The Chinese Dilemma

China seems to be determined to continue to peg the value of its currency against the dollar. Then it points its finger at the United States anytime someone representing the United States raises a question about its practice.

As long as China continues to follow this policy, the United States is locked into a corner with no really good options.

The problem of the United States is the problem of a country that has lost its discipline: a person, an organization, a nation, that loses its discipline is only left with painful decisions. And, given an adversary like China that knows when it has a favorable advantage over another, the bad situation only becomes worse.

The assumption of United States supremacy which most presidential administrations worked with since the 1960s created an aura of invincibility, a feeling that the government could conduct its monetary and fiscal policies without regard for the rest of the world. The Bush administration “strutted” into power in its cowboy boots and its Colt 45s ready to enforce this attitude on other nations.

Unfortunately, for the United States this assumption no longer holds. Although the United States is still the most powerful nation on this planet, both in terms of its economic machine and its military presence, it is not in the same place it once was relative to other nations. As a consequence, the country pays a price if it tries to disregard the rest of the world in the conduct of its monetary and fiscal policies.

The prodigal nature of Bush 43 resulted in the value of the dollar, using almost any measure, declining by about 40% between early 2002 and the summer of 2008. Obviously, the monetary and fiscal policies of Bush 43 were not well received by the international financial community.

After the flight to quality into the dollar during the financial crisis of 2008, the value of the dollar has dropped about 14% from its near-term peak in March 2009 to the present time. World financial markets are not approving the economic policies of the United States government!

Meanwhile the Chinese sell goods to the rest of the world and live off of an export driven economy.

And, what happens if the United States does nothing about this?

The value of the dollar will continue to decline and the prestige of the United States in the world will continue to fall. And, the carry trade will continue to prosper and big financial institutions and financial players will continue to rake in billions of dollars in profits by borrowing dollars at ridiculously low United States interest rates, selling the dollar, and investing in higher interest rates throughout the world.

The big banks will continue to get stronger…and bigger. The rest: well that is their problem!

The two major alternatives being suggested are either to raise interest rates and try to moderate the rise in government debt or to raise protective barriers against international trade.

The first of these alternatives does not seem realistic to expect at this time. With unemployment at current levels and with foreclosures and bankruptcies remaining high, the political interests in the United States are not going to condone higher interest rates and a less expansionary fiscal policy. Using monetary and fiscal policy to stem the decline in the dollar is, it seems to me, just not going to happen.

The other major alternative now being floated: greater protection for United States manufacturing and industry. Paul Krugman, the Nobel prize-winning economist, writes about “Chinese New Year” in last Thursday’s New York Times (see http://www.nytimes.com/2010/01/01/opinion/01krugman.html). He concludes as follows:

“there’s the claim that protectionism is always a bad thing, in any circumstances. If that’s what you believe, however, you learned Econ 101 from the wrong people — because when unemployment is high and the government can’t restore full employment, the usual rules don’t apply.

Let me quote from a classic paper by the late Paul Samuelson, who more or less created modern economics: “With employment less than full ... all the debunked mercantilistic arguments” — that is, claims that nations who subsidize their exports effectively steal jobs from other countries — “turn out to be valid.” He then went on to argue that persistently misaligned exchange rates create “genuine problems for free-trade apologetics.” The best answer to these problems is getting exchange rates back to where they ought to be. But that’s exactly what China is refusing to let happen.

The bottom line is that Chinese mercantilism is a growing problem, and the victims of that mercantilism have little to lose from a trade confrontation. So I’d urge China’s government to reconsider its stubbornness. Otherwise, the very mild protectionism it’s currently complaining about will be the start of something much bigger.”

If unemployment remains high and economic growth continues to stagnate, and the value of the United States dollar continues to decline, the argument that Krugman presents will become more and more convincing, especially as we move to an election. Krugman is now saying that a double-dip economy is more probable than it was a month or two ago and the current stimulus will disappear after the middle of the year. Thus, tighter monetary and fiscal policies, toeing this line, are not appropriate.

This alternative can, therefore, become a real threat and we could experience a rising tide of interest in greater amounts of protectionism as 2010 proceeds. Once the ball gets rolling in this direction it becomes hard to stop and other nations must respond in kind to protect themselves. This would just be a replay of the 1930s, when an earlier death spiral of globalization took place. Even a person who was generally in favor of free trade like John Maynard Keynes became, for a while, a supporter of protectionism because the British government was doing nothing else.

The United States is in a corner and there are no real good choices available to it. As said earlier, when one loses their discipline nothing becomes easier. Bush 43 was totally undisciplined and we are currently paying the price for it. No one seems to have a good idea how to get out of the current malaise and so alternatives like protectionism are bound to gain ascendency.