First the rate reductions, then money printing, then the currency war, then the tariffs, then….

The global economy, now supported in the main only by the overextended U.S. consumer, finds itself at stall speed, susceptible to any number of potential exogenous shocks. Ultimately, the economic malaise created by this confluence of events will take years to unwind. A positive outcome to this process is dependent wholly on liquidation of excess credit and consumption.

This process will be extremely painful in the short term, but will lead to a healthy economy long-term. Unfortunately, experience shows that these painful steps will only be taken as a last resort. Moreover, geopolitical events become volatile in a world of economic insecurity, leading to political upheaval and protectionism. Protectionism is a natural outgrowth of nationalist economic policy as it transfers wealth from foreign producers to domestic producers by cutting off access to lower cost excess capacity in the goods in service sectors. However, this also serves to transfer wealth from domestic consumers to domestic producers by increasing the price of goods in the protected sectors, ultimately reducing consumption demand.

For these reasons, I am cautious about the long-term outlook for the global economy and the U.S. economy in particular. The likely outcome for the next decade is one of sub-par global growth with short business cycles punctuated by fits of recession.

The US Economy 2008, Credit Writedowns, March 2008

This is where we have got to.  The global economy operating at stall speed, hit severe turbulence inducing the worst financial crisis in three-quarters of a century. What has the response been to this?

Short-term oriented pump-priming and liquidity injections all around were the first order of the day to stabilise things. Since then, policy makers have been in a desperate attempt to return to the asset-based economy world of external imbalances. But a global economy operating at stall speed simply does not have the lift to support this. The result has been a race to the bottom of beggar-thy-neighbour money printing and currency debasement now potentially leading to tariffs or worse — predictably I would say. In a world short of aggregate demand, economic nationalism becomes the order of the day as politicians look to assuage domestic constituencies suffering through economic depression.

Yesterday, I outlined how we got to this point. The question now is where do we go from here. I certainly believe odds favour escalation and tariffs, not that this is the right policy. But,  I would argue that Americans, for example, want protectionism; they want tariffs against China. They have soured on ‘free trade’.  So on this score, Marshall’s latest post, calling for tariffs is very much in line with the thinking in America. Yesterday, he wrote:

I’m totally with Krugman on this. I want a full employment policy, not a "free trade" policy per se.  It’s impossible to speak about "free trade" when it doesn’t apply both ways.  Free trade is another one of these neo-liberal myths, largely predicated on the notion that we need China to "fund" our deficits.  That’s nonsense. We continually read that nations with current account deficits (CAD) are living beyond their means and are being bailed out by foreign savings.

A CAD can only occur if the foreign sector desires to accumulate financial (or other) assets denominated in the currency of issue of the country with the CAD. China makes that choice.  I would rather go for higher tariffs than a forced revaluation of the RMB, as I don’t think that the promotion of exports per se is a good policy for the US.  We seem to be fixated on this idea of reducing domestic wages, often through fiscal and monetary austerity measures that keep unemployment high. The best way to stabilise the exchange rate is to build sustainable growth through high employment with stable prices and appropriate productivity improvements, which is what I want to do.  A low wage, export-led growth strategy sacrifices domestic policy independence to the exchange rate – a policy stance that at best favours a small segment of the population.

The US must erect tariffs against China unless they revalue

So it seems Marshall is advising us to speak loudly and carry a big baseball bat. I’m not going to take that baseball bat out like Stephen Roach.  But I do think this is the wrong approach. It seems to be the result of frustration after decades of middle-class stagnation and two years of living through a horrible economic environment. Ultimately, it is this frustration which will probably lead to these policies. But this ignores basic negotiation logic and places the blame squarely on China when the U.S. is hardly an innocent party.

H. Raiifa’s "The art and science of negotiation" sets out a framework based on three sets of data (as quoted by Max Bazerman’s "Judgement in Managerial Decision Making"):

  1. Each party’s alternative to a negotiated agreement (BATNA – Best alternative to a negotiated agreement)
  2. Each party’s set of interests
  3. The relative importance of each party’s interests

In any negotiation, the two parties have a "reservation point" beyond which they will refuse to negotiate and will simply walk away and accept their BATNA. The art of negotiating is finding an agreement which meets both parties’ thresholds on the main points of interest. Sometimes, the reservation point where one party will walk away is simply outside the area where the other party will engage.  For example, if I am trying to sell you a car and you are willing to pay anywhere up to $5,000 and I am willing to accept anything down to $10,000, we can’t strike a deal.

But if  you are willing to pay anywhere up to $20,000 and I am willing to accept anything down to $6,000, we can definitely strike a deal. The problem comes when one party starts from a position completely outside the other’s reservation point where she walks away.  For example, what if I am trying to sell you a car and you are willing to pay anywhere up to $20,000 but offer me $1,500 when I want $12,000 and the least I am willing to accept is $6,000? I am not going to consider you a serious buyer and simply disengage.  I walk away and expect my best alternative to a negotiated agreement.

Perhaps, Americans are so frustrated now that they think no deal with China can be made. I don’t think that’s the case. Nor does Michael Pettis.

So after years of dragging its feet, postponing a rebalancing, and forcing rising trade surpluses onto the rest of the world, China may have to adjust its currency policies so quickly that it risks a sharp contraction at home. So what will China do?

This, for me, is the most interesting and perhaps important question. Most probably Beijing will do the same thing Tokyo did after the Plaza Accords and Beijing did after the renminbi began appreciating in 2005. It will lower real interest rates and force credit expansion.

What happens if the RMB is forced to revalue?

The US should be urging China to revalue more quickly and limit US asset purchases  while promoting a rebalancing to more consumption demand domestically – something that won’t happen overnight, by the way. But Marshall’s advice assumes the Chinese are intransigent or that America can’t wait, implicitly arguing the American BATNA is superior to any minimally beneficial negotiated agreement. Is this really true?

If the US goes forward with tariffs, the Chinese cannot let this stand because it would undermine the Communist Party’s authority domestically. At a minimum China will retaliate in kind. Potentially they could escalate. Depending on the size of the sectors affected – to date, we have seen tariffs on chicken, steel and tires –  this could derail America’s nascent technical recovery, which I see leading to lower employment and output and depression. How is this in keeping with Marshall’s professed concentration on full employment? And why should we assume the Chinese won’t retaliate. They have done so every time as the examples above demonstrate. In my view, tariffs are an act of desperation and brinkmanship and not a good negotiating tactic.

But, then again, this is not just a bilateral issue. If the Chinese revalue, they could simply shift assets from the U.S to Europe or Japan, shifting the problem to different countries. This is what we have seen in the escalating Chinese-Japanese diplomatic disputes as China has bought Yen assets, causing the overvalued yen to become even more overvalued and forcing a unilateral Japanese currency intervention.  The Chinese actually have a larger trade relationship with Europe and have been arguing it is dollar volatility which is creating the problem for the Chinese, (Japanese) and the Europeans.

[Chinese premier] Wen said EU leaders should turn to the U.S. dollar for an explanation of the fluctuations in the exchange rate of the euro. He said China’s trade surplus against the United States was due to the specific structures of the two economies, not the yuan exchange rate.

When the dollar is strong, it kills Chinese competitiveness to their largest export market, which is Europe. It also kills their competitiveness in Japan. But since the Americans are debasing their currency with talk about quantitative easing and targeting higher rates of inflation, it is the Europeans and the Japanese who should be screaming bloody murder about currency manipulation.

Moreover, the United States has a current account deficit with ninety countries – that’s nine  zero. If the Chinese revalued the Renminbi, would all the benefits go to the US or most go to the likes of Vietnam , Indonesia or other low cost producers?  America has such a large deficit with all these countries because it has such a low savings rate to which economic policy is geared. In fact, America has a larger deficit ex China than it has with China alone. Singling out China is another example of the Blame Asia Meme. It is a distraction that won’t help solve America’s problems.



The tariff escalation is bilateral, but the rate reductions, money printing and currency debasement show the "currency war" is a multilateral issue. Here’s an interesting tidbit that I posted in April just as the issue became critical in Europe. It is a translation of a Les Echos French-language article on the plummeting euro:

At the sectoral level, it is "capital goods and investment which are generally the most sensitive to currency fluctuations", says Laurent Bilke, European economist at Nomura. Most manufacturing exporters should benefit from the current situation. To these we must add aircraft [manufacturers], which had been hit by the rise of the euro. Faced with a competitor, Boeing, situated in the dollar zone, Airbus now finds itself in a currency position that is exactly in the middle of where it had been at the inception of the euro.

So there is something salutary in this currency adjustment, which comes at a time when demand is booming in emerging markets. That is the particular point of view of Laurent Bilke. Note that at this time when the largesse of states is no longer great and countries like Spain and Ireland have seen their internal economic engine crash. "Europe has more need than ever to begin exports to restart its economy".

When it comes to quantitative easing, interest rate reductions and the like, currency debasement is a feature, not a bug. And the outraged intervention from Brazil ("we’re in the midst of an international currency war") and capital controls there and in South Korea tell you this issue is escalating multilaterally.

So are tariffs the Smoot-Hawley trigger for depression? I asked Marshall this, saying "The gist of what I will say is that this is what Americans want and if they get it it will lead to depression. Maybe I’ll throw in a Smoot-Hawley reference for good measure. Still taking form. " He replied:

Okay, but let me respond to that:  Smoot Hawley kills the creditor nations, not the debtor nations.

Many blame a good part of the Great Depression on the Smoot Hawley legislation passed in 1930. But Temin notes that during the 1930s, the Smoot Hawley legislation hurt countries like the U.S. which had large export surpluses and were large net creditor countries. It did not hurt countries that were on the other side of those trade surpluses and external credits, such as the UK.

What would happen if there was a trade war between the U.S. and Asia today? U.S. consumers might find their goods slightly more expensive at Wal-Mart if U.S. companies did not manage to move the locus of their offshore production from China to other low cost countries fast enough. Would that really be so grave a loss to the U.S. economy? Asia has conducted mercantilist policies at the expense of Asian consumers for decades, and the investment world regards it as having been a successful strategy. Would it be a disaster for the U.S. if U.S. consumers had to pay a little more for their goods, but more of those goods might be produced once again back home, thereby reviving the U.S. industrial base?

If one simply looks at the numbers, in a trade war the U.S., with a low share of industry in its GDP, would be hurt far less than Asia with a very high share of industry in its GDP.

This sentiment has now been seconded by Nobel Laureate Paul Krugman who typically has the guts to challenge the orthodox consensus when it makes no sense. Krugman in effect backs the thesis set out by Peter Temin.

My colleagues believe that we should lecture the Chinese on what a bad thing they’re doing, but not actually threaten sanctions, lest we start a trade war. My belief is that this gets us nowhere. …

I say confront the issue head on – and if it leads to trade conflict, bear in mind that in a depressed world economy, surplus countries have a lot to lose from such a conflict, while deficit countries may well end up gaining.

Paul Krugman, “Killer Trade Deficits”, New York Times, August 16, 2010.

Let me also add, that I would have no issue about China running a perpetual trade surplus with the US if we responded with a fiscal policy that promoted full employment.  That’s a basic accounting identity.  Given the political impossibility of doing this, China’s trade policies are likely to be extraordinarily destructive for the US economy.

This argument is as unconvincing for me as Eichengreen’s about how competitive currency devaluations don’t escalate into trade wars.  It is not comforting that the Chinese would suffer a worse depression than the US if we had a trade war. In any event, a trade war is probably coming because policy makers are concentrated on appeasing domestic concerns. Michael Pettis put it best earlier today:

So we are still pretty much stuck. China and other surplus countries like Germany and Japan need to understand that their policies are causing real damage in the US, and the US needs to understand that the surplus countries simply cannot adjust fast enough to suit the US, but neither side is very interested in understanding the other.

An optimal solution will require real grown-up behavior on the part of the major economies, who must agree to resolve the trade imbalances carefully and with determination. Of course grown-up behavior is probably too much to ask from countries that have displayed so little of it to date. Instead trade relationships will simply continue to deteriorate.

That’s my view too.

  1. Tom Hickey says

    China, Japan and the oil producers (net exporters of goods and petroleum) are colonies of the US (net importer). Australia (net exporter of materials) is a colony of China (net importer of materials). The rest of the EZ (net importers) is a colony of Germany (net exporter). Since when was it bad economically to have colonies?

    In the real terms of trade, net importers gain the benefit of real resources in exchange for financial assets. Unless the financial assets include real assets like companies, RE, mines, etc., the net importer benefits from the real terms of trade. Why would the US want to upset this applecart?

    The reason given is that the US is exporting jobs. No problem. The US just needs to run larger deficits to close the output gap by increasing effective demand, thereby stimulating productive investment, optimal capacity utilization, and full employment — while enjoying the benefits of imports. There is no contradiction here.

    The bugaboo, of course, is the rising deficit. So what? So far no one has given a coherent argument as to why this is a real problem. The national debt is, after all, the national savings of nongovernment net financial assets.

    Of course, these are not my ideas. I am just repeating what folks like Bill Mitchell and Warren Mosler have been saying for a long time.

  2. Jo says

    ‘The bugaboo, of course, is the rising deficit. So what? So far no one has given a coherent argument as to why this is a real problem. The national debt is, after all, the national savings of nongovernment net financial assets.’

    Nonsense, sir.

    1. Edward Harrison says

      Actually, this is largely correct, Jo. The government’s debt is the government’s liability but the debt holders asset, most of whom are domestic institutions (pension funds, banks, etc).

      See here:

      1. Marshall Auerback says

        It’s totally correct, dollar for dollar.

        In a message dated 10/7/2010 9:00:13 A.M. Mountain Daylight Time,

        Actually, this is largely correct, Jo. The government’s debt is the
        government’s liability but the debt holders asset, most of whom are domestic
        institutions (pension funds, banks, etc).

        1. Edward Harrison says

          It is correct only when adding the trade and non-government domestic sector together. To the degree that foreign entities hold the debt this does not represent domestic savings so you can’t call that national savings.

          1. Marshall Auerback says

            It still represents savings, but you are correct to state that these are
            not national savings. But it represents an asset for a Chinese or Japanese
            holder of US government paper.

            In a message dated 10/7/2010 12:55:21 P.M. Mountain Daylight Time,

            Edward Harrison wrote, in response to Marshall Auerback:

            It is correct only when adding the trade and non-government domestic
            sector together. To the degree that foreign entities hold the debt this does not
            represent domestic savings so you can’t call that national savings.

            Link to comment:

    2. Marshall Auerback says

      It’s not nonsense. It’s accounting 101.

  3. Cry Havoc says

    It is nonsense. It is not just nonsense, it is actually silly nonsense. It is nonsense because a national debt requires no savings whatsoever. It is silly because the idiotic charade of having a sovereign “auction” debt to the so-called “market” of primary dealers (who laughably buy the debt with their “savings”), under the pretense that this will somehow prevent monetization of the debt, is completely ridiculous. The only requirement for sovereign issuance of debt is a central bank and a sufficiently muscular police/military apparatus. The US treasury could issue $1Q of debt tonight if it wanted to, and that would require no savings at all. It only requires a central bank that credits accounts and enforcement mechanisms to ensure the currency is used in all necessary exchanges, both foreign and domestic, at levels dictated by authorities.

    As an example of a propitious use of $1Q debt issuance, I propose what I call the Christo Moon Dollar Project (hereafter CMDP). The great thing about CMDP is its magnificent scope as a public works project, and it is simply funded by the Federal Reserve, no savings required. This is a key point. CMDP is so much better than having people dig up jars of cash or fly around in helicopters. Think of all the technological requirements and research, innovation and labor required to get a sufficient workforce up to the moon safely, and equipped and properly trained to canvas the moon completely in dollar bills. Ipads, whatever, we’re talking about dollars on the Moon! This is entirely possible. Imagine you are sitting at your desk, worrying over 10-year swap spreads, and you get The Call. You are offered a job to travel to space, to the Moon in fact, to be trained and adorned in space gear, given a mop and some space glue and a huge bucket of dollars and a chance to participate in something mind-blowingly cool. Marshall, Ed, tjfxh (how do you pronounce that anyway?) you know you would jump at an opportunity like this. There would be hazard pay too. Unemployment problem solved.

    But I digress. Currently the so-called “debt held by the public” is $9,018B, of which $4,065B is foreign owned and $806B is held in SOMA. Ed’s earlier claim that “the government’s debt is the government’s liability but the debt holders asset, most of whom are domestic institutions (pension funds, banks, etc)” is technically not true. Private domestic is now less than half of marketable debt. Furthermore, with QE-lite the Fed has stated that it intends to use maturing proceeds from its MBS portfolio to buy treasuries, and has been doing so. The MBS portfolio currently stands at $1,078B. With an ongoing trade deficit, QE lite and a virtual guaranty of QE2 (of unknown size, but est. to be $.5T-$2T per year), the proportion of domestic non-official ownership of marketable debt is set to decline even further.

    Even with no “savings” from foreign sources the US can simply issue as much debt as it likes, or simply skip the ridiculous façade of debt issuance and just credit accounts, willy-nilly in fact, as long as it is willing and able to use the force necessary to make exchange on US terms take place. No one should suffer under the illusion that savings are required or that the threat of force is optional.

    The best thing about all of this, CMDP in particular, is that when the aliens do finally arrive, they will most likely pass the Moon en route, and upon witnessing the Moon thusly adorned, will quickly realize the preciousness of the Dollar. Using unknown and advanced technologies they will immediately calculate how many dollars they have found, commence to lunar harvest, and promptly come to the earth to shop, thus stimulating the economy. We can probably do this over and over again.

    1. Edward Harrison says

      Let’s be clear, my quote is indeed technically true. The quote is “most of whom are domestic institutions” which does not equate with your definition of “Private domestic.”

      As to the rest of your comments, I don’t really understand your point. If you’re saying that fiat money is a ponzi scheme that is destined to end in tears because government will just print money, I am sure many readers here would agree with you.

      My view is that government cannot be trusted to utilize its coercive power as the issuer of fiat currency to help allocate real resources effectively without some sort of artificial constraints. In all likelihood, resources will be diverted to special interests at the expense of the general public. This is the basic problem I have with ‘so-called’ big government. I’d love to hear what the others on this thread think about this.

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