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“These congressmen claim they are the white knights defending the interests of the American people, but in fact, they are nothing more than a bunch of baby-kissing politicians.” You’ve got to love Xinhua, the official Chinese news agency, for its colourful rebuttal of American sabre rattling, led by Democrat Senator Chuck Schumer, over alleged manipulation of the exchange rate of the Chinese currency, the renminbi. Xinhua may even be right.

First of all, let’s be clear that China is manipulating the value of its currency to keep its exports competitive. China holds massive dollar reserves and these reserves are growing as it continues to run a massive trade surplus. The sluggish U.S. economy, by contrast, is failing to make much headway in narrowing its trade deficit by exporting more, since the dollar has actually appreciated in value against most world currencies since the crisis of 2008. It is also clear that this situation cannot continue forever – the U.S. cannot keep financing domestic consumption with foreign credit indefinitely.

The problem is that trying to bully China isn’t going to work as a strategy for changing things. Indeed, it is fraught with dangers. Chinese currency manipulation is nothing new – popping over to Beijing to have a moan was just as much a part of Treasury Secretary Hank Paulson’s schedule as it is for his successor, Tim Geithner. The difference is that today the U.S. economy is struggling, which has upped the political ante.

Enter Senator Schumer, who is leading demands in Congress for the U.S. to take unilateral action by imposing restrictions on Chinese imports (a stance that has even won plaudits from trade guru Paul Krugman). It is this that provoked Xinhua’s robust reaction.

While American indignation is understandable, the lessons of history that we discuss in The Road From Ruin suggest that this muscular policy is missing the point and could backfire spectacularly.

First, however, the (semi) good news. Twenty-five years ago the U.S. economy was struggling to recover from a recession, impeded by a failure to get the rest of the world to buy its products, with Japan and Germany in the role now played by China of running big trade surpluses. Under a deal, known as the Plaza Accord of 1985, the world’s leading industrial economies agreed to work together to drive down the value of the dollar to rebalance global trade. The policy achieved its immediate objective (the dollar fell so far that co-ordinated action was required two years later to push it back up again) but, in the end, it had little impact on the U.S. trade deficit.

Twenty-five years is a very long time in global politics. The Cold War had not yet reached its surprise denouement and the U.S. was still the unrivalled capitalist superpower. Japan and Germany did not really have any choice but to give in to U.S. demands and, for both countries, an invitation to help out the American economy was a promotion on the world stage.

China today does not have the same incentives to give in to U.S. demands, not least because it is America’s main creditor. And creditors will always blame their debtors. That is exactly what America did in the 1920s and 1930s as European nations struggled to cling to the Gold Standard, torn between the imperative to slash their debts to maintain the value of their currencies against gold and the need to keep spending to stop their economies stalling entirely. The result of that impasse was the collapse of the Gold Standard and a global trade war that worsened the global recession, harming everyone. Sabre-rattlers beware.

So what can be done? First, we need to understand China’s behaviour. The policy of undervaluing the renminbi is, in part, driven by the false economic philosophy of mercantilism that associates building up currency reserves with economic success (fuelled by the powerful export lobby). China’s strategy might also be looked at as a rational response to an irrational world. The leaders of many of the emerging economies of Asia, not just China, took two lessons from the financial crisis of the mid 1990s. First, that borrowing dollars to finance their development exposed their economies to turbulence coming out of decisions made in Washington to suit the needs of the domestic U.S. economy. Second, that the U.S.-dominated IMF and World Bank could not be relied upon in times of crisis.

It was in the crucible of this crisis that the strategy of export-led growth for emerging economies was forged. In a sense this defies economic logic – by keeping the value of their currencies low to run trade surpluses countries such as China have forced their own, poor, citizens to pay the price of economic development rather than the rich citizens of America. Yet policy-makers decided that this was the least-worst option, as long as the American-controlled dollar remained the basic unit of currency for international finance.

At the G20 summit in April 2009 China put forward its own solution to the global financing problem – a new global reserve currency to replace the dollar – which has the support of Nobel Prize winning economist Joseph Stiglitz.

So far, this idea has made little headway but it is, potentially, a massive win-win for the U.S. and China. The dollar’s position as the global reserve currency massively distorts its value. This may seem like good news at the moment, since the willingness of the world to hold dollars is protecting the U.S. from speculative attacks on its currency over the country’s deteriorating fiscal position. The downside, of course, is that this drives up the value of the dollar, fuelling America’s competitiveness problem.

The U.S. economy would, in the long term, benefit from playing by the same rules as everyone else. Moreover, if a deal on a global reserve currency ended the currency manipulations of countries such as China, that too would be a boon.

The bottom line is that a new global financial architecture is inevitable – the world cannot continue anchoring its finances to the currency of its biggest debtor. China’s advocacy of a global reserve currency is an acknowledgement that the status quo is not sustainable (if America owes you a billion dollars America has a problem, if America owes you a trillion dollars you have a problem). There are misguided patriotic and short-term reasons for politicians like Senator Schumer to persist with their populist hectoring. Eminent economists like Krugman should not be so short-sighted: it is time for the ‘white knights’ of economics to refocus the debate on ideas that could really make a positive difference.

An entertaining spat has broken out between two famously liberal economists – Jeffrey Sachs and Paul Krugman – over the future of public spending. In Monday’s Financial Times, Sachs outed himself as a deficit hawk, dismissing government fiscal stimulus as an unnecessary part of the economic recovery. This drew predictable fire from Krugman, who when not making baffled cameo appearances in movies such as ‘Get Him to the Greek’ is now the official representative of John Maynard Keynes on earth, and continues to warn that stopping the stimulus when the economy is on life support (i.e. interest rates are at or near zero) risks tipping us back into recession.

While Sachs is right that public debts need to be tackled, history offers two cautionary tales about switching to deficit-reduction too early, which we discuss in The Road From Ruin. The most recent example was in the 1990s, when political paralysis and a culture of denial stopped Japan’s government from responding decisively to the stagnation in its economy, resulting in a ‘lost decade’ of zero growth. Happily, America is not there yet, though it will not be surprising if eventually it is, in a double- or triple-dip recession’s time.

When the Japanese economy did start to grow towards the end of the 1990s, it was tipped back into recession by a tax increase. But the situation in the US today has even stronger echoes of the mid-1930s, when FDR’s New Deal improvisations were finally starting to feed through into an economic recovery only to stall in 1937 as the result of an ill-judged premature fiscal squeeze. The mistake US policy makers made in the 1930s was believing too soon that they were out of the woods – an error that Sachs seems to be repeating today.

Sachs does, however, pose an important question -  when the time comes to cut, where should governments look for savings and where should they continue to invest public money to build a strong economy in the future? Krugman prefers not to answer this question, remaining faithful to his master’s edict that it is the spending itself that matters most, regardless of what it is on. (Keynes argued that the Treasury could do its job by burying bottles of banknotes and paying people to dig them up again – a policy that in today’s world, with confidence in government very low, might well make the economy not better but worse.) We believe that how the money is spent today is will make a potentially huge difference to what sort of economic recovery there is, and Sachs is right to argue that as much government spending as possible should be of the kind that can credibly be classified as ‘investment’.

That said, when it comes to the details of the deficit reduction he calls for, Sachs turns out to be wielding not an axe but a toothpick. (True, this is hardly a surprise, given Sachs has consistently championed more public spending on overseas aid.) Indeed, his plan is awash with spending commitments: education, welfare, healthcare, infrastructure, clean energy are all priorities for receiving more of the taxpayers’ dollar under Treasury Secretary Sachs. And it is noticeably silent on what he would cut.

We do not doubt that some of Sachs’ spending suggestions are sensible. Continuing to invest in education as the driver of the competitveness of rich (i.e. high-cost) economies is surely the right thing to do. (It is therefore baffling that the new UK government, for example, has made cuts in higher education part of their initial £6 billion ($9 billion) austerity package.)

So how would Sachs cut the deficit while protecting or increasing spending in these vital areas? By taxing the rich. While this might make populist sense it suffers from two problems. First, it’s impractical, at least on the scale that would presumably be needed to pay for the Sachs spending plan. The rich are notoriously difficult to tax, in part because they are internationally footloose, and can afford better accountants than the rest of us. Second, taxes on the rich too easily become taxes on wealth creation, which is the last thing, especially in these recessionary times, that any government should discourage, deliberately or by accident.

Again, consider the current situation in Britain, where the two parties in the new coalition government are fighting over whether to push capital gains tax up from 16% to match the top rate of income tax of 40%. Advocates of the increase are right to point out that there is something iniquitous in the situation that someone’s earnings from hard work are taxed at more than double the rate of someone making a killing off the sale of second home that has soared in value. On the other hand, that particular horse has surely bolted. In the coming decade, it seems highly unlikely that significant returns to capital will result from asset price bubbles rather than from innovation and industry – exactly the things our economies need most. Sachs’s proposal to ‘Tax the rich’, for all its obvious populist appeal, is almost as pointless an answer to the ‘how to cut the deficit?’ question as the usual politicians’ answer: cut waste.

Rather than looking at Sachs’ vacuous plan, a better guide to where the axe will eventually fall (as sooner or later it must) comes from the austerity measures that European countries have had forced on them prematurely by the flaws in the Eurozone (especially Greece). Sales tax and VAT increases are an attractive option – they are easy to collect, spread the pain broadly and do little harm to incentives. Cuts in public sector salaries are also a pretty fair way to reduce spending – civil servants’ job security and generous pensions mean they are protected from the risk of unemployment and well placed for a prosperous retirement (two assets that seem more aluable today than they did before the crash), so they are more capable of taking the hit than most ordinary families outside the public sector. Upping the retirement age would also be a boon to the structural deficit, especially if it was aplied to people currently nearer to retirement than governments are currently considering.

Ours is not a costed plan, but the underlyig principle is clear – governments should focus on filling the fiscal hole with taxes that do least to distrort incentives and expenditure cuts focused on transfer payments rather than investment (which includes investments in making public services more efficient in the future). That means all of us taking some pain now, and a proper safety net in place to protect the most vulnerable. The inevitable legacy of this crisis is that many of us will have to work harder for less money, at least for the next few years. Trying to soften the blow by cutting investment in our future productive capacity may be politically expedient in the short term but a decision we would repent at leisure. On this, no doubt, Krugman and Sachs, and maybe some less liberal economists too, would surely agree.

“I’d give it an F – no, make that a D.” So said veteran insurance boss Bill Berkley of the W.R. Berkley Corporation on May 26th, when asked to grade the US government’s involvement with AIG during the past couple of years – when it first let AIG reach the brink of failure, then rescued it (pumping tens of billions of dollars into the coffers of Goldman Sachs and other troubled banks as it did so) through what in any other country would be called nationalisation but in America had to be disguised as something called “conservatorship”.

Among other failings, according to Mr Berkley, the government “was obsessed with process over outcomes” and, as a result, failed to get to grip with the fundamental problems (though he reckons it did a better job sorting out the disastrous financial products unit than it did running some other parts of the business). In particular, it messed up a previously terrific life insurance business, and has seen its best employees leaving in droves, not least to Mr Berkley’s firm. “These employees didn’t want to leave, they loved AIG,” Mr Berkley explained, “But in they end they were demoralised.”

On the face of it, this disaster – along with the unresolved messes now in public hands that are Citigroup, Fannie Mae and Freddie Mac – provides yet more proof of why nationalisation is a bad idea. So should we be relieved that the US government did not take our advice in The Road From Ruin to nationalise more financial institutions in the aftermath of the market meltdown of late 2008? Let’s be clear. We are not in favour of nationalisation per se. However, we do think that a “Scandinavian style nationalisation” of financial institutions could have avoided many of the subsequent problems that have afflicted Wall Street and the economy.

In the early 1990s, Sweden, Norway and Finland nationalised troubled banks during a financial crisis – but this was always going to be a temporary arrangement, as bad assets were removed into government hands to clean up their balance sheets, so the restored banks could swiftly be returned to the private sector. This worked a treat, allowing bad debt to be restructured and confidence to return to the financial system quickly and more cost-effectively than has been the case in America – which is a case study not in the dangers of a surgical nationalisation but of an unthinking nationalisation as an act of desperation by a Treasury Secretary, Hank Paulson, who refused on ideological grounds to think about how nationalisation would work until it was too late and he had no choice but to nationalise in whatever way he could.

Not only has the US government failed as an owner of AIG, it has also created a new form of “moral hazard”, at least according to Mr Berkley. (Although his firm sometimes competes with AIG, Mr Berkley has a reputation as a straight shooter in the manner of Warren Buffett, but without the Sage of Omaha’s tendency to play to the gallery and occasionally talk up his own book.) He says that, since it has been in public ownership, AIG has been one of the most aggressive pricers of property and casualty insurance, and that the prices it has been selling at are “clearly uneconomic”. In other words, AIG is likely to make significant losses on these insurance sales. (Arguably, this subsidised insurance is a part of the government’s economic stimulus programme – though this is not an argument we’ve heard anyone in the government make.)

Mr Berkley says that there is no way that Hank Greenberg, the legendary long-time boss of AIG until he was forced out a few years ago, would ever have engaged in such uneconomic pricing. And is the reason why people are willing to buy insurance at a price that is clearly going to cause AIG to make losses because the market believes that the government will bail out AIG again if it has to? That’s what everyone believes, says Mr Berkley – who, if he is right, should have gone with his original instinct, and given the government an F.

Anyway, now that its new financial regulations seem about to be adopted by Congress, maybe Team Obama should turn their attention to sorting out as fast as possible the messes that are AIG, Citigroup, Fannie Mae and Freddie Mac?

On May 24th, the new British Chancellor of the Exchequer, George Osborne, will deliver on one of the Conservative Party’s big election pledges, to start to tame public borrowing by cutting £6 billion of public expenditure this year. This may seem like common sense, particularly as the Eurozone across the Channel is battered by the markets’ jitters about spiralling public debt, but it is not without risks and, worryingly, seems to be motivated more by politics than economics.

Like many other countries, the UK’s debt has soared during the economic crisis – probably to more than 70% of national income by the end of the year. While this is still lower than, say, the United States (80%+), the UK’s deficit for this year is forecast to be as big as that of beleagured Greece as a proportion of national income, so the borrowing cannot go on for ever. According to Osborne, Britain needs to get back on the road to fiscal prudence now, not least to reassure the markets and restore business confidence.

The problem with this strategy, at least according to ex-Prime Minister Gordon Brown during the election campaign, is that the recovery in the UK economy has only just started. Slowing the stimulus now risks letting the economy slide back into recession in a dreaded ‘double-dip’, which could lead to a 1990s-Japanese-style stagnation.

So who is right? Deciding whether this is a risk worth taking depends on two judgements.

First, will £6 billion make much of a difference to the recovery? True, while it is a lot of money to have in your bank account, it is only a tiny fraction of public expenditure. So maybe the impact won’t be so great. On the other hand, if it is such a small amount of money, why take the risk now? With further tax rises and bigger public expenditure cuts to come in future years the economy is going to have to take a cold bath eventually, but maybe it is better to let the nascent recovery gain a bit more strength before wielding the axe.

Which takes us to the second judgement: do the markets need this reassurance? Based on the numbers alone, while there will need to be tough medicine over the next few years, the case for urgent action is quite weak – the UK debt stock is nowhere near Greek levels and has a long average maturity, so the Treasury won’t be looking to the markets for significant refinancing in the near future.

The Chancellor’s aides are keen to point out that these cuts have the backing of the Governor of the Bank of England, Mervyn King, and he should know. Well, maybe. The Governor has his own worries at the moment. Prices are surging above his 2% inflation target and while there are good reasons to think that exceptional factors are the cause, he needs to reassure the markets that he has not gone soft on inflation. Backing the cuts sends the right signal without forcing him to change monetary policy, the area for which he has responsibility.

The economic rationale for the cuts may not be strong but the political logic, on the other hand, is compelling. Having made cutting government waste a key plank of their election campaign, it makes good politics for the Conservatives to say that, within a matter of weeks of taking power, the new administration has uncovered £6 billion of profligacy (a process that has already started). The cuts also play well with parts of the Conservative base least happy with the new sleeping arrangements with the Liberal Democrats – fiscal hawkishness is a good sop to the disgruntled.

In the end, these cuts will not tell us much about the future trend of UK public finances. The mandarins had fair warning that there was a good chance they would have to offer up £6 billion of savings, so will have prepared a contingency plan of cuts that don’t require really tough decisions for new ministers. The same will not be the case with the real cuts that will have to start in 2011. Worse, as Stephanie Flanders of the BBC has pointed out, the coalition agreement has already constrained the government’s room for manoeuvre.

Being Chancellor of the Exchequer is a tough job at the best of times. Osborne will be talking tough on Monday – but he should savour the moment, because his job is only going to get harder.

So America’s financial reform bill has moved a step closer to becoming law, with the Senate version getting the necessary votes late on May 20th. Now begins the conference process of reconciling the House and Senate bills, which have significant differences – a classic smoke-filled-room activity that always has the potential for surprises, often of the nasty variety.

We will write about what we think of the various aspects of the likely legislation in future posts. For now, suffice it to say that the Titans of Wall Street seem fairly relaxed about what now seems likely to emerge from the Washington legislative sausage factory. “You may accuse me of being too relaxed,” the head of one big Wall Street bank confided at an off the record lunch yesterday, “but we will adapt. We may have to spin off our real-estate and private-equity businesses, and a few others. But we will adapt and move forward. There are plenty of opportunities.”

So, what does keep him awake at night? Two things. First, that the ratings agencies will downgrade his and other Wall Street banks. Why might they do that? To summarise: They are not a very talented bunch, as their performance during the real-estate bubble demonstrated. The US government has been talking about how no bank is too big to fail, which literal-minded people at the ratings agencies might take seriously, especially if the current nervousness in the markets continues – even though everyone knows this talk is just political posturing and, in reality, after the fright letting Lehman Brothers fail caused, there is no way any systemically important financial institution will be allowed to go bust in the forseeable future.

Second, although he stresses that his bank is now extremely well capitalised, he worries that the world’s central banks will gang together through the Bank for International Settlements in Basel, to impose excessively tough capital requirements. Our talkative bank boss does not fancy having to initiate another capital raising campaign, particularly given the current market conditions.

He is not the only Wall Street Titan to worry about the potential for risk-averse cental banks to damage the wealth creation process by imposing heavy capital requirements on banks under the “Basel 3″ process now under way. The head of a big private-equity firm recently confided that he saw this as a far more likely, and serious, danger than any regulatory reform likely to emerge from Congress – especially because central bankers now represent the nearest thing the developed world has to unchecked, unaccountable political and economic power. Is this just scaremongering by wealthy financiers? Watch this space!