The News Is Full Of Portents

by hilzoy

As I said yesterday, in my one brief note, I am back from vacation. Due in part to an annoying series of flight delays, I wasn't good for very much yesterday, which is why it was so delightful to find that Amazon.com had kindly left a copy of the new Harry Potter book in my mailbox. (I've finished it, and it's very good -- unlike its predecessor, which was, to me, a complete disappointment.) Now, however, I'm trying to engage with the news again, and today it seems full of important developments whose significance is not yet clear. (Checking back on ObWi before posting this, I discover that von and Charles have posted about two of these stories, but still...)

* The BBC reports the following:

"A number of Tube stations have been evacuated and lines closed after three blasts in what Met Police chief Sir Ian Blair says is a "serious incident".
Sir Ian appealed to Londoners to stay where they were and said the transport system was effectively shut down. The minor explosions used detonators only, a BBC reporter said. In addition, a Number 26 bus in Hackney Road in Bethnal Green had its windows blown out by a blast. There were no injuries."

What is that all about? And why only detonators? Is it copycats, another al Qaeda attack, or what? Al Qaeda seems unlikely to me, at this point: if the current reports are accurate, the blasts were (mercifully) too non-lethal (and: too predictably non-lethal) for them. Here, I think we need to wait for further details.

* From the Financial Times:

"China allowed a 2 per cent appreciation of its currency on Thursday, ending a decade-old fixed peg to the US dollar and following months of intense pressure from its global trading partners. China’s central bank announced a mild appreciation of its renminbi, setting the peg at 8.11 to the dollar from the longstanding level of 8.28. It said the renminbi would now be pegged to a basket of currencies. The revaluation, effective immediately and coming after months of speculation, suggests China’s top leaders believe it is in the country’s best interest to have a mild currency appreciation during a critical juncture of its economic expansion.

"China will reform the exchange rate regime by moving into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies," said the People’s Bank of China in a statement on its website late Thursday. "The RMB exchange rate regime will be improved with greater flexibility," it added. (...)

The effect of China’s move was expected to spread to other Asian currencies as other countries in the region were set to decouple their currencies from similar pegs or adjust their mechanisms for managing their currency to make them more competitive. Shortly after China’s announcement, Malaysia said it would alter its peg and allow the ringgit to fluctuate freely and Singapore, whose currency is tied to a trade-weighted basket of currencies, was also due to make an announcement."

Here is the official announcement of the revaluation. It's small, but this is nonetheless a very big deal. First of all, there's fact that China is switching from a dollar peg to a peg against a basket of currencies. In order to maintain a currency peg, a central bank must be prepared to step in and buy or sell the currency it's pegging its own currency against. Until now, the Chinese central bank has had to buy dollars -- lots and lots of dollars -- in order to keep its currency at the desired level. As of today, it needs to buy all the currencies in its basket. This means that its need to purchase dollars will decline.

And this, in turn, is a big deal, since China's purchases of dollars has been one of the most important factors keeping our interest rates low, and thus enabling us to go on spending money as though there were no tomorrow. From another Financial Times article:

"China and other Asian countries have - because of massive dollar purchases to prevent their currencies appreciating - emerged as the financiers of the US's current account and fiscal deficits, providing cheap capital that has kept the dollar's decline orderly and helped bring economic growth and low interest rates. Sooner or later these countries may decide this is no longer in their interests. They face capital losses on their reserves as the dollar declines, while running the economy according to an exchange rate target means abandoning control of domestic policy. Market rumours of possible slower accumulation of dollar reserves, or diversification into other currencies, by smaller Asian countries have caused volatility in financial markets in recent months. A shift in China's exchange rate policy could have a far greater effect.

"If China and the rest of Asia reduce their supply of capital to the US, and the US, Europe and Japan do their part in reducing the fiscal deficit and promoting growth elsewhere, that's fine," says Nouriel Roubini, a professor at New York University. "If China and Asia do their part and the US does not, this would lead to a hard landing.""

Moreover, while this devaluation is small, both the shift to a more flexible peg and the shift to a basket of currencies allow the Chinese to undertake further devaluations appreciations more easily, and with less publicity. It would surprise me if this were the extent of the renminbi's devaluation rise. (Update: what was I thinking? Obviously, it's the dollar that sinks against the renminbi. Thanks to Jack Lecou for pointing this out.)

The dollar has already fallen sharply against the yen, and will probably fall further. Naturally, this (update: e.g., this move by the Chinese) makes all those Chinese goods we buy more expensive. Moreover, if Chinese demand for US Treasuries falls, interest rates may rise. This would have bad effects on investment, and of course on interest-rate sensitive sectors of the economy like, um, the real estate market.

On the other hand, to the extent that the renminbi rises against the dollar, our exports are cheaper in China, which helps us. But exports are not a huge part of our economy, and so it's not clear how much of an effect devaluation, especially a small one, would have there. It will surely be something, but I'm guessing it's dwarfed by the bad effects. However, these bad effects will have to happen sometime, since our trade deficit is not sustainable; I think it's better they happen sooner rather than later, since the more time passes, the more horrifyingly large the problems we have to address, and the worse the resulting correction.

But this is a very big deal.

* Prince Bandar of Saudi Arabia is resigning as ambassador to the US. He was enormously influential -- if memory serves, he saw our war plans for Iraq before Colin Powell did. I have no idea what his resignation means, but it surely means something.

Portents. Omens. Of unknown significance, but they don't look good.

Comments

[Slartibartfast]

I also read the new Harry Potter, but anything I'd want to say about it would be absolutely oozing with spoilers.

To keep it as generic as possible, though, I have this to say about the ending: I think things are almost exactly the opposite of how they appear, in key respects.

[Slartibartfast]

Oh, and: welcome back, hilzoy!

[hilzoy]

Slarti: thanks, and I agree about the end. I also have a view about RAB, which alas is also a spoiler.

[cleek]

come on guys, no spoilers!! not even hints! please?

[Tim]

Maybe, maybe not. The critical scene is so ambiguously written that Rowling can go in any direction she wants. She may not even know now where it's going.

[Slartibartfast]

She did telegraph the punch, though, so I think there was a plan.

[Slartibartfast]

This would have bad effects on investment, and of course on interest-rate sensitive sectors of the economy like, um, the real estate market.

I guess all good things must eventually come to an end.

[Sebastian Holsclaw]

Neil Gaiman once wrote about his "Sandman" series that he knew where he wanted to go with it, but that he planted a number of 'outs' in the series as it was going along in case he changed his mind before he was done.

[Tad Brennan]

Welcome back, hilzoy!

[Charles Bird]

The dollar has already fallen sharply against the yen, and will probably fall further. Naturally, this makes all those Chinese goods we buy more expensive.

Wouldn't that be Japanese goods? Do we know that China is including Japan in its "basket"?

[Jackmormon]

Welcome back, Hilzoy!

I didn't enjoy this Potter as much as you seem to have. I was at first appalled by the end, but a commentor at my site very gently pointed out that the seventh would likely put that little matter to right. I do think Rowling knows where her plot is going; it's the inflections in characterization that zigzag wildly, in my opinion.

[bob mcmanus]

"Wouldn't that be Japanese goods?"

The initial revaluation make Chinese goods 2 per cent more expensive. I was trying to think if there were other factors; I guess not; the resulting inflation would need additional Chinese revaluations to be meaningful, and might be offset by the inevitable interest rate increases.

If the Chinese were just to flat-out float the renminbi we might get a death spiral:

(revaluation -> inflation -> revaluation; or massive Fed increases)

we aren't there yet.

[Dantheman]

I think the biggest aspect of the Chinese action is being ignored. If the Chinese are going froma dollar pegged currency to a basket of currency pegged currency, they will decrease substantially their purchases of Treasury bonds (which Brad Setser has put as over $100B/year). If the change is big enough, US long term interest rates will start rising to compensate.

If so, that sound you hear will be the real estate bubble popping.

[bob mcmanus]

London Attacks

Billmon links to a systems analyst called John Robb, who is analyzing al Qaeda tactics and strategy. I couldn't decide what to cut and paste; the whole thing is worth reading. Totally non-partisan, for those who don't like Billmon.

"This group[London] even added their own innovation to the development of the systems disruption model (for other groups to adopt in the future): the bombs were exploded while the trains were in the tunnels rather than in the stations. This maximized disruption at the expense of body count."
...Robb

[jayann]

Bob

I don't understand John Robb's comment. It's true that a bomb in a crowded train as it emerges from a tunnel and draws alongside a very crowded platform might cause more casualties than a bomb on a crowded train in a tunnel, but otherwise, the effect of an explosion as it blasts along a tunnel would tend to be worse. Also, more people not killed instantly by a "tunnel bomb" would die because emergency services could not reach them, than would die in a "station bomb".

BTW I always thought if suicide bombers attacked the tube they'd set the bombs off in tunnels.

[Anderson]

Portents. Omens. Of unknown significance, but they don't look good.

CICERO Good even, Casca: brought you Caesar home?
Why are you breathless? and why stare you so?
CASCA Are not you moved, when all the sway of earth
Shakes like a thing unfirm? O Cicero,
I have seen tempests, when the scolding winds
Have rived the knotty oaks, and I have seen
The ambitious ocean swell and rage and foam,
To be exalted with the threatening clouds:
But never till to-night, never till now,
Did I go through a tempest dropping fire.
Either there is a civil strife in heaven,
Or else the world, too saucy with the gods,
Incenses them to send destruction.
CICERO Why, saw you any thing more wonderful?
CASCA A common slave--you know him well by sight--
Held up his left hand, which did flame and burn
Like twenty torches join'd, and yet his hand,
Not sensible of fire, remain'd unscorch'd.
Besides--I ha' not since put up my sword--
Against the Capitol I met a lion,
Who glared upon me, and went surly by,
Without annoying me: and there were drawn
Upon a heap a hundred ghastly women,
Transformed with their fear; who swore they saw
Men all in fire walk up and down the streets.
And yesterday the bird of night did sit
Even at noon-day upon the market-place,
Hooting and shrieking. When these prodigies
Do so conjointly meet, let not men say
'These are their reasons; they are natural;'
For, I believe, they are portentous things
Unto the climate that they point upon.

[bob mcmanus]

"I don't understand John Robb's comment."

Yet another link: Revolutionary Organization

"Arms and Influence" a very good blog.

The difference to keep in mind has to do with purpose. Palestinians bombing a nightclub in Israel is pure terrorism. Sunnis blowing up a police station in Baghdad has killing people and terrorizing civilians as a secondary purpose; the primary purpose is disrupting gov't operations, i.e., recruiting. Same with assassinating collaborators or disrupting oil production. The Palestinians or previous terrorists rarely did stuff like that. (OK, I guess they all kill collaborators.)

Attacking infrastructure is Leninist, implying a level of sophistication and strategy that I don't think we've prepared for. Latest post:

Iraq

[Jack Lecou]

...allow the Chinese to undertake further devaluations more easily, and with less publicity. It would surprise me if this were the extent of the renminbi's devaluation.

I think you mean appreciation. It's the dollar that's been devalued.

[liberal japonicus]

Wouldn't that be Japanese goods? Do we know that China is including Japan in its "basket"?

No, it's Chinese goods. The Japanese have embraced the idea of taking advantage of low labor prices as much, if not more, than the US. The basket of currencies is probably assigned by the amount of trading that each country does with China, so the yen and the euro would probably be the main components, which, judging from the jump in the yen is just what has happened.

And welcome back Hilzoy, you were missed.

[liberal japonicus]

Bob's link syntax was a bit off. Here is Revolutionary Organization

Robb is incredibly insightful, but what I don't like about Robb (and others like him) is that they seem to adhere to the theory that once a piece is on one side, it is always on that side. I think it comes from that game theoretic planning. F'rex, in the Lawrence post, he talks about nodes of different colors, with the blue and green nodes as

Blue and green nodes, not directly connected to the group, can still act. This large (1/3 of the community's mass is green nodes) stealth group presents a significant and ongoing threat. They are likely, given the group's new communications dynamic, to act independently or attempt to make connections in an effort to gain membership in the group. Full membership would be validated by passive leadership multimedia Web casts. The London bombers were likely blue nodes. As long as the top leadership remains intact and communicative, they are likely to act in concert with the community's goals.

This becomes the language of HUAC.

The IRA threat was turned back when those blue and green nodes were flipped. While I'm sure that we can't agree that on what did it and how much weight to assign to each action (overreach by the IRA, withdrawal by British troops, Good Friday agreement, Omagh, Downing Street Declaration, George Mitchell's intervention) viewing the 'nodes' as potential terrorists rather than as resources, means that we can't win.

I've mentioned this before but the 1997 report on Islamaphobia by the Runnymede trust set out many of the potential problems

Credit for any positive changes since 1997 had to go largely to Muslim organisations themselves which had become more organised, the report found.

Central government deserved some praise for moves on religious discrimination.

But it warned exclusion from public life perpetuated a feeling among some Muslims, particularly the young, that they did not belong in Britain.

This resentment and disaffection represented a time-bomb that needed to be dealt with now, it said.

[hilzoy]

Howdy (back from a nice long day of meetings.) I have updated to clarify some of the stuff I wrote. Jack L: yes (she said, smacking herself on the head), I meant appreciation. Or whatever you call it when the Chinese make their currency go up, and our currency go down. Charles: the 'this' was ambiguous; I did mean the Chinese decision to let their currency rise a bit. This particular move won't have much effect, but I don't expect it to be the last, and if I'm right, the effects could be significant.

[toby]

I suspect the basket of currency's they are using include the GBP, USD, EUR & JPY. If you are looking to slowly introduce a channel in which your currency can trade you will want to make sure the benchmark is as stable as possible. I supposed the AUD and CAD could be included in that group but who knows.

[Jackmormon]

Billmon has a loooong analysis of the possible implications of the shift up.

[bob mcmanus]

"but I don't expect it to be the last, and if I'm right, the effects could be significant."

Umm. As I understand it, the dollar is about 30-40% overvalued. And so, all US assets are similarly overvalued. A rapid adjustment would be catastrophic worldwide. If there be geniuses with nerves of steel, we might actually be able to inflate our way out of our account deficit and int'l debt, very slowly and gradually over the course of decades, simultaneously building infrastructure in the developing countries(China, India, etc.) by allowing them to be net exporters until they are secure enough to become more domestic consumption societies. I don't know what the world looks like under that scenario, but there aren't many ideas that allow us to keep our relative standard of living.

Three major problems:Americans don't save, Asians don't consume, and Peak Oil.

[Sebastian Holsclaw]

"I don't know what the world looks like under that scenario, but there aren't many ideas that allow us to keep our relative standard of living."

Fortunately I don't care about keeping our relative standard of living compared to the rest of the world. I would be thilled to see the rest of the world come up to our standard of living.

[bernard Yomtov]

As I understand it, the dollar is about 30-40% overvalued. And so, all US assets are similarly overvalued.

I don't think you can make a blanket statement that the dollar is X% overvalued. Against what currencies? On what basis?

Even if it is that does not mean that US assets are "overvalued" in dollar terms. That is not to say that a drop in Chinese demand for Treasuries wouldn't affect asset prices. Interest rates would rise, and asset prices would drop, but the linkage is not as you describe. It may also be that this risk is already reflected in the prices of US assets, so even if the interest rate scenario comes to pass, it will not be quite accurate to say, in retrospect, that the assets were overpriced.

[bob mcmanus]

"I don't think you can make a blanket statement that the dollar is X% overvalued. Against what currencies? On what basis?"

Hey, you're the economist. I guess one of the differences between amateurs and pros is evidence and citations, and I can't remember where that came from, tho I didn't grab it from the air.

I don't know that the premium we get for being the "reserve currency" is quantifiable.
You might look at P/E ratios with historical humility. You might compare rental prices to home prices. You could look at how high Asian reserves are above recommendations. Domestic capital expenditures are data. You could chart the S & P with oil prices, one of which doubled while the other remained interestingly flat. You could convert stock prices into Euros or Yen and get a fun graph for the last decade. Consumer debt to income is a neat number. Stuff like that.

Yeah, the adjustment, if you believe there will be one, is kinda unpredictable, because we will likely move out of the realm of "rational actors." But the 30% plus relative decline in SOL is what I am expecting. Not necessarily distributed evenly, of course.

[bob mcmanus]

"I would be thilled to see the rest of the world come up to our standard of living."

An optimist or philanthopist? :)

Will Wilkinson of Cato (and blogger) is working very hard on hedonics, because the evidence is very strong that one's relative economic position is more important to individual happiness than one's absolute position, given that minimal needs are satisfied. I think his current position is that happiness doesn't really matter anyway, or that happiness needs to be redefined so that massive inequalities don't matter.

America has been relatively better off for quite a long time.

[felixrayman]

"I would be thilled to see the rest of the world come up to our standard of living."

How is the world going to produce 750 million barrels of oil a day? Got any ideas, or just the glittering generality?

[dutchmarbel]

the evidence is very strong that one's relative economic position is more important to individual happiness than one's absolute position, given that minimal needs are satisfied.

A while ago I read an article in which the described a test about that. They asked students wether they would rather earn 100,000 dollars per year and have everybody earn a 100,000 dollars per year, or earn 75,000 dollars and have everybody else earn 50,000 dollars. Sebastian would have been an exception in that group :)

Do you really think the dollar is overvalued against the euro???

[bernard Yomtov]

Bob,

Actually, I'm not an economist, though I sometimes play one on the Web. I'm not a piano either, though I am learning to play one.

I don't disagree that there are substantial risks in the economy, and the concerns you raise wrt housing and the stock market are certainly legitimate. My main objection was to your notion of how the dollar's value and asset prices are related. Seems pedantic, maybe, but I don't think so. If you get the mechanisms wrong you get the policy wrong.

BTW, Krugman has a good column on all this in today's NYT.

[bob mcmanus]

"Do you really think the dollar is overvalued against the euro???"

Not as much as a year ago;Europe has had some recent problems.

Look it is entirely possible nothing important happens for a long time; or the that the adjustment is gradual and gentle. It is so far a very small change.

But if the yuan revaluation is the start of a movement, including the other smaller Asian economies (but likely excluding Japan) then most of the factors are political. The Asian economies will like to remain net exporters so will have to buy somebody else's currency. Buying each other's won't do the trick. I think there will be some movement towards Euros in any case.

The Asians will finance our consumption as long as we wish to consume. I think. But I think with just slightly higher interest rates and lower housing sales and refinancings, consumption could drop pretty fast. And America could become less politically stable, or international pariahs. I think Bush hasn't attacked Iran partly because China owns his butt.

The Euro is not real attractive right now. But if I was thirty I would putting my money there. If I couldn't invest in China. America would be pretty far down the list.

[Kevin Donoghue]

I don't think you can make a blanket statement that the dollar is X% overvalued. Against what currencies? On what basis?

The Economist newspaper had an article on this (June 25th page 88). It’s also on their website but you have to be a subscriber. Apparently a Morgan Stanley study suggests that the yuan is currently only 7% undervalued against the dollar. Simpler approaches such as The Economist’s own Big Mac index give a much bigger undervaluation. This Bundesbank PDF file is a reasonably non-technical description of how one can tackle this question, mainly focussed on Easter Europe.

Sebastian: I would be thilled to see the rest of the world come up to our standard of living.

That does you credit, but have you considered the sort of armed forces China and India could afford if they had America’s per capita GDP?

[Kevin Donoghue]

That's Eastern Europe obviously.

[Anarch]

Speaking of portentous news:

Multiple car bombs rock Egyptian resort town; many feared dead. - quoth MSNBC Breaking News.

[liberal japonicus]

Three major problems:Americans don't save, Asians don't consume, and Peak Oil.

I'm working on the middle one, if you folks could take 1 and 3, I'd appreciate it.

[dutchmarbel]

"Do you really think the dollar is overvalued against the euro???"

Not as much as a year ago;Europe has had some recent problems.

Ah, we seem to miscommunicate. In Dutch you would use the translation of overvalued for a currency that was too expensive, worth too much compared with the other currency. So I would tend to call the euro overvalued against the dollar, meaning that I think you would have to pay to many dollars for a certain amount of euro.

yes, euro is down slightly and rightly so IMHO.

[jayann]

Bob, this is the bit I don't understand (and somewhat disagree with):

"the bombs were exploded while the trains were in the tunnels rather than in the stations. This maximized disruption at the expense of body count."

as for attacking the infrastructure: a lot of us here expected an attack on the transport system -- it's been said so many times, the bombers could even have learned from it :) -- but I'd say we saw it in terms of maximising casualties and disruption, and I take the point. (And thanks for the links.)