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Pearlstein: Globalization and the Dollar

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Steven Pearlstein
Washington Post Columnist
Wednesday, December 12, 2007; 11:00 AM

Washington Post business columnist Steven Pearlstein was online Wednesday, Dec. 12, at 11 a.m. ET to discuss globalization and how the dollar peg of China and the Middle East makes it harder for the Fed to control inflation.

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Read today's column: Inflation Echoes From Abroad

About Pearlstein: Steven Pearlstein writes about business and the economy for The Washington Post. His journalism career includes editing roles at The Post and Inc. magazine. He was founding publisher and editor of The Boston Observer, a monthly journal of liberal opinion. He got his start in journalism reporting for two New Hampshire newspapers -- the Concord Monitor and the Foster's Daily Democrat. Pearlstein has also worked as a television news reporter and a congressional staffer.

His column archive is online here.

The transcript follows.

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Shelton, Wash.: Is there some short definition of what it means to peg a dollar?

Steven Pearlstein: It means to jigger things in some way so that the exchange rate between the dollar and another currency remains roughly the same.

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Bordeaux, France: If countries such as China decide to "unpeg" from the USD what level do you feel the USD would drop to and how would this impact the US economy in say the next 24 months. Martin

Steven Pearlstein: You know, there is a lot of speculation on what would happen if you unpegged completely, but I don't think that is a really a very pressing question. And the reason is that you'd want to gradually undo the peg, and let the yuan trade in a wider range that could let it rise or fall, say, by 10 percent from the current exchange rate. And then 15. and then 25. Until you get to a pretty free float. The Peterson Institute folks, if I'm not mistaken, now calculate that the yuan is as much as 40 percent undervalued. The problem in making such predictions is that there are so many dynamic effects that would result, on economies and markets, from a unpegging that its really hard to say what an equilibrium exchange rate would be.

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Portland, Ore.: First, thanks for your timely and insightful pieces that help fill in the blanks for your readers on arcane, but important, issues. Yeah, your beat won't produce a Wilbon or a Kornheiser, but keep up the good work, anyway!

Here in Oregon, we all look to Asia, not Europe for what is happening. How do you assess the Chinese-US tit-for-tat over Chinese currency revaluation? Secretary Paulson appears to be so much more deft than Sec'y Snow was in his Asia dealings. How does Paulson interact with Congressional leaders on China currency issues: OK or badly? Thnx--

Steven Pearlstein: Yeah, Wilbon and Kornheiser get all the glory! Which is why my son is studying for a role in sports broadcasting, not financial journalism.

Paulson is probably doing as much as he can. I'm of the belief that the Chinese will drag this out as long as they can, and that Congress could speed the process by imposing some across the board tarriff on Chinese imports in retaliation for currency manipulation, that needs to be renewed every six months or so. I think that would change the dynamic of the conversations with Paulson. At first, they will retaliate some and get all huffy, but in the end, I suspect it will work to our advantage. We are too mutually dependent now that it is unlikely things will get out of hand.

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Boston: Is the Fed's announcement today of a coordinated liquidity injection with other central banks really a signal that the global financial markets are seizing? What's the balance between ameliorative actions and panic signals for central banks?

Steven Pearlstein: That's a hard balancing act for them, taking definitive action without causing panic. That is always the challenge of a central bank during a financial crisis. And I think they are handling it pretty well, frankly. The coordinated action by the central banks is indeed in response to a seizing up of credit markets as banks husband their cash in an attempt to increase their regulatory capital in expectation of even more writeoffs and losses. There will be more of this, although at some point the central banks will run up against the problem known as "pushing on a string,"-- offering lower-priced money that nobody wants to borrow. But so far, the overall strategy is having the desired effect of steepening the yield curve, which is the best salve they can offer to banks that borrow short and lend long. Helping them restore and enhance profitability for their basic business is probably the surest way, if not the fastest way, to getting the credit markets working again. They just need to do this is a way that doesn't reflate the asset bubbles that got us into this mess in the first place.

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Boston: So Greenspan basically says in a WSJ op-ed today that the housing bubble and mortgage mess "is not my fault". Is he right? Were we the Dutch buying pretty tulips? Can central banks no longer affect long term rates? Have all the derivative markets disintermediated them?

Steven Pearlstein: These days, he gets blamed too much for causing the bubbles. I say that, by the way, as the one Washington financial journalist who was probably more critical of Greenspan earlier and often than any other. But the fact is taht there were a lot of other things going on in the global economy and global financial markets that kept the bubbles inflated, diminishing the influence of the Fed and other central banks, as Greenspan today acknowledged (he didn't always, by the way).

That said, he could have leaned against the bubble much more, particularly using the Fed's power as a bank regulator. But in that, he was constrained by his own deregulatory ideology. He is also wrong, in my opinion, in saying you can't identify bubbles until they burst. I think that beginning in 2005, you could identify a real estate bubble and a mortgage finance bubble; in 2006 you could identify a private equity bubble and leveraged loan bubble. And simply warning about them, and taking regulatory actions in response to those bubbles, would have been useful in dealing with them sooner than the market did on its own.

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washington, d.c.: first off, thank you for making your columns accessible to those of us who do not possess PhDs in economics.

onto my question: how long can nations such as China tie their currencies to the dollar? It seems to me that at some point, that strategy will backfire.

Steven Pearlstein: Well, there is a limit on how long they can do it, as we now see. Without getting into the details, let's just say that all the market turmoil you are seeing is an indirect effect of their currency manipulation all these years with the currency of a large trading partner. It causes all sorts of other distortions in market economies and financial markets, and those distortions eventually cause problems that come home to roost. These may look like our problems at the moment, not China's. But if you look more closely, you see that China's economy is overheating, inflation is very high and rising, there are bubbles in its real estate market and its stock market, and things are looking a bit dicey for them as well. Because they are still a controlled economy, they think they can handle this and let the steam out gradually -- they raised bank capital reserve requirements to 14.5 percent the other day, which is very very high in an attempt to slow growth in credit and money. But markets have a funny way of correcting indirectly what they are not allowed to correct directly. All of which is a longwinded way of saying that the peg can't last much longer.

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Baltimore, Md.: Re inflation in the U.S. economy: Can you tell me why the government excludes food and energy costs from the so-called core rate of inflation? I would think few things are more "core" than these items, but they are supposedly kept out of the index because of their volatility. Doesn't that make the government's official numbers on inflation highly suspect? Thanks.

Steven Pearlstein: The government publishes all the numbers, so it is not trying to manipulate anything. The Fed over the years has come to look at core inflation as the key measure because food and fuel are so volatile that, if they were not excluded, you'd have monetary policy shifting too and fro in a way that would be counterproductive. But the problem is taht when you have a one-time, structural increase in energy and food costs, like we are having now, to ignore those factors is to miss the inflation story. And if those prices don't come back down -- which they won't significantly--then it means they will, indeed, feed into higher wages, which is like saying they are entering the main arteries of the economic bloodstream.

In the end, monetary policy is an art as much as a science. And it takes experience and judgment and some guesswork to figure out whether changes in food and energy costs are enduring or just statistical noise that needs to be filtered out.

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danvers, mass.: How do these rising prices look through a lens of "gradual devaluation" compared to a lens of "inflation"? I'm thinking we don't have the kind of labor cost push we used to have. And it seems the Fed is stuck between trying to defend the dollar or trying to avoid recession.

Steven Pearlstein: I'm not sure that defending the dollar is very high on the Fed's agenda. the simple notion that lowering interest rates will weaken the dollar I don't think holds during this period. It may, or it may not. If global investors think that rate cuts will keep the US out of recession, for example, it may make global investors more willing to invest in US stocks and bonds, which would mean buying more dollars than they otherwise would have, pushing the dollar up rather than down. On the other hand, if US rates get far below those of other countries, hot money will leave the US and go elsewhere in search of the higher yields. So this is really a tricky business. If other major central banks are also lowering interst rates, which is the case (with the exception of the European Central Bank, at least for the moment), then lowering rates to stimulate economic growth probably won't, in itself, hurt the dollar. But that doesn't mean the dollar won't fall for other reasons (in fact, it almost surely will over the next several yars). The question is whether it will fall more than it otherwise would have, which is a question for academic economists more than business people and traders.

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Freising, Germany: China and other nations have been huge investors of treasury bonds, which has in one way created an equilibrium between export giants like China and the giant consumer nation, the U.S.

Do you think that this equilibrium is in danger? Is there a risk of making things worse by untethering their currencies from the dollar?

Steven Pearlstein: This yin-yen arrangement between their surplus and our deficit was pretty stable for a lot longer than most people would have expected. But it was not sustainable in the very long run, as we are now discovering.

That doesn't mean that China is going to dump all its Treasury bills and Fannie and Freddie bonds. It means that as part of a gradual devaluation, China will be able to diversify its holdings of currency reserves and even begin to reduce those reserves, which are much higher than they need to be. What we are talking about is how to handle things going forward.

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Richmond, Va.: Re: the housing mess. There is a lot of anger from people like me who played by the rules, and I say: too bad Wall Street didn't like the latest quarter point (though they liked the half point they got recently). You know, I'm waiting for Wall Street to start talking about how the housing market got to be so harmful to the economy and to put pressure on those that were the villains of this crisis. Quarter point, half point, the whole thing is a bail out of these greedy, crooked (take your pick) mortgage lenders. When are they going to pay for what they have done? Citigroup didn't even pay -- got a bail out and are now more in debt to Abu Dhabi (do you think Americans would be shocked to learn how many foreign countries we are in debt to?). Why not just let the chips fall where they may for once? With such bail outs, there is absolutely no incentive to stop these nefarious lending practices.

Steven Pearlstein: Look, I'll be very frank with you. I understand your anger. But you are just wrong about the situation now. Nobody is getting bailed out. The shareholders of these companies ARE suffering big time (the matter of the top executives and their golden parachutes is another matter, but in the scheme of things it is not a lot of money). Look at their share prices. These reflect very serious losses, they reflect the fact that big chunks of their business have sudden disappeared, they reflect the fact that these companies have had to raise new equity capital, diluting the ownership shares of existing investors. Meanwhile, bondholders are looking at taking haircuts of 40 to 80 percent on some of this more exotic mortgage backed paper. What else would you want to happen? Capital punishment?

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Laurel: Steven, are we about to repeat the 70s? That decade's economics were set up by:

an inextricable war

major domestic programs without tax increases

worldwide dollar pegs

baby boom population demographics (the baby boom echo, begun in 1982, are the same age today that the baby boomers were Nixon closed Fort Knox in 1971)

I don't know if the position of China and India today vs. the recovery of the rest of the industrialized world after WWII is a worthy analogy or not, but we're certainly competing for import resources much more than we used to.

Steven Pearlstein: There are good parallels to the 70s. But the bigger truth is that these kind of parallels aren't particularly useful because so much about the economy and the financial markets has changed that things simply don't work the way they did back then, in very fundamental and powerful ways. We are on uncharted territory here. And nobody knows that better than the top folks at the Fed, let me assure you.

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Bowie: I'm not sure if this is part of the same issue (as today's column) or not:

The Fed rate reductions since summer have reverberated pretty directly in short-term U.S. Treasury rates, which have dropped from about 3.5-4 percent to about 3 percent since summer.

But other short-term rates, like LIBOR and ARM teasers have hardly dropped at all. They've just stayed where they are, showing higher spreads vs. Treasuries.

Two part question: Has the private lending market become divorced from the federal government rate due to increased risk premium; and if so, does this imply that Fed rate drops won't have their intended consequences (stimulate economic activity through lower interest rates throughout the market)?

Steven Pearlstein: You are asking the 64,000 question that is keeping the folks at the Fed up at night. Obviously, spreads over Treasuries are rising and this reflects a more conservative attitude toward risk as well as a shortage of liquidity in the non-Treasury markets, even as investors flock to the safety of Treasuries. And this is why the Fed has to focus more, as Don Kohn said the other day, on other strategies for dealing with the liqudity shortgage than merely changing the federal funds rate. They have to do things like this morning's coordinated intervention in money markets, literally pumping new money directly into the money markets. We are in a moment where the availability is the bigger factor, not the price of the money.

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Quito, Ecuador: How can investors take advantage of the weakening USD?

Steven Pearlstein: Invest in Ecuador! (Oops, maybe Ecuador's currency is pegged to the dollar, in which case that would be a very bad idea). But you get my point.

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Prague, Czech Republic: Now that Bush has killed the dollar and placed the country in systemic debt, what is the preferred scenario and what is the most likely scenario:

a) The China, The EU, IMF and the World Bank bail us out (Fantasy Solution).

b) US Gov't prints lots of money (Congo Solution).

c) Default on debt (Russian Solution).

d) Congress will raise taxes, lower spending and close military bases in Europe (fiscal sanity).

Steven Pearlstein: This is not a Bush thing, primarily. There will be no bailouts. The US government will either have to increase taxes or reduce spending or some combination of the two. And the IMF might be helpful, as Fred Bergsten suggested the other day in the Financial Times, by offering up its own reserve currency, called Special Drawing Rights, that countries could use as a reserve in lieu of the dollar, that would take some of the sting out of the transition as central banks shift from dollars and diversify their holdings.

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Washington, D.C.: You said that central bankers in dollar-pegged countries pay local currency to buy up excess dollars from exporters and inflate their own currencies. Considering the size of our current trade deficits, how does that not cause massive inflation in these countries? Thanks.

Steven Pearlstein: It causes inflation, but not massive inflation, because they try to "sterilize it," by issuing government debt that has the oppopsite effect of taking cash out of the economy. That works up to a point. But as you point out, these trade surpluses are now so enormous that the efficacy of the sterilization process has declined.

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Arlington, Va.: There's a lot of chaff in today's column. The dollar peg makes Chinese local inflation irrelevant to the United States. As long as they can only exchange yuan for dollars at a specified rate, it simply doesn't matter how many yuan are being printed. If the currency were revalued or allowed to float, then there might be a huge inflationary wave, but there's no sign of that happening.

Also, the falling dollar reduces the currency imbalance produced by the peg. It results in cheaper, overprinted yuan being traded for a cheaper dollar.

Your point that a falling dollar means higher import costs for the US is true as a matter of classical economics, but not true as to China as long as the currency peg remains in place. As long as the currency is pegged, swings in the dollar don't affect Chinese pricing.

What's really happening is that labor costs in China are rising, as the country starts to get richer. This will eventually defeat China's cost advantage, and it may force a revaluation of the yuan. But the safety valve here is the rest of the developing world: as soon as China raises the price of shirts and toys, Wal-Mart will shift its buying to Vietnam and Cambodia.

Steven Pearlstein: Ah, someone with a license to practice this craft!

Just because the two currencies are pegged, doesn't mean that China can't export its inflation, as I tried to point out this morning.

First, if its domestic prices are rising, it will need to charge more for its goods, and that translates into higher prices int he US for Chinese imports. Point One.

Point two, which is the more original one, is that there are indirect ways in which China exports is inflation. Creating asset bubbles here, for one. Having an overheated economy that bids up the price of commodities for everyone, including the US is another. I could have added another: forcing the euro and yen to rise higher than it would have, which means higher prices for American consumers for imports from those countries as well. And then there is the effect of a falling dollar on oil producers, who raise the price of oil even further to offset the declining value of their dollar-denominated oil receipts.

You have taken the classical view of this. I was suggesting this morning that, over time, it IS possible for China, with its pegged currency, to exports its inflation to the US.

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from Maryland: Hi Steven - enjoyed your "class" in international economics this morning! It made me realize how little I actually understand about this stuff. It would probably take too long to answer my question, but maybe you could point me in the right direction for an answer. Why would a country "peg" its currency to the dollar in the first place? And for those countries that don't, what do they do?

Steven Pearlstein: Many reasons. Middle East countries do it because their economies are based on oil and, for reasons of convenience, oil is priced in the currency of the largest importer of oil (that would be us). China does it for mercantilist reasons -- they want to be able to continue running trade surpluses even as they get richer and more productive, so they are willing to deny producers the full value of their output in order to put more rural people to work in the coastal cities. Latin American countries do it do protect their export industries but also because many of them have to borrow in dollars and having a peg prevents them from getting into problems that lead to default.

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Atlanta, Ga.: I'm having a hard time seeing this as our problem. The Asian countries, not just China, send us all these goods, charge us rock bottom prices, in US dollars, lend us the money to buy the goods, and eventually are going get paid back in cheaper dollars. America wins both ways. Now eventually someone here is going to have to pay back the loans, even if in cheaper dollars, but that not China's fault, it's us voters and congress for running the deficits.

Steven Pearlstein: One reason we run large deficits is that, by recycling its surplus, China allows us to do it. If they didn't recycle (i.e. throw cheap borrowed money at us), we wouldn't be able or so willing to live beyond our means. That's why a floating currency is the market mechanism for keeping trade roughly in balance.

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Bethesda, Md.: Steve: Hard for you to pick a more exciting day this week for the Chat. What's your take on the Fed's Term Auction Facility announced this morning? Can the Fed really push on a string and generate enough incentive for banks to start lending again?

Steven Pearlstein: A lot of this is psychological. If the banks feel more confident that the Fed and other central banks are there for them and willing to do what is necessary to prevent a meltdown, then they may loosen up a bit. Fear and greed, remember -- and this is the fear part. What we have here is a classic collective action problem. It is in the best interests of everyone if everyone would start lending again. But since no one player can force the others to do it, the rational response for any individual bank is to hold back. And when they all do that, everyone is worse off. So the proper role of government is to try to solve those kind of collective action problems, as the Fed did this morning.

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Brooklyn, N.Y.: Great article as always Mr. Pearlstein. John Stuart Mill once likened currency-pegs to a tributary relationship. By offering their goods and money at bargain-basement prices to us, the Chinas, Saudi Arabias, and Brazils of the world have in effect been offering tribute to Mr. Global Hegemon. But are we too quick to blame these tributary states for our own gluttony? Now it's one thing for these countries to offer some of their wealth for us to spend, it's quite another to actually accept and stuff our faces with this largesse. Alan Greenspan opened the floodgates by lowering domestic interest rates, and the flood of tribute has propelled our own standard of living quite a ways above we are capable of sustaining ourselves. All this time we kept taunting the EU and Japan about how much faster our economy was growing relative to theirs. But they didn't have all that tribute and stayed in subcompacts as we supersized our SUVs. Now the tributary states are exhausting their ability to nourish us as rampant inflation swallow their hard-earned gains. We are now staring at the prospects of (gasp!) a drop in our standard of living, which you'd think is what we ought to expect. By calling for the currency-pegs to end right now, you seem to be calling for shock therapy. I agree that we need to tighten our belts, roll up our sleeves and earn our way back to the top. But we've been fattening ourselves for so long that it's not so easy to just get off the couch and start making things that foreigners want (right now, 70 percent of our economy is geared toward our own indulgence right?). And thankfully, our federal reserve seems to understand this dilemma and is doing everything it can to keep pumping greenbacks into the economy. Of course, cash without tributary goods and money backing it up is worthless paper. But I guess out of control inflation is next year's problem.

Steven Pearlstein: Great summary. Thanks.

We're out of time, folks. There were many more comments that we couldn't get to. Sorry about that. I'll print a few here with (almost) no response.

Hope to "see" you next week.

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Burke, Va.: Good morning - this may be off-topic this morning, but a Post cover story on a Fairfax budget shortfall got me thinking.

Many homes in Fairfax county (mine included) almost doubled in value between 2002 and 2005. The real estate taxes going to fairfax would also double in that timeframe. Their budget must have increased substantially. Now that prices are decreasing or settling down, that portion of the county income is going back down.

But shouldn't we look at this as "the budget spiked for a few years" rather than "the budget will suffer for years to come."

We all assumed that real estate would not sustain that high level - why didn't the budgeteers prepare more realistically?

Steven Pearlstein: thanks for that.

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Charlottesville, Va.: Your essays are always interesting: Thanks. As you study and evaluate contemporary processes do you use the historical discussions of Kondratieff Long Waves as any kind of guide? The years 1857-8, 1907-8, and 1957-8 were all periods of abrupt crises of intense but short duration. In each case it was another 8-12 years before major crises and re-adjustments came about.

Steven Pearlstein: Thanks.

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Anonymous: Thanks for the article. Your writings makes it easy for layman to understand complex/arcane economics.

Do you think investment dollars will continue to go to asian countries due to economic slowdown in US?

Steven Pearlstein: Thanks.

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Silver Spring, Md.: Can the Chinese continue "sanitizing" their dollar hoards forever without increasing domestic (and now exported) inflation? There are still millions of very poor people in China and inflation is the worst enemy of the poor. They must be concerned about this aspect.

Steven Pearlstein: Thanks.

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Savage: How does the fact that China is not a free country in so many respects, impact the effect of pegging.

If Chinese people were as free as Americans (and owned most the wealth) to buy and sell currencies and international stocks and bonds, would the effect of pegging be different?

Steven Pearlstein: Yes.

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