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  • Economic Mutually Assured Destruction Revisited

    Economic Mutually Assured Destruction Revisited

    • China's shaky financial system is dependent on America's shaky financial system
    • The virtuous cycle of disinflation and currency appreciation runs in reverse
    • The internal contradictions of Economic M.A.D. come home to roost

    Editor's Note: Editor's Note: iTulip first explored the idea of US and Chinese market co-dependence in our April 2006 article titled Economic M.A.D. As our use of term "mutually assured destruction" suggests, we are not fans of the decoupling theory. The contrary argument later came to be known as "decoupling," a theory that China and other so-called emerging markets don't need the US. This discussion started with an article by Peter Morici. Below is a debate on the US trade deficit and the idea of "decoupling."

    By Eric Janszen with Comments by John Craig of the Center for Policy and Development Systems


    The US recession is reducing demand for imports, such as from China, along with demand for domestic goods. In response China will continue or perhaps accelerate its shift in current account surplus based growth away from the US to other areas of the world. China has reduced its reliance on the US to approximately 20% of its global exports in 2007 from about 30% in 2000, according to WTO data. Most of China’s export growth continues to be within Asia.
    Comment: There is a critical difference between shifting China's exports away from US and shifting China's current account surplus. China runs only a very small current account surplus with the world despite its large surplus with the US because it tends to run deficits with its other trading partners - especially those in Asia. China, in fact, shares around the 'goodies' (i.e., the surplus that makes it less likely for countries with weak financial systems to run into financial crisis). China, and its economic tributaries, retain a very high dependence on a strong financial system in the US to find productive uses for their resulting savings surpluses.

    Information from many sources about the decoupling issue is presented in Decoupling: A New Urgency. This suggests that:
    • Many observers have argued that global growth can successfully decouple from conditions in US - eg noting strong growth while US has slowed; existence of large capital reserves in many countries;
    • Counter arguments are based on (for example) China's: GDP dependence on exports; low domestic consumption; over-capacity. The impact of a US slowdown on other world regions is also noted;
    • In response it is argued that: China doesn't only export to US; its trade dependence is exaggerated; domestic investment is very strong [in fact over 50% of GDP]; there is scope to increase domestic consumption and loosen fiscal policies; balance sheets and foreign reserves are sound; and reduced exports would also allow China's imports of component to fall;
    • The issues are more complex, because: other regions are badly affected by US instabilities; China's tools for economic management are blunt; foreign exchange reserves won't provide permanent protection where financial systems are underdeveloped; US instabilities make China's monetary management very difficult; the high rate of (unprofitable) domestic investment which drives China's economy is creating a financial bubble;
    • True decoupling requires not just the ability to survive a US downturn, but the ability to take on the 'consumer of last resort' functions that the US has had because of the strength of its financial system.


    Seems to me that if US demand for China’s exports falls by 10% that a corresponding decline in US demand from China from 20% to 18% can be easily absorbed by other trade partners that are not also heavily dependent on the US for export demand. Even if US import demand from China declined by half and China had to absorb the entire resulting 10% decline in total global exports that will not necessarily cause severe economic problems for China.
    Comment: China's exposure is in its financial system, not in its strong 'real' economy.
    As the US goes deeper into recession and US demand for China’s goods declines, on the other side of the trade is China’s demand for US financial assets which is declining proportionately. US merchandise trade balance always improves during periods of recession.
    Comment: Fair enough, though this raises complex questions. For example:
    • Trade involves services as well as merchandise. Does the precipitous change in merchandise trade in following diagram reflect all trade?
    • How does this diagram look when expressed as a percentage of GDP?
    • Is it possible to envisage a recession so severe (or other circumstances) in which US willingness to import for capital doesn't simply reduce but reverses?


    Note also that the last two periods of reversal in the US merchandise trade balance since the early 1980s were associated with major financial market dislocations, such as the US stock market crashes in 1987 and 2001. Is this one, too?




    Even without recession, it is hard to explain how the US with such a small portion of intraregional trade flows...


    Inter and intra regional trade flows (Source: WTO)
    Click to enlarge


    ...and a shrinking portion of global import demand...



    US import demand relative to global import demand has been declining since 2000
    Click to enlarge


    Growth in import demand has been the the least among major economic regions

    ...will be able to continue to collect the bulk of the world’s savings and import so much capital to fund its trade and fiscal deficits.


    The US imports 76% of the worlds' capital (Source: IMF)
    Comment: The US doesn't collect the bulk of the world's savings to fund its trade and fiscal deficits. It has imported that capital (and had large current account deficits) because it has had the most sophisticated financial system in the world.
    Given that that financial system is in trouble, until that problem is fixed:
    • The US will presumably no longer be so willing / able to import others savings;
    • Its current account deficits will also decline rapidly; and
    • Other countries which have relied on current account surpluses to protect weak financial systems will potentially be in trouble.
    China, by the way, is by no means the largest capital exporter.


    Global capital exports (Source: IMF)
    Comment: Absolutely. Japan has been the main source of global capital. And one needs to look at what is involved in this.

    At the time of the Plaza Accords, Japan was pressured to stimulate its economy in order to help overcome its trade imbalance with the US. However Japan's financial system is set up so that any stimulus must mainly flow into industrial capacity rather than into consumer demand (see Why Japan cannot deregulate its financial system).

    Since Japan's economic bubble burst in about 1990, Japan's authorities have created credit at very low interest rates supposedly to boost the Japanese economy, but this was impossible because of the structure of its monetary and financial system. Thus the only effect has been to boost the availability of cheap capital in the US (and in other capital importing economies), and contribute to the emergence of asset bubbles.

    Here in the US we are seeing two self-reinforcing processes causing the US economy to go into recession. We have identified two self-reinforcing processes that are causing a decline in aggregate demand.


    Comment: I see the sort of feedbacks that you perceive. This 'vicious' cycle is, in fact, the reverse of the 'virtuous' cycle that has been in place for the past couple of decades.
    The cash/goods inflation spiral is a function of an extended period of dollar depreciation, now in its eighth year. Short term currency depreciation does boost exports but longer term rising input costs are feeding into an inflation spiral.
    Comment: There are more factors than this in inflation/deflation equation (e.g., likely increases in prices of imports due to inflation in China - which will give pricing power back to US domestic producers and unions; effect of overall level of global demand on commodity - especially oil - prices)
    Given US dependence on exports as the one bright spot in a decelerating economy hit by declining asset prices and falling domestic demand, it’s not clear what US policy makers can do to reverse it.
    Comment: That's the big question!
    To drive that point home we conclude with this CNBC interview with veteran investor Julian Robertson.






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    Last edited by FRED; 03-29-08, 10:08 AM.
    Ed.

  • #2
    Re: Economic Mutually Assured Destruction Revisited

    i am not as sanguine about the possibility of decoupling, because i think a lot of the intra-asian trade is primary and intermediate goods that end up in final products going to the oecd countries. do you happen to have trade numbers for final goods?






    edit: then there's also

    Marketwatch: The survey of 56 major firms, mostly manufacturers, also found that nearly a third are trying to shift their production bases away from China to countries like Vietnam. Another survey jointly, conducted by the U.S. Chamber of Commerce in Shanghai and U.S. consulting firm Booz Allen Hamilton Inc. late last year of 66 foreign companies in China, found more than half perceived a decline in China’s competitiveness. Some 20% of the respondents said that they have already decided to move part of their Chinese operations outside the country, citing foreign exchange concerns as China’s yuan appreciates, rising wages and difficulty in retaining employees.

    and in vietnam
    Asia Times: The country’s main consumer inflation benchmark was up 15.7% year on year in February, the biggest jump in over a dozen years and currently the highest rate in industrializing East Asia. Inflation has jumped by double digits for each of the past five months.
    Discontent over increased inflation is on the rise in the industrial sector, the backbone of Vietnam’s export-driven economy. That’s been witnessed in the growing number of industrial disputes and strikes over wages and work conditions, which to date have disproportionately hit foreign-invested firms. 50 strikes took place across the fast industrializing country, according to the Ministry of Labor. In early March, some 10,000 workers walked off the job at the South Korea-owned Tae Kwang Vina factory, which makes shoes for US apparel company Nike on the outskirts of Ho Chi Minh City. Those factory workers similarly demanded higher pay to keep pace with rising prices.



    hat tip for both articles to http://wallstreetexaminer.com/blogs/winter/

    Last edited by jk; 03-28-08, 07:17 PM.

    Comment


    • #3
      Re: Economic Mutually Assured Destruction Revisited

      Originally posted by jk View Post
      i am not as sanguine about the possibility of decoupling, because i think a lot of the intra-asian trade is primary and intermediate goods that end up in final products going to the oecd countries. do you happen to have trade numbers for final goods?






      edit: then there's also

      Marketwatch: The survey of 56 major firms, mostly manufacturers, also found that nearly a third are trying to shift their production bases away from China to countries like Vietnam. Another survey jointly, conducted by the U.S. Chamber of Commerce in Shanghai and U.S. consulting firm Booz Allen Hamilton Inc. late last year of 66 foreign companies in China, found more than half perceived a decline in China’s competitiveness. Some 20% of the respondents said that they have already decided to move part of their Chinese operations outside the country, citing foreign exchange concerns as China’s yuan appreciates, rising wages and difficulty in retaining employees.

      and in vietnam
      Asia Times: The country’s main consumer inflation benchmark was up 15.7% year on year in February, the biggest jump in over a dozen years and currently the highest rate in industrializing East Asia. Inflation has jumped by double digits for each of the past five months.
      Discontent over increased inflation is on the rise in the industrial sector, the backbone of Vietnam’s export-driven economy. That’s been witnessed in the growing number of industrial disputes and strikes over wages and work conditions, which to date have disproportionately hit foreign-invested firms. 50 strikes took place across the fast industrializing country, according to the Ministry of Labor. In early March, some 10,000 workers walked off the job at the South Korea-owned Tae Kwang Vina factory, which makes shoes for US apparel company Nike on the outskirts of Ho Chi Minh City. Those factory workers similarly demanded higher pay to keep pace with rising prices.



      hat tip for both articles to http://wallstreetexaminer.com/blogs/winter/

      Maybe we were not clear: Economic M.A.D. = no decoupling.
      Ed.

      Comment


      • #4
        Re: Economic Mutually Assured Destruction Revisited

        It going to lead to one things & one thing only:-
        http://www.amconmag.com/2004_11_22/buchanan.html
        Mike

        Comment


        • #5
          Re: Economic Mutually Assured Destruction Revisited

          Originally posted by FRED View Post
          Maybe we were not clear: Economic M.A.D. = no decoupling.
          Thanks, it wasn't totally clear.

          Ever since the '70s, if US GDP drops 1% then the Euro area drops .3-.4% in 2-4 quarters. And if anything, globalization actually tightens the links between world economies.

          Twain will be right again:
          "History doesn't repeat itself, but it does rhyme."
          http://www.NowAndTheFuture.com

          Comment


          • #6
            Re: Economic Mutually Assured Destruction Revisited

            Originally posted by jk View Post
            edit: then there's also

            Marketwatch: The survey of 56 major firms, mostly manufacturers, also found that nearly a third are trying to shift their production bases away from China to countries like Vietnam. Another survey jointly, conducted by the U.S. Chamber of Commerce in Shanghai and U.S. consulting firm Booz Allen Hamilton Inc. late last year of 66 foreign companies in China, found more than half perceived a decline in China’s competitiveness. Some 20% of the respondents said that they have already decided to move part of their Chinese operations outside the country, citing foreign exchange concerns as China’s yuan appreciates, rising wages and difficulty in retaining employees.


            and in vietnam
            Asia Times: The country’s main consumer inflation benchmark was up 15.7% year on year in February, the biggest jump in over a dozen years and currently the highest rate in industrializing East Asia. Inflation has jumped by double digits for each of the past five months.
            Discontent over increased inflation is on the rise in the industrial sector, the backbone of Vietnam’s export-driven economy. That’s been witnessed in the growing number of industrial disputes and strikes over wages and work conditions, which to date have disproportionately hit foreign-invested firms. 50 strikes took place across the fast industrializing country, according to the Ministry of Labor. In early March, some 10,000 workers walked off the job at the South Korea-owned Tae Kwang Vina factory, which makes shoes for US apparel company Nike on the outskirts of Ho Chi Minh City. Those factory workers similarly demanded higher pay to keep pace with rising prices.
            The "surprise" will be how much production gets shifted back to the USA. The steadily depreciating US $, rising shipping costs, and trade barriers disguised as climate change legislation will be the main drivers.

            As the OECD populations, including the USA, ages and retires, this will create the domestic wage inflation so many today think will never happen (and is already underway).

            Comment


            • #7
              Re: Economic Mutually Assured Destruction Revisited

              Originally posted by FRED View Post
              Economic Mutually Assured Destruction Revisited

              • China's shaky financial system is dependent on America's shaky financial system
              • The virtuous cycle of disinflation and currency appreciation runs in reverse
              • The internal contradictions of Economic M.A.D. come home to roost

              [...]

              As the US goes deeper into recession and US demand for China’s goods declines, on the other side of the trade is China’s demand for US financial assets which is declining proportionately. US merchandise trade balance always improves during periods of recession.
              Comment: Fair enough, though this raises complex questions. For example:
              • Trade involves services as well as merchandise. Does the precipitous change in merchandise trade in following diagram reflect all trade?
              • How does this diagram look when expressed as a percentage of GDP?
              • Is it possible to envisage a recession so severe (or other circumstances) in which US willingness to import for capital doesn't simply reduce but reverses?


              Note also that the last two periods of reversal in the US merchandise trade balance since the early 1980s were associated with major financial market dislocations, such as the US stock market crashes in 1987 and 2001. Is this one, too?


              Here is a graph that shows both service and merchandise components, as a percentage of GDP. (Data from economagic. Service data was not available pre-1992.)



              The US is a net exporter of services but the volume of that export has remained more or less a constant fraction of GDP for the last 20 years.

              I'm not sure what conclusions to draw from this data. The 2001 recession definitely did not involve a very significant pull-back in imports. The net trade balance since '05 has already dropped nearly 2x the total drop in 2001, in percentage terms.
              Last edited by ldgirod; 03-29-08, 02:22 AM. Reason: typo and corrected import -> net trade

              Comment


              • #8
                Re: Economic Mutually Assured Destruction Revisited

                The other question the decoupling camp has never answered is the waterfall effect.

                By all possible measures, the US consumes disproportionate amounts of commodities, money, goods, and what not.

                As this overconsumption bubble deflates, these items must find buyers somewhere else, or feed directly into price deflation.

                I have repeatedly put up examples where China and India simply do not have the disposable income to buy the excess commodities.

                I have further also pointed out that China and India are also both still in the stages of consuming more capital than generating it.

                There is enough self-reinforcing dynamic in the capital spending/inflation spirals in both nations to continue for some time, but ultimately both are on trajectories where - despite a momentum boost from being shot out of the US overconsumption cannon - gravity will inevitably have its way.

                The idea of production returning to the US is an alluring one, but it will require decades for US domestic production to reassert ascendancy; there are multiple deadfalls ahead which will individually need to be overcome - starting with product dumping as offshore manufacturers ramp down overall production (dollars eventually losing almost all benefit as a value vehicle), thence to outright subsidies and/or nationalization for domestic companies, onwards to government mandated inefficiency via job maximizing incentives and legislation, and so forth.

                Comment


                • #9
                  Re: Economic Mutually Assured Destruction Revisited

                  Frank Holmes of U.S. Global Investor's expects copper – which has gained 400% in the past five years and now sells for $3.75 per pound – to hit $8 to $10 in the coming five years.

                  What does Mr. Holmes see that we are potentially missing?

                  Comment


                  • #10
                    Re: Economic Mutually Assured Destruction Revisited

                    Originally posted by Lukester View Post
                    Frank Holmes of U.S. Global Investor's expects copper – which has gained 400% in the past five years and now sells for $3.75 per pound – to hit $8 to $10 in the coming five years.

                    What does Mr. Holmes see that we are potentially missing?
                    his paycheck? [which is likely related to total assets under management in his fund]

                    Comment


                    • #11
                      Re: Economic Mutually Assured Destruction Revisited

                      JK - You are unquestionably iTulip's (most astute and articulate) UBER-bear.

                      Comment


                      • #12
                        Re: Economic Mutually Assured Destruction Revisited

                        Originally posted by jk View Post
                        his paycheck? [which is likely related to total assets under management in his fund]
                        cynic. that's my role.

                        "research shows that getting a haircut at least once a week is the best way to ensure your competitive position in this increasingly competitive job climate," said the head of the national barber's association. etc.

                        Comment


                        • #13
                          Re: Economic Mutually Assured Destruction Revisited

                          Originally posted by c1ue View Post
                          The idea of production returning to the US is an alluring one, but it will require decades for US domestic production to reassert ascendancy; there are multiple deadfalls ahead which will individually need to be overcome - starting with product dumping as offshore manufacturers ramp down overall production (dollars eventually losing almost all benefit as a value vehicle), thence to outright subsidies and/or nationalization for domestic companies, onwards to government mandated inefficiency via job maximizing incentives and legislation, and so forth.

                          Possible, as you mentioned, but takes decades, but how the world economic situation would be by then will be up for guessing.

                          Germany and Japan are manufacturing oriented. With costs, rent, and wages higher than America, if they can have an industrial base, why can't America?

                          Comment


                          • #14
                            Re: Economic Mutually Assured Destruction Revisited

                            Originally posted by metalman View Post
                            cynic. that's my role.

                            "research shows that getting a haircut at least once a week is the best way to ensure your competitive position in this increasingly competitive job climate," said the head of the national barber's association. etc.

                            "Apart from that Mrs. Lincoln, how was the play?" :eek: :rolleyes: :rolleyes:


                            (I'm working on being Chief Sar-chasm ;) )
                            http://www.NowAndTheFuture.com

                            Comment


                            • #15
                              Re: Economic Mutually Assured Destruction Revisited

                              Yeah and speaking of haircuts Metalguy, your avatar sure looks like he could use one (Bart's too for that matter)..

                              Comment

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