Sorry to say that you are mistaken, Professor!

I. Introduction

This article deals with three issues. In Section II, I explain why dollar de-valuation is not in America’s long-term interest. For this purpose, I analyze Professor Martin Feldstein’s latest article on Project Syndicate on the same topic quite closely. I explain how Professor Feldstein's arguments actually spring from the savings glut theory on global imbalances. In Section III, I make some remarks about how to de-toxify the toxic assets. This section is written in response to Professor Michael Boskin’s latest article “Of Banks and Bailouts” on Project Syndicate. I also refer to a recent article on the same topic, written by Professor John Taylor and Professor Ken Scott, that appeared in the Wall Street Journal. In Section IV, I study why my price adjustment mechanism, which I had explained in my recent article, “A New Perspective on the Global Economic Crisis”, is not being adopted by professional economists. To facilitate this study, I introduce the term “Old Keynesians”, and I raise the question whether the “Old Keynesians” would come to exert undue influence on the current administration, just like the “Neo-conservatives” came to hold extra-constitutional authority during the previous administration.

II. Why is Professor Martin Feldstein's reasoning in favor of the dollar's devaluation incorrect?

In his latest article, "America's Saving Rate and the Dollar's Future" on Project Syndicate, Professor Martin Feldstein makes the following prediction, "Although the higher level of household saving will limit the rise in US interest rates, it will not change the fact that the combination of large future fiscal deficits and foreign lenders' reduced willingness to buy US securities will lead to both a lower dollar and higher US interest rates". His reasoning is as follows. The savings rate of American households has risen sharply since the beginning of the year reaching 6.9% of after-tax personal income in May. This translates to an additional annualized savings of $750 billion. For comparison, the peak annual rate of capital inflow into America was $803 billion in 2006. Thus the increase in household savings has the potential to completely eliminate America's need for foreign funds to finance its business investment and residential construction.

Here's how that would play out, according to Professor Feldstein. The international value of the dollar declines (by the Fed's printing of trillions of dollars, which Professor Feldstein doesn't say). The dollar's decline implies both that foreign buyers will find US products cheaper in foreign markets, and American consumers will find US goods and services to be cheaper than foreign goods and services in domestic markets. Thus exports would increase and imports would decrease. Moreover, since the increased production of goods and services in the US would be financed almost exclusively by the increase in US household savings, the US current-account deficit would be eliminated almost completely, except for "net interest and dividends that America's government and businesses owe to the rest of the world". Further, Professor Feldstein warns that without a fall in the dollar, the current situation in which America has a higher savings rate and reduced consumer spending (in view of fall in house prices and in stock markets) could push the US economy into a deep recession. In contrast, a lower dollar would facilitate full employment since exports would then be more competitive, and domestic consumers would find American goods cost-competitive.

Professor Feldstein mentions that there are two caveats to this scenario of re-balancing the current account deficit. The first is that the US government's fiscal deficits are projected to remain high for many years. The Congressional Budget Office projects that the budget deficit will average 5.2% of GDP for the next decade, and be 5.5% of GDP a decade from now. Hence increased government expenditure would absorb all the rise in household savings. As a result, substantial inflows of foreign capital would continue to be needed to fund business investment and housing construction. This inflow would put upward pressure on the dollar and downward pressure on US interest rates. The second caveat is that, China and other foreign lenders, in all likelihood, will not be willing to continue to lend to the US. So, there would be reduced demand for the dollar and upward pressure on US interest rates. Thus the factors that moderate the US current account deficit would be the US government's spending, foreign lenders' willingness to continue to lend to the US, domestic business investment and residential construction in the US, and the international value of the dollar.

One should note that, except for his preference that the increase in household savings be spent by private businesses rather than the government, Professor Feldstein is essentially saying the same thing that Professor Krugman has been saying -- that America can finance its (public and private) spending plans through its own savings because there has been a 'savings glut' domestically, and that a revival of American manufacturing industry could be engineered this way. I had already explained the weaknesses of the savings glut theory in my recent article, "A New Perspective on the Global Economic Crisis" . I had, in fact, warned that the savings glut theory entertains certain elements of wishful thinking. But I have to say that Professor Feldstein's article does much worse damage. His analysis in his article essentially amounts to gambling away America's future.

First of all, Professor Feldstein assumes that the relative competitiveness of Chinese-made goods in American markets can be mostly attributed to the exchange rate policy of the Chinese government that holds the value of the Chinese currency steady against the dollar, which, in turn is achieved by the Chinese government accumulating massive foreign currency reserves. Professor Feldstein is going to find that in order to make American-made goods as cheap as Chinese-made goods, the US government would also have to provide massive subsidies to the American manufacturing industry. Moreover, American manufacturing companies have been languishing for many years, whereas Chinese manufacturing companies have gained expertise in reaching economies of scale very quickly. So, Chinese companies would be able to adapt more efficiently and retain their markets, if the US government favors American companies only moderately. Thus without an all-out protectionist trade war mentality, it would not be feasible for American manufacturers to re-capture markets from the Chinese manufacturers. Unfortunately, at this point, the American economy is in a precarious state. So, global trade policies that promote protectionism and isolationism, like the Smoot-Hawley tariffs of the 1930s, could result in more risks that America would fall into a depression-like situation than that China would.

Secondly, as I had explained in my article, "A New Perspective on the Global Economic Crisis", one weakness of the savings glut theory is that it is completely agnostic about connecting savings with investments. Professor Feldstein argues that the money that is saved in America would be invested in America, because of his implicit assumption that the domestic interest rates would adjust according to the global supply of funds. In reality, it is the money that is saved in China that is going to finance China's own massive fiscal spending programs (to the tune of $586 billion over two years). Whereas, the money printed by the Federal Reserve, in anticipation of the rise in household savings in America is simply lying dormant in the form of excess bank reserves (to the tune of $800 billion) because American businesses are not seeing growth opportunities that would induce them to borrow. Moreover, different people have different "expectations" for their money. The accumulated capital in America is going to find investment in the emerging market economies, like China, India and East Asia, quite attractive because of the expectation of high returns in those economies due to their rapid growth rates. Whereas, the high savings of Chinese households is going to find its way to America in search of a safe store of value.

In his article, Professor Feldstein considers only the annual $750 billion of extra savings in American households. The fact is that the accumulation of capital in the American financial system is in excess of 20 trillion dollars, mainly in the form of life-time savings of middle class citizens, for example, social security, mutual funds, pension funds, 401(k), IRA, stock portfolios, etc. It is quite conceivable that, in view, of the recession in America, and the high growth rate in the emerging market economies, a trillion or two of this accumulated capital would find its way to the emerging market economies in the next year or two. During this time, the American economy would get out of recession and start to show signs of robust growth. Then the global supply chain would restore itself because America's import orders from Chinese manufacturers would pick up. Meanwhile, China, which has been busy financing its own domestic consumption using massive fiscal deficits of its own in 2009-10, would get back to financing its exports. With the American economy revived and yet American consumers becoming more cost-conscious because of sharp drops in their personal wealth, there is going to be a revival of demand for cheap Chinese-made goods. Thus the trade deficit would continue to grow, and China would accumulate even more dollar reserves.

Thirdly, Professor Feldstein assumes that China would be neutral to the Fed's expansionary monetary policy. Perhaps he takes this position under the influence of the de-coupling theory -- that other things being equal, China would like to be able to sustain high economic growth on its own, without the assistance of exports. Professor Feldstein assumes that the Chinese would simply watch and clap their hands as the dollar devalues. In reality, China has closely pegged its future to that of America. So, while the Fed has flooded the American economy with 4 trillion dollars of excess money printing, the Chinese are doing a proportionate amount of fiscal spending financed partially by their own money printing and partially by their domestic savings. The money printing by the Chinese is calibrated exactly to the extent that the dollar-yuan exchange rate remains stable. Keeping this exchange rate stable preserves the value of China's foreign reserves (about 65% of the 2 trillion dollars of China's foreign reserves is currently held in dollars). Moreover, since the Chinese economy is growing so fast, there would not be a problem for the Chinese to keep lending money to the US. If China's GDP grows at an annual rate of 8% for 9 years, then the GDP would double. So the ratio of China's foreign reserves to its GDP could still stay at the same value, if China lent the US 2 trillion dollars more over the next 9 years.

The main benefit from the increase in household savings rate in America is that the American financial system would become more stable. Families would be able to put down more down payment towards the mortgages on their homes, or to buy cars. The purchase of luxury items and durable goods would be facilitated with people showing their ability to delay gratification and save. With people becoming more conscious of their households' balance-sheets, decisions regarding the long-term spending of families would show a marked improvement. For example, saving for children's college education or saving for retirement (in addition to automatic savings like social security and 401(k)) would be taken more seriously. There are many benefits to the increase of household savings in America. De-valuing the dollar is not one of them.

III. Why would Professor Michael Boskin's Plan B not work?

In his latest article "Of Banks and Bailouts" on Project Syndicate, Professor Michael Boskin says that he has a Plan B for dealing with toxic assets. Here's how it goes. The financial industry has shown huge profits in the second quarter and manufacturing has rebounded strongly in Asia. However, the economic recovery would not be strong and robust without dealing with the toxic assets. "Policymakers need a Plan B in the event that one proves necessary, modeled on America's rapid resolution of insolvent savings and loans in the early 1990s, together with sales of toxic assets in large blocks (to prevent so-called adverse selection from unravelling any bidding process)". I have to say that Professor Boskin is mistaken to suggest, in his Plan B, that the toxic assets could be valued by auctioning them off in large blocks. Isn't this the same principle by which the Public Private Investment Program (PPIP) had been designed? So, why doesn't the PPIP work then?

It is notable that conservative economists have suddenly chosen the present time to raise issues about toxic assets, after a long hiatus of nearly a year. In an Op-Ed, published in the Wall Street Journal on July 20, 2009, Professors Ken Scott and John Taylor have identified the massive complexity of the mortgage assets to be the main stumbling block for valuing the toxic assets. They propose setting up a centralized database for information on the mortgage assets so as to obtain transparency. Four letters to the editor referring to this article were published on July 27, 2009. These letters raised the question why it would become possible to value the toxic assets once one has a database. The main point is that there is no magic formula that would specify the value of the toxic assets once one has a database, or an auction to middle-men.

While dealing with toxic assets, it is useful to keep in mind that the value of a toxic mortgage security is not a single number. Rather, the market price of a mortgage asset is an inter-temporal quantity, with vast amounts of uncertainty associated with the asset, when the value is low (i.e., when the asset is toxic). The only way to deal with a given group of toxic assets is to auction this group among those home-owners whose mortgage loans are pooled together to form the mortgage securities that this group of toxic assets are a part of. Since there would be thousands of home-owners in these auctions, the market for toxic assets would not suffer from illiquidity or fire-sale prices that is currently afflicting it. To conduct these auctions, a direct channel of communication between the home-owners and the security-owners has to be established. It is for this reason that a centralized database is needed. In this way, the prices on mortgage assets is adjusted, in exchange for better loan recovery. I have explained this price adjustment mechanism in detail in my article, "A New Perspective on the Global Economic Crisis".

IV. Why wouldn't economists adopt my price adjustment mechanism?

In this section, we discuss why economists wouldn't adopt my price adjustment mechanism. We provide three reasons.

(i) Pre-occupation with global imbalances: As I had already explained in my "A New Perspective on the Global Economic Crisis II: Fear of Reverse-colonization Did It", during the last five or six years, professional economists, both conservative and liberal, had been pre-occupied with the imbalances in global trade, savings and current accounts. In my opinion, this attitude is mainly motivated by their fears of reverse-colonization. As a result, when the financial crisis hit due to the collapse of the mortgage industry, Western economists blamed it all on global imbalances. As the stock market crashed last Fall and the manufacturing industry took a nose-dive, the Chinese economy also tanked because exports to the advanced countries collapsed. The expectation was that the rapid growth of the Chinese economy would collapse, because of the loss of its exports markets. However, at this point, de-coupling did take place in earnest. China announced its own fiscal spending program and in the first two quarters of 2009, China was able to generate sufficient growth opportunities domestically so as to be able to get back to its rapid growth-path (8%+ annual growth in inflation-corrected GDP).

For this reason, engineering a dollar devaluation through the Fed's expansionary monetary policy is going to do permanent damage to America's geo-political credibility. Unfortunately, fears of reverse-colonization prevails supreme. Hence Western economists are trying to use some excuse to transmit trillions of dollars of losses to the rest of the world. I have explained in Section III of my article quoted in the previous paragraph, how the losses in the American financial system can be transmitted through dollar devaluation.

(ii) Economists from the cities: Economists who reside in metropolitan areas do not want the government to be promoting home-ownership. They would prefer that the government spend to clean up inner cities. Moreover, liberal economists don’t like the idea of property rights at all. So, they do not even want to consider my proposal for connecting the property owner with the security owner. These liberal economists believe that the government would be able to solve the financial crisis. They even went to the extent of suggesting temporary nationalization of the Wall Street banks. On the other hand, the conservative economists would like to be seen as friends of businessmen and financiers. So for a long time during the George W. Bush Presidency, they didn’t want to help homeowners avert foreclosures. Only recently, conservative economists like Professor Michael Boskin and Professor John Taylor are beginning to focus again on the issue of toxic assets.

(iii) The wrath of the Old Keynesians: The term “Old Keynesians” refers to a group of highly influential economists who have been using the current crisis as an excuse to implement Keynesian policies to the extreme. On paper, they say that their idea of paradise is the post-war American society of 1945 -- 70, when Keynesian economists wielded a lot of influence on government policies. However, in private, these economists would like to re-shape America as the Great Britain of the 1930s and 40s, when Britain came under great challenges to defend its colonial empire. These Old Keynesians have been working furiously to run up public debt, under various excuses that include (a) replacing the fall in consumer spending, (b) correcting global imbalances, (c) rescuing financial institutions, (d) preventing foreclosures, (e) propping up securitization markets. They have also been actively promoting Great Depression mania. These economists believe that a shared sense of hardship would make American society more cohesive in the future. That American youth would go out into the world to fight against impossible odds in the cause of an empire, just like the British youth did in the 1930s and 40s. Just like the so-called “Neo-conservatives” functioned as an extra-constitutional authority and exerted undue influence on the previous George W. Bush Presidency, there is a danger that the "Old Keynesians" would come to exert undue influence on this administration in due course of time. These “Old Keynesians” have been instrumental in cooking up dubious theories of economics, like the savings glut theory and the de-coupling theory, in complete dis-regard for the concerns of the rest of the world. They would not like to see a viable solution for the global economic crisis anytime soon.