Andy Xie thinks the Fed is on an inflationary path.  Last month, he wrote an article in Caijing which says that ‘stagflation lite’ is the Federal Reserve’s preferred outcome. What’s interesting is his recent article about the need for China and Japan to join forces under an ASEAN umbrella, rejecting the APEC umbrella shared with the U.S.

In last month’s article, Xie said:

The bottom line is that, regardless what central banks say and do, the world will be awash in a lot more money after the crisis than before — money that will lead to inflation. Even though all central banks talk about being tough on inflation now, they are unlikely to act tough. After a debt bubble bursts, there are two effective options for deleveraging: bankruptcy or inflation. Government actions over the past year show they cannot accept the first option. The second is likely.

Hyperinflation was used in Germany in the 1920s and Russia in late 1990s to wipe slates clean. The technique was essentially mass default by debtors. But robbing savers en masse has serious political consequences. Existing governments, at least, will fall. Most governments would rather find another way out. Mild stagflation is probably the best one can hope for after a debt bubble. A benefit is that stagflation can spread the pain over many years. A downside is that the pain lingers.

If a central bank can keep real interest rates at zero, and real growth rates at 2.5 percent, leverage could be decreased 22 percent in a decade. If real interest rates can be kept at minus 1 percent, leverage could drop 30 percent in a decade. The cost is probably a 5 percent inflation rate. It works, but slowly.

If stagflation is the goal, why might central banks such as the Fed talk tough about inflation now? The purpose is to persuade bondholders to accept low bond yields. The Fed is effectively influencing mortgage interest rates by buying Fannie Mae bonds. This is the most important aspect of the Fed’s stimulus policy. It effectively limits Treasury yields, too. The Fed would be in no position to buy if all Treasury holders decide to sell, and high Treasury yields would push down the property market once again.

I certainly agree with him. You don’t have to be in the hyperinflation camp like Marc Faber to think the Fed takes Ken Rogoff’s suggestions about 6% inflation seriously. In a May post, I said:

Basically, the Fed wants to inflate our way out of this depression – that’s the dirty little secret.  There is really no other policy choice because the mountain of debt in the United States is immense.  And I think Bernanke, Geithner and Summers have proven they are willing to do anything to reflate this economy and avoid debt deflation dynamics.

And when I say anything, I mean create asset bubbles that are being given intellectual cover by the likes of Frederic Mishkin. This is a policy of economic weakness.

So what should the Asians do?  China is desperate to employ its tens of millions of countryside transplants cruising its cities in search of urban employment. That’s a major reason it keeps its exchange rate fixed to a plummeting dollar, making not just Americans but Europeans irate?  Japan has been in a modern day depression for twenty years. Its sovereign debt-to GDP is now over 200%, risking a downgrade.

Xie says the two should join forces – in part as a rejection of the U.S., which he basically calls a fading power (although the paragraph above points to serious weaknesses in China and Japan as well).

Here is an excerpt of Xie’s article:

Yet the fundamental case for Japan to increase integration with the rest of Asia and away from the United States grows stronger every day. Despite high per capita income, Japan remains an export-oriented economy, having missed an opportunity to develop a consumption-led economy in the 1980s and ’90s. In the foolish belief that rising property prices would spread wealth beyond the industrial heartland in the Tokyo-Osaka corridor, the government of former Prime Minister Kakuei Tanaka pursued a high-price land policy, discouraging the middle class from pursuing a consumer lifestyle as they saved for property purchases…

The point is that Japan has a strong and genuine case that favors more integration with East Asia. The United States is unlikely to recover soon and with enough strength to feed Japan’s export machine again. There is no more room for fiscal stimulus. Devaluing the yen to gain market share is not an option as long as Washington pursues a weak dollar policy. Without a new source of trade, Japan’s economy is doomed. Closer integration with East Asia is the only way out…

Five years ago, I wrote an op-ed piece for the Financial Times entitled China and Japan: Natural Partners. At the time, a prevailing sentiment was that China and Japan were antithetical: Both were still manufacturing export-led economies and could only gain at the other’s expense. I saw complementary demographics and capital: Japan had a declining labor force and China needed to employ tens of millions of youths migrating to cities from the countryside. China needed capital and Japan had surplus capital. And their trade relations indeed tightened, as Japan had increased the Chinese share of its overall trade to 17.4 percent in 2008 from 10.4 percent in ‘04.

Today, the situation has changed. China has a capital surplus rather than a shortage. Demographic complementarity is still good and could last another decade. As China shifts its development model from resource intensive to environmentally friendly, a new complementarity is emerging. Japan has already made the transition, and its technologies that supported the transition need a new market such as China’s. So even without a new trade agreement, bilateral trade will continue growing.

An FTA between China and Japan would significantly accelerate their trade, resulting in an efficiency gain of more than US$ 1 trillion. Japan’s aging population lends urgency to increasing the investment returns. On the other hand, as China prepares to make a numerical commitment to limiting greenhouse gas emissions at the upcoming Copenhagen summit on global warming, heavy investment and rapid restructuring are needed for its economy. Japanese technology could come in quite handy.

An FTA involving Japan and China would be a serious threat to American economic power. You can imagine that policy makers in Washington are opposed to this idea.  Let’s watch to see what kind of rhetoric comes out of Barack Obama’s China trip to see if this issue is discussed.

Xie’s article in its entirety is at the link below.

Source

Andy Xie: Why China and Japan Need an East Asia Bloc – Caijing

Related posts:

• Stephen Roach: Downturn in Asia less severe, but recovery later
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• The Dollar
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The Canadian daily National Post has a good piece out today that highlights how the ‘Buy American’ provision is being seen in Canada.  Many see it as an affront that America could and would favor domestic firms over those of its largest trading partner and next-door neighbor despite the North American Free Trade Agreement.

For the second time in six months, pipe fittings in California are being ripped from the ground because they were stamped "Made in Canada," a move manufacturing companies say hurts both sides of the border.

Cambridge Brass Inc., a Canadian brass fittings manufacturer, discovered Thursday that it stands to lose more than $1.5- million in this most recent fallout from the Buy American protectionist measure.

Greg Bell, vice-president of sales and marketing for the Cambridge, Ont., company, received a call Thursday from the City of Sacramento, where the parts were being fitted into the public water system. He was told his product was no longer acceptable because it was not made in the United States.

"It’s disheartening. (The city) wants American-made products and there’s nothing I can do about it," Mr. Bell said. "Business is tough enough these days without having to deal with these roadblocks."

Anything already in the ground will have to be ripped back up at Cambridge Brass’s expense, Mr. Bell said. Between the costs of losing the project, pulling up the pipes and legal fees, he estimates his company stands to lose money in the seven-figure range.

Cambridge Brass has been based in southern Ontario for more than a century and has survived two world wars and the Great Depression, but Buy American may be what finally causes the company to bid farewell to the province.

Mr. Bell said losing a major project like this would mean more layoffs for the already suffering company.

It has already lost a supply distributor in Maine, and it has had to lay off half of its own employees in Cambridge – from a workforce of 140 it is now down to 77 – since the introduction of Buy American policies this year.

And if these protectionist measures continue, he said, the company will likely be forced to move its manufacturing to the United States in order to stay in business.

America seems clueless at how protectionist policies build rage that politicians abroad must quell or heed through retaliation. It’s as if only American politicians want to protect jobs.

It bears repeating because some people don’t get it: it’s not the act of protectionism itself which is so damaging, it is the retaliation and escalation that results.

"The government has got to stand up and propose some serious retaliation," said John Hayward, president of Hayward Gordon Ltd., noting the Halton Hills, Ont.-based industrial-pump manufacturing company has been barred from bidding on U.S. products. He said he has had to switch manufacturing from three Canadian plants to U.S. sites in order to stay in business, a survival decision that has resulted in local layoffs.

Read the full account below.

Source

‘Buy American horror stories’ building – National Post

Related posts:

• ‘Buy American’ will translate into a 21st century Smoot-Hawley
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• China launches retaliatory investigation into U.S auto subsidies
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• China: we “will take steps to protect the interests of our domestic industries”

China on Friday accused the US of protectionist and biased trade policies less than a week before president Barack Obama’s first visit to Beijing.

In a stinging rebuke to Washington, China’s commerce ministry promised to take measures to protect its domestic industry after the US slapped anti-dumping duties on $2.6bn of Chinese steel pipe imports. The duties are part of a growing roster of trade conflicts between the two countries, despite a high-level meeting last week in China aimed at reducing tensions.

“China resolutely opposes such protectionist practices and will take steps to protect the interests of our domestic industries,” Yao Jian, ministry spokesman, said on its website.

I see this coming to a head.  More here.

Related posts:

• China launches retaliatory investigation into U.S auto subsidies
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• Free trade is dead: victim of a poor economy

Marshall Auerback here. You saw Ed’s last post on China, quoting from Peter Tasker, one of the top analysts in Japan when I lived there. I take Peter’s insights very seriously. His analysis implies something a lot more in regards to currencies, trade and credit.

China’s bank credit expansion is so great that even if nominal GDP is up five to ten percent, the credit to GDP ratio will rise by about thirty percentage points.  It took Japan ten years to  take it up by fifty or sixty percentage points, and it has already been high in China before this credit boom. How high, no one knows because there is no good data on debt outside the banking system.  But there is such debt.  The debts of households and firms outside the banking system could be thirty percent of GDP.  The total ratio now could be 185%.  This is the same as Japan at the peak and close to the US now. 

This could keep China going for quite some time, but the consequences for Japan could be disastrous.  Indeed, for most of Asia, which could precipitate another crisis for them down the road.

One relatively unexplored aspect of the emerging Asia crisis of 1997 was what pushed these countries heavily into current account deficits.  But between 1992-94, China devalued the RMB by close to 60% (she was already running a current account surplus when she did it the second time), which created huge competitive pressures for the other countries and pushed them rapidly into deficit.  This time, China is devaluing along with the US dollar and reflating a credit bubble — not to encourage domestic demand, but to create a renewed export juggernaut, at a time of weak external demand.  This could really be problematic for the rest of the world.

I wonder how long before the protectionist pressures emerge?

Related posts:

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China has sent yet another public signal that it is unhappy with the U.S. and its trade policy by prepping an investigation into alleged illegal auto subsidies by the U.S. government.  The timing of this announcement puts a spotlight on the bailout of GMAC, the auto financial company which effectively has been nationalized the firm. This may be by intention.

The Financial times reports:

China is preparing to launch a trade investigation into whether US carmakers are being unfairly subsidised by the US government, according to people familiar with the matter.

The move comes at a time of heightened trade tensions between the two countries after the US imposed duties on Chinese tyres last month. Many warned this would prompt Beijing to retaliate.

Few vehicles are actually exported from the US to China, but the move would have symbolic power by turning the tables on Washington.

US labour groups have long accused Beijing of unfairly subsidising its exporters. However, through a “countervailing duties” investigation, China would assess whether the US was open to the same charge. The investigation could lead to import duties.

General Motors and Chrysler have received about $60bn in government bail-out funds, though Ford has received nothing.

Yes, General Motors has a large presence in China and its bailout by the government has an impact on its ability to operate competitively in China. But, because the U.S. does not export many cars to China, one might see this as a strange action on China’s part.  In my view, China is telling us with this action that “what is good for the goose is good for the gander.”

I find this story a bit curious because China already said in September that it would investigate autos and chicken in retaliation for U.S. tariffs on tires. But, we should look at this in a wider context. The US is also angling to get Chinese to revalue renminbi. The Chinese are resistant to this and their actions here can also be seen as a warning to the U.S. that any and all protectionist threats will be met with retaliation.

Elliot Feldman, head of international trade at Baker & Hostetler, the law firm, said his firm warned the USTR last January that the approach the US was taking towards China and other countries over subsidies was dangerous in the light of the US’s own support for carmakers, banks and financial institutions.

“We warned that other countries could apply to the United States the same principles the United States was applying to them,” he said. “Apparently we have arrived.”

The problem with protectionism is not that it can protect sectors, but that it leads to retaliation and escalation. This is now what is beginning to occur.

Related posts:

• China: we “will take steps to protect the interests of our domestic industries”
• Should we expect a protectionist China?
• Beijing starts a ‘Buy China’ policy
• Tariffs: Other industries may line up for sanctions against China
• China detains Rio executive on suspicion of espionage

This morning, I ran across a post by Prieur du Plessis, which linked out to a Stephen Roach interview on Charlie Rose.

Roach is the head of Morgan Stanley Asia and has been a voice to listen to when trying to discern where China is headed and how its relationship with the United States will develop. That was the topic of conversation between Roach and Rose. Through the links on that post I happened upon a 1996 Roach interview on Charlie Rose of a very different sort where he talked about the hollowing out of America and his concern for the future. I want to link those two below.

In the transcript of the recent China interview on Rose’s website, Roach marvels about the progress made in China:

CHARLIE ROSE: You left Wall Street to go live in China.

STEPHEN ROACH: I did. About three years ago, your friend and mine, John Mack, called me up and said, 25 years as an economist, a long time, good job. How would you like to do something different and be the chairman of Morgan Stanley’s business activities in Asia? And I told John I thought he was nuts. I had the best job. I wasn’t going to leave it. He said, "Think about it."

And, you know, John, when he says, "Think about it," there’s a fair amount of emphasis there. I did think about it. And I’d built fabulous relationships in Asia over the years, Charlie. I was passionate about the region. I thought I knew it well, but I knew in my gut that it would be a lot different from the inside than from the outside, and I said, yeah, I’m going to go for it.

And I’ve been out there now about two and a half years. And I have no regrets. I love it. I have learned an awful lot about Asia, and I thought it was time to put it down in a book and get it out there when the world is very focused on Asia, its own challenges and its role in the global economy.

CHARLIE ROSE: What do you love and what have you learned?

STEPHEN ROACH: What I am most passionate about in terms of Asia is what they’ve done, especially in China, over the last 30 years. You know, big celebration, 60th anniversary of the People’s Republic of China. But the first 30 years were pretty awful and the next 30 years have been spectacular. And the difference is they have really put huge focus on transitioning this economy from one that was owned by the state to one that is more of a market-based economy. They’ve taken huge risks in terms of reforms, layoffs, building market structures, building companies that we’ve never seen before. And to be on the inside and watching, watching that risk taking up close is a pretty fascinating experience for anyone. And I love every bit of it.

They go on to talk about the outlook there as well as how the government is dragging its heels on increasing domestic demand and shoring up a porous social safety net among other things. I definitely suggest you read the full transcript here. It makes for a better understanding of China. A snippet of the video is embedded below.

However, what was equally interesting to me was that Roach and Robert Reich were talking to Rose about concerns over the hollowing out of America’s workforce through downsizing (off-shoring had not yet gathered full steam).

Roach says:

“What has changed for me is my appreciation for what it has taken to get from point A to point B over the last ten years. It would be one thing if these productivity gains were built on the back of a more talented, skilled, educated, dynamic work force, but it’s another thing altogether if these productivity or efficiency changes were built on the basis of strategies that are hollowing out our companies, hollowing out our workforces, stagnating real wages – tactics in the end that can really lead to industrial extinction.

I’m sure you see the connection. If not, watch the video below in the context of the more recent video and your knowledge of what is happening in the global economy. I will say this: Roach was right about the dichotomy between the benefits to the owners of capital and the benefits to labor that these corporate strategies created.

Where I think his view could be tweaked looking back 13 years is in terms of what it has meant for Corporate America.  The hollowing out of America’s workforce and lack of investment domestically has not meant a hollowing out of Corporate America. Those companies that did downsize American workers in a ‘short-term’ play for next quarter’s earnings are many of the ones which have outperformed for the last 13 years because they have gone global. And the impressive leaps forward in China are testament to the gains made in places like China due in part to that move. It’s called ‘global labor arbitrage’ and it is what I see as the defining element of globalization as practiced.

In the end, however, a day of reckoning will come – not for the managers of the companies who have profited over the time span between these two interviews because they are going to keep their bonuses.  The day of reckoning for America will come in terms of the growth and dynamism of its middle class. Whether the U.S. then moves toward a Latin American style economic structure of a few rich at the top, a weaker middle class, and everyone else at the bottom or back to a more equal income and wealth distribution depends on the reaction by the ‘body politic,’ not on Wall Street.

Related posts:

• Stephen Roach: Downturn in Asia less severe, but recovery later
• Stephen Roach and Jim Grant: Video of credit crisis thoughts
• Stephen Roach is still bearish, no recovery until 2010
• Stephen Roach sees a W-shaped recovery for China
• Stephen Roach is talking double dip again

Paul Krugman has noticed that trade has absolutely collapsed with this economic downturn. It is worse than the Great Depression.

Question: is this aiding global re-balancing?

Here are two data points from Europe today which lead to that question.

The BBC reports on Germany:

Germany’s trade surplus fell 43% in August after a drop in exports from Europe’s biggest economy, according to the national statistics office.

Germany exported 8.1bn euros (£7.45bn;$11.95bn) more goods than it imported in August, down from 14.1bn euros in July.

The fall in exports was the first for four months and had not been expected.

Most focused on whether this trade reduction, especially the decline in export from export-powerhouse Germany meant that recovery has stalled.  I think the more important question is whether the trade flows are representative of re-balancing.

On that same subject, we get data from debtor Britain via the Guardian saying the current account imbalance is also narrowing:

The trade deficit has narrowed during the financial crisis from £8bn to £6.2bn in the year to August, while the tentative global recovery is also helping exporters.

Britain’s trade deficit with the rest of the world narrowed modestly in August to £6.2bn as exporters sought to capitalise on the sliding pound, and the recovery in overseas markets.

Yawning trade deficits have been a symptom of Britain’s out-of-kilter economy over the past decade. Mervyn King, the Bank of England governor, has repeatedly said he would like the weakness of sterling to bring about a "rebalancing" in the economy, by boosting exports.

The trade deficit in goods has been narrowing since the crisis began, and official figures released this morning showed that it was £6.2bn in August, down from £6.4bn in July, and more than £8bn in August 2008.

The ONS said exports actually fell, by £100m over the month, but imports fell faster, by £300m, as consumers tightened their belts. However, Vicky Redwood, of Capital Economics, pointed out that exports rose by 1.6% in the three months to August – the first quarterly rise in over a year.

It certainly helps that the pound has fallen apart, but the decrease in Britain’s current account deficit is mirrored in debtor America as well.  So, while trade flows are diminishing, so too are trade imbalances.

Related posts:

• European-Asian trade falls off a cliff
• The Euro and Baltic currency overvaluation
• When will Sterling hit Euro parity?
• The Cult of Zero Imbalances
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Marshall Auerback here. This is a cross-post from an article I wrote at the finance site New Deal 2.0, a one-stop-shop for current news, sharp analysis and potential solutions of the country’s fiscal crisis.

We’ve said it before and we’ll say it again. As a matter of national accounting, the domestic private sector cannot increase savings unless and until foreign or government sectors increase deficits. Call this the tyranny of double entry bookkeeping: the government’s deficit equals by identity the non-government’s surplus.

So, if the US private sector is to rebuild its balance sheet by spending less than its income, the government will have to spend more than its tax revenue. The only other possibility is that the rest of the world stops saving on a massive scale — letting the US run a current account surplus. But that is highly implausible and socially undesirable, since it means we export our economic output, rather than consume it domestically. And if the government deficit does not grow fast enough to meet the saving needs of the private domestic sector, national income will decline, which, given the size of the private sector’s debt problem, will generate a huge debt deflation.

This is the foundation of modern monetary theory. Would that the IMF and the G20 understood these basic facts. The anodyne communiqué from last weekend’s Pittsburgh summit makes clear that this is not the case. Western policy makers appear determined to consign us to years of additional economic misery because of the continued embrace of a flawed market fundamentalist economic paradigm.

So far, instead of trying to revive the productive economy, most of the G20’s resources have consisted of mouth-to-mouth resuscitation for a dying financial sector. This has not “worked” to the extent that last weekend’s communiqué advertised. The best analogy to describe the current state of our financial system is that we have placed scaffolding over a decaying building, but done little to repair the underlying structure. What happens when the economic scaffolding is removed via “exit strategies”, as the G20 participants have advocated?

For many generations, we didn’t face the unprecedented financial fragility we are experiencing today. But there are good reasons why we avoided this until recently. We have spent the past quarter century eviscerating what was fundamentally a robust structured originally devised during New Deal, a system which basically saved the US capitalist system and served the interests of its citizens very well until it was hijacked by a bunch of corporate predators under the guise of deregulation and neo-liberalism.

To read the communiqué from the Pittsburgh summit is to gain insight into an ideology which views government, not as a stabilizing influence protecting us from private sector rent seeking monopolists. Rather it’s an unwanted stepchild, brought out on display as a necessary evil, and destined to be shoved away as soon as we get back to a “normal” economic state of affairs, where the government minds its own business and lets the magic of the “free market” operate. Hence, the emphasis by the Pittsburgh summiteers on “sustained, strong and balanced growth“, the usual code words designed to encourage budget surpluses, more private sector savings and shift from public to private sources of demand.

There is little understanding that if households and firms try to net save (save more out of income flows than they tangibly invest) incomes collapse, and desired private net saving is thwarted. The private “excess saving” cannot exist without a budget deficit or a trade surplus. Many people make this mistake. At best, we can talk about planned private saving being in excess of planned private investment, but other than that, we are violating double entry book keeping principles.

And consider this: in 1998, 1999 and 2000 (increasing each year), the US government “virtuously” ran budget surpluses. And guess what happened? The private sector became more heavily indebted than before as the fiscal drag squeezed liquidity and destroyed aggregate demand and incomes. Along with our misconceived embrace of financial deregulation, the combined result was sharply rising unemployment and a major recession in 2001-02 with unemployment rising sharply and the automatic stabilizers pushing the budget back into deficit.

Unfortunately, that was the yellow flag for what was to follow, a warning signal blithely ignored by our economically illiterate policy makers. Instead, we perpetuated a massively leveraged financial system via Frankenstein financial products such as collateralized debt obligations, and credit default swaps. We squeezed private sector incomes via constrictive fiscal policy, thereby inducing the debt-fueled consumption that is now regularly decried by our officialdom and the commentariat.

The bottom line is that if we want habitual private sector savings, we need habitual government deficits.

And government deficits are not an aberration; they are the norm. Our first (and possibly greatest) Treasury Secretary, Alexander Hamilton, called the national debt a “national blessing”. Similarly, Paul Krugman and L Randall Wray have argued that it was World War II and the subsequent cold war that ended the depression, which created the foundations for a significant expansion of government debt, which in turn set the stage for the “Golden Age.” The government deficit reached 25 percent of GDP during the war, providing a massive amount of private sector saving in the form of safe financial assets that strengthened balance sheets. From 1960 onward, the baby boom drove rapid growth of state and local government spending, so that even though federal government spending remained relatively constant as a percent of GDP, total government spending grew rapidly until the 1970s. This pulled up aggregate demand and private sector incomes, and thus consumption.

This is unsurprising: The private sector cannot create “net nominal wealth” because every private financial asset is offset by a private financial liability. Over the long term, the maximum that a government can hope to collect in the form of taxes is equal to its purchases of goods of services. There is no hope of running long-term budget surpluses because the government cannot possibly collect more than the income it has created as it paid out dollars. When the government attempts this, as it did during the Clinton Administration, the public finds that its net financial assets would be less than its tax liability, requiring households to dip into its “reserves” of accumulated savings, which gradually become depleted. In the absence of other factors, demand slows and the government almost invariably falls back into deficit.

If an external creditor is added (such as China or Japan) it merely delays or extends the process, since for a time, countries running current account surpluses with the US can use their surplus dollars to accumulate additional US dollar financial claims. But in the absence of any increase in US government spending (which is the only source of NEW NET FINANCIAL ASSETS), the end result is still a massive accumulation of private sector debt, which is what got us into this mess in the first place. By contrast, assuming a non-convertible, freely floating fiat currency, a government can never be insolvent even if its tax revenue declines significantly. Its balance sheet can never become precarious in the same way that a household balance sheet can.

In the abstract, this always sounds controversial to those uncomfortable viewing the world within a financial balances construct. It also helps to explain the intellectual incoherence at the heart of the G20 communiqué and the Obama Administration’s economic policies, which has been dominated by Wall Street interests.

So it’s worthwhile considering some historic examples, which illustrate the point better. During WWII, the US government generated huge deficits and bond issues. The record expansion of government deficits not only facilitated the war effort, but created full employment. (As an aside, it is always interesting to pose the following question to “deficit terrorists “: if government budget deficits are so awful, and so egregious for the long term performance of an economy, then why run them at all during wartime, when presumably we need the economy to be functioning in an optimal manner?) After the war, the Fed was concerned with potential inflationary pressures and raised interest rates. President Truman, a hard money man par excellence, drastically cut defense spending from $90.9bn to $10.3bn and the US accumulated huge fiscal surpluses. Post war surpluses, combined with Fed tightening, contributed to a recession in 1949. Unfortunately, it took the “military Keynesianism” brought on by the Korean War to shift Truman away from his aversion to deficit spending, which was continued by Eisenhower, and sustained via his national highways building program. During that period, unemployment decreased. Similarly benign effects on unemployment were manifested in the wake of the Kennedy tax cuts and those of Reagan in the early 1980s.

Today, budget deficits are the highest as a percentage of GDP, but they are overstated to some degree, because they include the TARP measures to stabilize the financial system which brought the global economy to its knees in 2007/08. Classic Treasury expenditures deal with the purchase of real goods and services; Federal Reserve functions deal with the purchase and sale of financial assets. And yet, the focus of policy makers is quickly reverting to “exit strategies” and a reduction of budget deficits, where the Pittsburgh communiqué pledged to “prepare our exit strategies and, when the time is right, withdraw our extraordinary policy support in a co-operative and co-ordinated way, maintaining our commitment to fiscal responsibility.”

If only that were true. The only way one could politically justify a government running a sustained surplus would be to make the case that unemployment created a more functional way of ensuring high profits (via wage discipline) than full employment. Put in those terms, it’s not a particularly compelling message, but it has the virtue of being consistent with modern monetary theory.

Oddly enough, the G20 communiqué devotes considerable attention to the government’s “exit strategies”, which came in response to the destructive private sector financial practices which created this catastrophe. There has been less attention directed to the underlying causes themselves. Thus the IMF, in its latest “Global Financial Stability Report”, suggests that restarting securitization markets is “critical” to a wider economic recovery, and that current US and European proposals to force banks that originate loans to hold on to the first 5% of losses in all securitizations, were not sufficiently flexible and might backfire. In the words of Credit Lyonnais Asia strategist, Christopher Wood:

“[The IMF] is yet again doing the world a disservice by acting as a lobbying group for the securitised debt peddlers. It is clearly fundamentally correct that the agents of securitisation should be made to retain some ’skin in the game’ after the terrible damage they have inflicted. It is true that the collapse of securitisation represents a massive deflationary risk for the global economy. But that does not mean that the answer is to allow a new free-for-all in securitisation assuming, charitably, there is demand for the securitised product.” (”Greed and Fear”, 24 Sept. 2009, CLSA, Asia Pacific Markets)

The IMF, the G20, indeed virtually all policy makers — including the Obama Administration — will make themselves far more relevant when they emphasize that full employment and prosperity can only be achieved to the extent that governments are prepared to spend up to a level justified by non-government saving. That does not mean unconstrained government spending. But the spending ought to be set with regard to results desired and competencies to execute plans — not out of some pre-conceived notion of what is “affordable”. Our federal government can afford anything that is for sale in terms of its own currency. And if it spends too much after getting us to a state of full output, it can get inflationary. But let’s get to that state of affairs first before we start worrying about perpetuating the flawed model of the past. That got us transitory prosperity and wage gains. And it promises years of economic misery if we do not move beyond neo-liberal economic fairy tales.

Related posts:

• Minsky: Turning neoclassical economics on its head
• The Cult of Zero Imbalances
• Low savings, high debt and interest rate policy
• Stephen Roach: Americans’ abandonment of overconsumption is a good thing
• UK consumers don’t save

I have to admit to hyping the debate now swirling about protectionism. I believe that tariffs are not a very good solution to a trade problem as they are likely to result in retaliation and/or escalation. Moreover, they end up protecting small groups at the expense of higher prices for everyone else.  That is why I wrote the provocatively-titled “Murder-Suicide in Chimerica.”

But taking a step back from the rhetoric for a second, I want to highlight two recent articles and make a few comments.

Is the protectionist bogeyman really coming?

First, while a protectionist backlash is a distinct possibility which I see as the main threat to sustained recovery, I recognize that countries like China and the United States are co-dependent and loath to permanently altering the status quo unilaterally. So while I condemn the recent tariffs imposed on Chinese tires, I recognize that the tariffs were imposed in the calculus that this issue would not or could not escalate.

This is what James fallows argues in a post yesterday:

I keep putting this off, so before it finally disappears into the mists of time, here is a bullet-point summary of what I would have said at greater length when the Chinese tire tariff first arose.

1) There is not now, and there never was, a serious possibility that this would escalate into some sweeping, self-intensifying, global-recovery-threatening "trade war."  The many publications and commentators who raised their hands in "Oh no! It’s Smoot Hawley again!" horror need to calm down — and to have their tendency toward over-reaction noted for the record. Yes, I’m talking about you, Economist magazine cover-designers (last week’s cover image, below), but you had tons of company.

There is too much going on, on too many other fronts, involving affairs of incomparably greater consequence between China and America, for this to have been more than a contained, specific dispute — contained in both duration and sweep. This was clear at the time and should have buffered the shock-horror tone of the stories. Why this matters: because of the  boy-who-cried-wolf principle. There are issues between China and the outside world in which a small disagreement could spiral into a very dangerous confrontation. Many of these involve Taiwan, for reasons to be spelled out another time. But tire tariffs, agree with them or not, were never going to set off a global economic confrontation.

In effect, Fallows is saying that it undermines ones argument to scream, “Smoot-Hawley, Smoot-Hawley” every time there is some issue that deviates from the idealized world of free trade. Eventually people will block this out, especially in an environment like this, in which populist sentiment is running high. Fair enough.

Protectionism is more than just tariffs

So with those thoughts in mind, I read Edmund Conway’s article “We are entering a new age of protectionism” in the Telegraph. Conway says:

Some are "traditional" measures, familiar from the Depression and elsewhere – subsidies for domestic producers or tariffs on imports, President Obama’s move to slap a 35 per cent charge on Chinese tyres being a prime example. Such measures are provoking fury, and with good reason: the protectionist spiral into which the world plunged in the 1930s almost certainly contributed to the war at the end of the decade.

However, such visible signs of protectionism tell a fraction of the story. For the shocking truth is this: over the past year, the costs and obstacles faced by exporters have, according to a study by economists David Jacks, Christopher Meissner and Dennis Novy, increased by almost the same scale as in the early 1930s when the US and others were imposing a range of protectionist laws, including the infamous Smoot-Hawley Act.

Partly this is one of the perverse consequences of the financial crisis, which crippled the system of trade credit that underpinned the international flow of goods, making it impossible for some companies to ship products from one part of the world to another. But, far more worryingly, it is also a product of explicitly protectionist measures imposed by countries such as the UK in an effort to save their domestic banking systems from collapse. Most egregiously, these included so-called financial mercantilism, whereby governments, having rescued a bank, insisted that it had to lend far more to domestic customers than business or individuals overseas businesses.

This new protectionism is a different beast from that of the early 20th century, but the result is the same. According to the Bank for International Settlements, the amount of money flowing across national borders has collapsed in a way never before witnessed. Put simply, financial globalisation, which helped power economic growth in recent years, has gone into reverse over the past year. All the more worrying is that it has done so without people noticing.

If I read Conway correctly, he is rightly pointing out that all the bailouts and subsidies we have seen – especially in the financial sector – are the economic equivalent of tariffs.  Protectionism is not just about tariffs. We are moving to a world in which domestic jobs are ‘protected’ via non-tariff remedies.

Extending Conway’s argument to the auto industry, it should be patently clear that this is what is happening. Here are a few posts I wrote on the issue.  The titles should give you the gist.

• Volkswagen: if the American carmakers can get bailout funds, so can we – Dec 208
• Sweden: competitive auto bailouts begin with Saab and Volvo – Dec 2008
• Germans reject Chinese offer for Opel – Jul 2009
• Cash for Clunkers will put GDP over the top in Q3 – Aug 2009

Every car company has its hands out for a subsidy or bail out and most of them are receiving it. Certainly, the U.S. has led the way, but the Germans have been as bad as anyone here.  The deal that the German government struck to save Opel with Magna, a Canadian-Austrian auto parts manufacturer, is widely perceived as having been slanted in favor of German jobs over Spanish, Belgian or British.  All of these countries are complaining bitterly to the EU that the deal represents a subsidy and is anti-competitive.

This is why you see the Germans talking up regulatory reform in finance and the Americans and the British are talking up re-balancing:  The U.S. and the U.K. have strong financial services industries and Germany has a strong export sector. Of course the Americans are opposed to financial reform.  Of course the Germans don’t want global rebalancing.

Politics is domestic

In a prior life I was a foreign policy guy.  In my time living and breathing foreign policy it became evident to me that politics is always domestic first.  If you want to know why a foreign leader is acting a certain way or taking a specific position, take a look at the domestic political environment.

Do you think the Chinese cared what Americans think, when they threatened to retaliate to the tire tariffs? Do you think Angela Merkel cares what happens to workers at Vauxhall plants in the U.K. when she arranged the Magna deal? Do you think the Americans care about what happens to Frankfurt as a financial center when they bailed out BofA and Citgroup? Of course not.

What matters is placating domestic concerns and consolidating power domestically. So while I talk about the “cozy” relationship between China and the U.S. as a marriage, I am under no illusion that this is anything more than a business relationship. When push comes to shove domestic concerns will win out. And if that means placating rioting workers in fear of losing jobs, so be it.

Expect more, not less protectionism

So I am not optimistic this protectionist wave is going to go away. My baseline sees more not less protectionism.  What would be wonderful is if the recovery taking hold were robust enough so that nations came together and worked out a workable forward-looking global solution to some of the more intractable macro problems. However, for the time being most people are retreating to their corners, making protectionism a continued threat.

Related posts:

• Should we expect a protectionist China?
• Populism: The real economic danger in this recession
• Jagdish Bhagwati: Obama is a protectionist
• Murder-Suicide in Chimerica
• China launches retaliatory investigation into U.S auto subsidies

I just finished reading a Financial Times article about the likely coordinated global policy solutions to emerge from the upcoming G-20 meeting in Pittsburgh.  It does not sound like there is a huge amount of consensus. Indeed, it sounds like there is a lot of finger pointing regarding what the true causes of the financial crisis were.

China expressed scepticism on Thursday about a US and European push to launch an effort to tackle global economic imbalances at next week’s G20 summit in Pittsburgh.

Zhou Wenzhong, China’s ambassador in Washington, said: “People should not focus on only one thing, that is balancing the economy.” The International Monetary Fund should concentrate on doing a better job of monitoring the build-up of financial risks.

Translation: You lot in the West created a house of cards in the financial sector to fund a drunken binge of excess consumption. Your guy Stephen Roach even says so. Clearly, this is where we need to focus future reforms.

Edward here.  Don’t take my word for it that this is what the Chinese are saying.  Later in the same article, we get the following from Ambassador Zhou:

Imbalances were “certainly not the root cause of the problem”, Mr Zhou said. “The root cause of the crisis is the lack of supervision and abuse of the openness of the market, very risky levels of leverage and too much speculation.”

Unfortunately for Zhou, this is not the interpretation of events being drawn in the West.  Western officials are more interested in correcting ‘global imbalances.’

“Global imbalances have to add up to zero, so if the US is going to be less the consumer and importer of last resort then other countries are going to need to be in different positions as well,” a senior administration official told the Financial Times recently.

Britain, France and other European nations are backing a push on global imbalances at the G20 summit. Gordon Brown, the UK prime minister, said this week: “When I attend the G20, I will be putting the case for a global compact for growth and stability for now and for the future.”

Brown and the other Western leaders are not denying responsibility for the global meltdown as directly as Zhou seems to.  Nevertheless, you must realise that this is a coordinated effort to re-focus the policy debate on China, its pegged currency, trade surplus and huge accumulation of foreign currency reserves.  I call this the Blame Asia meme. I would be curious to hear what the Brazilians, Indians and Russians are saying about all of this.

The question is whether this tiff over who caused the crisis in the first place will impede consensus about coordinated global policy going forward.  No one country or set of policy makers covered themselves in glory in the lead up to this panic.  Yet, because the same set of individuals is still at the table, we now see greater interest in putting a positive spin on past events than on moving forward in a constructive way.

Correct me if I am wrong.  It sure looks like we shouldn’t expect anything substantive to result from the G-20 meeting in Pittsburgh.

Source

China scorns focus on imbalances – FT

Related posts:

• Tear gas and rubber bullets at G-20 Protests
• China wants to get rid of the dollar
• Japanese defend dollar’s status while China tears it down
• G-20: China is clearly looking for a new world order
• China slams U.S. for inflating global asset prices via carry trade

Now that President Obama has signalled his willingness to punish the Chinese for dumping on tires, a whole host of other industries are likely to file their own ‘copy-cat’ complaints.

Reuters says:

President Barack Obama’s decision to restrict tire imports from China after union workers complained of a surge could lead to copycat cases in areas such as steel, clothing, paper, machinery and consumer goods, trade experts said on Monday

"It’s a target-rich environment," said Lewis Leibowitz, a lawyer who represents the Consuming Industries Trade Action Coalition, which opposed relief in the tires case.

"There’s almost anything you can hit. And even within import categories that have gone down, there may be smaller product categories that have gone up," Leibowitz said.

However, the question of which industries could qualify for relief is complicated by the fact that overall U.S. imports from China have fallen in 2009 because of the global and U.S. economic downturn, he said.

Obama’s decision late Friday to restrict the tire imports was the first time the United States had used a special import safeguard provision against China known as Section 421.

It triggered an angry response China, which said it planned to challenge the action at the World Trade Organization and begin new anti-dumping investigations against U.S. products.

Beijing agreed to the anti-surge measure when it joined the World Trade Organization in 2001 and former President Bill Clinton’s administration relieved heavily on that commitment to help persuade a reluctant Congress to approve the pact.

Given that the WTO ruled against China on tires, it stands to reason that some grievances in other industries filed in the WTO against the Chinese would also likely be successful.  How can the President not slap tariffs on these products as well, given his actions in this first test case?  Clearly, what works for tires should also work in steel, clothing, paper, and elsewhere. If I were an American exporter in any of these industries, I would be lawyering up right now.

My hope is that we can get a comprehensive and equitable bilateral trade resolution with China to avoid more tariffs on either side.

Related posts:

• Should we expect a protectionist China?
• China: we “will take steps to protect the interests of our domestic industries”
• China launches retaliatory investigation into U.S auto subsidies
• Murder-Suicide in Chimerica
• China cutting overcapacity

In 2002, the global economy was weak and equity markets around the world were at multi-year lows following the greatest equity bubble and bust in world history. Many policy makers including Alan Greenspan, chairman of the U.S. Federal Reserve, feared a deflationary spiral of Great Depression proportions resulting from the stock market collapse.

To prevent such an outcome, the United States embarked on an historic monetary experiment to reflate a post-bubble economy by lowering interest rates to 1%, the lowest in 50 years. The result was a huge global economic boom which benefitted nearly every economy and every asset class on the planet. But the boom has turned to bust. In its wake, the cozy relationship between China and the United States that developed during boom time is unravelling.

Just Friday, Barack Obama slapped Chinese tire imports into the United States with tariffs of up to thirty-five percent. China was outraged and immediately threatened to retaliate. I now see a trade war between China and the United States as the biggest threat to global economic recovery.

With this trade war looming, one must wonder if Chimerica, the marriage of China and America as one economic entity, will end in murder-suicide, taking the global economy down with it.

Chimerica’s origins

Niall Ferguson and Moritz Schularick invented the term “Chimerica” in 2006 to describe the underpinnings of the 2000s boom. In their view, this economic upswing resulted from an America and China joined at the hip in a state of economic interdependence. Americans were the spenders and the Chinese were the savers and producers. The United States spent far in excess of what it saved. Meanwhile China ran a huge current account surplus, accumulating a $2 trillion stash of largely U.S. dollar-denominated international reserves, effectively funnelling America’s borrowed money back into the U.S. economy.

This state of affairs was always unsustainable – more so after the collapse of the associated credit and asset bubble exposed fissures in the global financial system in 2007. However, the flashpoint came in 2008 when the U.S. dollar plummeted to record or multi-decade lows against a host of other major currencies, leaving China’s reserves diminished in value. For the months since, the Chinese have expressed growing concern that they could get the short end of the stick if the marriage which created Chimerica dissolves.

Chimerica’s unravelling disturbs China

If one looks at any one incident involving China and the United States during the global economic crisis in isolation, it is easy to lose sight of the big picture. However, threading the events of 2008 and 2009 together makes a compelling case that the Chinese – U.S. marriage is coming apart.

The first indication of Chinese concern which I detailed came as the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac collapsed last August. The Chinese had put much of their reserve money into GSE debt, believing it as safe as U.S. government debt. It was evident that the GSEs were not a safe investment except through an implicit government guarantee (as I said in May 2008). But when the GSEs collapsed, the Chinese were caught out and warned they could dump dollar-denominated assets unless they were made whole.  Subsequently, Fannie Mae and Freddie Mac were nationalized and creditors were made whole.

The next flashpoint was created by comments by incoming Treasury Secretary Tim Geithner at his confirmation hearings before Congress. Geithner charged China with ‘manipulating’ its currency in an environment in which many western policy makers were openly blaming Asia’s mercantilism for the economic crisis.  The Chinese retaliated, with Chairman Wen slamming the U.S. as a profligate nation in unusually stark terms that raised quite a few eyebrows.

At just about this time, the first hints of real American protectionism came into being in the form of the Buy America provision attached to the stimulus bill. There was quite an uproar from America’s major trading partners like Canada and China – and I saw this as a 21st Smoot-Hawley at the time, a view I still hold. (To make matters worse, the provision has had perverse consequences.)

By this point – early 2009, the Chinese were done. They had suffered the potential for massive losses through the dollar’s weakness and the failure of the GSEs. Now, they were being blamed for a crisis which began in the west.  It was at this time that I noticed a steady drumbeat of ditch-the-dollar talk coming out of China. By the G-20 meeting in April, the Chinese central bank head Zhou outright called for a new international reserve currency.

The drumbeat of anti-Dollar news coming from China got louder and louder during the spring. The Chinese started settling trade in Yuan (Apr. 9) instead of dollars. The Chinese were discovered to be stocking up on gold supplies (Apr. 24). The Chinese central bank attacked the policy of quantitative easing in its quarterly report (May 9). The Chinese positioned themselves as the champion of emerging market nations and assembled support from Russia, Brazil and India for reforms in the international reserve system (Jun. 12).

And then came the retaliation.

Protectionism rises

On June 16, I wrote a post “Beijing starts a ‘Buy China’ policy” which clearly demonstrated that the Chinese were incensed by the Buy America provision in America’s stimulus bill. The trade war was on.

The ‘Buy America” and the “Buy China” provisions were nationalistic and prevented goods from other countries being bought. However, they were merely passive protectionism i.e. legislative exclusion of foreign goods and services. No tariffs were assessed.

But when Barack Obama chose to slap 35% tariffs on Chinese tire imports, this was an unmistakable act of active protectionism. This was the proverbial serving of divorce papers.

Expect prices to rise as a result:

Marguerite Trossevin, who represents a coalition of U.S. tire companies that import Chinese tires, said the tariff decision is “very disappointing.” She predicted price increases for U.S. consumers and losses for U.S. tire importers.

The Chinese have now said they will look to retaliate on U.S. poultry and auto products:

China announced dumping and subsidy probes of chicken and auto products from the U.S., two days after President Barack Obama imposed tariffs on tires from the Asian nation.

Chinese industries complain that they’re being hurt by “unfair trade practices,” the nation’s Ministry of Commerce said on its Web site yesterday. The dumping investigation relates to poultry alone, a spokesman said in Beijing today. The ministry didn’t specify the value of imports of the products.

To be honest, the protectionism should not be a surprise.  Obama is no free-trader. And I certainly foresaw a rise in protectionism and indicated in December 2008 the United States was the likely first mover:

Tariffs, export subsidies and currency devaluations will roil the desire for free trade.  Initially, countries will seek relief at the WTO (World Trade Organization) but later they will begin to act unilaterally.  The U.S. will be the first to unilaterally retaliate.

Even the resistance to unwinding excess capacity and global rebalancing are all very predictable as nations retreat into nationalistic thinking when the chips are down. As far back as March 2008, I warned of a likely multi-cycle W-recession predicated on resistance to unwinding the status quo:

The global economy, now supported in the main only by the overextended U.S. consumer, finds itself at stall speed, susceptible to any number of potential exogenous shocks. Ultimately, the economic malaise created by this confluence of events will take years to unwind. A positive outcome to this process is dependent wholly on liquidation of excess credit and consumption.

This process will be extremely painful in the short term, but will lead to a healthy economy long-term. Unfortunately, experience shows that these painful steps will only be taken as a last resort. Moreover, geopolitical events become volatile in a world of economic insecurity, leading to political upheaval and protectionism. Protectionism is a natural outgrowth of nationalist economic policy as it transfers wealth from foreign producers to domestic producers by cutting off access to lower cost excess capacity in the goods in service sectors. However, this also serves to transfer wealth from domestic consumers to domestic producers by increasing the price of goods in the protected sectors, ultimately reducing consumption demand.

For these reasons, I am cautious about the long-term outlook for the global economy and the U.S. economy in particular. The likely outcome for the next decade is one of sub-par global growth with short business cycles punctuated by fits of recession.

Yes, trade and dumping are difficult issues. But, protectionism makes most everyone a loser. In June, I wondered should we expect a protectionist China. But I ended saying it was how the Obama administration responded to the green light given by the WTO to impose sanctions which would be most instructive. Obama has gone protectionist.

Chimerica marriage is ending in divorce

All need not be lost. Global re-balancing, where the American partner in this marriage does a little bit more of the saving and a little less of the spending and the Chinese partner does just the opposite, is what most economic counsellors suggest. This could save a strained relationship and put the partners on a sustainable path. This does seem to be happening.

Nevertheless, could this relationship between China and America be coming to an end?

I say emphatically yes. 100%. There is no going back now. Each partner in this marriage, China and the United States, has a bevy of domestic constituencies which are forcing a dissolution of the relationship. Hardliners in China want to move away from the dollar. And populists in America want to punish the Chinese for allegedly manipulating their currency and dumping goods below cost in America.

So, as surely as day turns to night, this arrangement between China and the United States will end.  This marriage is over. The question is whether it will end gradually and peacefully in divorce or violently in murder-suicide. Right now, it’s looking like the latter.

Related posts:

• Tariffs: Other industries may line up for sanctions against China
• The U.S. is exporting unemployment with ‘Buy America’
• China slams U.S. profligacy
• Should we expect a protectionist China?
• The protectionism bogeyman

Chinese vice-premier Wang Qishan has been appointed to lead a taskforce to make the renminbi the currency of choice for trade settlements, especially with regional trading partners. HSBC economist Qu Hongbin believes this latest salvo in China’s intensifying efforts to ditch the dollar demonstrates the Chinese are moving sooner than most expect to internationalise their domestic currency.

Hu Xiaolian, vice-governor of the People’s Bank of China, is being enlisted to head the research division of the taskforce. Officials from six other central departments have also been drafted to the taskforce.

"China really wants to give a big push in internationalising the renminbi," notes Qu. "Of course it would be a multi-year, long-term process". Still, he adds, the initial stage of expanding the renminbi’s role in trade settlement could be "faster than many expect".

Since China recently became the world’s largest exporter and is the second-largest trading country, expanding the role of renminbi in cross-border trade settlement is "simply a catch-up game," says Qu. "I won’t be surprised if, in the next three to five years, around half of China’s annual cross-border trade is settled in renminbi rather than US dollars."

Given the high volume of China’s trade, even if half of its trade flows are settled in renminbi, that would make it "one of top three international currencies in the world." This, he adds, "will have a substantial impact, not only on China but also the global economy."

I still believe there is no currency that can replace the dollar as the world’s reserve currency in the next few years.  But, the Chinese certainly are hedging their bets.  Eventually, these efforts will bear fruit.

More here.

Related posts:

• Chinese to start settling trade in Yuan
• Mea culpa on the need for a new currency
• Japanese defend dollar’s status while China tears it down
• Is China avoiding using US dollars?
• China launches retaliatory investigation into U.S auto subsidies

When the stimulus bill was being crafted, I wrote three posts lamenting the protectionist Buy American provision attached to the bill.

• ‘Buy American’ will translate into a 21st century Smoot-Hawley
• The U.S. is exporting unemployment with ‘Buy America’
• Canada is furious about U.S. protectonism

The last of these three demonstrated that the provision was needlessly creating lots of ill will north of the border.  As I am in Canada right now, I found the following story from the Sydney Morning Herald particularly laughable:

US President Barack Obama’s stimulus spending has run into a problem: A shortage of General Electric water filters.

GE makes them in Canada. Under the program’s `Buy American’ rules, that means the filters can’t be used for work paid for by the $US787 billion ($935 billion) fund.

Contractors are searching the US in vain for filters as well as bolts and manhole covers needed to build wastewater plants, sewers and water pipes financed by the economic stimulus. As officials wait for federal waivers to buy those goods outside the US, water projects from Maine to Kansas have been delayed.

“It’s added a whole new level of difficulty,” said Kathy Emery, a senior engineer for the West Virginia Department of Environment. “We’re continually having changes and further guidance” from federal rule-makers, she said.

At stake are the president’s efforts to fuel an economic recovery in the US by funneling stimulus funds to communities, including $US6 billion for municipal water projects. Lawmakers mandated that the money be spent on US products, with exceptions to meet international trade obligations.

GE says it assembles high-tech filtration systems for North American markets at its plants in Toronto and Oakville, Ontario, with parts from Hungary and elsewhere.

These are the absurdities that result from protectionism. In a globalized economy, it is often difficult to say where a product was actually made.  For example, there is a huge transfer of parts to GM Detroit from GM Canada in Windsor, Ontario, which is actually geographically south of Detroit and right over the border.  Were GM building cars under the Buy American provision, this type of transfer would be illegal.

The article points out that, just as the plants in GM Canada are fully integrated with GM Detroit, the GE facilities in Oakville and Toronto are fully integrated with GE’s US operations as well.

The purchasing rules are hurting the stimulus program, said US Representative Kevin Brady, a Texas Republican. He has called for a congressional review of the Buy American plan.

Losing jobs

“There are some real downsides to Buy American,” Brady said in an interview. “It delays projects. We have to look at what jobs we are losing.”

Lawmakers in America who pander to voters who do not live in these communities might think these provisions are justified.  However, this one example is one of scores of similar logistical minefields created through protectionism. Here is another from the same article.

At Aquarius Technologies, which sells equipment to US wastewater plants, domestic business has slowed to a trickle, said Tom Pokorsky, president of the closely held company in Port Washington, Wisconsin.

`Buy American has stopped US wastewater work this year,” he said. “I’m surviving by selling to Canada.” Even that market won’t be safe if Buy American sparks a “Buy Canada” retaliatory initiative, he said.

After watching trucks send manhole covers flying, officials in Auburn, Maine, switched to hinged covers years ago. The ductile-iron ones they used were made across the border in Canada.

While they waited for weeks for a waiver to buy more covers for a new sewer project, Norm Lamie ordered steel plates placed over the exposed holes. “EPA did eventually give us the waiver,” and the manhole covers are in place, said Lamie, general manager of Auburn’s water and sewer district.

To my mind, the biggest takeaway here is that this is what should be expected when the government inserts itself into a relatively free market legislatively.

Source

‘Buy American’ backfires – Sydney Morning Herald

Related posts:

• ‘Buy American horror stories’ in Canada
• ‘Buy American’ will translate into a 21st century Smoot-Hawley
• Congress ready with second stimulus package
• Canada is furious about U.S. protectonism
• The U.S. is exporting unemployment with ‘Buy America’

During the Great Depression, it was the Smoot-Hawley Tariff Act, which in hindsight is blamed for triggering a wave of protectionist actions globally.  Protectionism was a major contributor to the downward spiral that created depression.  So, have we avoided this kind of outcome this go around?

At this juncture, it is pretty unclear we have. Simmering disputes with China in particular are creating anger in Beijing.  First, there was the U.S. steel industry complaint over the dumping of cheap Chinese tires in the U.S.  This dispute has received little press.  However, the International Trade Commission(ITC) has just sided with U.S. steel interests. I reckon the issue will now become more important.

Then, there was the link between Rio Tinto, the Australian commodities producer and Chinalco, the Chinese commodities company. Rio got itself in a bit of a mess when it leveraged up only to see commodity prices tumble. As a result, the company was forced into the arms of Chinalco.  But, Australians and Rio shareholders did not like the concept of the Chinese having such a huge stake.  So, BHP Billiton came to the rescue and Chinalco was stuffed (and received a hefty breakup fee).

These types of things are really getting the Chinese sour.  And the China of 2009 is akin to the United States of 1930 as Alpha Creditor to the world economy. So, when just days ago Beijing started a ‘Buy China’ policy, we should realize that a Smoot-Hawley outcome is still something we need to act vigorously to avoid.  It is protectionism in China as retaliation that we must worry about.

Now that the U.S. has received a green light from the ITC to restrict Chinese tire imports, it will be instructive to see what the Obama Administration does.

Related posts:

• China detains Rio executive on suspicion of espionage
• China launches retaliatory investigation into U.S auto subsidies
• China: we “will take steps to protect the interests of our domestic industries”
• Tariffs: Other industries may line up for sanctions against China
• Jagdish Bhagwati: Obama is a protectionist

This comes via Bloomberg:

Global central banks risk inflation, currency devaluation and a “big consolidation” in bond markets by pumping cash into their economies, the People’s Bank of China said in its quarterly monetary policy report.

The Federal Reserve and the Bank of England this year started quantitative easing, or printing money to buy government bonds, a policy that the Bank of Japan pioneered to revive its economy at the start of the decade. The European Central Bank’s 22-member board, which meets tomorrow, is split on whether it should buy financial assets to tackle its recession.

“A policy mistake made by some major central bank may bring inflation risks to the whole world,” China’s central bank said in the report today. “As more and more economies are adopting unconventional monetary policies, such as quantitative easing, major currencies’ devaluation risks may rise.”

Chinese Premier Wen Jiabao expressed concern in March that the dollar will weaken, eroding the value of China’s holdings of Treasuries, as the U.S. borrows unprecedented amounts to spend its way out of recession. China’s Treasury holdings climbed 52 percent in 2008 and stood at about $744 billion as of the end of February, according to U.S. government data.

I don’t think you can take this statement as an idle comment from an anodyne central bank quarterly report.  All evidence suggests that China is legitimately concerned about a competitive devaluation in the U.S. and elsewhere as a result of easy money policies.  In my view China has long been preparing for this eventuality and is shifting money away from problem areas like the U.S. dollar (see my post “Breaking news: China has been secretly stocking up on gold”).  In addition, an Asia-centric dynamic does seem to be in its incipient phases. I mentioned this in a recent post “Asia is de-coupling,” suggesting that the $120 billion crisis fund set up by the Asian Development Bank was a move in that direction.

To be sure, it will take a very long time for the domestic demand within an Asian bloc to replace the export-oriented mercantilism we now see. But, you can definitely see the outlines of a push in that direction. And when one thinks back to the formalization of the Eurozone/EU, Mercosur or Nafta, I can see this developing over a number of years.  Generally, one should see this as a positive development because it will help end the unbalanced dynamic where the U.S. is the consumer of last resort to Asia’s producer of last resort.  The darker view of these developments is that the world is splitting into regional trading blocs in a new 21st century version of Smoot-Hawley.

Time will tell which view is accurate.

Related posts:

• Is quantitative easing really inflationary?
• Stephen Roach: Downturn in Asia less severe, but recovery later
• Morgan Stanley warns of a new inflationary period
• Quantitative easing in the U.K.
• Ahead of G-20, China blames west and west blames China for meltdown

After a good run-up in the last month, the Mexican Peso is getting crushed in the currency markets today.  How much of the pullback is a result of the news regarding Swine Flu and how much is technical, due to the prior run up, is hard to identify.  Nevertheless, the outbreak will have a negative effect on the Mexican economy and trade, making the recent IMF package Mexico has received a good buffer in case things get worse. Russia and China have already banned U.S. pork imports as well (Sounds like a political move if you ask me).

The Currency Strategy Team at Brown Brothers Harriman notes that the U.S. Dollar and the Japanese Yen are benefiting against a wide swathe of Emerging market currencies, not just the Peso.  And airline stocks are getting hammered as well.

The US dollar and yen are up against the major and emerging currencies. Concerns Mexican swine flu could become pandemic after Pres Obama declared it a public health emergency helped drive the dollar and the yen higher with the Mexican peso the hardest hit, falling over 2% against the US dollar. While the outbreak has potential to create additional problems for the global economic slowdown, so far officials have responded quickly and decisively to the outbreak, something that did not happen during the SARS outbreak. The euro is already overextended on the downside and is likely to trade higher as the focus turns to other event risks this week, the FOMC meeting, the release of further bank earnings reports and the stress test.

The global equity markets are being hit by concern about swine flu adding to existing concerns about US banks amidst talk 3 of the 19 US banks that underwent Federal stress tests have been asked to raise capital. Still, airlines have been amongst the hardest hit today while health care related equities are benefiting. In Asia, China’s Shanghai Composite, down 3.2%, and the Hang Seng, down 2.7%, were amongst the hardest hit in Asia but not just due to memories of China’s slow response to the SARs epidemic. China’s largest bank, ICBC fell over 5% on reports Amex and Allianze planned to sell shares. Japan’s Nikkei bucked the trend, adding just 0.2% as M&A related news supported the market. European bourses are lower, erasing some of last week’s gains while early indications suggest US markets will open sharply lower. On a positive note, Chrysler reached a tentative agreement with UAW that boost the odds it can avoid bankruptcy. Most commodities are lower including gold and oil. Grains are also lower on concern demand for animal feed grains could fall.

While the crisis has not hit epidemic proportions (see Paul Kedrosky’s bubonic plague map), an epidemic outbreak is clearly on everyone’s minds as more than 100 people in Mexico have died.

If you are looking to get a read on epidemics, try John Barry’s The Great Influenza about the Spanish Flu epidemic of 1918-1920.

Below is a CNBC video of how Swine Flu spreads in humans.

Related posts:

• Does the Swine Flu really have the makings of an epidemic? Yes.
• Swine Flu Tempature Rises, Dollar and Yen Remain Firm
• WHO: Swine Flu Pandemic is imminent
• Swine Flu video primer from the Wall Street Journal
• First Swine Flu death in Texas (video)

This past week, I caught an article in Wirschaftswoche (WiWo), the German Business Week, which suggested that the South Koreans were very confident about their economy and had learned from the Asian Crisis.

Just today, the South Koreans released GDP numbers that many would find amazing, showing that the economy grew 0.1% in the first quarter compared to Q1 2008 Q4 2008.  Q4 2008 was a 5.1% fall, so that’s a pretty prodigious uptick which comes largely from household and private consumption.  It certainly begs the question as to whether the Asians are ‘de-coupling,’ a term I never though I would use in a positive sense.

What is clear from the reports at a minimum is that intra-Asian trade is increasing and keeping countries like Korea from feeling the full impact of the slow down in the West. (A 30% currency devaluation helps too.)

Below is a Bloomberg video on the Korean economy:

Also, here is what WiWo had to say (my translation):

South Korea wants to present itself at the just opened Hanover Fair as a country with a promising future – and as an unbroken dynamic export nation. The worst is behind the country. But, the Koreans find one development unpleasant.

Like a ballerina, the young lady dances around in front of the black sedan of Mr. Yoo. She leads the heavy but graceful Hyundai into the car park at the Seoul Lotte warehouse and bows so deeply that her little pink hat almost touches the ground. She chirps, that she is sorry for the precious time that had to be wasted by the important Client in the queue. Yoo Jae-Wook, head of consultancy Nemo Partners, sees the ‘parking show,’ as a good sign: “Every day the same large crowd. Officially, we have crisis, but they are all go shopping! ”

South Korea, this year the official partner country at the Hanover Fair, wants to present itself to the world as a haven of stability amid the present global crisis. This is not only outdoor advertising, but is quite the mood in the country itself. The fourth largest economy in Asia has come through the global shock calm. Quite unlike the Asian crisis of 1997/98, when some Koreans even donated their gold to support the economy. “In Seoul, they are not making cuts to their quality of life,” says Kim Nan-Do from the National University in Seoul. The Koreans, according to the local Siemens boss Josef Meilinger, understand the global crisis as an opportunity: “You look at which share of the world pie you can grab now.”

Crisis? What Crisis?

What crisis überhaupt? The Koreans come to Hanover full of self-confidence: “Our economy is overcoming the global crisis faster than other countries,” said Cho Hwan-Eik, president of the trade promotion company Kotra,. “We have high-performance products, sophisticated marketing strategies, and government and businesses have relatively low debt-burdens. Indeed, South Korea with government debt of 38.5 percent of annual gross domestic product is much better than Japan, for example, with almost 185 percent. The country has dealt with the recession from just over a decade ago and it is partially immunized against new problems – at least in many Koreans opinion. “The Asian crisis has made us seem well trained. We have learned to survive,” says business consultant Yoo.

In the areas of information technology, electronics, shipbuilding and auto industries, South Korean firms are forcing their way into the world class tier, but also lately in green technologies. In addition: The banking system is reasonably stable. “In comparison to the great Asian crisis a decade ago, our banking and financial system today is less vulnerable,” says Jong-Goo Yi of the state financial oversight of FSC. At that time, many indebted Korean conglomerates like the car manufacturer Daewoo and KIA, the Hanbo steel producer as well as several banks were forced into bankruptcy or had to give up their independence. Today, however, the liquidity of the 44 major Korean corporations is “so high that these companies have even more months to survive crisis,” says Yi.

Cautious optimism in the boardrooms

It is also reassuring, according to Yi, that the Korean banks, on average, have less than one percent of their loan portfolio in “toxic” assets – they have little invested in complicated derivatives. Accordingly, the financial structure is much healthier than in Europe or the USA.

In the boardrooms of the export-dependent companies, the typical sound is somewhat subdued optimism. In 2008, the export share of the economy was about 55 percent. Now, in the face of the crisis of world trade, sensitive setbacks are threatening. “Until now we have had the rapid depreciation of the won to hold us above water,” said Ko-Yung Sang of Standard Chartered Bank in Seoul. Against the dollar, the exchange rate of the Korean currency fell by almost 30 percent in the past twelve months. So Korea’s largest car manufacturer Hyundai / KIA lost in the U.S. less than one tenth of its turnover, although the total there saw a 40 per cent fall. The worst for Korea could already be behind them. The most difficult month was January, when the Korean exports crashed 34.2 percent. Afterward, the figures have improved. In March, the trade surplus was even at a record high of 4.6 billion U.S. dollars. For 2009, the economy ministry expects an increase of approximately 20 billion U.S. dollars, significantly more than previous estimates.

Even in crisis, South Koreans can rely on their main trading partner China, which at last count bought 23 percent of all Korean exports – 14 percent went to the European Union, and nearly ten to the U.S.. Above all, the shipbuilders were successful: Korean shipbuilders recorded a sales increase of 61 percent in March.

Such export power could ensure that South Korea’s recession in 2009 is relatively mild with a fall of minus two percent, the government previously estimated. Some prognosticators still hold a crash of up to six percent possible. The FKI Industries notes, however, that the mood among business people has improved significantly. “The downturn will lose significant momentum,” said JP Morgan economist Lim Ji-Won Lim. He holds a recovery already this summer for possible.

Need for social consensus is growing

Koreans feel uncomfortable, however, with the development of its labor market – despite the fact that other industrialized countries might be jealous at the figures. The unemployment rate has gone since February 2008 from 3.5 to 3.9 percent. Especially small and medium-sized enterprises should cut some 200,000 further jobs, which would bring the rate upward a further percentage point.

Therefore, the need for social consensus is rising. Entrepreneurs, workers and government have agreed on a program “to share the social pain.” In many companies the employees take up to 30 percent wage cuts. Managers voluntarily reduce their salaries, officials waive ten percent of their salaries and donate the money for the needy. Several unions, in fact notorious for militant strikes, want to work, fighting to forgo wage increases – in exchange for guaranteed jobs and recruitment.

In addition, the government is on a major stimulus program: 25 billion euros – about 2.5 percent of gross domestic product – to keep the economy on track: “The main objective is the preservation of jobs,” President Lee Myung-Bak announced.

The same applies for the job of dancing white car park in the Lotte department store. Strikingly, many customers pay with cash coupons, which the State distributed as part of the economic program to 2.6 million poorer citizens.

Watch developments in Korea. If we do see de-coupling oin the way up, it is going to be in countries like Korea where the upswing will happen first.

Source
Südkorea gibt sich auf der Hannover-Messe krisenresistent – WiWo.de

Related posts:

• South Korea going gangbusters in contrast to UK
• Asia is de-coupling
• Trade flows in flux: is this re-balancing?
• Pesek: Asia is de-coupling
• China warns that the west’s quantitative easing is inflationary

Marshall Auerback here with a few thoughts about this economic cycle, external imbalances, fiscal stimulus, and current account deficits.

This is not the Great Depression. We are going to have “muddle through” here precisely because we lack the courage to deficit spend on the magnitude we did in World War II. We are spending too much time fretting about “external imbalances” (Martin Wolf’s latest piece in the FT, “The Urgency of Now” is an illustration of this:  The resolution of external imbalances is the main problem and should be the policy objective right now.)

We are no longer operating under a fixed exchange rate regime or a quasi gold standard (much as some countries curiously want to recreate this). We have a flexible exchange rate regime, where capital inflows have to equal the current account deficit. Dollars flow out through the trade deficit (which is a large part of the current account deficit) as the US spends more on imports than it earns on exports. Those dollars are net saved by our trading partners and they are reinvested in dollar-denominated assets. If portfolio preferences of foreign net savers shift away from holding US dollar denominated assets, asset prices have to adjust until they are willing holders of the dollars they earn in trade (that is, interest rates must rise, equity prices must fall, until expected returns are attractive enough for foreigners to maintain their US dollar holdings). Also, if foreign net savers of dollars favor particular assets, like US Treasury bonds, for a variety of institutional reasons, then relative US asset prices can also be influenced.

The money that flows out through the current account deficit flows back in through the capital account. For a nation with a flexible exchange rate, there is no change in the money supply from trade activity. This is just the opposite of a fixed exchange rate system, of which gold based systems are one type, and that is why James Grant advocates leaving flexible exchange rate systems in the dustbin of history. In a fixed exchange rate system, money balances of trade deficit nations are drained off to the trade surplus nation, and the trade deficit can only be run until the existing money balances of the trade deficit are exhausted.

Neither foreign private or public entities can create US dollar reserves out of thin air. That is the charge of the US central bank and commercial banks. Foreigners have to earn dollars from sales of goods or assets to US dollar holders. So it seems to me that the imbalances Wolf describes are almost a necessity as far as the US goes.

That means the ultimate source of the credit to support US trade deficit spending could not have come from abroad as some have alleged. Rather, credit was created in the US as households engaged in mortgage equity withdrawal during the housing boom, and spent more than the earned. Neither foreign savings nor foreign capital inflows were required to create this credit. All that was required was a household willing to borrow with identifiable equity in their home, and a bank willing to expand its balance sheet, with new home equity loans creating new deposits out of thin air. The loan is made, which shows up on the banks asset side of the balance sheet, and the homeowner has a credit line it can draw down, which shows up on the liability side of the bank balance sheet. Nobody here or abroad needed to save beforehand for this money deposit and credit loan to be created.

So what happens when the housing bubble bursts? Equity in homes shrinks, mortgage equity withdrawal shrinks, bank balance sheet growth reverses, household deficit spending reverses as they begin to net save, the trade deficit begins to turn, foreign net saving is reduced, and foreign capital inflows to the US are also reduced. The trade deficit is the twin of the household deficit spending, and the household deficit spending was made possible by credit expansion by US financial institutions on the back of the housing bubble.

In other words, foreign saving and capital inflows are at the tail of the dog, not the head. The only way the tail wags the dog is if foreign portfolio preference shift suddenly or persistently against US dollar denominated assets or specific US asset classes, in which case asset prices must adjust to keep foreign investors willing holders of US dollar denominated assets. We must always be careful to distinguish between shifts in preferences with regards to existing holdings, and shifts in saving out of income flows. The two are not the same, but they often get conflated.

That is not to say the threat of foreign investors dumping US assets isn’t a danger, but it may not be the central risk, which as far as I can see remains the concerns of people who fret about today’s imbalances. To me, the central risk is that the US private sector is shifting to a net saving position in a dramatic way for the obvious reasons – loss of wealth, precautionary saving given recession, etc. Arguably, this needs to happen if households are going to pay down debt and reduce debt burdens, and if they are realizing capital gains are not guaranteed.

The risk of this necessary adjustment arises because if the private sector moves to a net saving position – spending less than it earns – the income level in the US will fall unless the trade deficit turns quickly enough, and unless the fiscal deficit expands commensurately. In other words, we should be applauding this increased fiscal deficit because the alternative would be disastrous, not just for the US, but the world as a whole.
For every net saver, there must be a net deficit spender, or else the net saving cannot be accomplished without an adjustment of incomes. This is where the so called paradox of thrift comes from, as you well know. If incomes fall, debt defaults and delinquencies will increase more dramatically, and there is a good chance of heading into a debt deflation spiral, a la Irving Fisher.

In Q4 2008, US nominal GDP fell. Incomes have started to fall. That indicates the private sector is trying to net save more than is feasible given the shrinkage of the trade deficit and the expansion of the fiscal deficit, largely through so called automatic stabilizers, to date.

I suppose you could argue that from a US only perspective, ideally all of the increase in the private sector net saving position would come from a reversal of the trade deficit, but this isn’t going to happen. China earns about 10 times as much on its external sector than the domestic market, so its decision to become an export juggernaut, taken in isolation, was perfectly understandable. But in a world where global trade is collapsing, in part because export dependent economies have just had the rug pulled out from underneath them as US consumers (and others) try to save, it is a fantasy to think the adjustment process can be done entirely through trade. The only way to avoid a debt deflation outcome, as long as the private sector is trying to increase its net saving, is through an expanding fiscal deficit. And the reality is that we don’t need a G20 summit to accomplish this. The US can do this on its own, as can Japan (as PM Aso indicated on the front page of your paper today). As the government spends more than it earns in tax revenue, private sector incomes are boosted, and the private sector can earn more than it spends. They are two sides of the same coin. In that sense, if you agree private sector deleveraging is necessary part of the adjustment process, or at least important, it comes at the price of public sector releveraging, barring a heroic reversal in the US trade deficit (which would throw our trading partners into an even more severe recession unless they also pursued domestic demand led polices, a la China).

To illustrate this, the current account deficit has already gone from about 6% of GDP to 4% of GDP. Let’s say further consumer and inventory contraction gets us to 2% of GDP by year end. The CBO suggests the federal fiscal deficit will be out to 12% of GDP. I think that’s a bit high, as it incorporates TARP. But even assuming a trailing deficit of 8% (which is roughly what we’ve got now in the US), the private sector can net save around 7-8% of GDP without nominal incomes falling in the economy. At the depths of the 1973-5 recession, private sector net saving hit a post WWII high of nearly 9% of GDP. Maybe it needs to go higher this time because of the larger shock to household balance sheets with home and equity price deflation. But at least we can say the fiscal deficit is now programmed to scale up fast enough to reduce or contain the risks of US income deflation, and hence a runaway debt deflation process. To me this is crucial.

So can the foreign trade and US household spending imbalances be adjusted? Yes, they can. Does that adjustment process create further challenges? Yes it can, to the extent massive fiscal deficit spending is required to allow the private sector to accomplish its net saving objective without cratering private incomes and setting off a debt deflation spiral.

Then the question really boils down to, can the massive Treasury bond issuance be placed, especially if a smaller US trade deficit means foreign investors have fewer dollars to reinvest in US assets?

Treasury bonds were once 40% of commercial bank balance sheets. They were below 1% last I checked. Default free securities might look attractive to banks these days, especially with a positively sloped yield curve. The Fed used to hold 70-80% of its assets in Treasuries, now down to 20%. The Fed will want to have plenty of Treasuries to sell into the market once the eventual recovery comes and private investor liquidity preferences fall.. Remember, the Fed has no budget constraint.

Does this imply an increase in liquid assets in the economy? Yes it can, but we are also undergoing a large financial sector deleveraging, and we have begun a household sector deleveraging as well for the first time in the post WWII period. As loans are paid backed, deposits are cancelled out, shrinking conventional measures of the money supply. Much of the credit in the shadow banking system has been obliterated, and will not be coming back soon.

Is there nevertheless a risk of a flight from the dollar to the extent the US is willing to be the first mover, and an aggressive one at that, down these paths of quantitative easing? Yes there is. Is there a risk investors seeing the more central banks pursing the quantitative easing path will take flight into precious metals and other real assets as prospective inflation hedges, even if product price deflation is showing up in more countries? Yes there is. Could that complicate the policy exit strategy to the extent some of these commodities, like oil, are inputs to production, and so higher commodity prices could lead to an adverse shift in supply curves (to the left in price/quantity space, as in stagflationary periods)? Yes it could. But I think the alternative of focusing first on the external imbalances between China and the US is the wrong way to go about it. Look at what happened to budget deficits during W.W. II: at its peak, the US budget deficit as a percentage of GDP went to 30.3% in 1943. Yet by the end of the war, US households and the private sector were once again in a position of massive savings surplus. This is the financial correlative to those huge government deficits on the side of the ledger.
Remember, there is no ‘cost’ to a federal deficit.  It’s not a free lunch, it’s a free tool to prevent loss of output.

One last point about “muddling through.”  Here are some graphs to illustrate the differences between now and the Great Depression (hat tip Warren Mosler).

Nothing remotely like this is currently in the cards. It was the last gold standard collapse. The US gold standard was abandoned domestically in 1934.

Nothing remotely like this will happen this time around. World War II deficits exceeded 20% of GDP annually. Currently Personal Income is muddling through with flat to modestly positive gains month over month. This is not the Great Depression.

Related posts:

• What are the consequences of the huge U.S. deficit?
• The dollar is rising against floating currencies
• The US Dollar – don’t just do something, stand there!
• The G20 Summit: Hijacked by neo-liberalism
• Why I am bearish on the U.S. Dollar

I plan to visit Mexico early next month as I do at least one or twice every year. This year I question what awaits me as evidence that Mexico’s economy and civil order is imploding mount. The latest strike against Mexico comes in its now escalating trade war with the United States.

The Mexican government said Monday it would slap tariffs on 90 U.S. industrial and agricultural products, in a trade dispute that underscored the difficulties facing President Barack Obama as he tries to assure business and global allies that he favors free trade.

Mexico said the tariffs were in retaliation for the cancellation of a pilot program allowing Mexican trucks to transport cargo throughout the U.S.

Unions have for years fought to keep Mexican trucks off U.S. highways, despite longstanding agreements by the two countries to eventually allow their passage. Legislation killing the pilot program was included in a $410 billion spending bill Mr. Obama signed last week.

The White House responded Monday to the tariff threat with assurances that Mr. Obama would work with Congress to create a new cross-border trucking program that addresses safety concerns.

White House spokesman Robert Gibbs said U.S. and Mexican officials would work on legislation for a new plan “that will meet the legitimate concerns of Congress and our [North American Free Trade Agreement] commitments.”

Mexico’s Economy Minister Gerardo Ruiz Mateos said Monday the legislation signed by Mr. Obama was “wrong, protectionist, and clearly violates” the free- trade treaty signed by the U.S., Mexico and Canada in 1994. Mr. Ruiz Mateos said the ban protected U.S. truckers while hurting Mexico’s ability to compete.

The Mexican government wouldn’t say Monday exactly which products would be hit with tariffs but that the total value of the products was $2.4 billion in 2007 and originated in 40 states. A detailed list was expected to be published this week.

Republican members of the House suggested such commodities as wheat, beans, beef and rice would likely be targeted.

Certainly, I fully anticipate protectionism to increase globally in the months ahead. However, this is not Mexico’s only problem. Mexico’s largest oil field has peaked, oil prices are way down, remittance income has shrunk, and drugs are a big concern.

Concern about a potential failed state — not Pakistan, not Somalia, but California’s neighbor Mexico – is mounting in Washington as an all-out war involving 45,000 Mexican military personnel fails to quell rising drug violence that is spilling from such Mexican cities as Tijuana into the United States.

An estimated 6,290 drug-related murders occurred in Mexico last year, six times the standard definition of a civil war, said Vanda Felbab-Brown, a leading scholar on the issue at the Brookings Institution.

All of this has had a very negative impact on Mexico’s currency as the chart below reveals. Last year just after the Lehman crisis, the Mexican Peso was trading at just over 10.50 to the dollar, today it trades over 14 pesos to the dollar. It has been over 15.

While recent reports from the likes of Morgan Stanley have been largely positive about Mexico’s economy, the backdrop is clearly deteriorating and the growing trade war with the U.S. is but one sign. If Mexico and its workforce come under pressure economically, the impact will surely be felt in the United States as well.

Update 430PM ET: A good video over at Bloomberg Television adds a bit more color to the situation. Enjoy.

Sources
Mexico Strikes Back in Trade Spat – WSJ
Migrant Workers Sending Less Money to Latin America – WSJ
Mexican Banks ‘Party’ May End as Economy Shrinks: Week Ahead – Bloomberg.com
Concern Grows in the U.S. That the Drug War Is Destablizing Mexico – AlterNet
Currency Charts – FXStreet.com

Related posts:

• Mexico: Central bank to cut today
• ‘Buy American’ will translate into a 21st century Smoot-Hawley
• Will Mexico suffer contagion?
• Tariffs: Other industries may line up for sanctions against China
• The dollar is rising against floating currencies

The “Buy American” clause stuck onto the stimulus bill wending its way through Congress is a pernicious piece of legislation because it has engendered a ferocious response from trading partners, not the least of which is Canada.

Below is a Wall Street Journal video clip discussing this piece of legislation and the Canadian reaction to it. In addition, the video rightly claims that the bailouts now being conducted for financial services industries around the world are subsidies that are equally protectionist. None of this bodes well for the global economy.

Related posts:

• ‘Buy American horror stories’ in Canada
• Canada: Boom in progress
• The protectionism bogeyman
• Canada joins the list of housing busts
• Sheila Bair talking to Bloomberg’s Al Hunt

The statistics coming out of Japan have been truly awful of late.  In my last post, you saw a small video connecting reduced spending in the U.S. to Japan.  However, I need to be more explicit about how things are unraveling in Japan.  The industrial production number that was released this past Friday was a wake-up call that Depression has arrived, at least in Japan.   Industrial production fell a stunning 9.6%, the most since statistics began in 1953.  This is a figure that translates into a GDP of 10% — and this in the world’s second largest economy.

Frank Veneroso’s latest piece “The Yen is madness” sums it up quite well (hat tip Scott):

December industrial production came in down 9.6%, worse than the METI forecast. It is now down almost 21% year over year. METI forecasts a further 4.7% decline in February. The inventory to production ratio soared again. Maybe METI will be correct. If it is Japan industrial production will have fallen 28% (non annualized) in four months. It will have fallen by a third in about a year. Nothing in the history of major nations compares. A 28% decline in four months would be more than half of the entire decline in U.S. industrial production over the 3 years and nine months of the U.S. Great Depression. It would be a greater decline in four months than in any 12 month period in the Great Depression in the U.S. We are literally looking at the unimaginable.

This is a wake-up call to everyone, especially China bulls because everywhere in Asia, a similar story can be told. The Economist puts this into context.

It seems so unfair. Most Asian economies have been models of prudence. While American and European households were borrowing up to the hilt, Asian ones were tucking away their savings. While rich-country banks were piling into ever-riskier assets, Asian banks kept their holdings of such assets small. And while America and Britain were sucking up the world’s savings, Asian governments piled up vast stocks of foreign reserves.

Yet many of Asia’s tiger economies seem to have been hit harder than their spendthrift Western counterparts. In the fourth quarter of 2008, GDP probably fell by an average annualised rate of around 15% in Hong Kong, Singapore, South Korea and Taiwan; their exports slumped more than 50% at an annualised rate. Share prices in emerging Asia have plunged by almost as much as during the Asian financial crisis a decade ago. That crisis was caused by Asia’s excessive dependence on foreign capital. This time the tigers have been tripped up by their excessive dependence on exports.

Asia’s emerging economies have long been the world’s most dynamic, with GDP growing at an annual rate of 7.5% over the past decade, two and a half times as fast as the rest of the world. Only last summer, many of these countries were being warned by foreigners that they were growing too fast and needed to raise interest rates to prevent a surge in inflation. Now, many seem to be in free fall and the news is likely to get grimmer.

In the fourth quarter of 2008, real GDP fell by an annualised rate of 21% in South Korea and 17% in Singapore, leaving output in both countries 3-4% lower than a year earlier. Singapore’s government has admitted the economy may contract by as much as 5% this year, its deepest recession since independence in 1965. In comparison, China’s growth of 6.8% in the year to the fourth quarter sounds robust, but seasonally adjusted estimates suggest output stagnated during the last three months.

Asia’s richer giant, Japan, has yet to report its GDP figures, but exports fell by 35% in the 12 months to December. In the same period, Taiwan’s dropped by 42% and industrial production was down by a stunning 32%, worse than the biggest annual fall in America during the Depression.

Asia’s export-driven economies had benefited more than any other region from America’s consumer boom, so its manufacturers were bound to be hit hard by the sudden downward lurch. Asian exports are volatile anyway (see chart 1). And though the 13% fall in the region’s exports in the 12 months to December was slightly smaller than in 1998 or 2001, those dismal records seem certain to be beaten soon.

The plunge in exports has been exacerbated by the global credit crunch, which made it harder to get trade finance. Destocking on a huge scale has further slashed output. Trade within Asia has dropped by even more than the region’s sales to America or Europe. Exports to China from the rest of Asia were 27% lower in December than a year earlier, partly reflecting weaker demand for components for assembly into goods for re-export.

Shocking as the export figures are, they are not entirely to blame for Asia’s woes. A closer look at the numbers reveals that in most countries imports have fallen by even more than exports, and that weaker domestic demand explains a larger part of the slump.

In China, for example, weaker domestic spending—mainly the result of a collapse in housing construction—accounted for more than half of the country’s slowdown in 2008. In South Korea, net exports actually made a positive contribution to GDP growth in the fourth quarter, while consumer spending and fixed investment fell at annualised rates of 18% and 31% respectively. South Korea is an exception to the rule of Asian prudence. Its households’ debt amounts to 150% of disposable income, even higher than in America. The banking system, which borrowed heavily abroad to finance a surge in domestic lending has also been badly hit by the global credit crunch, making it harder for firms to finance investment.

Domestic spending has collapsed elsewhere. Over the past 12 months, retail sales have fallen by 11% in Taiwan, 6% in Singapore and 3% in Hong Kong. As big financial centres, the two city-states have been battered by the global storm. Both have high levels of share ownership, so tumbling stockmarkets and property prices are depressing consumption. In Hong Kong average house prices have already fallen by almost 20% since the summer and Goldman Sachs, an investment bank, forecasts another 30% drop by the middle of 2010.

Do I need to go on here? All of Asia is in a recession more severe than the Asian Crisis in 1997-98.

So, what does all of this mean?

First and foremost, one should look at Japan. Here’s a country that has gone through massive monetary and fiscal stimulus for a decade, ballooning their government debt level to 200% of GDP. And, yet, they are seeing a collapse worse than the Great Depression. Japan has a massive domestic savings to absorb government debt. However, one cannot just continue printing money without consequence.

Question: will stimulus save us or is Japan just a bad example? The conventional wisdom is that Japan waited too long to provide stimulus and they also propped up their financial sector in ways that the West will not. Carl Weinberg of High Frequency Economics certainly takes that line in the video I from the last post. But is that really true? I see Japan as a worrying example of how ineffective stimulus can be. As I have said before, stimulus is no panacea. We are still going to suffer greatly nevertheless. Fixing the banking system and liquidating overcapacity are more important even than stimulus.

Then comes the question of what Asia’s collapse portends for North America and Europe. After all, exports from Asia are collapsing largely because demand in North America and Europe is collapsing. The Economist demonstrates in their article that Asia was too dependent on exports as a model for growth. However, I can’t help but think the interconnectedness of the global financial system will bring all of this back to the West in terms of reduced appetite for financial assets as Asians reduce their exposure.

My own view is that the West too often views Japan as a separate case and fails to appreciate the parallels there with what is occurring in the West — the asset bubble, the aging population, the monetary stimulus, the fiscal stimulus, the broken banking system.   Japan is in Depression.  However, Japan is not that different. What is happening there could just as easily happen here.

Sources
Record 9.6% fall in output sparks fear for Japan’s future – Times Online
Troubled tigers – Economist

Related posts:

• Japan does not demonstrate the failure of stimulus
• Is Japan next on the road to quantitative easing?
• Trade flows in flux: is this re-balancing?
• ISM Manufacturing Index: Deep recession territory
• Japan: stimulus without reform leads to a policy cul de sac

Everyone should be concerned about the increasing tone of trade friction in the global economy.  While Chinese Premier Wen and U.K. Prime Minister Gordon Brown are setting a positive tone in London today regarding bilateral trade agreements, the U.S. is doing its best to put off trading partners.  In fact, in Canada, there seems to be a lot of rancor regarding the ‘Buy America’ provision now being attached to the U.S. stimulus package.

Comment: ‘Buy America’ policy a veiled attempt to export unemployment

Free trade afforded by goodwill in times of economic expansion is ending rapidly with the lurch of the world economies into recession.

Plans by U.S. Congress and President Barack Obama to put a fence around its US$825-billion stimulus package by implementing a “Buy America” policy is a veiled attempt to export unemployment to the rest of the world. The result could be slower growth and a higher cost of credit for the U.S. economy, two good reasons for investors to “Sell America” now.

Attaching a “Buy America” policy to the US Stimulus Package is a futile and dangerous attempt to protect American jobs. America’s best export right now is unemployment. U.S imports are falling and the trade deficit is improving due to the fall in U.S demand. U.S imports fell 12% in November taking the trade deficit to its lowest level since 2003.

China’s export sector is reeling from the sharp fall in U.S demand. Exports in China fell the most in a decade in December and are likely to continue falling over the next six months as demand from the U.S, Europe and Japan dries up. Manufacturing in China has contracted for the past six months and has made roughly 10-million migrant workers jobless.

President Obama should tread very softly when it comes to trade policy. Firstly, it is widely acknowledged that free trade contributed to global economic prosperity. Free trade with China brought an era of low inflation to the United States and to the rest of the developed world. Trade in general leads to higher productivity and potentially higher levels of global growth.

On the flipside, rising trade barriers that protect industries lead to the misallocation of resources, lower productivity, higher prices and lower levels of economic growth. They are especially dangerous in times of recession. They are tantamount to suicide for the U.S administration given the high level of savings that China has shipped abroad.

The U.S Treasury Department is justified in pointing the finger at China for practicing mercantilist-style trade policies: China’s massive trade surplus and multi-trillion dollar store of foreign exchange reserves provides strong evidence that trade policy in China is designed to keep its currency weak. But the timing is all wrong.

Agitating for a revaluation of the Yuan and a “Buy America” policy could backfire in a big way. The U.S is like a junky with a US$2-billion a day borrowing habit, so getting on the bad side of its best dealer could be a big mistake.

China has been a major source of cheap credit to the U.S over the past few years. The People’s Bank of China has parked roughly US$680-billion in U.S Treasury securities making it the single biggest source of credit to the U.S Treasury from abroad. This “savings glut” as it has been referred to allows the U.S Treasury to borrow money at very low rates of interest, and China could end that by easily converting those reserves to Euros or Yen. U.S Treasury Secretary Tim Geithner might get the revaluation of the Yuan he is looking for in the form of a dollar rout.

Access to cheap credit has never been more critical to the U.S economy at this juncture. The U.S Federal Reserve Bank has been buying mortgage securities to reduce the cost of credit to U.S homeowners, to slow the rate of foreclosures, and to support the price of mortgage securities held by U.S banks.

Moreover, the U.S Treasury will need to borrow heavily to support its multi-trillion dollar fix to the U.S economy. President Obama’s attempt to keep every dollar of his stimulus package from leaving the U.S by issuing a “Buy America” policy could cause the unintended consequence of foreign capital flight.

This is an editorial comment in today’s Financial Post, a leading newspaper in Canada. One should note how strong the language is in this editorial.  While the quote concentrates on trade between China and the U.S., Canada itself is quite worried about the increase in protectionism in the United States.  The Financial Post is angry that the United States is looking to foist its own unemployment problem off on its trade partners.

The long and short here is this:  China, the EU, and Canada have now all warned the U.S. about “Buy America.’ Any protectionist measures implemented by the United States WILL be met in kind by retaliatory measures.

The tone in the U.K. is very different where Gordon Brown announced in a press conference with Chinese Premier Wen that he is looking to double trade in the next eighteen months. Wen may be using the U.K. as a foil to the United States, in effect saying, “Look America, we have other options.” Nevertheless, Brown and Wen are demonstrating that global trade does not have to collapse due to the economic downturn despite protests because of job losses.

When I find a video or quote from the press conference, I will post it.  Also, you should note that the Financial Post editorial begins with a picture of Obama and Biden, linking the Obama Administration with Canada’s perception of protectionism.

Sources
Comment: ‘Buy America’ policy a veiled attempt to export unemployment – Financial Post
Wen Says China to Begin European Procurement Missions – Bloomberg

Related posts:

• Beijing starts a ‘Buy China’ policy
• China launches retaliatory investigation into U.S auto subsidies
• Will Asia’s downturn be worse than America’s?
• Stephen Roach sees a W-shaped recovery for China
• ‘Buy American’ will translate into a 21st century Smoot-Hawley

Politicians in Washington D.c. have cooked up a nice way to re-create the mistakes of the Great Depression by attaching a ‘Buy American’ provision onto the stimulus bill making its way through Congress.  Apparently the Canadians and Europeans have already voiced their concerns, with the Europeans threatening to retaliate.

The White House has promised to review the protectionist proposals, passed last week by Democratic allies in the House of Representatives, which would ban the use of non-American steel in the $800 billion of construction projects.

Obama officials are under pressure from what European diplomats in Washington describe as a discreet but outspoken campaign of “quiet fury” from America’s closest allies.

They regard the move as a provocative shift away from free trade and towards economic populism at a time of turmoil.

Anyone who has read a cursory history of the Great Depression knows that protectionism and the banking system were at the core of events. As time goes on, I have become increasingly pessimistic about the skill of the political establishment in the U.S. and elsewhere to navigate this economic crisis. Certainly, the response to the banking crisis has been less than stellar. However, increasingly, it is also apparent that countries are turning to export subsidies and protectionism in a bid to favor domestic producers as trade plummets. The auto sector is front and center in this effort. I am certainly not convinced that Obama’s team will brush back the tide of protectionism — his record on the issue is dubious at best. However, America’s neighbors to the north are trying to stop the protectionist train from gathering steam.

Canada and other nations fear “Buy American” barriers could trigger a cycle of retaliation that would strangle world trade and undermine efforts to end the global economic crisis.

The measure would not raise any illegal tariffs but some experts say it may violate public-procurement provisions signed with the World Trade Organization by Canada, the United States, the European Union and other countries.

“There’s some pretty furious legal research that’s going on right now to see where it potentially may cross the line,” Day said.

Let’s see where this leads.  The Telegraph in the U.K. has reported this:

Privately, diplomats are withering about the “excitable” US rhetoric in support of the Buy America proposals. But they are resigned to a solution that leaves Mr Obama with something he can sell as protecting American workers, so long as it does not violate the letter of the trade arrangements.

European Commission representatives and diplomats from the British, French, Canadian and Mexican embassies in Washington have all launched an intensive lobbying operation to convince senators to strike the provisions from the bill they will debate this week.

A Western diplomat in Washington made clear that otherwise a trade war was in prospect. “The EU has said it will not stand idly by and let this happen. I’ve not heard words that strong from Brussels in 20 years,” the official said.

This certainly is not the makings of recovery and prosperity. Stay tuned. Apparently, in uncertain economic times, it’s every nation for itself. Economic nationalism has well and truly arrived.

Sources
Barack Obama to dilute ‘Buy American’ plan after Europe threatens US with trade war – Telegraph
Canada may raise “Buy American” issue with Obama – Reuters
Protectionism could destroy us all – Telegraph
Buying American – Economist

Related posts:

• ‘Buy American horror stories’ in Canada
• The absurdities of ‘Buy American’
• China: we “will take steps to protect the interests of our domestic industries”
• The U.S. is exporting unemployment with ‘Buy America’
• Is Mexico imploding?

I have been out the entire morning and haven’t been able to read any news reports on the GDP numbers.  However, I have just now had a chance to look at the data and wanted to share my thoughts with you, unfiltered by the media reports.  I would sum it up by calling it a story about the three I’s of imports, inflation and investment.  But, I will also have a few words to say about state and local government spending as well.

We all expected a bad number.  Therefore, in the scheme of things, -3.8% was not so bad, despite being billed as the worst economic performance in 27 years.  There were no big surprises, so I want to focus on the deltas — that is on the things that changed the most from Q3 to Q4. This may give us a clue as to what to expect going forward.

Now, I am going to be discussing the non-inflation-adjusted numbers because I do not want the GDP deflator – which is used to go from these numbers to the ones you hear in the media – to skew the analysis.

Here are the deltas I see:

Inflation

The first number to note is the GDP deflator itself.  Now in case you don’t know what the hell a GP deflator is – it is the number the government statisticians use by which they ‘deflate’ the Nominal GDP number in order to calculate the Real GDP number reported in the press.  (For more on this, see my post “The GDP deflator.”)

This number often seems bogus as it does not include an adjustment for imported goods and services like oil.  So it’s like measuring domestically-derived inflation only.  It gives a good read on prices generated in the domestic economy.  The annualized quarterly number for Q4 2008 was -0.07%, the first negative number since Q3 1954, which was 54 years earlier.  Translation:  deflation has arrived.  We are not talking about oil prices here.  We are looking at deflation of prices for domestically generated goods and services.

Durable Goods
Now, if you recall from Econ 101, GDP equals C + I + G + (Ex – IM) — Consumption + Investment + Government Spending + Net Exports.  When people talk about over-consumption, they mean that the C has been growing faster than everything else.  For instance, in 1984, 25 years ago, Consumption was 63% of nominal GDP.  Just before GDP growth turned negative last year, it was 71%.  That’s overconsumption!

But, this has come to an end. And it is durable gods – cars, refrigerators, and the like – that have seen the lion’s share of the fall, an annualized 12.8% last quarter alone. People are obviously deferring purchases of big-ticket items due to economic uncertainty. Expect this trend to last for all of 2009 at a minimum. This is one reason the automakers’ problems are not temporary. I anticipate they will come looking for more money from the government sometime soon.

Fixed Investment
Then there’s the Investment side of things. Fixed Investment as fallen for 8 quarters now, since the beginning of 2007. However, the drop of 7.4% last quarter indicates that the falloff is increasing. But, as capital spending is a lagging indicator, this doesn’t really say much about where things are headed except with regard to the employment market where it signifies an increase in job cuts. (See my post “The Economy’s Four Horsemen” for more on this).

State and Local Government
This is an eye-opener. Government spending is down from Q3 to Q4 because municipalities are having to cut back more than the feds have increased. Basically, your local county or city government doesn’t have a printing press to cover deficit spending with. That means that when tax revenue decreases, so too must spending. And this is exactly what s happening at the state and local level. In fact, the annualized drop in state and local government spending was 7.8% in Q4. That’s huge. Economic stimulus at the federal level will be offset by contraction in local government spending unless local governments receive funds soon. Translation: Obama’s stimulus package is not going to do the trick.

Trade
Finally, we come to net exports. Exports were down an annualized 36% in Q4. But, imports declined even more: an annualized 46%. So net, net we saw a better trade balance in Q4. What this means is that the recession is reducing American reliance on foreign goods and services. I see this as a necessary re-balancing which will be useful once the U.S. leaves recession.

On the whole, my takeaways from this are the following:

1. Overconsumption in the U.S. is at an end.  Consumers are spending less.
2. Durable goods are going to take the biggest beating here.  Position your investments accordingly.
3. Losses in tax revenue by local and state governments mean reduction in spending, which will partially offset the Obama stimulus package.  This makes it likely that the stimulus will fail.
4. The absolute value of trade is plummeting.  This will cause exporters to lobby for export subsidies, increasing trade friction and protectionism.

Source
National Income and Product Accounts Table – Table 1.1.5. Gross Domestic Product – U.S. Bureau of Economic Analysis

Related posts:

• The GDP deflator
• GDP: 4th quarter 2008 was worse
• Highlights from report with Q1 U.S. GDP down 6.1%
• Breaking down the Q3 GDP numbers
• The GDP’s inflation metric is clearly bogus