In 2002, the global economy was weak and equity markets around the world were at multi-year lows following the greatest equity bubble and bust in world history. Many policy makers including Alan Greenspan, chairman of the U.S. Federal Reserve, feared a deflationary spiral of Great Depression proportions resulting from the stock market collapse.
To prevent such an outcome, the United States embarked on an historic monetary experiment to reflate a post-bubble economy by lowering interest rates to 1%, the lowest in 50 years. The result was a huge global economic boom which benefitted nearly every economy and every asset class on the planet. But the boom has turned to bust. In its wake, the cozy relationship between China and the United States that developed during boom time is unravelling.
Just Friday, Barack Obama slapped Chinese tire imports into the United States with tariffs of up to thirty-five percent. China was outraged and immediately threatened to retaliate. I now see a trade war between China and the United States as the biggest threat to global economic recovery.
With this trade war looming, one must wonder if Chimerica, the marriage of China and America as one economic entity, will end in murder-suicide, taking the global economy down with it.
Chimerica’s origins
Niall Ferguson and Moritz Schularick invented the term “Chimerica” in 2006 to describe the underpinnings of the 2000s boom. In their view, this economic upswing resulted from an America and China joined at the hip in a state of economic interdependence. Americans were the spenders and the Chinese were the savers and producers. The United States spent far in excess of what it saved. Meanwhile China ran a huge current account surplus, accumulating a $2 trillion stash of largely U.S. dollar-denominated international reserves, effectively funnelling America’s borrowed money back into the U.S. economy.
This state of affairs was always unsustainable – more so after the collapse of the associated credit and asset bubble exposed fissures in the global financial system in 2007. However, the flashpoint came in 2008 when the U.S. dollar plummeted to record or multi-decade lows against a host of other major currencies, leaving China’s reserves diminished in value. For the months since, the Chinese have expressed growing concern that they could get the short end of the stick if the marriage which created Chimerica dissolves.
Chimerica’s unravelling disturbs China
If one looks at any one incident involving China and the United States during the global economic crisis in isolation, it is easy to lose sight of the big picture. However, threading the events of 2008 and 2009 together makes a compelling case that the Chinese – U.S. marriage is coming apart.
The first indication of Chinese concern which I detailed came as the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac collapsed last August. The Chinese had put much of their reserve money into GSE debt, believing it as safe as U.S. government debt. It was evident that the GSEs were not a safe investment except through an implicit government guarantee (as I said in May 2008). But when the GSEs collapsed, the Chinese were caught out and warned they could dump dollar-denominated assets unless they were made whole. Subsequently, Fannie Mae and Freddie Mac were nationalized and creditors were made whole.
The next flashpoint was created by comments by incoming Treasury Secretary Tim Geithner at his confirmation hearings before Congress. Geithner charged China with ‘manipulating’ its currency in an environment in which many western policy makers were openly blaming Asia’s mercantilism for the economic crisis. The Chinese retaliated, with Chairman Wen slamming the U.S. as a profligate nation in unusually stark terms that raised quite a few eyebrows.
At just about this time, the first hints of real American protectionism came into being in the form of the Buy America provision attached to the stimulus bill. There was quite an uproar from America’s major trading partners like Canada and China – and I saw this as a 21st Smoot-Hawley at the time, a view I still hold. (To make matters worse, the provision has had perverse consequences.)
By this point – early 2009, the Chinese were done. They had suffered the potential for massive losses through the dollar’s weakness and the failure of the GSEs. Now, they were being blamed for a crisis which began in the west. It was at this time that I noticed a steady drumbeat of ditch-the-dollar talk coming out of China. By the G-20 meeting in April, the Chinese central bank head Zhou outright called for a new international reserve currency.
The drumbeat of anti-Dollar news coming from China got louder and louder during the spring. The Chinese started settling trade in Yuan (Apr. 9) instead of dollars. The Chinese were discovered to be stocking up on gold supplies (Apr. 24). The Chinese central bank attacked the policy of quantitative easing in its quarterly report (May 9). The Chinese positioned themselves as the champion of emerging market nations and assembled support from Russia, Brazil and India for reforms in the international reserve system (Jun. 12).
And then came the retaliation.
Protectionism rises
On June 16, I wrote a post “Beijing starts a ‘Buy China’ policy” which clearly demonstrated that the Chinese were incensed by the Buy America provision in America’s stimulus bill. The trade war was on.
The ‘Buy America” and the “Buy China” provisions were nationalistic and prevented goods from other countries being bought. However, they were merely passive protectionism i.e. legislative exclusion of foreign goods and services. No tariffs were assessed.
But when Barack Obama chose to slap 35% tariffs on Chinese tire imports, this was an unmistakable act of active protectionism. This was the proverbial serving of divorce papers.
Expect prices to rise as a result:
Marguerite Trossevin, who represents a coalition of U.S. tire companies that import Chinese tires, said the tariff decision is “very disappointing.” She predicted price increases for U.S. consumers and losses for U.S. tire importers.
The Chinese have now said they will look to retaliate on U.S. poultry and auto products:
China announced dumping and subsidy probes of chicken and auto products from the U.S., two days after President Barack Obama imposed tariffs on tires from the Asian nation.
Chinese industries complain that they’re being hurt by “unfair trade practices,” the nation’s Ministry of Commerce said on its Web site yesterday. The dumping investigation relates to poultry alone, a spokesman said in Beijing today. The ministry didn’t specify the value of imports of the products.
To be honest, the protectionism should not be a surprise. Obama is no free-trader. And I certainly foresaw a rise in protectionism and indicated in December 2008 the United States was the likely first mover:
Tariffs, export subsidies and currency devaluations will roil the desire for free trade. Initially, countries will seek relief at the WTO (World Trade Organization) but later they will begin to act unilaterally. The U.S. will be the first to unilaterally retaliate.
Even the resistance to unwinding excess capacity and global rebalancing are all very predictable as nations retreat into nationalistic thinking when the chips are down. As far back as March 2008, I warned of a likely multi-cycle W-recession predicated on resistance to unwinding the status quo:
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.
Yes, trade and dumping are difficult issues. But, protectionism makes most everyone a loser. In June, I wondered should we expect a protectionist China. But I ended saying it was how the Obama administration responded to the green light given by the WTO to impose sanctions which would be most instructive. Obama has gone protectionist.
Chimerica marriage is ending in divorce
All need not be lost. Global re-balancing, where the American partner in this marriage does a little bit more of the saving and a little less of the spending and the Chinese partner does just the opposite, is what most economic counsellors suggest. This could save a strained relationship and put the partners on a sustainable path. This does seem to be happening.
Nevertheless, could this relationship between China and America be coming to an end?
I say emphatically yes. 100%. There is no going back now. Each partner in this marriage, China and the United States, has a bevy of domestic constituencies which are forcing a dissolution of the relationship. Hardliners in China want to move away from the dollar. And populists in America want to punish the Chinese for allegedly manipulating their currency and dumping goods below cost in America.
So, as surely as day turns to night, this arrangement between China and the United States will end. This marriage is over. The question is whether it will end gradually and peacefully in divorce or violently in murder-suicide. Right now, it’s looking like the latter.