Andy Xie: Steering Out of a Smash-Up No One Wants

U.S. President Barack Obama dramatically altered policy direction during his first State of the Union address by announcing plans to focus fully on creating jobs while doubling exports in five years.

This could put the United States on a collision course with China’s export strategy. And a head-on crash, possibly centered on China’s foreign exchange rate policy, might occur before America’s mid-term elections in November.

No one wants confrontation, especially at such a critical time for global trade, the world’s recovering economy and China’s property market. But a changing political mood is steering Washington into Beijing’s lane. China can respond by turning the wheel before it’s too late.

The trigger for Obama’s policy turnaround was the defeat of the Democratic Party in the Massachusetts election for a U.S. Senate seat left vacant when Ted Kennedy died. The Democrat tapped to succeed Kennedy was a well-known attorney general, and no serious Republic candidates had emerged until a little-known state senator, Scott Brown, accepted the GOP nomination. Brown won by a landslide.

Few doubt this was a protest vote against the Obama administration. Massachusetts voters apparently thought the country was on the wrong path and that Obama had ignored their top concern – employment – while being bogged down by an unpopular Wall Street bailout and poorly timed healthcare reform.

Why protest the bailout? In previous financial crises, big shots who contributed to bubbles went to jail; Americans expect heads on pikes after a financial crisis. Jailing even a few crooks is extremely important because it resets the system with a new psychology. For example, after the junk bond bubble burst in the 1980s, junk bond king Michael Milken and top executives at many bankrupt savings and loans went to jail. And after the IT bubble burst in 2000, jail terms were ordered for top guys at Enron, Tyco and even some Wall Street analysts.

The bubble that just burst was bigger than any in the past, yet none of the big shots went to jail. Instead, the president has dined with them and begged them to support his financial reforms. Americans see this as a farce. And if the Obama administration is unwilling to change, voters will choose someone else.

In addressing the financial crisis, Obama’s team continued a Bush administration policy aimed at protecting the status quo. Obama didn’t have to, but the government needed a financial system to protect the economy. It could have let the system go down before nationalizing it, leaving a clean sheet for a new system without the flaws that led to the bubble. Instead, the Obama administration created an enemy to its own financial reforms by bailing out the existing system wholesale. No one could expect the same people who benefited from the system’s flaws to support abolishing them.

Since the bailout, the administration has focused its remaining energy on healthcare reform — no doubt the biggest problem for the U.S. economy. Health costs account for 16 percent of GDP, twice as much as the OECD average, and they are growing twice as fast as the rest of the economy. The sector’s excess costs are comparable to total profits for the U.S. corporate sector.

The truth is high costs have not brought a fair system; between 40 and 50 million Americans (or up to 16 percent of the population) have no healthcare insurance. This is the country’s biggest social equality issue.

The Obama administration initially set out to address cost and coverage issues with its reform agenda. But as opposition to cost-cutting initiatives rose, the government compromised. Over time, it changed to concentrate solely on expanding coverage and spending more. Costs would be born by raising taxes on the middle class. The reform became bad for the middle class and good for a minority underclass, triggering social division as a lightning rod for middle class anger.

At the same time the biggest issue – rising unemployment – has been pushed to third place on Obama’s priority list. He has been repeating Wall Street’s mantra: Reviving Wall Street would revive the economy, which in turn would revive employment. And in just one year, Wall Street bounced from government bailout back to big bonuses. Yet the unemployment rate rose to 10 percent – even 17 percent if underemployment is included. Taxpayers whose money revived the Wall Street party are still looking for jobs. How could they not be angry? And so the Massachusetts election was an opportunity to vent.

Job One
Thus, Obama’s new policy direction. Creating jobs is everything. Indeed, unless the administration can have a significant impact on employment soon, the Democrats could suffer a major defeat in November, even losing their majority in the House. That would be an unmitigated disaster for Obama. Facing a Republican majority in Congress, he would accomplish little. Thus, we expect Obama to make many employment-related policy decisions in coming months.

His first decision was to offer a US$ 5,000 tax credit and cap the benefit at US$ 500,000 per employer, for a total cost estimated at US$ 33 billion. That’s a small amount for a US$ 15 trillion economy, and it won’t be enough to change political fortunes for the Democrats. Obama needs bigger, more substantive action soon.

Obama’s dilemma is that Washington’s political structure won’t allow substantive measures. The Senate voting system implies the opposition must support whatever the ruling party wants. As the opposition has no interest in helping the ruling party succeed, it’s only willing to support what it champions. Hence, the ruling party must adopt the opposition’s agenda to get anything done.

The Clinton administration passed a few measures the Republicans championed. The Bush administration did the same for the Democrats. This means, overall, nothing radical can be accomplished. When the economy is cruising along, this sort of Washington gridlock works well. But when the economy is in trouble, the system means offers no meaningful solutions.

When the government’s hands are tied, the Federal Reserve gets called upon to shoulder the economic burden. But its only tool is the currency printing press. This is why the Fed usually leans toward loose monetary policy, giving the U.S. economy an inflation bias. For the past two decades, low commodity prices and global labor surplus kept inflation low, so the inflationary consequence of the Fed’s bias failed to surface. Now, both factors have reversed, which means inflation is coming soon, constraining the Fed’s ability. Odds are that the Fed would be forced to raise interest rates soon, and by 2012 the Fed funds rate could top 5 pecent, despite a sluggish U.S. economy.

Export Push
With the Fed restricted by inflation and the government paralyzed by gridlock, the only policy option for the United States is to pursue export expansion. The U.S. trade deficit peaked in 2006 at US$ 760 billion, with exports equal to one-third imports. Last year’s deficit was probably half that peak, although the contraction was due to an import collapse rather than an export expansion.

This is a contractionary approach to resolving the deficit problem and, hence, not sustainable. If the U.S. economy expands, the deficit will rise again, with trade subtracting from rather than adding to economic expansion. With no internal levers for sustaining demand growth, the United States must change the external situation and make trade a positive element for its economic expansion. This is why Obama called for doubling U.S. exports in five years.

One option for expanding exports is to devalue the dollar. But as the Fed enters a tightening cycle, the dollar can’t fall much. Indeed, as I wrote a few months ago, the dollar has bottomed. Its lowest point was in May 2008 when the dollar index reached 71, and it peaked during the crisis at 90 when safe haven trade pushed money into the dollar. It has been in the 75-80 range for the past six months, and will likely stay there for the rest of 2010.

As devaluation isn’t a way out, the United States will likely turn to trade policy to increase exports. China is the most obvious target. The yuan peg to the dollar is likely to be the focus again. During the crisis, the peg was a stabilizing force, preventing a total collapse of the dollar while the Fed maintained a zero interest rate. Now that financial stability has been restored, and the Fed is ready to raise interest rates, the yuan’s dollar peg isn’t as important to the stability of the dollar. Actually, it could make the dollar stronger than what the United States wants. So breaking the yuan-dollar peg is now in the best interest of the United States.

U.S. pressure over China’s exchange rate policy began with protectionist measures, such as tariffs on steel pipes, tires, poultry and electric blankets. Protectionist measures against China are so far worth several billion dollars, which is small relative to total imports from China and won’t create enough U.S. jobs to make a dent in the unemployment rate. But the publicity is good for Obama, who will likely step up protectionist measures. Since unemployment is a do-or-die issue for the administration, it must be seen as doing something.

U.S. trade policy will likely morph from political publicity to serious tool for economic expansion. With monetary and fiscal policies constrained, this is the only way to decrease unemployment. The administration’s goal to double U.S. exports won’t happen organically. U.S. exports rose one-third in the past five years. Even if we assume U.S. exports could rise another one-third over the next five years, exports to financial crisis-weakened overseas markets would fall short of Obama’s goal by more than US$ 600 billion. China would become an obvious target for making up the difference, requiring that China appreciate its currency dramatically and make a major switch to consumption-oriented economy.

Avoiding Japan’s Fate
Current U.S. woes mirror the economic difficulties seen in the 1980s, when it pushed Japan to double the value of its currency. To cope with the negative effects of the yen’s appreciation, Japan’s central bank followed a loose monetary policy, which in turn created the biggest property bubble in history. During the restructuring, Japan’s bubble economy did give some help to the U.S. economy because the U.S. economy was restructured for another growth cycle after the bubble burst. That ended in 2008 with the bursting of the U.S. property bubble.

It is extremely likely the United States would push China to play the same role Japan played two decades ago. Its policy focus could be aimed at forcing China to double its currency value. But as the profitability of China’s export sector is already poor, the economy would face enormous pressure.

China is already experiencing a big property bubble. The overvaluation of China’s property stock may already exceed 100 percent GDP, higher than the peak excess value during the U.S. property bubble but still much lower than the 300 percent GDP overvaluation that Japan saw during its bubble period. So it is possible that China’s bubble may triple.

Even before lurching into a destructive property bubble, Japan was a high-income economy. China is still at a lower-middle income level, with a per capita income that’s one-tenth Japan’s. So a China property bubble bursts would stagnate the economy a la Japan but at a lower income level, trapping China at a low level, perhaps permanently.
However, it would be unwise not to respond to U.S. pressure constructively. Without benefiting from China’s growth, the United States lacks incentive to be China’s biggest export market. So to pressure China, I expect many more U.S. protectionist measures this year. Before the November mid-term election, Congress could pass a bill that calls for a 30 percent tariff on all Chinese products unless China appreciates its currency by the same amount.

China’s best reaction would be a proactive policy that benefits the United States and China’s economy at the same time. First and foremost, as China’s competitive advantage has shifted from cheap labor to cheap capital, it could open its capital markets to U.S. companies, thus decreasing bubble pressure at home and giving the U.S. economy a lift during a troubled time for its financial system. This would give Chinese investors more choices and a chance to benefit from the success of multinationals in China.

I think the proposed International Board for the Shanghai Stock Exchange should be set up as soon as possible. Among the first listed should be U.S. companies with major interests in China, such as Proctor and Gamble, Kimberly Clark, Coca-Cola, Pepsi, Yum!, Starbucks, General Motors and Monsanto. The list could be much longer, China already accounts for their biggest growth markets and boosts profits; it would be good for Chinese investors to invest in their China successes.

Second, China should lower tariffs on some imports that benefit the U.S. economy. For example, China has the largest and fastest growing auto market, and the government has been using the market’s attraction to lure international companies to produce in China. But the tariff and tax structure prevents foreign production from benefiting. If China opens its auto market, U.S. labor unions might shift their position and support trade with China, giving Obama an incentive not to push for a doubling of China’s currency value.

Third, the U.S. agriculture sector has a disproportionate influence over its political system, so it would be wise for China to open its agricultural market. This may exert more pressure on China’s rural sector, but any negative effect could be offset by more fiscal support. China’s rural problem is tied to a low labor-to-land ratio and the way out is urbanization, which could be accelerated by reforming the household registration system and letting farmers own their land.

Clouds are gathering over China’s exchange rate policy. We’ve seen these clouds before. This time, however, the U.S. pressure is much more serious. Without careful handling, a stormy trade war could erupt, with negative consequences for all. So rather than playing defense, China should move soon to adopt constructive measures and prevent confrontation.

Steering Out of a Smash-Up No One Wants
Creating jobs by boosting exports could save the Obama administration but hurt China’s position, unless Beijing acts
Andy Xie, 02.09.2010 15:09

Full article in Chinese:

Print Friendly, PDF & Email

What's been said:

Discussions found on the web:

Posted Under