U.S. Asks China Not to Destroy World Economy

As efforts to contain economic damage stumble,  fail, around the world , it's time to revisit a post from November 2009.   I've updated with a few notes added in blue (below).  China's sustained effort to increase its exports through subsidies (via its currency peg/manipulation) -- which also raises the prices of American goods in China -- have greatly worsened devastating global trade imbalances.

The effect of these gigantic trade surpluses are widespread joblessness and gradual economic collapse in the western world.

But global trade imbalances maintained by currency pegs, like stress in the earth, must eventually release.  We now are witnessing the escalating quakes in Europe as both austerity and ability to borrow are failing.  These are like the little tremors and the medium sized tremors before the big one.

One wonders how long China will drag its feet to rebalance its own economy as the world economy falters.  Will it wait until exports collapse and it sees riots in its own cities?

But then, rarely are people willing to realize, to comprehend, the harmful effects of actions they believe benefit themselves, especially if the illusion can be maintained a little longer....

They don't want to know that their export model is slowly destroying the world economy, via their sheer size and manufacturing investment. Not any more than Germans would like to understand that their prosperity has come in large part from a currency peg against the rest of Europe via the EMU (European monetary union -- the Euro).  Were a (reestablished) German Deutsche Mark and the Chinese Renminbi allowed to freely float, so that their exchange rates were freely set by markets, nations like Greece, Italy, Ireland, Portugal, Spain, the U.K....and the U.S., to name a few, would quickly feel a fresh breeze of new economic activity and hope.

In fact, we could change course away from a very dark future (see this post).

But Germany has experienced record low unemployment (as the world economy deteriorates).  Why would Germans want to recognize reality?

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November, 2009:

Finally, after years, even economists like Krugman are publicly recognizing that the Chinese peg of their currency to the dollar is more than a nuisance or a developing-country tactic. It's a profound handicap placed on American manufacturing.

(2012: During the last year, the understanding of the effects of the Chinese peg has become widespread.)

The peg threatens American recovery. It is in effect a Chinese trade war against America, ongoing for years.

Many economists haven't yet really wrapped their minds around the reality that if exports are heavily subsidized (relative price held down) by a currency peg during an imbalance, then it is no longer "free trade."

We do not have free trade with China.

"Free trade" is effectively an ideology in recent times. Economists understand the advantages of free trade -- how it increases most everyone's absolute wealth (buying power in goods). It's understood the disruption and economic damage the raising of trade barriers would cause. All true.

But not enough. The thinking simply needs to continue beyond this basic level of understanding.

When a government intentionally bends a nation to accomplish an international goal of gaining manufacturing jobs at the expense of other nations (at the expense of jobs in other nations), this is a kind of powerful trade interference. It becomes in effect a trade war.

Damage to the U.S. isn't the only result of this managed effort. The peg actually threatens Chinese stability by extending a reliance on an unsustainable imbalance.

But more, the Chinese peg threats global economic stability.

(2012: Witness Europe)

And that raises an open question.

Does China have the smarts to recognize that both alternatives that could follow from maintaining the currency peg are quite harmful to China itself?

It's a multi-trillion dollar question.

Here are the two alternative scenarios I see if China maintains the peg.

Either:

A) As Martin Wolf points out, the U.S. is truly forced, without choice, to initiate major tariffs within a few years:

“Yet we do not have that much time. If the US domestic economy remained weak and unemployment high, while our trade deficit soared, particularly our bilateral deficit with China, the pressure to ‘do something’ would become irresistible. I would have to consider the sort of actions that Richard Nixon took in 1971. To force revaluations by Germany and Japan, he threatened a 10 per cent import surcharge. With great regret, I might feel obliged to do the same. I would then argue that China’s determination to thwart needed adjustment in exchange rates had become intolerable. The US is entitled to protect itself against such mercantilism. The trading system would be terribly damaged. But the alternative would be unbearable.”

OR

B) If somehow the U.S. government delayed such a response for little longer based on "free trade" fallacies, then the buildup of political pressure in the U.S. due to joblessness would only lead to a more drastic final U.S. response than the one Martin suggests.

Ideology -- the mental error of trying to maintain "free trade" when the U.S. faces in reality a kind of ongoing trade war -- can only withstand a contrary reality up to a certain limit, at which point the ideology, or illusion, collapses and great political energy is released. America could actually be pushed into a genuine change in ideology.

China by nature should be a natural ally of the U.S. Only the paranoid right has needed to see China as a serious rival.

That could change.

So this question is really a question of smarts. Are they smart enough to see the train coming down the track? Are we smart enough to sound the horn instead of patiently waiting for China to answer a diffident phone call?

It has become evident that conditions similar to the 1930s could arise... (2012 update: have arrived.  We have economic depression in several nations in Europe now, and are seeing a dramatic rise of nationalism.  We are progressing on the list towards a much darker time I reluctantly laid out in the link above.)  ... if these trade imbalances persist, which could lead to a increased risk of economic wars and even a general destabilization of currently peaceful parts of the world, with risk of major warfare.

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Update (2010):

Cui Tiankai, a Chinese vice foreign minister who is in charge of preparing for the G20 summit, said the yuan was "China's currency, so I don't think it is an issue that should be discussed internationally.

Regardless of internal Chinese politics/signals, the exchange rate of the yuan to the U.S. dollar, which China is massively intervening to control, is with the U.S. dollar and directly intervenes in U.S. exports by controlling U.S. export prices to China and many nations.

China is controlling U.S. export prices by directly controlling the value of the U.S. dollar.

Is that an "international" issue? Yes.

The U.S. dollar is the currency of the United States, so interventions that affect the dollar are central to U.S. economic health, and fully within the purview of the federal government of the United States.

National Debt Illusion and Reality

The national debate on the budget has two primary issues:

A) Ideological: What Government is for -- what it should and should not do.

B) Practical: Whether we have to quickly reduce deficit spending to avoid a loss of confidence in US debt sustainability and a resulting rise in interest payments on US debt (this idea illustrated below).

...

The first issue -- What Government Is For -- is the real sticking point in Congress now.

Pragmatic questions are solved in negotiations and blending of ideas. Ideology often will not be blended, and accounts for the real hardness of positions.

I've addressed this question fundamentally here: What Government Does Well/Poorly.

But for once the pragmatic question -- issue B -- is a central question and a sticking point for a sufficient number in Congress to matter, as votes could be close.

...

This 2nd issue, B, has a great danger -- that we may rush in fear about possible loss of market confidence in the US debt and implement deep cuts in Government spending soon -- while private spending remains tepid and slow (it will for years).

Early and deep cuts in government spending would cause a circular reduction in demand for goods, and thus a progressive loss of jobs. Therefore such early cuts would do little to help the budget deficit, as tax revenues would fall as jobs are lost.

How do we know that would surely happen? It would happen due to the Savings Conundrum (illustrated here).

...

So does debt matter?

The answer is yes and no. Less than popularly thought at the moment....

The argument that we have to do something soon about the national deficit and debt is summarized by this good Washington Post overview in its last point:

Here’s a phrase that most Americans have never heard but that will be really, really important over the coming decade: “debt dynamics.”

That’s the concept that deficits and debt have a built-in feedback loop. So when debt levels rise too high, interest rates can rise, making the debt problem all the more onerous. Debt dynamics are the reason that, even though interest rates are very low now, it is worth worrying about current U.S. debt levels.

A debt level that is completely manageable when interest rates are 3 percent can become burdensome when rates are 6 percent. Every rise in interest rates by a single percentage point increases the annual cost to service that debt by about $140 billion, or $450 for every American.

What that means is that with debt levels high relative to the size of the economy, a country loses control of its own destiny in terms of public finances. If global lenders lose faith that the U.S. government is the safest entity on Earth to lend money to, the fiscal situation would go from being a long-term challenge to a near-term crisis.

But this is wrong, illusory, for a pragmatic reason.

Why?

Because the worldwide savings glut, which makes US treasury interest rates on our national debt so low, isn't going away, not for decades.

Why?

Because China implemented a One Child policy a few decades ago, and the consequences will play out for decades more. China will continue to consume less than it produces, and will have excess savings needing to be invested somewhere.

As will Germany, and much of the West, and even most Americans, as private savers. Americans hold most U.S. federal debt.

This private saving is a far more powerful force than any political hand wringing about US debt levels and a supposed market reaction.

Money has to go somewhere, and US treasury notes will continue to be a very popular place to put some money so long as the US has a reasonably large economy. We do, and will.

So, yes, we do need to make long term plans about government spending.

And we need to avoid really deep cuts in government spending soon, in fact anytime even in the next 2-5 years.

We need only a long term plan, and more than anything that means fixing Medicare costs growth over time. And here's how to do that.

Obama's Catch-22, Or Can A Good President Do Much About A Depression? It's Time to Talk about Reality

Some voters have been trained over the years to believe that Presidents have a decisive influence on the American economy.

Presidents influence the economy much like the captain of a out-of-control supertanker who commands a small auxiliary engine and rudder.

As the tanker itself powers forward, or not, under control of sea conditions and of its own massive engine and sea-spirit-guided rudder.

In calm sea conditions, the captain can gradually have an effect on the tanker's direction if the main engine and rudder aren't pushing in the opposite direction. Or, he can get more influence if he can convince the crew to break open that mysterious door deep in the bowels of the ship and activate the emergency engine in compartment zeta.

The captain might be able to reverse the direction of the supertanker during a full day (a full 4-year Presidential term), if he/she is lucky enough for the large engine and sea spirits to cooperate.

Maybe.

So, can Obama, faced with the beginning of a full-scale great depression, do much about it?

Not unless he can talk about actual economic reality, instead of the normal-to-date practice of hoping for the best and sounding optimistic.

President Roosevelt was able to take dramatic actions in 1933-1935 only and exactly because the Great Depression had so hammered the American economy during 1930-1933 that no one could pretend it was only another slowdown or deny the downward feedback loop.

Today, it is easy for political opportunists and demagogues to pretend that the economy only needs tax cuts, deregulation, etc., to just recover normally (as if it could just roar back to full steam ahead).

This is Obama's catch-22.

President Obama could not safely talk about being in an incipient depression or "lasting downturn" during 2009 because the psychology of everyone suddenly seeing the actual abyss we've entered into would only have intensified the downward plunge.

Talking about reality in 2009 or during the first half of 2010 might have caused the deeper collapse we feared, and have so far avoided.

But not talking about reality -- the known effects on nations of financial bubbles that burst -- prevents us from being able to do anything about it.

...

So the question, now, is whether it is time to talk about getting out of this Depression no. 2. Diplomatically. For instance, about being "still within the powerful hangover from the collapse of the housing bubble and its financial effects on everyone -- savers, businesses and lenders. This is a slump that can continue for years if left to its own slow processes of economic unraveling and rebuilding."

Is it too soon? Will voters be able to understand this isn't just a strong recession or do they need proof, 1932-1933-style proof like we'll get if we have deficit reduction/austerity starting anytime soon?

Do we need to continue to pretend a recovery is soon to lift us upward, in order to maintain some confidence?

I think the right time to talk about reality is now, because most people have already lost confidence in an oncoming recovery.

There is little real confidence to protect.

Obama should address the nation, from the oval office, and explain exactly where we are, using such economic history as Rogoff and Reinhart on the normal outcome of financial crises. He should explain what happens in every nation consistently when a credit or asset (housing) bubble inflates then collapses.

He needs to lay out this knowledge clearly to the American people, so that we can start to talk about the way things actually are, and not be caught any longer in illusions.

It would help greatly to talk in ways that cut through the jargon and create understanding -- he should explain to Americans the savings conundrum and why is it necessary for the government to reinvest the excess private savings to prevent a continuing downward spiral. He should talk of investing in America for our future, until economic growth picks up strongly enough to significantly raise the demand of businesses for new loans as shown by natural interest rates.

President Obama should explain how we can increase future productivity and economic growth by investing to produce a stronger economy 2, 3 and 10 years from now.

Obama needs to lay out for the American people a road out of depression.

Of course, he needs to use language more along the lines: "Reinvesting in our future to restore the growth and optimism America has known since the huge investments of the 1940s, 50s and 60s."

This is a key point -- that the tremendous prosperity America has known has been the result of massive federal investments in the 1940s, 1950s, and 1960s.

That's reality, and not enough Americans know it.

We need to cancel the distortion field by talking about reality.

The Savings Conundrum -- Our Future?

Suppose you and I were young and loved the wilderness and by chance we both moved to a small, remote meadow where we lived in teepees not far from each other, bringing with us basic tools by which to get our living. Suppose not long after we arrived we found an old cache of golden stones in a nearby cave from prehistoric times, and divided them equally, so that we had 20 golden stones apiece.

Suppose you loved to garden and forage, and had tools and seeds, and that I loved to hunt and trap and fish.

Not long after we arrive, you might well begin to want some meat to go with your meals, and I would surely like to have some vegetables, fruits or nuts to go with my meat.

While the first time or two we might simply trade a few items in barter, soon it would likely happen a day would come when I had a large haul of fish and you might have only a few nuts and I might suggest that you simply give me 1 of your golden stones (a "goldie") as a token for future food which I might buy back from you on another day when you had more.

We would have an economy, not fundamentally different from the global economy, even with its exchange rates, central banks, factories and technology.

Soon we might well have typical prices for our goods. A fish might cost a goldie, and so might 2 potatoes.

Perhaps on an average day we'd exchange a goldie or two, and in a week, perhaps several would go back and forth. Eventually, seasonal patterns might show up, and over the years we might have habits of me buying more vegetables in the summer, and you more meat in the winter, so that in the summer you would have more goldies and by early spring I would have more goldies.

Now, suppose one day, after several years of a stable, productive economy, I decided I wanted to save goldies for the future. Suppose I went on a savings binge. To save, I begin buying less from you, keeping more of my goldies in the summer, and foraging some for myself.

At the end of the summer, when you would usually have had plenty of goldies to buy meat from me in the winter, you'd find you have much fewer.

You've experienced a big loss of income. And winter is coming on. You've been saving nuts and potatoes, but you know it's going to be a hungry winter.

In desperation, due to your reduced income you begin buying less meat from me during the fall.

Now my income is reduced also.

In sum:
a) I've had less vegetables than usual
b) your income was reduced
c) you are poorer, and now now must make due with less meat than usual
d) and therefore my income is now reduced also.


I saved, and no one borrowed that savings and put it back into the economy, and the result was an economic spiral downward.

You are hungrier. I am hungrier.

Unless I stop saving, or someone starts borrowing my savings and spending it, trade would decline week after week, as I withdrew more and more goldies from circulation. Most likely what would happen is that due to my reduced income, I would be forced to begin choosing whether to save another goldie or have vegetables to eat that week, or take on extra work to grow my own, so that I worked 16 hour days. Eventually, my savings rate would stall out and decline, in spite of my plan. Either I'd stop saving in order to get some rest and eat at least a few vegetables, or I'd stop saving because I no longer have any income left to save. Trade would either stop entirely or be maintained at a low, impoverished level.

This is ultimately the real thing that is behind the abstraction of the "worldwide savings glut" -- a great excess of global savings over the sum of global consumption and sensible investment.

It is economic decline, joblessness, even economic downward spiral.

The only difference between our meadow and the global economy that matters here is that in the global economy, the massive savers -- the Germans and the Chinese -- loaned their savings to the rest of the world into financial markets and mortgaged-backed securities so that the money went into house-price bubble countries whose bubbles were filled exactly by that excess of savings.

This massive credit delayed the downward spiral a savings glut must cause, but only to make the shift more sudden, so that the inevitable downward spiral was more like falling off a cliff (2009).

Unless the excess savers change course, this will touch everyone, and may well even slam those that have a lot of savings in every nation, because savings cannot earn interest or dividends of any significance unless the invested-into economies grow.

In nations like China, such investments can take many forms, including such basic needs as railways, health clinics, hospitals and schools. And in underdeveloped nations, investments could take almost unlimited forms.

Because we are afraid of the economic uncertainty, even those of us that wouldn't ordinarily hoard a great excess of savings are trying to save more rapidly now.

People in many advanced nations are demanding their governments reduce deficits at the same time that they themselves save more.

In other words, the savings glut is likely to grow again in proportion to the world economy. Conditions could soon be getting worse.

Unless good investments quickly ensue, the unused savings could indeed spiral the global economy, and that of most all nations, down into a great depression.

There is no long-term solution to this more general new psychology of hoarding short of creating renewed confidence in most nations where fear of the future holds sway. For instance in China this would take many forms, including visibly increasing the future economic security of retirees so that Chinese households would feel more confident about spending part of their large savings now.

Around the world, changes are needed now, before our global crisis deepens.