Monday, January 21, 2008

Banana Dollar

The term "banana dollar" owes its origin to the ten-dollar bank note issued during the Japanese occupation of Malaya between February 1942 and September 1945. The obverse side of the note had a picture of bananas hanging from a palm tree. (One and five-dollar notes only displayed coconuts.)

The pre-occupation Malaya dollar was a standard currency board bank note in which each locally-issued note was backed by an equivalent value in sterling, set at M$1 = 2s. 4d. sterling, held in London by the Board of Commissioners of Currency Malaya. Japan chose to issue money in the currency of its occupied territories: Occupation money in the Philippines, Netherlands Indies, Burma, and the British Islands in the Pacific was designated, respectively, in pesos and centavos, guilders and cents, rupees, and pounds and shillings .

As Japan’s defeat became imminent, the banana dollar fell precipitously in value. Banana money thus came to signify a rapidly depreciating currency.

This historical footnote bring us to the U.S. dollar. Good as gold for much of its history, the U.S. dollar began to fluctuate in value after 1971 when President Richard Nixon closed the "gold window," the promise to exchange an ounce of gold for thirty-five dollars in U.S. currency. Since then the value of the U.S. dollar has fluctuated.

From January 1, 2001, to January 18, 2008, the dollar lost 54% of its value against the euro, 30% against sterling, and 32% against the Swiss franc. It has remained relatively stable against the yen, which reflects Japan’s weak economic performance during these years. The principal cause of the dollar’s decline is large U.S. current account deficits, $800 billion in 2007 alone. In order to correct this large deficit, the dollar must fall against foreign currencies to cheapen the price of U.S. exports, thereby increasing foreign demand for U.S. products, and raise the price of imports, thereby lowering U.S. demand for foreign goods. Due to the high cost of imported oil, about $500 billion a year, the falling dollar has made little headway in reducing the trade deficit. Foreign central banks and other holders of dollars have been losing trust in the U.S. dollar, gradually diversifying into other hard currencies. Russia’s large earnings from natural resource exports and China’s large trade surpluses have pushed the ruble up 23% since 2002 and yuan up 12% since July 2005. They stand to join the ranks of hard currencies in the not-too-distant future. How embarrassing for American tourists to learn that tickets to visit the Taj Mahal and other museums in India can no longer be paid in dollars, but only in rupees!

The expected decision of the Federal Reserve Board to cut interest rates at its next and perhaps following meetings, reducing returns on dollar-denominated bonds and other financial assets along with raising the specter of inflation, could make dollars even less attractive.

The dollar has gone from good as gold to a lower and lower valued piece of paper. Is it only a matter of time till a freshly designed Federal Reserve Bank note has a picture of bananas on it?

Monday, January 14, 2008

China and Kuwait to the Rescue of Citigroup

The sub-prime mortgage mess has blown huge holes in the balance sheets of America’s leading financial institutions. Analysts project that Citigroup will write off as much as $20 billion and Merrill Lynch between $10-20 billion in losses in their next quarterly reports. To restore their respective balance sheets, Citi plans to raise up to $14 billion and Merrill Lynch billions more.

Of the money for Citi, China’s government-owned and directed China Development Bank is projected to provide $9 billion, with the Kuwait Investment Agency and other public investors the balance. Kuwait is also prepared to put $4 billion into Merrill.

In 2007 China’s trade surplus with the rest of the world, largely concentrated in Europe and the United States, amounted to $262.2 billion, a monthly average of $21.9 billion. To put those numbers in perspective, the cost of U.S. military and civilian operations in Iraq and Afghanistan ran in the neighborhood of $200 billion over the last twelve months, a monthly average of $16.7 billion. Nine billion dollars from the China Development Bank amounts to about sixteen days of military operations in Iraq and Afghanistan, with Kuwait and other investor’s another 7 days.

Global free markets in goods, services, and capital flows are healthy for the world economy. But investments from China and Kuwait represent the acquisition of Citigroup equity by sovereign wealth funds or foreign government entities. This amounts to partial foreign nationalization of the U.S. financial infrastructure. If partial nationalization is required to restore the health of U.S. financial institutions, perhaps it would be better if the Social Security Trust Fund provided the resources. Much as one may dislike having Social Security take a stake in U.S. corporate equities, it can’t be worse than having the stake in Chinese and Arab hands.

The U.S. is fighting terrorism and trying to establish viable democracies in Iraq and Afghanistan. But these noble efforts may come at the price of increasing foreign ownership of the most important U.S. financial institutions.

Worse still, the United Nations Office on Drugs and Crime reported that opium production in Afghanistan reached an all-time high of about 600 million tons in 2006, nearly double that of 2001. (The Taliban regime was overthrown in November 2001.)

Friday, January 11, 2008

Afghanistan Agonistes

The United States has 17,000 troops in Afghanistan and is planning to send 3,000 more to forestall a possible Taliban spring offensive. The reason for the additional U.S. troops is because America’s European allies, which have supplied a smaller 11,000 troops, have failed to meet NATO’s request for an additional three battalions.

Between fiscal years 2001 and 2007, adding in 2008, the cost of U.S. military operations in Afghanistan will exceed $100 billion. To that number should be added $7 billion in U.S. civilian aid for reconstruction and development projects.

Private investment, in marked contrast, is minuscule by comparison, $690 million in 2004, $570 million in 2005, finally surpassing $1 billion in 2006. These include soft drinks, bottled water, cement factories, and mobile phones and telecommunications.

In a competitive tender that took place on November 20, 2007, on the $3 billion Aynak copper mine near the capital of Kabul, the China Metallurgical Group won out over two western, one London-based, and one Russian companies. Aynak is estimated to contain up to 13 million tons of copper, the second largest unexploited copper deposit in the world. In its January 9, 2008, edition, the Wall Street Journal wrote that the Chinese company offered the highest price in that it was most willing to accept the political, economic, and social risks associated with mining in Afghanistan.

Several inferences can be drawn from these facts. One is that security is so weak in Afghanistan that three western and one Russian companies were unwilling to risk $3 billion to secure a vast new source of copper. Another is that the U.S. has spent well over $100 billion in Afghanistan overthrowing the Taliban and trying to stabilize the Karzai government, but a potential victor could be China, which won the reddish brown prize.

Tuesday, January 8, 2008


Secretary of the Treasury Henry Paulson appeared on Squawk Box on cable channel CNBC on January 8, 2008.

Paulson was asked if his good relations with China contributed to the recent appreciation of China’s currency. He credited China for letting its currency appreciate against the dollar, which is helping U.S. exports, but said that China needed to do more to liberalize its financial system.

Paulson did not blame China’s undervalued currency as the principal source of the U.S. trade deficit with China. He attributed it to a more fundamental problem, namely, the low level of domestic savings in the United States. In economic jargon, the gap between U.S. domestic investment and saving takes the form of a surplus on the capital account (net inflow of foreign capital). In accounting terms, a capital account surplus has to be offset by a current account (largely trade) deficit. Higher domestic savings would reduce U.S. dependence on foreign capital (foreign savings), thereby reducing the trade deficit. However, higher domestic savings comes at the expense of domestic consumption.

It is the fear of lower domestic consumption that gives rise to concern about a recession. In this regard, Paulson was asked if the U. S. should adopt a fiscal stimulus package (cut taxes and/or increase government spending) and cut interest rates to prevent the economy from falling into recession. He replied that he was not prepared to comment on interest rates, which falls under the ambit of the Federal Reserve Board. Nor would he discuss the specifics of a fiscal stimulus until the president had made up his mind.

A fiscal stimulus that increases the budget deficit constitutes an increase in government dissaving (that is, the government has to borrow more to pay its bills). Coupled with lower interest rates to spur consumption means a reduction in household saving, the fundamental problem that causes the trade deficit in the first place.

In the short run, fear of recession, especially in an election year, invariably exceeds concern about low domestic savings. The problem is that "for the moment" always seems to trump the need for more saving.

Monday, January 7, 2008

Why Americans Don’t Save

Economists bewail the low savings rate of Americans, noting that the U.S. depends heavily on foreign savings to finance the gap between domestic investment and domestic saving. The consequence of sustained low domestic savings is the transfer of ownership of U.S. real and financial assets to foreigners. As foreigners increase their holdings of U.S. assets, they gain greater influence on U.S. domestic and foreign policies. Those who doubt this outcome should remember the golden rule: "He who has the gold rules."

An increasing number of prominent economists are calling for the Federal Reserve Board to sharply cut interest rates, down from the current 4.25% federal funds rate to a much lower 3%, to prevent a recession and help the U.S. economy work through the sub-prime mortgage problem. If the fed complies, it would follow in the footsteps the fed took under Greenspan in the wake of the bust in 2000, when it cut rates to 1% and held them low much too long. Easy money was a principal factor causing the subprime mortgage mess.

One percent interest on loans and deposits had two harmful effects. First, it reduced returns to savers across-the-board, thereby discouraging saving. Second, as individuals reach retirement age, they tend to shift assets to more secure fixed-income instruments away from riskier equities. When returns on certificates of deposit fall from 5% to 1%, many elderly lose a substantial share of their non-social security income.

It seems that savers and the elderly are being forgotten once again in the rush to cut interest rates. Economists who are pushing aggressively for cuts in interest rates should not be surprised when they discover that the savings habits of Americans continue to erode. Perhaps the light will come on when many of them retire and become more concerned with interest income and less with interest cost.

China Building

China plans to build 5,000 kilometers of highways in 2008, bringing the total to 60,000. China plans to have built 85,000 kilometers by 2020, roughly equal to the United States, completing its inter-provincial highway network thirteen years ahead of schedule. In addition, in the two years 2007-08, China plans to complete the building or upgrading of 693,000 kilometers of roads in rural areas, tying more villages into the national highway network.

Meanwhile, U.S. roads and bridges continue to deteriorate.