new economic geography

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The Start of the Sino-American Trade War

So the global currency wars are hotting up.

As I expected, the first aggressions across the Pacific are coming from America. Why? Because with the current drift of globalisation, America is losing out, while other nations are gaining.

From Zero Hedge:

A few hours ago, the maniac simians at the Senate finally did it and fired the first round in the great US-China currency war, after they took aim at one of China’s core economic policies, voting to move forward with a bill designed to press Beijing to let its currency rise in value in the hope of creating U.S. jobs. As Reuters reports, “Senators voted 79-19 to open a week of Senate debate on the Currency Exchange Rate Oversight Reform Act of 2011, which would allow the U.S. government to slap countervailing duties on products from countries found to be subsidizing their exports by undervaluing their currencies. Monday’s strong green light for debate on the bill bolsters prospects it will clear the Democrat-run Senate later this week, but prospects for action in the Republican-controlled House of Representatives are murky. If the bill did clear both chambers, it would present President Barack Obama with a tough decision on whether to sign the popular legislation into law and risk a trade war with Beijing, or veto it to pursue a more diplomatic approach.” The response has been quick and severe: “China’s foreign ministry said it “adamantly opposes” a bill pushed by the U.S. Senate that will allow the United States to impose duties on countries that undervalue their currencies.” And just because China is now certain that the US will continue with its provocative posture, most recently demonstrated by the vocal response in the latest US-Taiwan military escalation, we would not be surprised at all to find China Daily report that China has accidentally sold a few billions in US government bonds.

Now there are two angles to approach this from. Firstly, the cheapness of Chinese goods. In my view the cheapness of Chinese goods has absolutely nothing to do with currency manipulation, and everything to do with economies of scale, cheapness of labour, and the fact that jobs and productivity migrate to places with the highest population density. It seems like — to some extent — the growth of China is a reversion to the historical mean:


What does it mean for America (and other nations) to pursue the trade war route? Well, it means a whole lot of effort and policy-making will go into a “solution” that really doesn’t have much bearing on reality. Currency manipulation doesn’t necessarily boost export competitiveness. That’s because in a global marketplace prices aren’t that sticky — they adjust to reflect the relative values of currencies. If Chinese goods were so under-priced, Chinese inflation would likely be significantly higher. Chinese inflation seems to be slowing. If China ceases to peg the yuan to the dollar, the yuan would certainly strengthen, but goods priced in yuan might not ultimately get much more expensive in dollar-denominated terms, especially in the long run. 

Second, the uncompetitiveness of American manufacturing. In my view American manufacturing is uncompetitive because trade conditions are artificially level, and global shipping costs and insurance costs are artificially low — a situation bought and paid for solely with American tax dollars. This means America not only accrues debt through military overspending, but it also has gutted much of its productive infrastructure, and hard-to-rebuild supply chains and skills.

If America were to close half its military bases, and slash its military spending in half (still leaving it as by-far the biggest military spender in the world), insurance and shipping costs would likely significantly rise, making made-in-America goods significantly more competitive in the American market — and making a balanced US Federal budget much more achievable. Other nations would either have to choose between making up for the deficit in global security out of their owns budgets, or forfeiting the benefits that global security brings to shipping costs.

The ultimate consequences of this crazy zero-sum trade/currency war will be a swifter end to the reign of the dollar as the global reserve currency. Why? Because threatening your greatest creditor with tariffs is a surefire way to get them to dump your debt, bursting the bond bubble, and making American debt significantly harder to sustain with resorting to money-printing.

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The Only Chinese Hard Landing Will Be On America’s Head

A lot has been made of the so-called Chinese property bubble. And after 2008, when America’s subprime bubble was the straw that broke the camel’s back, who can blame those who see China as low-hanging fruit? In the hedge fund world, both Hugh Hendry and  Jim Chanos (among others) are significantly outperforming the market by shorting Chinese companies.

But the naysayers will be proven sorely wrong.

There are many differences between the Chinese situation and the American one but there is one that outsizes all the others. Over-inflated American (and by-extension, Western) property was being used as a spring-board to fund consumption. Growing home equity allowed real-estate owners to remortgage, and use their surpluses to buy boats, cars and trips around the world; i.e., living beyond their productive means. Once the property bubble burst, not only were many home-owners left underwater, but all of that excessive consumption came to a halt, with a significant negative effect on GDP. China simply doesn’t have that problem. The Chinese nation and its government are not net-borrowers but net-savers.

In addition, there is no evidence that China has the same problem with widespread securitisation that America had in 2008. The subprime bubble created huge systemic risk in the financial sector by bundling up subprime debt in mortgage-backed securities and collateralised debt obligations, and spreading it around American and European balance sheets. This made the system very fragile — as a few defaults, could lead to a global cascade of margin calls and defaults.

In fact, Chinese leverage levels are dropping.

From RBS:

Chinese firms are generally in good financial conditions. The latest data suggests that Chinese companies actually have seen their leverage ratios decline in the past three years, on the back of strong profitability and retained earnings. Most sectors have seen a decline in leverage. Property development was the only main sector that shows the opposite trend of rising leverage but it accounts for only about 6% of total loans. In fact, the average leverage ratio of Chinese companies is one of the lowest among key economies and emerging markets. At the same time, they have maintained one of the strongest profitability.

Chinese GDP (and profitability) is ballooning (and will continue to do so) because of global demand, even on the back of the recessions in Europe and America. That’s because China does everything much more cheaply, and so now controls crucial supply chains in components and products. Now that the world is flat, manufacturing such components in other places is not economically viable, so the supply chains no longer exist, and manufacturing-oriented labour markets are stagnating.

China’s good fortune is its high population levels and high population density.

From Noahpinion:

It is expensive to move products around. This means that if you have a factory, you want to locate it close to where your customers are, to avoid paying a bunch of shipping costs. Now consider two factories. The workers in the first factory will be the consumers for the second factory, and vice versa. So the two factories want to locate near each other (“agglomeration”). As for the workers/consumers, they want to go where the jobs are, so they move near the factories. Result: a city. The world becomes divided into an industrial “Core” and a much poorer agricultural “Periphery” that produces food, energy, and minerals for the Core.

Now when you have different countries, the situation gets more interesting. Capital can flow relatively easily across borders (i.e. you can put your factory anywhere you like), but labor cannot. If you start with a world where everyone’s a farmer, agglomeration starts in one country, but that country gets maxed out when the costs of density (high land prices) start to cancel out the effect of agglomeration. As transport costs fall and the economy grows, the industrial Core spreads from country to country. Often this spread is quite abrupt, resulting in successive “growth miracles” that get faster and faster (as each new industrial region starts out with a bigger global customer base). The evidence strongly indicates that agglomeration is the driver behind developing-world growth.

Looking at global population density — with American taxpayers subsidising the cost of a flat global marketplace — where can we expect productivity to agglomerate?


Of course, China does have a property bubble and a scary-sounding $1.6 trillion in local government debt. But $1.6 trillion of local government debt is still significantly less than China’s dollar and treasury hoard. The bottom line is if that China’s real estate market collapses, China can bail itself out with money it has saved from the prosperity years, not through new debt acquisition. This was the lesson of John Maynard Keynes — governments should save in the boom years, to spend in the bust years and even-out the business cycle — a lesson which seems lost on Western policy-makers, who seem to believe that you should borrow massive amounts every year.

So taking the absolute worst-case-scenario, China has plenty of leeway to bail itself out. Of course, this would mean China might decide to liquidate a significant amount of its treasury holdings — especially seeing as bonds are at all-time highs.

Could such a liquidation be the event that finally bursts the Treasury bubble, sending yields soaring and making it much more difficult for America to acquire new debt?

With 10-year yields now well below 2%, that sure looks like a bubble to me.

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Is Bernanke Letting the Economy Crash?

So we know Bernanke didn’t print. Let’s survey the damage.

From Zero Hedge:

This is what happens when the market prices in $1+ trillion in loose money from the Chairman, and gets a sharp stick in the eye instead.

Stocks plunge, commodities collapse, Morgan Stanley refutes facts presented by a fringe blog, gold and precious metals are liquidated as margin calls explode, dollar soars as every bank in Europe scrambles to get its hands on every Benjamin it can get, Treasurys surge to never before seen prices even as CDS of the underlying countries soars, and the DJIA posts the third biggest weekly drop in history (and the week is not even over yet)…

…And beneath it is all is the creeping realization that the Fed’s most recent global bailout action with the ECB, the SNB, the BOJ and the BOE does not start for another 20 days, or October 12, 2011. That’s right: three weeks in which there is  to provide the much critical trillions of dollar that every bank in the world so desperately needs. We wish Europe all the best in pretending for 20 days that it can survive on its own, even as Greece is about to become the riotcam’s favorite destination once again.

What readers will want to know is why Bernanke didn’t print. There are three chief theories.

  1.  Inflation Fears; American CPI recently hit 3.5%. Are central bankers that excessive liquidity are causing the economy to overheat?

    From Paul Krugman:

    Like me, Tim Duy comes down hard on Paul Volcker’s inflation-is-history’s-greatest-monster op-ed. I pointed out that the last time we were in an economic trap resembling our current predicament, inflation actually helped get us out. Duy adopts a somewhat different but complementary approach: he asks just how bad the evil inflationary 1970s actually were. And the answer is, not nearly as bad as the noninflationary 00s. For example:

    Now Krugman is not Bernanke, but it does sum up the Keynesian perspective: inflation is not taken to be half as bad (and in many case beneficial) by monetary authorities as it is by the public. So is it inflationary fears that have caused Bernanke not to print? I doubt it.

  2. Bernanke has been ordered not to print; Debt-holders around the world are uncomfortable with QE because they feel that it is adversely affecting the purchasing power of their holdings.

    As I wrote last month:

    Wen Jiabao is bluffing for time. China knows America is sitting on a house of cards, and is quickly changing its tack away from criticising America, to getting the heck out of dodge. It is becoming clearer and clearer that America cannot and will not produce a coherent deficit-reduction strategy, a strategy to boost domestic manufacturing, or any meaningful economic plan at all outside of printing money. China is offloading not only its Treasury balance, but also its dollar pile. It has long been getting into productive assets and gold, and out of fiat money.

    Now we know that China wants to get out of US debt. But is America really coward enough to let China boss it around? American foreign policy (at least the slice of it we get to see) is conducted to show America as a global leader financially, politically and ethically. Certainly Bernanke is being as conservative as possible with bondholder purchasing power. But does that explain the full picture?

  3. Bernanke is deliberately letting the economy crash; he realises that further easing is politically and internationally untenable — even if it is necessary to stabilise and inflate asset prices — and he wants to show other actors the consequences of the Federal Reserve stepping back so that future action — both fiscal, monetary and organisational — is made politically viable.
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Bernanke Didn’t Pump, Equities Get Dumped

So what happens now QE3 hasn’t occurred? Let’s see what I wrote last month:

QE3 has already been priced in so there would be shock. Confidence would plummet, followed swiftly by asset prices, especially the blown-up pufferfish S&P, DJIA and Nasdaq. Two exceptions would be gold, which would shoot up — well above $2000 — and treasury bonds, whose yields would edge ever lower. And plummeting asset prices would mean debt-deflation, leading to more bank failures, and the debt-deflation spiral posited initially by Irving Fisher, and later by Friedman, Schwarz and Bernanke.

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