. On being advised that we would have to either increase the official gold price or run out of gold reserves, President Richard Nixon decided to put an end to all gold redemptions.

Before August 1971, the dollar had always been defined as some quantity of gold. Since then, the dollar has been adrift, and it should have been no surprise that in the decade that followed, US price inflation rose as high as 14 percent. Interest rates went even higher.

Inflation was eventually brought down to low levels, and some countries have chosen to fix their currencies to the dollar. China is one of those countries, but there are at least two reasons why China is likely to allow its currency to appreciate relative to the dollar. The recent expansion of the US money supply threatens to cause price inflation in China; and US trade protectionists are exerting political pressure to demand that China appreciate the yuan.

This could precipitate at least a mild slowdown in China, though it won't be as bad as it would be if they were to delay. But here in the US, the result will be an earlier manifestation of increased price inflation and greater pressure on the Fed to raise its target interest rate.

If it must happen, the administration would want the Chinese to do it either before June or after November. They want the imagined protectionist benefit, but wish to avoid any disruptions just before the midterm elections.

Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail:

Copyright © Richard J Grant 2010

Sunday, April 18, 2010

High tax rates reduce trade value; we trade less

Published in The Tennessean, April 18, 2010

High tax rates reduce trade value; we trade less

by Richard J. Grant

There is a conceptual difference between having a job and doing something useful. The difference is found in the purpose and in the relative importance of one action compared to other possible actions.

If you were alone on an island, what would you do? If you wished to live, you would set about finding and making food, building shelter, and then work to provide for your next priority. If you wished to escape from the island, you might first estimate your location; then you would devise some method of communication and transportation.

In such a simple setting, it is clear that survival depends on work. Someone must do that work. If you are able to provide for your survival needs sufficiently that you can occasionally take time off to go birdwatching, then that’s fine. It is your choice. But if you approach your life as though you have a right to a full-time career in birdwatching, then you had better enjoy it while it lasts.

In a real society we are never truly alone: It is in our interactions with others that true economic relations develop. Working together, each of us can do more than could any one of us alone. We can help each other; we can specialize; we can exchange. We can even give gifts. But that does not change the fact that someone must do the work.

Not all work is equal. Alone on our island, it is perhaps easier to see that. But in a more complex society where we benefit from the division of labor and the ability to invest our savings, it is harder to see what is really happening.

If we invest our time and financial resources preparing ourselves to provide services that are not highly valued by those with whom we would like to trade, then the results of our preparations will bring us less satisfaction than we might have expected. Just as we hope that others will train themselves to be able to provide goods and services that we like, we will have an incentive to play that role in the lives of others.

This is the real reason that cooperation is so highly valued. This is how communities organize themselves. The key is that our interactions be voluntary and not restricted by those who would arbitrarily take options away from us.

It should be obvious that when we are free to live and associate peacefully with one another, unemployment would never be a matter of not being able to find work. Never in the history of mankind has there been a natural scarcity of work. Such would imply that we could have a shortage of needs and desires, a world in which everyone is satisfied with things just as they are.

Everyone that I work with seems to have more work than time to do it. We must all prioritize; we must all do the essential and most important tasks first. There will always be something left undone because there will always be something more that someone desires.

You say, "Aren't you ignoring the fact that we have a 10 percent unemployment rate in this country?" The real question is why are they unemployed when there is so much work to be done?

Higher tax rates reduce the value to us of our trades; we trade less. Arbitrary regulations prevent us from producing or offering services that others might be willing to pay for; so we produce less. These are all opportunities lost.

Most of the history we study really consists of people in government doing stupid things. They tax us; they regulate us; they send us to war. Each of those powers, although justifiable at times, gives them the power to destroy.

When the president and Congress promise us a new "jobs bill," let us remember how much they must destroy in order to offer us what little they create.

Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail:

Copyright © Richard J Grant 2010

Sunday, April 11, 2010

The Fed will find itself in a lose-lose situation

Published in The Tennessean, April 11, 2010

The Fed will find itself in a lose-lose situation

by Richard J. Grant

The Federal Reserve Board has a tiger by the tail. It knows it cannot hold on indefinitely; but it fears what will happen when it lets go.

They know that sometime this year they will have to allow interest rates to rise. If they don't, the result will almost certainly be an upsurge in price inflation. But members of the Federal Open Market Committee also fear that if they allow rates to rise "too soon," they risk precipitating more symptoms of recession and prolonged high unemployment rates.

Since late 2008, the Fed has been holding interest rates at artificially low levels to encourage borrowing and to prop up asset prices. But in order to do this the Fed has had to create a lot of new money. During that time, the monetary base, which is the most basic quantity of money, has increased by about 140 percent.

Under normal circumstances the Fed would never have dared to do this. The result would almost certainly have been double-digit, possibly triple digit, price inflation. But the circumstances were not normal: The Fed had already just taken us through a cycle of low interest rates to stimulate artificially a recovery from the collapse of the tech bubble. This was followed by a steady increase in interest rates from 2004 through 2006. The Fed's target, the Fed funds rate, increased from 1 percent to 5 percent. It is now close to zero.

Periods of artificially low interest rates subsidize borrowers at the expense of lenders. Credit is now cheap, if you can get it. Homeowners have been scrambling to refinance their mortgages, while those who depend on interest income, such as retirees, are suffering unexpectedly low incomes. This encourages would-be lenders to shift their funds into riskier investments that offer hope of higher returns.

The important point is that when the Fed interferes with interest rates, people react by taking actions that they would not normally take. Artificially low interest rates bias investors toward overestimating the profitability of their planned projects. That means that more projects than usual will turn out to be unsustainable.

During 2007 and 2008, as information emerged about the true extent of malinvestment in the real estate finance markets, related assets held by most financial institutions had to be marked down in value. Suddenly, many financial institutions found themselves to be undercapitalized and vulnerable to failure. They needed reserves.

The huge amounts of money created by the Fed were almost entirely taken up as reserves by the financial institutions. Although we hear much politically driven talk about the need for more lending, the Fed has been paying banks interest to encourage them to hold more reserves rather than to lend. This also explains why the Consumer Price Index has increased by little more than two percent, rather than rising at double-digit rates.

But prices are higher than they would have been. Had the Fed not injected huge amounts of cash, the financial institutions would have had to liquidate and write down larger portions of their assets. These liquidations, and the resulting credit contraction, would have precipitated more widespread price reductions than those that we actually witnessed.

Given that some prices are fixed by contracts while others would be free to fall, large unexpected changes in relative prices could have caused even greater disruption than what we experienced. But we haven't escaped; we have merely slowed down the adjustment.

As businesses reorganize and gain confidence, banks will have increasing incentive to lend again. To the extent that they shift reserves into loans, the broader money supply will increase. As this occurs the prices of more assets, particularly consumer goods, will be bid up. That is when we will begin to see increased price inflation.

The Fed will react by either withdrawing reserves from the banking system or by slowing down the increase. Either way, we will soon see rising interest rates.

Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail:

Copyright © Richard J Grant 2010

Sunday, April 04, 2010

Facts about health-care reform will doom the Dems

Published in The Tennessean, April 4, 2010

Facts about health-care reform will doom the Dems

by Richard J. Grant

The losers of intellectual battles, especially in politics, often resort to a “red herring” defense. They deliberately attempt to divert attention from the original topic by presenting the audience with a new, largely irrelevant topic.

The new topic is, figuratively, dragged like a real red herring across the trail to distract the pursuing hounds from the scent of the fleeing fox. In fox hunting this makes the chase more challenging. But in politics it is used to enable a devious faction to get away with bad arguments, or to lead voters’ memories away from the faction's most unpopular policy actions.

As the political battle over health-care reform finally came to a vote, it was clear that although the final bill passed both houses of Congress, most citizens were unimpressed and remained opposed. The defiance of the popular will, as well as the sleazy techniques employed to paste together what was clearly a bad deal, understandably aroused anger in the electorate. With the midterm elections only seven months away, the offending party needed a distraction.

Enter the red herring. Suddenly media attention focused on the angry reaction as if that were the real story. Those who clearly felt violated by blatant government intrusion into their lives were smeared with the imagery of violence and extremism. A paucity of evidence was not allowed to interfere with belief in the official thesis.

Once the health-care reform bill passed, it was possible to quantify the likely consequences for individuals and companies. It should have been no surprise that increased government interference in the medical and insurance industries would raise costs. Sure enough, reports appeared that younger workers would soon face higher medical insurance premiums as a result of the new law.

More notably came the rude news that the tax implications of the new law were forcing companies to take huge writedowns, totaling billions of dollars, against future earnings. AT&T alone took a charge of $1 billion, while Deere & Company and Caterpillar each reported charges of at least $100 million. These reports are required by law.

This outbreak of reality did not fit with the utopian imagery of health-care reform so carefully cultivated by the Democrats. How dare anyone point out that costs, particularly taxes, would in fact rise as a result of the reform? It wouldn't take long before everyone could see that the enacted health-care reform was really a budget buster and a job killer.

The immediate political response was to shoot the messengers. Henry Waxman lost no time in demanding that these rude companies justify their reports at April 21 hearings before his congressional committee. Let other companies be warned.

But reality won't quit: it is just a matter of how much will be revealed before November. Although the tax and regulatory burden of the reform will be heavy, the actual tax revenues generated will be far less than predicted. There is no way that those targeted for tax increases will stand still. They will reduce their tax exposure. Susceptible companies will shift to a more tax-resistant corporate form; high income earners will avoid taking capital gains and will make greater use of tax-protected investments; and some people will just trade off income for more leisure.

Taxes for health-care reform will be imposed several years before most of the promised benefits come along. This was arranged partly to help give the illusion that the reform package would be self-financing and partly, in the meantime, to help keep the operating deficit lower than it would have been. But neither of these goals is likely to be realized: costs will be higher and revenues will be lower than predicted.

Although we should be recovering from the recession, whatever prosperity we experience will be diminished by the extra ballast of government interference. In recognition of this, perhaps our November message to the Democrats should be, "So long, and thanks for all the fish."

Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail:

Copyright © Richard J Grant 2010