Monday, February 9, 2009

China and the Vulnerabilities of the US Economy

I met today with a former boss and ongoing mentor and adviser. I'm always impressed by how knowledgeable and insightful his observations are. We had an interesting discussion, so I've presented a few of the significant points that came from what we talked about.

-If China reduces or eliminates consumption of US debt, interest rates go up by a couple percentage points, and we see hyperinflation. Anyone who remembers the stagflation of the 70s knows it's not a good position to be in. Thus, we're hanging by a thread.

-China overbuilt manufacturing capacity, and when we have economic trouble, they're now forced to shutter a great deal of it, which is why China is having some trouble. However, they benefited from buying our debt because it allowed us to buy a lot from them, which allowed them to have all sorts of money to build out their economy. In other words, the ability to loan to us to purchase from them was tremendously valuable for their development, as long as their growth remains fast. The hit now is far less than the benefit has been.

-We both agreed that Geithner's call-out of Chinese for currency manipulation was absolutely idiotic. You don't mess with your only real creditor.

-The US auto industry employs 3 million people. The most optimistic number for the stimulus package is to preserve or create 3 million jobs. Bailing out the Big 3 would be cheaper than the current stimulus package. Therefore, you're probably better off bailing out the automakers than you are going with this stimulus package. I think this point undersells some of the important externalities from things in the bailout like investing in science but I absolutely agree on general principle; I'd much rather see an auto bailout than the tax cuts, broadband buildout or DTV coupons currently in the stimulus. We need to save jobs, especially ones that contribute positively to science and US economic strength.

-He disagrees with my "A dollar of savings capitalizes banks just as effectively as a dollar of bailout" point because we need to save jobs, so we need to increase consumer spending (in the short term) as much as possible. His rebuttal is very fair; a bailout doesn't crowd out spending, it crowds out investment, whereas savings substitutes for spending.

-He pointed out that the US economy is built on the notion that most things are scalable. The failures of the banks disproved that. The executives had no idea what the underlings were doing because the banks were too big and sprawling. You have a whole lot of managers who don't know how their businesses work because all they learned was "leadership". He feels the same problem exists with the auto industry, and most others. I agree with his "leadership" objection, and I agree with de-scaling component in any industry with low fixed costs (like banking). On an economic basis, high fixed cost industries should see scaling, though admittedly that assumes rational management. I'd bet the level of required fixed costs correlates with the amount of mismanagement you'll tolerate in a scaled organization. I'm sure that still means many scaled-up industries would be better if they were composed of smaller companies even in the presence of high fixed costs.

-We need to start thinking outside the normal economic paradigm. Building roads may not be the best idea because the notion of automobiles isn't scalable to the 1 or 2 billion people who will drive them - it worked back when it was just us, but it can't work on a large scale including another billion people in India and China. We need to start thinking about alternative modes of transportation and build out THAT. In other words, the public mindset, the stimulus, the media and everyone else are solving yesterday's problems.

In light of these, I've changed my mind on a bunch of these stimulus measures. I'm going to go back and update.

He feels we're hanging by a thread; I understand the sentiment, although I think we've seen a lot of the worst in the short-term because the market is no longer consistently responding badly to bad news.

We didn't discuss this, but it's becoming more and more my opinion that China still has a bunch of development left, so we can run a deficit while they still need to develop quickly because they'll still buy our bonds. As soon as it no longer becomes profitable to the Chinese to "sacrifice" money for incremental growth, which funding our debt could become if we can't finance it, the US is screwed. In other words, the US budget needs to balance by the time Chinese growth slows down to the point of maturity. It's not there yet, but it's gonna get there, and I'd bet in the next decade. This stimulus is therefore a serious, serious problem, because it ratchets up our spending with questionable GDP efficiency.

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