Groundwork for Trade Conflict Being Laid?

We have worried out loud that the policy remedies being pursued by the US amount to trying to restore the status quo ante to as great a degree as possible, particularly in trying to resturn US overconsumption to something approaching its former levels. Although it may be difficult to work two agendas, crisis response and addressing the root causes of our economic mess in parallel, focusing solely on the former runs the considerable risk of that we will see only a shallow recovery, with many of the elements of the crisis soon reasserting themselves in more virulent form.

Similarly, the Chinese, who at least in theory had accepted that they needed to let their currency rise (and presumably over time move to a more balanced, less export-dependent economy) have similarly gone into full reverse gear. The RMB has now been more or less re-pegged to the dollar, and China is moving in other ways to shore up exporters (such as pressuring banks to lend).

Michael Pettis points to a related, troubling development: other emerging economies are seeking to restore or increase trade surpluses. That in turn means SOMEONE has to import. But the US wants to increase exports (and the move by the Fed to quantitative easing will have the side benefit, from its perspective, of weakening the dollar). Euroland is neither keen nor able to step into the US role of importer of the last (and first) resort (boldface ours):

One consequence of the financial crisis will inevitably be capital outflows from developing countries. The necessary corollary of capital outflows is trade surpluses. Without running a trade surplus no country can consistently support capital outflows, and as obvious as this is, it also seems to be a source of tremendous mystery to many experts and policymakers. Keynes for example pointed this out in his fury at the way Germany was required to post war reparations in the 1920s while its ability to generate export surpluses was all but eliminated by the victorious powers. Capital exports by definition require trade surpluses.

This is just another way of saying that a lot of developing countries that had been running trade deficits will soon be, if they aren’t already, running trade surpluses. Instead of contributing their net demand to the world economy, as they had via their trade deficits, they will now be contributing their net supply.

This will not help the world imbalances. The biggest contributors of net demand are the US and non-Germany Europe, and both of these regions are seeing a rapid decline in their net demand contribution (i.e. their trade deficits are expected to shrink). To adjust to this decline the world needs new sources of net demand or else global production must contract sharply via factory closings and rising unemployment. But the largest net supply country, China, is increasing its export of net supply (its trade surplus has been rising) while several trade deficit countries in Asian and elsewhere are switching to trade surplus or otherwise trying to reduce their deficits.

This cannot be sustainable. We cannot expect production to rise while consumption declines except if it comes with a dangerous rise in forced investment (also known as inventory). The crisis cannot even begin to be considered in its final stages until this issue is resolved.

Pettis addresses another issue, namely, that China’s interest rate cuts will do little for consumers, and will instead exacerbate global imbalances:

For me, interest rate cuts in China will have very different effects than they might in the US. In the US, where a great deal of credit goes to consumption, lowering interest rates can be seen as boosting consumption as much as boosting production. At any rate the US, which contributes the largest amount of excess net consumption to the world and must bring it down, has every reason to focus on production-boosting measures as well as consumption-boosting measures.

But China is different. First of all there is little to no consumer credit in China, so cutting interest rates won’t do much to boost consumption. It might do so indirectly by reducing mortgage payments (Chinese mortgages are all floating-rate mortgages) and perhaps by slowing the decline in real estate prices, but it is not clear how big an effect that might have on increasing consumption, especially since even lower interest rates aren’t likely to create much buying interest for real estate. In fact there is some evidence in China that households may actually contract spending when deposit rates are cut since they need to save more to achieve their precautionary savings targets.

On the other hand with most credit going to investment, lowering interest rates definitely reduces further the cost of production. I know that the idea of lowering interest rates in an economic contraction is firmly entrenched in economic wisdom, and I am taking what may seem like an extremely opposite viewpoint, but I doubt that cutting interest rates is what China needs to do if it is expecting to adjust to the global payments adjustment. Every domestic policy must be aimed at boosting demand, and anything that increases China’s “competitiveness” is a dangerous detour since it can only exacerbate global imbalances and increase the likelihood of trade friction.

In down times, it’s every man for himself. The interesting question is whether these conflicts come to the fore in 2009 or take a bit longer to become acute.

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  1. Anonymous

    It seems a little hypocritical for Uncle ZIRP to be blaming China on interest rate cuts.

    The other assumption that always gets me is the notion that RMB has to rise. Now Chinese exports has contracted, so should capital inflows into China. Logically the RMB will fall. Having China using reserves to defend a falling currency to the point of causing it to rise smacks retarded to me.

    What I see is a whole lot of hostage taking from America. And very little in the way of actually solving anything.

  2. fresno dan

    ” In fact there is some evidence in China that households may actually contract spending when deposit rates are cut since they need to save more to achieve their precautionary savings targets.”
    Kinda sounds like Fresno Dan.

  3. Steve Higgins

    The original goal of all the government hyperactivity was to rescue real estate and get mortgages happening again… The results so far are more programs, more government and fewer loan programs.
    Steve Higgins
    Boulder Real Estate and Mortgages

  4. donebenson

    If you also assume that there is still a MAJOR worldwide problem with bad debt/insolvencies, and then add this problem of excessive exports and currency depreciations, unfortunately Yves is right in that it is FAR too early to see the end of these very trying times.

  5. Anonymous

    My wife is a paramedic, when they are called to a code one and the patient is obviously going to die. They make a little show for the on lookers, to make the on-lookers feel good about it all. They tried and all, in the end they just let them go. Kinda like the world economy eh.


  6. Anonymous

    “Every domestic policy must be aimed at boosting demand, and anything that increases China’s “competitiveness” is a dangerous detour since it can only exacerbate global imbalances and increase the likelihood of trade friction.”

    The qualifier is that Chinese domestic policy must be aimed at increasing Chinese demand. So far, they seem more focused on boosting US demand through still lower prices. My mind cannot let go of the specter of world-wide deflation and job wars followed by …

    The perfessers, who created this monster from their tenured perches, are still ranting against “protectionism”. They really haven’t factored in world war or worse, loss of their own jobs.

  7. Anonymous

    China, it seems, insists on maintaining and even expanding its trade balance with the US.

    Doesn’t that mean that the proper policy for the US in this situation – for our own benefit and for the benefit of the rest of the world – is to erect trade barriers such as tariffs or quotas to reduce the trade imbalance?

  8. john bougearel

    lowering interest rates in China to lower the costs of production will only serve to lead to more over-investment from the credit creation boom era that just won’t die.

    Policies like this that exacerbate the overinvestment and production capacity in China will only worsen the developing crisis.

    How long is it going to take for the collective world to learn the music has stopped playing and that it is time to stop dancing?

  9. Anonymous

    The Chinese will claim a bigger and bigger piece of the market share as their prices tumble. This leads to a rapid acceleration in job losses in the US. There are two alternative escape routes for the US, the first being protectionism and the rest of the world slowly shunning the US, or currency devaluation and loss of reserve currency status. Either way living standards in the US would drop.
    Perhaps the best option would be an engineered gradual devaluation of the dollar before too many jobs are lost. Still I am not entirely happy with the way that the money flows are described by Michael Pettis. Something tells me though that his basic premise is not quite right and it has to do with the subtle difference between capital exports and investment. Investment is not really an export as it can be pulled back.

  10. Anonymous

    certainly the US hasn’t stopped believing that its economic model of the last 60 years of getting credit into the hands of american consumers and supporting the real estate and paper asset markets should cease, so why blame the chinese for continuing their production based model: the result of the FED’s money printing would be more debt for americans, devaluation of the US currency and eventually default of treasuries. It is a death spiral for everyone, americans chinese etc. But don’t shift the cause of the problem from the US to the rest of the world.

  11. Anonymous

    To play devil’s advocate the relationship might work between America and China. What if China just said screw it, they will fund the trade deficit of America and the federal government deficit up to basically any level.

    Even if they had to fund a trillion dollars a year, it sounds like it would be impossible. But its only 1,000$ per Chinese person.

  12. Richard

    Reading Brad Setzer, it appears that is exactly what the Chinese are doing and intend to do, buy every last Treasury they can lay their hands on. What is the alternative (the Germans and the EU would go ballistic if they started buying EURO bonds and drove up the EURO), or basketcase Japan and its Yen who would also frown on further appreciation)? But the American is spent out, her income flat for seven years. Now she is underwater with the asset price declines, she either wants to just pay off this debt or else default in face of the hopelessness of the situation. Those who aren’t, are saving (see the already current swing from a negative savings rate in 2005 to a 3.5 savings rate in 2008)as the only way to build an emergency fund for job loss and for retirement.

    If China can’t find jobs for its people, they, the Chinese people may conclude that the Chinese Communist Party has lost the “Mandate of Heaven” and it is time for a new Emperor. A Chinese civil war (along with a Pakistan-India Nuclear war)I guess is one way to get rid of surplus capacity.

    As far as “investments” coming back, the descendants of the those who invested in pre-1917 Russia and pre-1949 China are still waiting to get their money back.

  13. Anonymous

    We’ve got a govt run by millionaire congressman who engorged themselves on the status quo. There is no hope for the US worker save getting these villains out of high office.

    It will never happen.

    Martial law in 2009-2010. The rich have stolen the money and they ain’t giving it back.

    Internet will be shut down and the constitution suspended.

  14. S

    Why wouldn’t the rest of the world erect trade barriers? Isn’t this basically what European champions are all about? Why is it so hard for the US to fathom that the rest of the world doesn’t see ZIRP as the answer? Is it because the rest of the world serves a pagan constituency of savers? The high priests at the Fed and treasury hve decreed that US is doing the yeoman’s work spending other people’s money. The Pharisees, or is it pharaohs) simply can’t conceive of the idea that their entire kingdom is a mirage resulting in malinvestment the likes of which the world has never seen. Overcapacity is rampant everywhere, no more so than in the financial community.

    Is it not a little shocking that the same crowd that has been at the globalization fore is screaming loudest for neo Keynesianism? Diversionary catcalls about free market jihadism only detract from the unholy ideological alliance hatched in the wake of BWII. It’s not regulation rather the foundations of the system itself.

    The dirty little secret is that the globalizers cum Keynesians had to embrace the free markets because the ideological achievements of pushing for max integration trumped the short term Faustian bargain. Seen in this light, the Keynesianism shouting make perfect sense. On need only read the latest post on Economist’s View about the Fed adding a asset inflation target mandate to its charter. The globalizers appear to have more in common with the Chinese and Sun Tzu than would be given credit – win the battle before it is fought, right.

    The globalizers are just opportunistic, or cunning, socialist. They are about bigger and bigger government and integration begets that goal. The ICC, UN, Kyoto and the fondness of the Davos crowd to talk about global cosmopolitans all speak to the not so thinly veiled agenda. Abby Joseph Cohen has been promoted to work on environmental and world issues after being so prescient in her market analysis. Her ilk will lift the world out of poverty; so long as the multinational meets financial set continue to extract their rents, at the continuing expense of those they seek to help. No BRICs in the Gulfstream, or is tit G7.

    The upper west side ulema sit squarely at the vanguard of this agenda. And the illuminati have been fighting their dirty war for decades. It shouldn’t shock that Hollywood captures the esprit de core perfectly in Col. Jessup’s rant in a Few Good Men:

    “I have a greater responsibility than you can possibly fathom. You have the luxury of not knowing what I know. And my existence, while grotesque and incomprehensible to you, saves lives (substitute investment banks)…You don’t want the truth. Because deep down, in places you don’t talk about at parties, you want me on that wall. You need me on that wall”

    He believed it and they do to. Be worried as they say. Paulson tirade in today’s FT is yet more of the oozing puss. The agenda marches onbama, for now.

  15. S

    File this one under the mosiac theory…

    “December 29, 2008, El Paso, Texas – A U.S. Army War College report warns an economic crisis in the United States could lead to massive civil unrest and the need to call on the military to restore order.
    Retired Army Lt. Col. Nathan Freir wrote the report “Known Unknowns: Unconventional Strategic Shocks in Defense Strategy Development,” which the Army think tank in Carlisle, Pa., recently released.
    “Widespread civil violence inside the United States would force the defense establishment to reorient priorities … to defend basic domestic order and human security,” the report said, in case of “unforeseen economic collapse,” “pervasive public health emergencies,” and “catastrophic natural and human disasters,” among other possible crises.
    The report also suggests the new (Barack Obama) administration could face a “strategic shock” within the first eight months in office.
    Fort Bliss spokeswoman Jean Offutt said the Army post is not involved in any recent talks about a potential military response to civil unrest.
    The report become a hot Internet item after Phoenix police told the Phoenix Business Journal they’re prepared to deal with such an event, and the International Monetary Fund’s managing director, Dominique Strauss-Khan, said social unrest could spread to advanced countries if the global economic crisis worsens.

  16. lineup32

    The multi-national corporation has a heavy hand in this situation as their investment both in China’s production model and political/PR/financial power within the U.S. promoting global trade benefits are hitting a wall.
    Clearly years of careful financial and political ploys are rapadily coming undone here and abroad with real massive loss for their financial investments overseas and poltical and public relations influence within the U.S.

  17. sanjay

    I think you nailed it and good to know I am in good company. Sometimes cutting interest rates can be the wrong thing to do. I believe this crisis was precipitated by the Fed. cutting rates in response to a solvency crisis. In a solvency crisis lenders need a higher not lower interest rate! In doing so they destroyed the entire financial architecture- the spread relationship between various asset classes. That break down in turn was viewed by the markets as reflective of even greater problems the death spiral was on.

  18. mxq

    The US has collapsed (or is still collapsing) b/c they realize credit is finite. The hideous financial adjustment is underway.

    China is politically inured to the current mercantilist structure, so i agree with Richard Kline, China is going to have to go through a period of social instability — imo, probably tantamount to the financial instability the US is going through — if they ever hope to create net demand.

  19. Waldo

    Yves Smith, your insightful analysis of the trade machination revealed in your leading piece to these blogs contains tremendous brevity and intellectual erudition. “Par excellence.”

    In all this powerful and heady analysis of Yves’s point of view we must first understand the fundamentals of a working economy before we rant about financial and economical metrics to try to inflate our egos and “shine” our intellects to others.

    For any economy to work (moving forward) there must be physical work done. In the most simple point of view (caveman) hard work is critical to any societal amelioration. China is working hard and we are ingesting this work into our standard of living (WalMart affect). This has occurred ever since this great free market experiment has been “frothing” in the test tube (America).

    If it wasn’t for our demand supply (squeezing out labor and creating an innovation power) I say our computer and internet platforms would not be here today or at the very least at the level of maturity that exists.

    With determination the voids created by job loss can be filled through innovation (societies advance forward).

    But still the biggest factor screwing our aggregate point of view of this mess we are in is the stealing (heist) of our top-line free cash by the American oil thugs (this stealing has had the ability to penetrate right into the most private of American family settings; who does not pay for gas?). Wall street forced into real estate and families herding (normal for any natural system) into better homes (amelioration). But take out all the available cash and the system we will get is what we have. Do not punish this Administration (real punishments is former Presidents incarcerated and the oil profits being disgorged back to the Treasury) and wait to see what else happens. It is important for our society to punish its felons. This same them is congruent with the value of hard work.

  20. Anonymous

    Weeeelll…I could have told you that.

    my take:

    1. It’s the end of dollar era. In a sense that G-7 is not big enough to fix evrything behind the door when things go wrong. Not like before. Previously when things go very wrong, G7 can simply met and decide what global currency exchange and major policy should be. No more.

    2. So, I think what happens now is “cautious” free market. Everybody is looking at their number, their national indicators, their reserve, and their trade pattern and see how far they can get away with it.

    in asia: the primary concern would be maintaining export lead growth.

    in the middle east: developing stabil economy beyond oil.

    China: We gonna do what we have to do. And we know we can do it.

    in europe: get away from US policy.

    SE: formation of free trade to counter china

    Russia: FU, US. We are back.

    Latin america: ditto. We are going left.

    As you can see, even taking a generalized trend, it’s extremely hard to predict the outcome.

    China for eg. will do combination of currency peg, devaluation, tax tuning, hidden bailout, etc. They know they have the momentum and cash to get out of this mess. THey also know how much they can get away with. (not to mention ability to control US dollar value, and US consumption pattern. Hence preparing for Taiwan reintegration)

    Another example: Vietnam. That little country is vicious. It’s Korea wannabe. That little country alone can flood the planet with cheap goods just like Korea or Taiwan. And they have the human power and capital to pull it off. They will starve to gain global marketshare if they have to.

    The rest of south east asia will ahve to go down that path too.

    So, now that we see excahnge rate/loan stabilizes, we are entering the competitive devaluation. Everybody in asia knows where their voting is.

    The market fight about to enter the next stage.

    It’s going to be VERY brutal to medium manufacturing in western world. Small machine, generic products, industrial feeds, etc will soon plummet.

  21. Anonymous

    btw, also,

    I wish people quit talking about “oh, export surplus, these poor people don’t consume”..bla bla..

    well that’s true for consumer product,

    but if you look at infrastructure, weapons spending, etc, they are all climbing …

    Russia and china’s weapon export to third world country are growing exponentially.

    My point, the so called trade imbalance only exist because everybody is thinking abotu real estate and cheap walmart toys.

    But nobody is talking about the poor country can’t get access to advance equipments and service (the only thing they need really, they can produce cheap crap better than anybody else)

    at this point , I for one say…fk it. The global market will rebalance itself and keep turning.

    SO the big question how will domestic economy will come out of this. (not so good, I think, because DC mindset still stuck in 80-90’s cold war G7 era. They don’t know how to navigate in complex world.)

  22. Juan

    neo-liberal/washington consensus ‘development’ model since the 1970s demanded trade liberalization and export orientation — this has been a multi-decade _global_ restructuring and one which has been intertwined what michael hudson termed ‘the treasury-bill standard’ (that boils down to dollar recycling into u.s. t-paper through the mediation of the different central banks); in effect rest of world has had little option but to finance u.s. bop deficits, a process that at the same time has been one of unequal exchange.

    given the relative undevelopment of internal markets, supranational support for and duration of the above structure, no one should imagine anything close to a smooth or simply financial/fx ‘rebalancing’, rather a uncontrollable and systemic fracturing.

  23. Waldo

    “rather a uncontrollable and systemic fracturing.”

    It might sound odd but systemic fracturing is a normal maturation process of a free market economy.

    I think the marketing industry is getting a real taste of this process due to the internet.

    The only dangerous aspect is that it is the “process” has been or will be accelerated due to the financial equilibrium we now are experiencing. Reminds me of the idea of electric cars and expensive hybrids being rational at $147/barrel of oil as compared to $38/barrel.

    Dangerous distortions are occuring and unnatural occurance we are experiencing and trying to explain. Good luck to all of us.

  24. Ken Stremsky

    “Hiding in the Shadows
    The Growth of the Underground Economy” is located at

    The less underground an economy is the more money that governments may obtain from sales taxes and income taxes.

    If the federal government wants to grow the economy and create jobs, it should stop taxing interest from savings accounts, dividends, capital gains, and estates.

  25. Steven Higgins

    The conflict could be ended pretty quickly. Simple solution.
    1) we finalize the $ amount for stimulus “2” let’s call it 900 Billion, then
    2) we send 80% of that directly as cash payments to the Chinese citizens
    Sincer most of it ends up over there anyway, we can get money in the hands of the final recipients with the least amount of red tape and time waster.

    Subprime and Alt A loans are what brought about our Real Estate Boom. So, just turn on the subprime and Alt-A loans, stop asking for Income documentation, and let the government guarantee the difference between the “stated” income and the “Liars Loan” income.
    I know Boulder Real Estate and Boulder Mortgages will certainly skyrocket!! :)
    Steve Higgins
    Boulder Loan Ranger

  26. Audio Tactics

    The more I think about the current situation, the more I think we are heading for a classic deflationary spiral.

    If demand is contracting all across the world, then prices need to fall. This will create advantages for low cost producers (China, Korea, etc.) and will put US businesses at an even greater disadvantage.

    It will also mean that in order to continue to compete, US businesses will have to export even more jobs to China, Korea etc.

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