Monday, February 8, 2010

International concerns - please stop referencing Europe or China as ideals

I don't claim to offer new thoughts with this, but merely to provide some perspective on the US vs the two areas we are compared to most often: Europe and China.
I was thinking today about the international outlook. There is this tendency on the right to want to move us towards more of what China is doing in its country - Drive growth at any cost (including human costs) through empowering corporations and cutting taxes, wield international dominance in foreign policy and tolerate no dissension in the country from our traditional values (largely Christian, anti-atheist, anti-foreigner ones in the US and Communist, ethnic-superiority ones in China - in the US, this is characterized by opposition to immigration, gay marriage, abortion and gun control and support for invasive government anti-terrorism enforcement). There is also a tendency on the left to move us more towards what Europe is doing - using government as a tool of blunt redistribution to ensure everyone's static equilibrium is equal (if not "fair") and disregard future outcomes and ways that equilibrium can change. This is characterized by their recent efforts to socialize healthcare, bring banks under greater Federal supervision and regulate pay at private institutions, intervene in energy policy on the demand side while largely assuming the supply side will take care of itself if the demand side changes, etc.
In general, it may be better to err towards the side of the right for the simple reason that a) rightward errors are easier to undo, largely by default (entrenched fiscal programs on the left are very, very hard to rework) and b) rightward errors have a tendency to improve over time as the country grows, whereas leftward errors tend to get much, much worse over time (see Greece, Portugal, Italy, Ireland, Spain, the UK, etc).
But I'd hypothesize that the US is currently in a better situation than EITHER of those two regions, and that our "central" path - recognize the intrusive, anti-progress power wielded when governments intervene too much in the fiscal equation, while still recognizing the value of tolerance, freedom and appropriate safety nets for those who are genuinely a victim of bad luck (I'd argue there are many fewer in this latter category than anyone on the left wants to admit, and many more than the right wants to admit).
I then read a number of things about the economic situations of Europe, China and the US that seem to confirm this hypothesis.
Europe is in serious, serious trouble because the fiscal situations in almost all of its weaker countries have become absolutely unworkable:
"What are the stronger European countries, specifically Germany and France, doing to contain the self-fulfilling fear that weaker eurozone countries may not be able to pay their debt – this panic that pushes up interest rates and makes it harder for beleaguered governments to actually pay?

The Europeans with deep-pockets are doing nothing – except insist that all countries under pressure cut their budgets quickly and in ways that are probably politically infeasible.  This kind of precipitate fiscal austerity contributed directly to the onset of the Great Depression in the 1930s.

The International Monetary Fund was created after World War II specifically to prevent such a situation from recurring.  The Fund is supposed to lend to countries in trouble, to cushion the blow of crisis.  The idea is not to prevent necessary adjustments – for example, in the form of budget deficit reduction – but to spread those out over time, to restore confidence, and to serve as an external seal of approval on a government's credibility.

Dominique Strauss-Khan, the Managing Director of the IMF, said Thursday on French radio that the Fund stands ready to help Greece.  But he knows this is wishful thinking.

  • "Going to the IMF" brings with it a great deal of stigma.  European governments are unwilling to take such a step as it could well be their last.
  • The IMF is supposed to provide only "balance of payments" lending.  That doesn't fit well when a country is in a currency union such as the euro, which floats freely and does not have a current account issue, and the main problem is just the budget.
  • Greece and the other weak eurozone countries need euro loans, not any other currency.  If the IMF lent euros, that would be distinctly awkward – as this is what the European Central Bank (ECB) is supposed to control. 
  • Sending Greece to the IMF would result in some international "burden sharing," as it would be IMF resources – from all its member countries around the world – on the line, rather than just European Union funds.  But is the US really willing to burden share through the IMF?  After all, Europe has long refused to confront the trouble in its weaker countries, now known as PIIGS (Portugal, Ireland, Italy, Greece, and Spain)?  How would the Chinese react if such a proposition came to the IMF? 
  • Would the Europeans really want the IMF and its somewhat cumbersome rules to get involved – this would be a huge loss of prestige.  It could also lead to some perverse outcomes – you never know what the IMF and the US Treasury (and Larry Summers) will come up with in terms of needed policies (ask Korea about 1997-98; not a good experience).  The European Union (EU) has handled IMF recent engagement well in eastern Europe (from the EU perspective), but that was seen as the EU's backyard.  If the eurozone is in trouble, everyone will be paying much more attention – no more sweetheart deals.
  • The IMF gave eastern Europe amazingly good deals over the past 2 years (by IMF standards).  Would this fly with financial markets in the sense of restoring confidence in the PIIGS and their medium-term fiscal futures? 
  • Does the IMF really have enough resources to backstop all the PIIGS?  The IMF's notional capital was increased substantially last year, but just based on what we see now, the Fund would need even more ready money to tackle the eurozone – all the weaker countries would need at least preventive lending programs and these would need to be large.  If that is where this goes, the EU looks simply awful and has failed at a deep level.
  • The IMF could play a constructive "technical assistance role" alongside the European Commission, but everyone would want to keep this pretty low profile.  Anything that goes to the IMF executive board would result in a lot of cheering and jeering from emerging markets.  This would break the power of Europe on the international stage – perhaps a good thing, but not at all what the European policy elite is looking for.

The IMF cannot help in any meaningful way.  And the stronger EU countries are not willing to help – in part because they want to be tough, but also because they do not have effective mechanisms for providing assistance-with-strings.  Unconditional bailouts are simple – just send a check.  Structuring a rescue package that will garner support among the German electorate – whose current and future taxes will be on the line – is considerably more complicated.

The financial markets know all this and last week sharpened their swords.  As we move into this week, expect more selling pressure across a wide range of European assets. "

more on Europe:

On the other hand, China's economic growth has not been balanced, and the historical precedent is not with them:

"China's foreign reserves are certainly huge. They add up to an amount equal to about 5-6 % of global gross domestic product.

But they are not unprecedented. Twice before in history a country has, under similar circumstances, run up foreign reserves of the same magnitude.

The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as "all the bullion in the world". At the time, total reserves accumulated by the US were more than 5-6% of global GDP.  My back-of-the-envelope calculations suggest that this was probably the greatest hoard of central bank reserves ever accumulated as a share of global GDP, but please check before you accept this claim.

The second time occurred in the late 1980s, when it was Japan's turn to combine huge trade surpluses, along with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves only a little less than the equivalent of 5-6% of global GDP.   By the late 1980s, Japan's accumulation of reserves drew the sort of same breathless description – much of it incorrect, of course – that China's does today.

Needless to say, and in sharp rebuttal to Friedman, both previous cases turned out badly for long investors and brilliantly for anyone dumb enough to have gone short....

The risks that China faces today (and the US in the late 1920s and Japan in the late 1980s) is of excessive domestic liquidity having fueled asset and capacity bubbles, the latter requiring the uninterrupted ability of foreign countries to absorb via large and growing trade deficits.  These risks include an explosion in domestic government debt directly and contingently through the banking system.

These are, very typically, the kinds of risks that threaten rapidly developing large economies, unlike the external debt and currency risks that typically threaten small economies.  And reserves are almost totally useless in protecting these economies from the risks they face...

In fact, it was the very process of generating massive reserves that created the risks which subsequently devastated the US and Japan. Both countries had accumulated reserves over a decade during which they experienced sharply undervalued currencies, rapid urbanization, and rapid growth in worker productivity (sound familiar?). These three factors led to large and rising trade surpluses which, when combined with capital inflows seeking advantage of the rapid economic growth, forced a too-quick expansion of domestic money and credit.

It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed."


As hypothesized, I'd rather have China's future than Europe's, simply because while China will face pain in the short to medium term, they will still slowly improve the lives of their people, while Europe is almost certain to take a step back in self-driven quality of life (technological change, largely from the US and Asia, of course, have many positive externalities from which Europe benefits, but Europe is going to have to step back its spending massively, but the private sector no longer has the ability to make up for it because the government has moved in on so many places).

Then I look at our "massive" economic problems:

Calls for a second stimulus are dumb, because job growth always lags, the first stimulus was a fine size but just too slow, excessive sovereign debt is a problem as much as insufficient aggregate demand and the government can't create jobs in a cost-effective manner.



Given those three sets of crises... wouldn't you always choose the American crisis? I understand how difficult the US' situation is with a 10% jobless rate (which would be in the bounds of normal for most of Europe and China), but China is in an asset bubble that makes our subprime and tech bubbles look reasonably minor, and Europe is in a serious, serious fiscal quagmire and has actually been affected, as a whole, worse than the US by the US subprime crisis. Isn't the danger here then pushing too far to the left or right? In both cases, the biggest problem has been over-intervention in the economy - in China by relentlessly pushing for growth and in Europe by relentlessly pushing for redistribution and increased government spending on individuals... isn't that the big hazard here? Nobody thought the UK would be where they are currently.


Obama's big challenge is going to be re-disengaging the US government from micromanaging the economy, not figuring out ways to "regulate it" for safety while racking up massive debt, and nor figuring out ways to directly force economic growth and innovation. George Soros has noted that while unlevered bubbles and collapses tend to follow sine-wave patterns (symmetrical on the up and downside), leverage-fueled bubbles drift upward much more slowly than they collapse on the downside because the leverage must all be unwound at once in a systematic asset sale, while the leverage can be taken on over time. A large debt burden endangers us far more than the current crisis (remember, this crisis started with mortgage debt to low-income borrowers in the interest of helping them afford houses). Similarly, government reorganization of GM and Chrysler, the banks, energy policy and healthcare to drive future growth and benefits for everybody is more likely to cause problems than solve them. Additionally, we've all seen the calamity that has been the Patriot Act and the deleterious state of immigration and teen pregnancy in this country (people don't necessarily understand that restricting immigration hurts the economy badly).

Conversely, I'm not saying the government has no role in energy policy or healthcare reform (I'd argue it does have no place in autos), but simply that its solutions should be far more geared towards facilitating a government step-back and allowing private organizations to provide multiple solutions to our big problems in these areas, rather than one government drive to fix things.

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