The Meltdown Lowdown, No. 10

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Dean Baker
The American Prospect Online, June 19, 2008

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This week in economic news: A Chinese central banker makes some very odd complaints, Wall Street bankers got bonuses for profits that we now know were bogus, and McCain doesn't understand what cap-and-trade means.

What Were China's Central Bankers Thinking?

The New York Times reports that China's WTO representative has been complaining because the United States has allowed the value of the dollar to fall. This drop has been very costly to the Chinese central bank since it holds close to $1 trillion worth of dollar denominated assets.

This complaint is, nonetheless, more than a bit bizarre. China's central bank has been propping up the value of the dollar with its massive purchases of dollars. The higher dollar in turn caused the U.S. trade deficit to grow (much of it with China), peaking at $760 billion, almost 6.0 percent of GDP, in 2006.

This huge trade deficit meant that more dollars were leaving the U.S. through trade than entering it. This increased supply of dollars in world markets would have lowered the price of dollars in other currencies (made one dollar worth fewer Yen for example) unless the central banks of China and other countries were prepared to keep buying and holding dollars.

While China took a bath on its dollar holdings, it has supported the development of its economy through the enormous growth of its export sector (a strong dollar makes Chinese goods cheaper for Americans). Given China's record of extraordinary growth over the last decade, this was arguably a good deal from its vantage point.

But now a high-level Chinese government official is complaining about the fall in the dollar. Didn't the Chinese central bank know that it was going to take a big hit when it was buying up hundreds of billions of dollars?

My own guess is that the Times got something wrong in the story. I very much doubt that China's central bankers did not know recognize that they would take large losses on their dollar purchases.

However, if the Times got the story right, we could have saved everyone a great deal of trouble a few years back if we just sat down with the Chinese central bankers and explained that dollar assets were a very poor investment. They then would have invested elsewhere, which would have allowed the dollar to fall 7 or 8 years ago. The trade deficit never would have grown to such enormous levels, and millions of manufacturing jobs in the United States could have been saved. See what a little economics education can do!


Those Wild Wall Street Boys and Their Wacky Profits

The New York Times does the numbers and determines that almost half of the record profits earned by the Wall Street banks in the 2004-2007 boom have already disappeared in debts gone bad . My guess is that we will see a big bite out of the other half in the months ahead.

We know that the top executives at these banks pulled in tens of millions or even hundreds of millions of dollars of compensation based on what we now know to be phony profits. In other words, these people got incredibly wealthy, not because they were skilled at finance, but rather because they were skilled at manipulating financial statements.

Now let's think about the steelworkers or autoworkers who lost their jobs because of trade agreements. Many of us have been concerned about getting these workers reemployed at jobs that pay comparable wages. Some have argued that retraining can get these workers back on a sound career path, while others question whether good-paying jobs exist.

Now we have the answer. If we can just make these workers skilled at manipulating financial statements, they can earn 7 or 8 figure salaries on Wall Street. If we also train them to donate money to the right politicians, they won't have to worry about serious sanctions if they get caught, and they may even be able to count on assistance from the Federal Reserve Board if things get too out of hand. This is what we call the "new economy."


Senator McCain Does the Rope-a-Dope on Cap and Trade

John McCain might be almost 72, but when it comes to ducking and changing positions, he can still move like a champ. After being co-sponsor of the McCain-Lieberman bill, which would place tradable caps on carbon dioxide emissions, McCain now insists that he only supports voluntary targets, not mandatory limits.

This one really is a mind-bender. Since the McCain-Lieberman bill proposes that caps can be sold from one company to another, why would anyone ever pay money for a voluntary target? This would be like the state police putting up signs for voluntary speed limits (you have the option to limit your speed to 65 MPH).


Baker Eats Crow

Okay, I got two predictions wrong. I expected that vanishing home equity would cause many families to save their tax rebates rather than spend them. It doesn't look that way. The retail sales numbers for May suggest that people were spending in a big way.

This is good news for the short-term. We wanted people to spend the money to give the economy a boost. However, it's not very good news for the longer term. We have a huge cohort of baby boomers at the edge of retirement who have accumulated almost no savings and just saw their home equity wiped out in the housing crash. If these baby boomers don't get in the habit of saving in a very big way very soon, they will be reaching retirement with nothing but their Social Security to support them. That's not a pretty picture.

My other wrong call was on the May inflation data. I bet the house that core inflation would begin to accelerate as higher prices at earlier stages of production would begin to affect prices at the consumer level. That may still happen in the months ahead, but it didn't happen in May.

There were several more surprises (see my Prices Byte) but the biggest surprise remains the slow growth in health care costs. For some reason, the rate of inflation in medical care has plummeted this year, with the annual rate of inflation over the last three months averaging just 1.8 percent, after coming in at over 5.0 percent in 2007.

I haven't seen any major changes to the health-care system that could account for such a rapid slowing of inflation which makes me think health-care inflation will pick up in the months ahead, as will other consumer prices. It's not going to be the 70s again, but it will be more rapid inflation than we have been seeing.


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer (www.conservativenannystate.org). He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.