Roach Shows Little Economic Understanding vs. Krugman

Includes: CNY, CYB, MS, UDN, UUP
by: Howard Richman

On March 19, Morgan Stanley Asia Chairman Stephen Roach responded to Nobel-Prize winning international economist Paul Krugman's March 14 call for a 25% across-the-board tariff on Chinese products. Paul Krugman, who had won his Nobel Prize for his contributions to international economics, had written:

Most of the world’s large economies are stuck in a liquidity trap — deeply depressed, but unable to generate a recovery by cutting interest rates because the relevant rates are already near zero. China, by engineering an unwarranted trade surplus, is in effect imposing an anti-stimulus on these economies, which they can’t offset.

Roach disparaged Krugman's analysis, arguing that America's low savings rate causes our trade deficit with China. reported:

Morgan Stanley Asia Chairman Stephen Roach said that Paul Krugman’s call to push China to allow a stronger yuan is “very bad” advice and that increased Chinese spending is a better way of reducing trade imbalances.

“We should take out the baseball bat on Paul Krugman -- I mean I think that the advice is completely wrong,” Roach said in an Bloomberg Television interview in Beijing when asked about Krugman’s call, characterized as akin to taking a baseball bat to China. “We’re lashing out at China rather than tending to our own business,” which is raising U.S. savings, Roach said.

Roach is making two arguments, both of them suspicious:

  1. China will buy more US Products. In 2009, the Chinese economy grew by 8.7% while the Chinese government kept purchases of American goods from growing at all.
  2. Low U.S. savings caused the trade deficits. Actually, Asian mercantilism caused both the trade deficits and the low U.S. savings rate.

Let me explain: In economics, trade deficits are caused when foreign savings flow into a country. There are two different types of foreign savings, private foreign savings and foreign government savings. Private foreign savings get pulled into a country when its interest rates are high. Foreign governments push their savings into a country, causing interest rates to go low. If you want to tell the difference, you need to look at the direction that interest rates are going.

Private Savings Caused Trade Deficits

A fall in domestic savings causes interest rates to go up, which pulls in private foreign savings and causes trade deficits. The graph below illustrates the trade deficits that occurred from 1980-1984 when Paul Volcker stopped monetizing the U.S. government's budget deficits in order to bring inflation down:

As a result of the increased demand by the Fed for bonds, real long-term interest rates rose from 2.3% in 1980 to 8.7% in 1984. In order to take advantage of our high real interest rates, private foreigners traded in their currencies for the dollar, strengthening the dollar which, in turn, caused the trade deficits.

Foreign Government Savings Caused Trade Deficits

The increased supply of foreign government savings caused our interest rates to go down from 1996 to 2005. In Trading Away Our Future, my father, son and I extrapolate the IMF's COFER database, confirming that the majority of savings flowing into the United States over this period came from foreign governments.

When the real U.S. interest rate fell to 1.3% in 2005, the US. personal savings rate fell to below zero as homeowners took out second mortgages on their homes to take advantage of the low interest rate. Until the mortgage bubble burst in 2006, Morgan Stanley (NYSE:MS) and other U.S. banks benefited from the inflow of foreign savings, which they were able to lend to American households and corporations. When the bubble burst, they were able to rely upon governments to bail them out. In December 2007, Morgan Stanley got an infusion of $5 billion in cash from the Chinese government in return for a 9.9% interest in the company.

American producers did not do so well as Morgan Stanley during that period. Our blue collar manufacturing workers lost millions of productive jobs that will never come back. Now the Chinese Government is insisting that American companies move their R&D and patents to China in order to participate in China's growing markets. If we do nothing, as Roach recommends, we will lose our productive white collar R&D jobs and have to join Roach in China if we want to prosper.

At the moment, Krugman is showing that he may deserve his economics Nobel Prize, but Morgan Stanley's Stephen Roach is not showing a very good understanding of international economics.

Disclosure: I own Chinese yuan through CYB