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This Faustian bargain is too good to break

Author: Roger M. Kubarych
February 11, 2005
Council on Foreign Relations


It’s the oldest game in town: lend money to rich folks who don’t need it. That’s what the Asian people, through their governments, central banks, and financial institutions, have been doing these past few years. Since the beginning of 2002, they have lent something like $700 billion to the US—by purchasing debt obligations of the US Treasury, by acquiring housing-related securities of Fannie Mae and Freddie Mac, and by buying US corporate bonds. What did they get? A total return of perhaps about 6% per year.

They could have done better, a lot better. The same investment in euro-denominated government bonds would have yielded a return over 50%, an improvement of better than 12% a year.

But then the objective wasn’t entirely to display financial acumen. For the central banks and governments involved, it was to keep their currencies from strengthening too much against the dollar (or, in the case of China, to resist any and all market pressure for the renminbi to go up). That helped their exporters, already highly competitive in world markets both on price and quality, maintain that competitive advantage. During the period of heavy Asian official and quasi-official involvement in the foreign exchange markets, Japanese exports to the US grew by 12%; Korean exports climbed by 42%, Taiwanese by 18%. And Chinese exports to the US? Up 120%. Not bad.

Aiming for an export surplus by preventing timely foreign exchange rate adjustment, while squeezing domestic consumers, used to be called “mercantilism.” For a long time the policy was frowned against. But it is still being practiced, in amounts unimaginable even ten years ago and with nary an eyebrow raised against it.

What did the US get out of this Faustian bargain? Plenty of desirable rewards:

  • Lower inflation, because a high and rising level of imports and a strong dollar held down the prices of both imports and domestic goods that compete with imports.

  • Lower interest rates, because foreign purchases of US debt took the place of mediocre American demand for our own securities.

  • Cheap and abundant mortgage finance, letting the US homeowner and homebuyer increase mortgage debt by $2 billion, lifting the ratio to GDP from 66% to over 80%.

  • A strong housing market, both in terms of new construction and higher sales of both existing and freshly built homes.

  • A big injection of net worth, as home prices were driven up by eager buyers able to borrow cheaply and voluminously. In the first nine months of 2004 alone, owner equity in household real estate soared by $1 trillion, or a breath-taking 20% of total wage and salary income earned by American workers during that time.

Incidentally, a strong housing market certainly helped George W. Bush get reelected, the mirror image of 1992 when a weak housing market pushed many Republican voters to desert George H. W. Bush and embrace the maverick candidate H. Ross Perot, who got 20% of the total vote, allowing Bill Clinton to get elected with a minority of just 43%.

So what’s the problem? Unfortunately there are losers and they are concentrated in a few industries. Worst hit is the US motor vehicle industry. They are locked in a life-or-death struggle with Japan and Korea in which the persistence of a strong dollar against Asian currencies stacks the deck heavily against the US producers and their workers. The share of the domestic US market for the Big Three US automakers has sunk to under 60% today. Their stock market capitalization has also shrunk, and what’s left mainly reflects the franchise value of their finance subsidiaries. The car operations have regularly been making losses. Jobs are down throughout the car and part making sector. US manufacturing as a whole has lost about 2 million jobs during the period of the strong dollar and heavy Asian foreign currency market intervention. Not all of this is attributable to the exchange rate manipulation, but a good portion is.

But aren’t Americans as a whole better off with trillions of additional housing wealth compared to the relatively small magnitude of lowered stock market valuation of US manufacturers? Job losses in manufacturing are painful and inflict costs on government insurance programs and on affected communities. But there is plenty of evidence that the American economy is flexible enough to create more than enough jobs in the various service industries – in the fields of health and medical care, business services, home improvement and maintenance, retailing, and education, for instance -- to offset the declines in manufacturing employment. Many of these jobs don’t pay as well as in manufacturing but many pay more. The latest evidence is that the ratio of high wage to low wage jobs is back to its long-term average, with an improving trend over the past year or so.

In sum, today’s US economic outlook is pretty good, notwithstanding the record trade deficit the US is running. Real GDP growth is likely to rise in the range of 3% to 3 1/2% in 2005, far better than Europe or Japan. Inflation should stay below 3%, another positive indicator. Gradual tightening of monetary policy by the Federal Reserve is in the cards. But given how fully advertised that policy course has been, it is unlikely to spook the bond market very much. The stock market should generally do OK.

So what’s the threat? I’m always asked. A sudden shock to the housing market, I always answer. And what could cause that? A sharp rise in mortgage interest rates and an abrupt contraction in the availability of mortgage finance. And what could cause that? A sudden halt to the lavish purchases of US bonds by Asian public and private investors. And what could precipitate such self-destructive behavior? A variety of triggers, but especially if the US Congress loses patience with the burgeoning trade deficit. Prodded by local political pressures a coalition of Congressional Republicans and Democrats could force the Bush administration to abandon its tolerance of Asian currency market intervention and to start erecting trade restrictions instead.

Republican presidents have gone down that road before: Nixon in 1971, when he imposed an import surcharge, and Reagan in 1981, when he arm-twisted Japan into accepting so-called “voluntary” export restraints on auto exports to the US. This time the spotlight would inevitably focus on China, since China exports to the US every month over 5 times what it buys from the US. But all of Asia would feel the chill, and just the mere mention of the word “reciprocity” would send shock waves through the global financial markets.

The policy implication is that the Bush administration has to be careful, tactful, and maybe even a little humble. We like their products, we need their money, and the US economy needs a healthy housing market to sustain consumer confidence and a high level of consumption spending. Don’t blow it on the mistaken notion that a large and growing dependence on capital inflows from Asia is a grave threat to the US. The bigger threat is to try to change the current situation precipitously. Seeking to provoke economic and financial regime change in Asia would be a dangerously bad idea.

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