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Thursday, January 15, 2009


how stimulus might lead to trade war

martin wolf's latest piece in the ft has touched off some very thoughtful commentary which, to complete the circle, is summed up at ft alphaville.

starting out with the mathematics of stimulus:

Last week, President-elect Barack Obama duly unveiled his American recovery and reinvestment plan. Its title was aptly chosen, for Mr Obama spoke, astonishingly, as if the policies of the rest of the world had no bearing on the fate of the US. He spoke, too, as if a large fiscal stimulus would be enough to restore prosperity. If that is what he believes, Mr Obama is in for a shock. The difficulties he confronts are much deeper and more global than that. ...

First, the Japanese policymakers who told everyone the US was in danger of falling into a prolonged period of economic weakness were right. ...

Any complacency about US recovery prospects is perilous. Moreover, the fact that the US has a structural current account deficit has bearing on the second point Mr Obama’s advisers must make. Fiscal stimulus is a necessary palliative for a debt-encumbered economy afflicted by falling asset prices. But the likely longevity and scale of the needed fiscal deficits are quite scary. ...

indeed, yves smith does the sums and finds

So if I have this right, "needed" stimulus is the 10% (full employment" deficit + 7%, or 17% in each of the next two years. What Obama is delivering is 5% over two years, or 2.5% a year, plus a baseline of 8.3%, for a total of 10.7%.

So to get where we need to get (if you buy the logic of this sort of exercise) is an additional 6.3% PER ANNUM deficit as a % of GDP. Remember, Obama's plan is roughly 2.5% per year. 6.3/2.5= 2.5 times.

Read that again, If you believe the math, Obama's program would need to be 2.5 times bigger to live up to its billing. And that is before you get into details like "tax cuts are likely to be less effective than other measures".

which is what wolf means when he says

As long as the private sector seeks to reduce its debt and the current account is in structural deficit, the US must run big fiscal deficits if it is to sustain full employment. That leads to the third point Mr Obama’s advisers must make. This is that running huge fiscal deficits for years is indeed possible. But the US could get away with this only if default were out of the question. ...

[Therefore] It is necessary to make structural changes in the US and world economies first. This is the last point Mr Obama’s advisers must make.

those changes -- which smith labels "sobering" -- are, first, a credible programme for what Americans call “deleveraging”, involving banking system nationalization and forced debt-to-equity swaps as well as the punishment of holders of all manner of securitized receivables; and second, a reduction in the structural current account deficit ostensibly through a reduction in consumption and the encouragement of exports.

the former is something i've harped on for what seems a very long time now -- as smith says

The US has not been willing to inflict pain on lenders and investors, even though over-their-heads borrowers will go bust and deliver losses. But too many holders of the paper seem to derive false comfort from having the losses show up a tad later than they would anyhow.

that must end, however painful for the ruling elite of this nation, if the financial system is to emerge from its terminal paralysis.

but smith further cites michael pettis, getting to the issue of whether massive deficits over even the handful of years that would be needed to effect a restructuring of the american current account problem.

... I would argue that if the US trade deficit had been funded by equity inflows that resulted in an increase in domestic investment, there would not be a trade-sustainability problem. If it was funded by a household borrowing binge, then trade-deficit sustainability is necessarily constrained by the household balance sheets. This is why I have argued that a program of massive fiscal spending to replace household demand is not going to solve the current problem. It simply replaces one kind of unsustainable behavior with another, and still has to be resolved at some point with massive deleveraging.

To get back to China and current issues, the problem with the US trade deficit now is sort of a “Keynesian” problem. US demand has the impact of generating both US production (and employment) as well as foreign production (and employment), and in a world of contracting demand, it is natural that countries that export demand – i.e. trade deficit countries – are going to be a lot less eager to do so. Anything that brings imports closer into balance with exports is likely to have a demand-enhancing impact similar to fiscal expansion, with the benefit that this isn’t achieved by running up fiscal debt. On the other hand it will have a demand-reducing impact for trade surplus countries. That is why trade disputes are likely to be very attractive to trade deficit countries who have – I will continue to insist but it seems recently that this has become a much less “surprising” claim – the upper hand in any dispute with the “virtuous” countries with high savings rates and trade surpluses.

this again is the beggar-thy-neighbor scenario -- few of the economists who have filled the seventy intervening years since the last depression with invective against trade restrictions explained how terribly attractive a trade war might appear. back to alphaville:

The below graph is from Albert Edwards at Societe Generale. It’s frightening (click to enlarge):

The OECD’s leading indicators are pointing to a total and swift collapse in Chinese GDP growth. Edwards produces two more graphs, using another indicator not included in the OECD’s calculations - electric power output:

And the relationship between electric power output and GDP:

this seems to be the collapse of the chinese economy i've been waiting on. edwards mimics the analysis of vitaliy katsenelson on electricity output.

If the Chinese economy collapses, or even slows dramatically, then the raison d’etre for the country’s huge FX reserves - as a sterilisation measure to dampen domestic inflation - will evaporate. With that, so will China’s US Treasury holdings. Or alternatively the Chinese could devalue the yuan.

Either way, the US will be in trouble
. Treasury prices could collapse (although given the current renewed banking collapse fears, not before a significant rally has occured) and if that happens, the Fed’s yield-lowering credit easing policies will be left in tatters. As will any plans for economic stimulus packages. Hypothetically that would leave just the nuclear option: devaluing the dollar.

ergo, competitive devaluation facilitated by a pyrrhic trade war in an attempt to get china to abandon its dollar peg.

Why would the Chinese let that happen?

…surely the authorities have learnt the lessons of the 1930s and we can rely on them to do the right thing? It depends what the alternative is. A Yuan devaluation would undoubtedly be likely if the alternative was the overthrow of the Communist Party. As The Economist pointed out recently, economists and bankers begged President Hoover not to sign the 1930 Smoot- Hawley Tariff Act.

the plausibility of this well-reasoned decision tree is absolutely depressing. at this time i think this is the preliminary road map by which we will be able to interpret first a disproportionate contraction in capacity in the united states accompanied by devastation in germany and japan as china weakens the RMB; then a sino-american trade war resulting in a much deeper and longer depression whose weight falls primarily on asian trade-surplus nations like china.

UPDATE: more via yves smith on china's increasingly bleak outlook, including a citation to ambrose evans-pritchard's question, "will china lead the world into depression?", discussing albert edwards' terrifying forecast.

"Technicals say it is time to bail out. Cut equity expose and prepare for rout. US depression looking likely. While China's 2009 implosion could get ugly. ...

"The Chinese economy is imploding and this raises the possibility of regime change. To prevent this, the authorities would likely devalue the yuan. A subsequent trade war could see a re-run of the Great Depression.... Do you really trust politicians to 'do the right thing'? ...

"We continue to emphasize our long-held view that emerging economies are particularly vulnerable to a reversal in the global liquidity pump. ...

"Could the economic situation in China become so bad that it threatens the regime itself? Of course it could. But before being swept away in a tidal wave of worker unrest it has one key tool in its economic armoury it has used before. MEGA-DEVALUATION. China has a track record of such things. At the end of 1993 the authorities devalued the yuan by 33pc. ...

"Amid confidence that the ongoing, massive, monetary and fiscal stimulus will prevent a repeat of the Great Depression, will it instead be competitive devaluation and implosion of world trade that we should watch out for."

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