- Written by John Mauldin
- Saturday, 20 March 2010
The Threat to Muddle Through
I have pretty well laid out over the past decade that I think the US will Muddle Through what promises to be a period of below-trend growth and a long-term secular bear market. It will not be pleasant or fun - there will be a lot of pain - but we will get through the coming crisis (note: I think the Big One is still in our future). That is what we do in a more or less free-market world. But, as I wrote 7 years ago and have written since, there is one caveat that turns me from a Muddle Through-er into a real doom and gloom type, and that is the threat of protectionism and trade wars. As in Smoot-Hawley, which made the Depression into something much worse than it should have been.
Yet that is the prescription that Paul Krugman is advocating. In a commentary in Sunday's New York Times (" Taking on China"), he called for an across the board 25% tariff on Chinese goods:
"In 1971 the United States dealt with a similar but much less severe problem of foreign undervaluation by imposing a temporary 10 percent surcharge on imports, which was removed a few months later after Germany, Japan and other nations raised the dollar value of their currencies. At this point, it's hard to see China changing its policies unless faced with the threat of similar action - except that this time the surcharge would have to be much larger, say 25 percent."
Krugman doesn't think the Chinese can really retaliate by dumping their hoard of dollars. He points out:
"It's true that if China dumped its U.S. assets the value of the dollar would fall against other major currencies, such as the euro. But that would be a good thing for the United States, since it would make our goods more competitive and reduce our trade deficit. On the other hand, it would be a bad thing for China, which would suffer large losses on its dollar holdings. In short, right now America has China over a barrel, not the other way around."
I probably shouldn't take on a Nobel Laureate who got his prize for his work on trade, but this truly scares me. People pay attention to this nonsense, including the five Senators, led by Schumer of New York, who want to start the process of targeting China.
First, the Chinese have got to be wondering what they have to do to make these guys happy. In 2005 they were demanding a 30% revaluation of the Chinese yuan. And over the next three years the yuan actually rose by 22% at a gradual and sustained pace. Then the credit crisis hit, and China again pegged their currency. From their standpoint, what else were they to do? Force their country into a recession to appease our politicians?
They responded by a massive forcing of loans to their businesses and governments and huge infrastructure projects. Kind of like our stimulus, except they got a lot more infrastructure to show for their money. It remains to be seen how wise that policy was, and how large the bad (non-performing) loans will be that came from that push - just as there are those (your humble analyst included) who do not think the way we went about the stimulus plan in the US was the wisest allocation of capital.
But the reality is that the Chinese will do what is in their best interest. I wrote in 2005 that the yuan would rise slowly over time. The political posturing of Schumer, et al., was counterproductive then, and it still is now.
My prediction? The Chinese will begin to allow the yuan to rise again sometime this year, just as they did three years ago, because it will be to their advantage. A stronger yuan will act as a buffer to inflation, which they may face due to the massive stimulus they created. They are going to need some help in that area. But it will be 5-7% a year, so as not to create a shock to their export economy. Not 25% at one time. And at some point they will allow the yuan to float against the dollar. They know they will have to get the currency status they want. As an aside, are we going to put a tariff on every country that pegs their currency to the dollar? That is a whole lot of countries.
Back to 1971
By the way, let's go back to the 1971 that Krugman mentions. The Japanese yen was around 350 to the dollar. They revalued by 10%. Oh goody, salvation for the US. The yen is now at 90, and the Japanese are still producing massive trade surpluses, about half the size of Chinese surpluses, with less than one-tenth of the people. That is an almost 75% devaluation, and yet the world keeps buying Japanese products.
Why? Because they make good stuff we all want. The Chinese could raise the value of the yuan by 25% over the next year and they would still run a surplus, because like the Japanese, they make good stuff we want at prices we like. Would their surplus still be as high? No. Because a 25% increase in prices would mean that we could afford less of what they sell. But of course it would also give them wider profit margins, which would help hold their trade surplus up.
And it would also introduce inflationary increases in our imports and higher prices for lower-income families. Yes, a 25% tariff is such a smart idea that it took a Nobel laureate to think it up.
What Krugman argues is that we should pay more for Chinese goods, so that we will buy less of their goods. As if we wouldn't buy the same goods from Vietnam or Brazil or Pakistan, if those goods were cheaper than Chinese goods. For the life of me, I can't see how substituting goods from foreign countries other than China helps our trade deficit.
Are we going to start targeting the currencies of every nation that runs a surplus with us? What about Europe? And Great Britain? Their currencies are dropping against the dollar, in the case of England rather precipitously. Are they pursuing mercantilist policies, Senator Schumer [in reference to his recent scandalous press conference]? What happens when the euro goes to parity against the dollar (and it will!) because the Europeans are having trouble getting their act together? Are we going to demand they force the euro to rise? Tell the ECB to raise rates and shove the whole euro area into an even worse recession?
Do you think Japanese businessmen believe the yen is too strong, and we should make the dollar stronger against the yen? What are we going to do in three years when the yen is at 150 on its way to 300 because Japan is getting ready to hit the wall, due to their massive government deficits? Accuse the Japanese of mercantilism and try and force them to revalue the yen?
Maybe Canada should put a 25% tariff on US goods, because their dollar has risen by almost 40% against ours in the last few years. That would teach us a lesson. It would also destroy trade and a very good relationship.
It is a dicey damn world we live in. We are coming to the end of the debt super cycle, as I have written elsewhere in this letter. It is a very perilous time. Things are going to be hard enough. We have a huge problem with deleveraging and controlling our fiscal deficits, not just in the US but in the entire developed world. Starting trade wars is the absolutely worst possible thing to do. For the US to even suggest that such a policy is reasonable is the worst possible kind of message. Where are the adults in the administration?
The fault, dear Brutus, is not in our stars,
But in ourselves, that we are underlings.
Let's look at the actual trade deficit. This past month it rose to $40 billion, but that is down from the $70 billion it was only a few years ago. Over half that deficit is oil and energy. The Chinese "deficit" fell to a four-year low.
Trade deficits actually matter in a deleveraging cycle. Let's go back to the Outside the Box I sent you a few weeks ago from Rob Parenteau and review.
"... if we divide the economy into three sectors - the domestic private (households and firms), government, and foreign sectors - the following identity must hold true:
Domestic Private Sector Financial Balance + Fiscal Balance + Foreign Financial Balance = 0
"Note that it is impossible for all three sectors to net save - that is, to run a financial surplus - at the same time. All three sectors could run a financial balance, but they cannot all accomplish a financial surplus and accumulate financial assets at the same time - some sector has to be issuing liabilities."
As Rob noted, this is an "identity" equation. It is always true for all nations. In order for the US or any nation to be able to see both its government and private sectors reduce their leverage or deficits, the country must run a trade surplus.
Let's look at the implication of that equation. Most everyone in the US (other than Paul Krugman and his fellow uber-Keynesians) think that reducing the federal deficit would be a good thing. And the private sector is busy reducing its leverage and "deficits" as well. But if we really want to reduce the government and private deficits at the same time, we have to be able to run a trade surplus.
Those numbers must ALWAYS add up to zero. The US trade deficit is due to a lack of savings in the US. No one is forcing us to buy goods from abroad. If we saved more and bought less we would have a trade surplus. It's really that simple.
Another implication. And a rather sobering one. For the US to continue to run such massive government fiscal deficits, either the private sector is going to have to massively increase its savings or we will have to reduce the trade deficit by buying less goods and energy, or some combination of the two. There is no other option. And if the savings of the private sector are funneled into government debt, then that crowds out private investment. And it is private investment that produces jobs.
GDP = C + I + G + Net Exports
The above equation is another identity equation. It says that Gross Domestic Product is equal to total Consumption (consumer and business) plus Investments plus Government Spending plus Net Exports (which in the case of the US is a deficit and in the case of Germany or China is a surplus).
We are going to examine this in great detail in the coming weeks, as there are serious implications for the economy contained within these simple terms.
But for our purposes today, if you play with the above equation a little you find that savings is equal to investments. But if the government "dis-saves" or runs a deficit, that means that savings have to go to cover the government deficit, which means there is less for investment. And it is investment that produces jobs.
Krugman and the Keynesians are right in this regard. If consumption falls, as it does in recession, then a corresponding increase in "G" helps offset that drop. But Keynes assumed that in good times government would run surpluses. It seems that we forgot that part.
What Greece is learning, as will all nations, is that you cannot increase "G" in an unlimited fashion. There is an end to the ability of governments to get investors to lend them money. That level is different for different countries, but the work of Rogoff and Reinhart (which we have looked at extensively in previous letters) clearly shows that at some point, and generally rather dramatically, markets lose confidence in the government's ability to pay, and the game stops.
Let's assume (and here I put on my optimist hat) that the US decides that reducing our deficit over time is a good thing. Fiscal conservatives get into Congress and we reduce the deficit by (say) $200 billion a year for five years, with a growth in revenues, so that the budget deficit is less than the growth in nominal GDP.
The first identity equation says that to do so we must either increase savings or reduce the trade deficit or some combination. If we use all our savings to cover the government deficit, then we have nothing left for private investment. And yes, it is not quite that simple, as we could use already accumulated savings, but over the medium run, large government deficits will crowd out private investment, the engine of job growth.
As we will see in a few weeks, reducing "G" (government deficits) in the short run is a hit to GDP. There is no question about that. But in the medium run (we no longer have the luxury of the long run) running massive deficits, as we are now, will mean that we, too, will become Greece. As will much of Europe and Japan if deficits are not brought under control.
It is not a question of pain or no pain. We are going to have the pain. The question is whether we take it in small doses or all at once. Slow growth, or a depression?
Part of that process that we MUST address is getting the trade deficit down, as we need that money for handling the deleveraging process.
A rational energy policy that gets us off foreign oil as quickly as possible must be enacted. Senator Schumer, if you are so worried about deficits, why not demand that we drill for oil offshore on the continental shelf, where we know there are massive deposits? And why not aggressively encourage the use of natural gas in the medium term for transportation? Nuclear energy?
And why are we not aggressively doing as many open-trade agreements as we can? Columbia and Korea have been done, and it would open up those markets for our exporting businesses. Yes, they get a shot at us, but I will bet on the home team. Our exports are growing every month. It seems, Senator, that you oppose all those policies. But simple accounting demands that we reduce the trade deficit, and tariffs are the worst possible way to try to do so, and won't work. And the possibility of a trade war and the real damage to our export sector? I really get alarmed.
Instead of bashing China over their currency valuations, let's challenge them where it would make a difference, on opening up their markets to our products and businesses more than they already do. Seriously, if we did impose a tariff on Chinese goods, US consumers would just switch to goods from other countries. It would be meaningless. But if we could sell more to them?
If we are going to put our fiscal house in order in the US, we are going to have to get a handle on our trade deficit. The operative word is "our." Not Chinese deficits. They are not responsible for what we choose to buy.
When we look into our economic mirror, we must confess, "We have met the enemy, and he is us." We can't borrow our way out of a debt crisis, Paul. At some point, we just have to get on with it.
One last thought. The whole world cannot run a trade surplus. Someone must actually consume. Germany and Japan are also running huge surpluses. Many of the problems in the peripheral European countries are because they are running trade deficits. Would not the rational extension of Krugman's and Schumer's ideas mean that we also target Germany and Japan? The world is out of balance, and getting it back will not be easy, and certainly not easier if we all pursue beggar-thy-neighbor policies.John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore