Thursday, February 18, 2010

The US prospects from the Chinese bubble

I have been asked if my hypotheses on China (which almost invariably end in US inflation as China combats the effects of a bubble yet to pop with its massive US Dollar reserves) mean that the economic recovery will be tepid and the US is screwed. I outlined the China problem here:
No, I don't believe so. Although I certainly don't claim to know how to time the market, bubbles have historically had a tendency to persist before popping, and the Chinese government has a strong incentive to force the bubble to persist, both because of short-term political maneuvers and also a hope that it can stimulate Chinese consumption and perhaps lessen the fall. As long as the Chinese bubble remains intact, we're fine.
There's more nuance to it.
If US government policy can stay out of the way of the economic recovery (to be determined - I don't like handing over control of the financial system to a political Treasury department instead of a nonpartisan Fed, I don't like the press for top-down renovation of the US economic system, etc), we'll recover; at the very least, I'd expect much lower unemployment at year end. Consensus still has unemployment at 10% and various gvt estimates at 9.5%. Remember how suddenly unemployment cratered? It's perfectly capable of reversing nearly as quickly, with just as little warning. I'm not saying it'll get back to what it was, but the inventory bounce alone should ramp up production more than consensus believes.
Action by the Obama administration on Chinese trade imbalances could cause inflation via the chain listed yesterday, but we're still at a low level of aggregate demand, so a little (keyword: little) inflation wouldn't kill us, because the Chinese government spending its dollar reserves is no different than the US policy of quantitative easing to stimulate the economy*... action on the trade deficit and real action on cutting government spending could combine to make a) US exports more competitive, stimulating employment, while b) lowering the impact of inflation due to the existence of a savings rate in private capital,** and a beneficial improvement in the currency because the national debt doesn't increase so quickly (and because the trade deficit would be going away).
In fact, I wonder if action on the trade deficit right now would actually work to shrink the budget deficit, because the Chinese government would start quantitative easing for us, and that would allow governments to spend less on things like unemployment benefits, etc. This doesn't work anymore once you're into a recovery, but while it may not be good in the medium term, it'll be beneficial in the short term (free stimulus!) and long term (rebalancing). This assumes, of course, that all of these policies (US cutting trade deficit with import certificates, Chinese spending US dollars to keep development going) happen today - the time lag would remove some of these effects. Still worth thinking about.
*EDIT: Bill Miller supports the concept behind my view of the idea that Chinese spending their dollar reserves won't cause significant inflation while the economy is still weak: "Inflation can only arise if labor or business, or both, have pricing power. Labor is still around 70% of the cost of doing business, and there won’t be any inflation there with unemployment at 9.5% and [when this was written in July 2009,] rising. Capacity utilization is 68%, among the lowest in the postwar period. Businesses will have no pricing power until that number is at least over 80%, a long way away."
**(For econ people, yes, I am asserting that private capital is both more effectual and more efficient than government spending, due to government bureaucracy, but also less inflation-causing, because there's less of it due to a savings rate. The inability to deal with government efficiency in a way that would satisfy the Austrian brick-through-a-window parable is what dooms Keynesianism in my eyes as anything but a highly secondary and supplementary policy when monetarism fails.)
EDIT: more from the inimitable Bill Miller, in his July 2009 market letter:
"Our friends at GaveKal Research³ have reminded
us there is a certain rhythm to the remarks
surrounding recessions and recovery. The
psychological cycle goes something like this: first
it is said the fiscal and monetary stimuli are not
sufficient and won’t work. When the markets start
up and the economic forecasts begin to be revised
up — where we are now — the refrain is that it is
only an inventory restocking and once it is over
the economy will stall or we may even have a
double dip. Once the economy begins to improve,
the worry is that profits will not recover enough
to justify stock prices. When profits recover, it is
said that the recovery will be jobless; and when
the jobs start being created, the fear is that this
will not be sustained."

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