Wednesday, September 17, 2003

Strangers Killing America

If things are improving, why would I be coming across so much material to the contrary? Been reading about the derivatives possible future problem all day. Yesterday, I finished reading an older book given to me recently, "The Vandals' Crown", excellent. Tremendous amount of information about the derivatives markets and history of, as well as other market and eco-political history... Well anyway, I have always been a bear, but recently I am a seriously dedicated deflationary bear.

I thought I'd start this off with the most interesting up to date paper I could find. Marshall has done an excellent job of informing us.


"International Perspective, by Marshall Auerback

The Kindness Of Strangers Is Killing America
September 16, 2003

The Fed’s flow of funds data that was released last week more than ever highlights America’s acute dependence on the kindness of strangers, particularly those of the Asian variety. Globalisation has been turned on its head. Instead of the centre lending capital to the developing periphery, capital is flowing back to the centre--that is, the United States. Even poor nations are lending the United States huge quantities of surplus capital, mainly to keep America afloat as the world's buyer of last resort. China is the new “bad boy” of the global economy, having displaced Japan as the aggressive emblem of a trading system ferociously out of balance. Congress has begun making increasingly loud protectionist threats; the latest example is legislation that threatens to impose 27.5% across-the board tariffs on Chinese exports into the US if the RMB peg is not abandoned.

Even traditional American champions of globalization (including Federal Reserve Chairman Alan Greenspan) have begun scolding China for excessive ambitions, just as they once criticized Japan, to no avail. The National Association of Manufacturers issued a report warning that 2.3 million US manufacturing jobs have disappeared since 2000, largely due to international competition (not entirely from China). The United States risks losing "critical mass" in manufacturing, says the NAM. A Defense Department technology-advisory group confirmed that so much “intellectual capital and industrial capability” has been moved offshore, particularly in microelectronics, that the Pentagon is dangerously dependent on foreign producers to make its high-tech weaponry.

If the United States falters and can no longer act as the engine of global growth, the entire system is in deep trouble. Of course, the corollary also applies: With the current account deficit at 5% of GDP for the first time in history, America’s dependency on Asia’s central banking fraternity is gargantuan. China, Japan, South Korea and Hong Kong now own a combined total of about $696 billion in Treasuries at the end of June. China alone now holds $290 billion in US government debt, more than any other foreign lender, according to Chen Zhao of the Bank Credit Analyst Research Group. “The flow of Chinese savings has enabled Americans to borrow and spend more,” he explained in the Financial Times. “China is glad to see Americans going on another shopping spree. Its factories are cranking up production at an unprecedented pace.... China's exports to the U.S. jumped 35 percent in the first quarter” compared with the first quarter of 2002. The drive for China to export more will increase as measures to slow down the domestic capex and real estate booms begin to bite, and Chinese manufacturers increasingly look to America as a potential growth offset.

If the US were a developing country, there would already be widespread speculation as to how long before the IMF was wheeled in to help. Compare the situation to that of Argentina: Argentina’s problem was too much debt for too small an economic engine. When foreigners stopped investing in Argentina, the music stopped and there were no chairs. The fervent hope of US policy makers is that the US economy will surge, its debt repayment capacity will grow, as the country grows its way out of a looming debt trap dynamic. But the arithmetic is hardly compelling support for such a benign outcome.

It is true that the potentially dire effects on the level of activity since 2001 has been mitigated by a transformation in the stance of fiscal policy, accompanied by a radical change in attitudes to budget deficits, which have suddenly became respectable (even under an ostensibly “conservative, small government” Republican administration). The expansionary fiscal policy initiated by President Bush was reinforced by a further aggressive relaxation of monetary policy so that short term interest rates have fallen almost to zero, thereby giving the consumer boom a last gasp. Yet, with all this help, the recovery from the recession of 2001 has not been particularly robust. Growth has generally been below that of productive potential and there is a widespread sense that all is not well.

Today, the US private sector financial balance is almost back to neutral after a long stretch since 1997 in deficit spending territory. Because low interest rates encourage households to keep borrowing and spending, the private sector has yet to return to its traditional net saving position of 1-2% of nominal GDP. Virtually all of the improvement has been on the back of the largest fiscal stimulus in history, as opposed to genuine balance sheet repair.

The deepening trade deficit has confounded the ability of fiscal deficit spending to push the private sector back into a net saving position. That means fiscal policy has had to go alarmingly deep into deficit spending to prevent a private income growth collapse. This is inherently unstable: the rate at which foreign debt has been accumulating is such as to generate a further, accelerating, flow of interest payments out of the country, which might necessitate even larger budget deficits in subsequent years.

Such is the current state of affairs that we now have the reappearance of the “twin deficits” so feared by bond investors during the Reagan Administration. Investors used to fret perpetually about this condition. The dollar’s trend each month was largely determined by widely scrutinized trade reports which highlighted growing imbalances, even though the external condition of the US was nowhere near as dire as today. Then, America was still a net creditor, the current account at its worst never exceeded 3% of GDP, and the US could still grow its way out of the problem, given the robust economic condition of some of its major trading partners, such as Japan.

Equally significant was that the geopolitical circumstances of the era largely ensured the maintenance of the status quo, no matter how economically untenable longer term. The nations of emerging Asia built up their manufacturing apparatuses during the Cold War when they abutted major sites of “communism”, which gave the United States an overriding interest in fostering their state-led capitalisms in order to prove that capitalism was superior to the communist systems next door. By the start of the 1980s, when the U.S. began to move from competing in manufactures to dominating through finance—and importing a rising fraction of manufactured goods—capitalist East Asia was well placed to ride the surge of U.S. import demand and even to provide out of its growing financial surpluses the savings needed to cover escalating U.S. current account deficits.

Things have changed somewhat today in the post cold war era. Asia is no longer a cold war ally, but a “strategic competitor”, particularly China. Yet, in the economic sphere the US still relies on this old cold war construct: Asia exports its goods into a relatively open American consumer market, and then recycles its savings back into Treasuries. But as countless analysts are now warning, the risk of an external creditor revulsion may finally force foreign investors to demand a higher required return (that is, higher interest rates and lower stock prices) in order to both continue holding their massive US dollar denominated assets, and continue to purchase any new financing issued by US public or private entities. It is possible such demands could derail the US economic reacceleration, and this must be considered the major downside risk at the moment.

The challenge ahead with regard to US financial balances is pretty clear: the US trade deficit must be reversed before the fiscal deficit peaks. There is no indication the Administration recognizes this challenge, or is even exploring options to address it, beyond the current protectionist rumblings in Congress and the ineffectual if not counterproductive jawboning of Asia, especially China, on the issue of currency pegging. In fact, threats of increased protectionism to counter China’s alleged “unfair” pegged rate monetary regime, might well prove counterproductive, given the extent to which the Chinese are now continuing to provide the fuel to motor further US economic growth, the very dynamic American policy makers hope will allow them to escape their debt conundrum.

It is highly unlikely that the Chinese authorities will accede to such pressure imminently. However, it is certainly dangerous for Washington to raise the issue so publicly at this time. Investors the world over may rapidly come to believe that eventually the US will get its way, as it usually does, and there is no telling how big or how fast the downward adjustment to the dollar could be at that stage. It would be natural for investors to want to immediately start padding the marginal return demand for buying US dollar assets if American political pressure becomes too extreme.

Further complicating the picture is that too much growth abroad, ostensibly helping the trade deficit, creates other potential problems. Clearly, America’s interest rate structure is closely tied to how well growth and investment demand proceeds overseas. This is why the pickup in the Japanese economy is probably the biggest story in global finance, yet it is getting only moderate attention. If that nation ever really did right its economic ship and sail off on a three or more year period of strong growth, the amount of upward pressure the US would experience on market-based interest rates could be astonishing, particularly in the absence of genuine balance sheet repair.

Thus, there is a troubling circularity to US economic policy making. Growth, which is an essential prerequisite to continued debt repayment, is largely fuelled by further debt accumulation. And the countries that continue to perpetuate this paradoxical state of affairs, notably China, still face unremittingly hostile pressure from American policy makers to revalue the currency, thereby potentially precipitating the sort of dollar crisis that could well induce sharply lower growth in the US; foreign creditors may well demand correspondingly higher risk premiums (through higher long term rates) to compensate for a fall in the external value of the greenback.

Given the precarious nature of America’s predicament, one would have thought that a prime objective of diplomacy would be to cement good relations with its largest creditors, so as to minimize these economic vulnerabilities. Yet, just two years after the September 11 attacks, the opposite appears to be the case. Traditional alliances in Europe are marked by increased friction; for all of the talk of new “friendships” with Russia, the global economic system’s prosperity ultimately rests on the US-EU alliance which, if it really breaks down, will take the global economy down with it.

As in Europe, the United States today is finding a new coolness in its relations with old friends in Asia. Whether in Tokyo, Beijing, Jakarta, or Bangkok, the analysis of US objectives and motives is sharply at odds with the standard American rationale. In their view, the US wants a strong and prosperous Asia, but only on American terms – economically sound, politically obeisant to Washington, and largely accepting of the American economic model.

This was also being reflected in the country’s current negotiating stance in the global trade talks at Cancun. The rights of foreign capital and corporations are to be expanded; the rights of sovereign nations to decide their own development strategies steadily eliminated. A country must not require multinationals to form joint ventures with domestic enterprises. It must not limit foreign ownership of its natural resources. Capital controls are to be abolished. National health systems, water systems and other public services must be open to privatization by foreign companies. Underdeveloped countries must, meanwhile, enforce the patent-rights system from the advanced economies to protect drugs, music, software and other “intellectual property” assets owned by wealthy industrialists. Any poor nation that dares to resist the WTO rule will face severe “sanctions”--huge cash penalties--and possibly de facto expulsion from the trading club. On the other hand, any talk by developing countries to eliminate the west’s agricultural subsidies is quickly shot down and left as a vague subject for future negotiations. It was on the basis of this widely perceived double standard, that the negotiations ultimately foundered.

America’s hard-line stance might be understandable were its military dominance matched by comparable economic might. But such a position is far less tenable when the US is the world’s largest supplicant for global capital flows and fighting an increasingly expensive global war on terror. It is premised on the misconceived notion that the US remains an economically vibrant country that can easily press the weak to accede to their terms or else get nothing back at the bargaining table, and very possibly lose their access to foreign capital or development aid. But who is it that is most dependent on foreign capital at this stage?

Asia in particular appears to have learned its lessons well from 1997: policy makers in the region have concluded he who holds the credit, gets to choose when to pull the rug out from under the dependent debtor, and on terms fairly non-negotiable. At best, then, the imperial debtor can try to be cordoned of his consumers of global goods from such blackmailing creditors, thereby undermining their ability to accumulate further claims against him. But since it is in no small part US based corporations or subsidiaries operating out of export platforms in China and other Asian nation, this would be a hard one to pull off without the imperial debtor power slitting its own throat. Lenin's “sell them enough rope and capitalists will hang themselves” theory was incomplete. As China may have figured out, you have to sell them the rope on credit to really hang the little piggies high (or, at the very least, to keep the protectionist wolves at bay).

But the nexus between China and the US is fundamentally unhealthy and ultimately points to the fragility at the heart of the global economy right now. China’s “kindness” is in effect killing America, although in the absence of Congressional disruption this curiously symbiotic death spiral could continue for a while longer. By allowing the US to buy more than it produces and borrowing to do so, it will eventually force an ugly reckoning. With its ever-swelling trade deficits, the moment of painful adjustment draws closer, but the debt cycle is unlikely to stop until creditor nations conclude that the US debt position is too dangerous and start withholding their capital. Alternately, if China's overheated economy gets mired in financial disorder or inflationary pressures, as appears to be the case today, it might need to bring its capital home--thus pulling the plug on American consumers and the “buyer of last resort” for the global system at large. The paradoxical relationship between China and the US provides a clear illustration as to why the global economy is so precariously placed. The two epicentres of growth both exhibit tremendous structural problems, so a multitude of things could go wrong in the months ahead. Ironically, Congress might turn out to be the author of America’s own misfortune. That is, if the Chinese don’t beat them to it first." Article Link

Again, a vote of thanks to Marshall Auerback for an excellent piece.

No comments: