Airs - Ian Lance Taylor

The flow of money in the U.S. for the last several years has been as follows. Somebody in the U.S. buys something made in China. The dollars are aggregated and sent back to the Chinese manufacturer. The manufacturer converts them to Chinese renminbi at a Chinese bank at the government mandated exchange rate. The Chinese bank is required by the Chinese government to send the dollars to a couple of government controlled institutions. Those institutions wind up with a lot of dollars–a million dollars a day, or something like that. They take most of those dollars and use them to buy U.S. Treasury bonds. I may have some details wrong, but that is the general trend.

The Chinese goverment keeps this flow running smoothly by controlling the exchange rate. The exchange rate is lower than one would normally expect. This has the effect of keeping prices in the U.S. low: the dollars we send buy more renminbi than one would expect, which multiplies the effect of the relatively low wages in China. Conversely, it means that Chinese workers get less renminbi than one would expect, which means they have less ability to buy things made outside of China. Thus the policy encourages the U.S. to import goods from China.

However, most of the money actually winds up back in the U.S. By consistently buying U.S. Treasury bonds, the Chinese government is holding down interest rates in the U.S. This makes it easier for people in the U.S. to borrow money and buy more things, many of which are made in China. Without this money flow, the interest rates on Treasury bonds would rise. The U.S. government can not stop issuing bonds because it is so deeply in debt. If the money flow stopped, he effect would be that money in the U.S. would be diverted from productive investment into investment in Treasury bonds. It would be more expensive to borrow money. Of course, on the Chinese side, money in China is being forced into investment in U.S. Treasury bonds, rather than being used as productive investment in China.

So this flow of money is good for the U.S.–interest rates stay low, money is invested productively, the government can run a large debt without pain–and bad for the U.S.–goods are imported from China, discouraging local manufacture, effectively exporting manufacturing jobs to China. And the flow of money is good for China–lots of exports to the U.S. mean lots of local jobs–and bad for China–the money being made by Chinese workers is not being invested in China, Chinese workers can not afford to buy imported goods.

As a steady state, this is workable. Since workers in China are starting from such a low base, even the share of money and investment that they do receive is a significant improvement. It will take a long time for them to get up to the level of the U.S., when some adjustment would have to be made.

However, it’s not a steady state. The Chinese goverment is getting more and more dollars, and using them to buy more and more U.S. Treasury bonds. That process can not go on forever. Therefore, it must stop.

One good way for it to stop would be for the U.S. government to stop running a deficit. This is not silly–until the early ’80s the U.S. was the largest creditor rather than the largest debtor, and even recently the U.S. ran a surplus in the late ’90s. If the U.S. started to run a surplus it would stop selling Treasury bonds, and the Chinese goverment would find new things to do with their dollars. They could invest them locally in China, or, if they wanted to avoid the resulting inflation, they could invest them back in the U.S. in some more productive way. The accumulation of dollars in China would stop, and the bonds which the Chinese government currently holds would be paid off over many years.

That does not seem to be a particularly likely scenario at the moment. However, it is not impossible. If the next president is a Democrat, it is likely that the Bush administration tax cuts for the very wealthy will expire, and it is likely that spending on Iraq will decrease. These steps could move the U.S. economy back toward a surplus without significant harmful effects.

Another likely scenario is that the Chinese goverment stops buying U.S. Treasury bonds, and instead starts investing their dollars elsewhere. The U.S. government will still be running a deficit, and will still have to sell bonds. Interest rates will go up significantly. It will be harder to borrow money in the U.S. Investment will go down. The economy will slow down. People will have less money to spend on Chinese goods. The Chinese govermnent will accumulate fewer dollars.

A responsible U.S. government will break this money flow in a way which is advantageous, or at least not harmful, for the U.S. Unfortunately the current government is not responsible, and none of the candidates are talking about how they would handle this issue. The problem only gets larger over time. The sooner it is tackled, the better.

The Fed made a big cut in interest rates today. These days everybody looks to the Fed to fix all economic problems, but the funny thing is that they don’t really have very much control. Since the dot com collapse, the U.S. economy has been driven largely by the housing market. Homeowners were able to take out equity loans at low rates to get more money to spend. Since the housing market has collapsed, that is no longer possible for many people.

It follows that people are naturally cutting back on their spending. That means that stores are selling less, which means they are buying less, which means that manufacturers are buying less. The general effect is that more people get laid off, fewer people get hired, fewer people get raises and bonuses, and there is less money to spend. This leads to a slow downward spiral. Of course it won’t go down forever or even necessarily all that long. But it will go down for some time.

Now, if mortgage interest rates start to drop, then people will continue to be able to borrow money on their houses, and continue to be able to spend it (only qualified people, of course–no more subprime borrowers). Also business will find it easier to borrow money to invest. That is what the Fed is trying to do by cutting their rates: make it easier for people to borrow and spend and invest, to move the economy from a downward spiral into an upward spiral.

The funny thing is that the Fed has been lowering rates for a few months, but the rates for mortgages and other borrowing haven’t dropped. That’s because the subprime mortgage debacle has made the big lenders nervous about lending money. They are worried about maintaining reserves for the loans they have out, and they’re worried about whether they will be able to sell their debt to others as they have gotten used to doing.

Having the Fed drop their rates isn’t going to make the lenders any less nervous. It’s not that they don’t have the money; it’s that they are scared to lend it. There is a point at which they will happily borrow from the Fed and lend to others at lower rates then we have today; I don’t think we’ve reached that point yet.

Ethical investing is the practice of not investing in companies which engage in ethically reprehensible behaviour. There are many varieties, but, for example, some people refuse to invest in companies which sell tobacco. Does this make any sense?

There are presumably two goals here. One is to punish companies which act badly, in the hopes of changing their behaviour. To other is to discourage companies which currently behave well from starting to act badly, and similarly to discourage new companies which act badly from being created. Pragmatist that I am, I’ll neglect the “dirty money” issue: you feel better because your income does not come from contaminated sources.

For an existing company, when a pool of people refuses to buy shares in that company, it is possible for the share price to go down. Whether it really will go down depends on a number of factors. As I’ve written elsewhere, share price is largely a hallucination. It is rarely governed by any sort of supply and demand. The share price is a reflection of the perceived value of the company. If we assume that no more than, say, 25% of available investment money refuses to buy shares in the company, I see little reason to assume that the lowered demand would have any effect on the share price. However, it is certainly possible that a well-known share boycott would tend to make the company look bad, and push the share price down for that reason.

What is the effect on the company of having the share price go down? It becomes harder for management to raise money in the public markets, and it becomes harder for them to acquire other companies for stock. Executive management these days is generally paid in stock, so it becomes harder for the company to recruit executives from outside. It has no significant effect on sales or profitability.

These seem to me to be fairly weak long-range effects. Companies do often work hard to prop up their share prices, because it benefits the executives. However, as noted above, increasing demand for shares need not directly lead to an increase in share price, and it takes a long time to change a company’s image. If the undesirable behaviour is profitable, it is unlikely that a company would change it merely to prop up the stock price.

With new companies, the issue is different. Share prices during an IPO do have a lot to do with demand. On the other hand, only wealthy investors participate in IPOs; the behaviour of the average investor is irrelevant.

So it seems to me that if the goal is to change company behaviour, ethical investing is not very useful. It would be better to take steps to make the unethical behaviour unprofitable or illegal. It would be better to get wealthy investors to sign declarations that they will not participate in IPOs of unethical companies. Ethical investing might make you feel better, but I think it will have little practical effect.

Paul Krugman recently admitted that in some limited cases free trade is not a good idea. This an interesting admission from an economist who in the 90s was a strong proponent of globalization and free trade.

I’ve thought for some time that free trade, and free flow of capital, without free immigration, leads to a race to the bottom. The country whose people are willing to work for the least amount of money, including the least amount of required regulation, will tend to attract factories. Since manufacturers are well aware that it may be economical to move to another country soon, they minimize the investment in the country and the people. Money does flow in, but not very much. If the workers start to demand higher wages, the factories move. Other countries have a strong incentive to ask for even less money, so that they will at least get something rather than nothing. The general trend is that wages go down and prices go down. This is good for the customers, but not good for the workers.

Since the factory workers are not the customers–in fact, they live in different countries–this cycle is difficult to break. The only ways I see to break it are global labor regulation, or global labor organization (which requires support from local governments), or customer demand for global fair labor practices. There is some of the latter, but not much as yet–there is fair trade coffee, but no fair trade toys.

Unfortunately I suspect that Krugman has lost his credibility with the people who need to listen to him on globalization.

When capitalism is working well, it unleases the creativity of everybody in society. Because capitalism specifically rewards people who do what other people want, and because it gives everybody the freedom to try and fail, the effect is that society as a whole gets steadily better at giving people what they want.

Of course, that was a simplification. Capitalism provides rewards in the form of money. Doing what other people want is one good way to get money, and that is the strength of capitalism. The weakness of capitalism is that there are other ways to get money, and the freedom required to make capitalism work also permits those other approaches to occur.

These problems arise when a small number of people make money by doing things that a majority of people do not want to happen. One myth of the market economy is that these things can not happen, or at best can only happen on a very temporary basis. But of course that is false. There are two obvious continuing failures of this sort.

The first occurs when costs are not properly accounted for in the market. The most obvious effect here is environmental: for example, Maxxam Lumber, in which the market capitalization of the owner of an old forest became less than the market value of the lumber. Thus, the forest was cut down. If the value of the forest had been counted as more than the value of the lumber in the market, this would not have happened. Another example is computer security: the costs of insecure software are borne by the customer, not by the maker of the software. Since the customer does not have the expert knowledge required to identify secure software, and since writing and testing secure software is more expensive, the effect is that software is insecure. If the security costs fell on the software maker rather than the software customer, software would be secure.

Another obvious failure mode of capitalism is insider trading. By exploiting private information and manipulating public information, a small minority can make enormous profits at the expense of a large majority. For example: CEO salaries. For another example: capture of regulatory agencies by the industries they regulate, which shows itself most obviously in the cycling of people between low paying government jobs and high paying lobbying jobs.

There are of course ways to correct for these issues. And no known social system is perfect. But with capitalism, the same characteristics that make it good for society when it is working well make it hard to control when it is not working well. Just as people have a strong incentive to do what people want, they have a strong incentive to beat the system when possible. Their interest in beating the system is going to tend to make them move faster and think harder than the people trying to stop them.

Götterdämmerung capitalism is what we get when the accelerating efforts to beat the system get ahead of the regulatory efforts to fix the system. We get a system which moves so fast that it destroys itself. The interesting question for today is how fast we are headed in that direction, and which side is going to win.