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Cyclical Endgame

The politics over the Renmimbi are increasingly about the outcome for the global economy claims Andy Xie in an interesting article on the Cyclical Endgame that came out just today. I believe this is the key idea: Pressure on China's Currency Is a Strategic Game.

The intensifying pressure on China to change its currency regime should be viewed in the context of the conflicting interests between China and the US on how the business cycle should end. If the Fed raises interest rates to lower the US current account deficit, China could enjoy relatively good growth rates at the bottom of the cycle, while the US could experience growth rates significantly below 3%. If China were to suffer a hard landing, the US could enjoy high growth rates at the bottom of the global economic cycle, as during the Asian Financial Crisis.

The following discussion on endgame scenarios is similar but not always identical to the views presented by Andy Xie. One way or another, the US current account deficit is not sustainable and there seems to be several ways to fix it. Let's look at some possibilities:

1) China has a hard landing right here, right now. That would help alleviate the pressure on oil, copper and other commodities as well as end the property boom in China. The Fed could then pause or perhaps cut interest rates. This would prolong the US housing bubble. In short, a hard landing for China would lower consumption costs for the US, boost US asset prices, and perhaps strengthen the US dollar as well. This scenario would be similar to the Asian Financial Crisis of 1997-98. The problem with this "solution" is twofold: It would add more fuel to asset bubbles in the US and it would support continued US consumption when the problem is clearly US over-consumption and too little savings. All in all, this is hardly in the US's long term best interest but as with "China Bashing" and nonsense tariff talk, no one here cares to look ahead. In addition to this not being in the long term interest of the US, a crash landing in China is certainly not in China's best interest now as it struggles to get its banking system in order.

2) The US could fix its current account deficit by raising interest rates, cutting consumption, and cutting government spending. Further hikes in interest rates in the US would cool the inflow of hot money into China. No doubt such actions by the US would lead to a US recession, sooner rather than later. These actions would also hurt Chinese exports but China's export prowess is not all that it appears to be. If you look under the hood at the details you will find that 62% of Chinese export growth over the past decade came from Chinese subsidiaries of multinational corporations headquartered elsewhere (Asia, Europe, and the US). Should the US attempt to solve the problem via tariffs, the US would inflict more damage on itself than China (both at the consumer level with higher prices and at the corporate profit level as well). Tariffs can readily be dismissed from any proposed solution.

3) The world goes on a buying spree of US goods and takes FED governor "Helicopter Drop" Ben Bernanke's message to heart that the problem is not with the US but with the rest of the world saving too much. I dismiss this solution as obviously absurd as well as unsustainable but include it for sake of completeness. After all, a FED governor was silly enough to suggest it.

It seems that everyone wants a soft landing. Given the global imbalances, I do not think a soft landing scenario is possible for either the US or China (or anyone else for that matter, especially the UK), but certainly not everyone simultaneously. The World's economy is just too FUBAR'ed for multiple miracle soft landings.

Unfortunately it is increasingly obvious that the US has no intention of fixing the problem where it should be fixed (cutting US consumption). Congress is increasingly aggressive in its China Bashing and we hear Snow talking nonsense about every other day about the RMB. The current goal of the US is to "fix" the problem by attempting to prod China into stupid actions that will cause an immediate and severe hard landing in China at the worst possible time for Chinese banks (a slowing worldwide economy). Long term I have no doubt that the US will be forced into saving more and consuming less and that enforcement mechanism will be a housing slump followed by a severe recession.

In the meantime, it remains to be seen if China can be goaded into foolish actions. If for some reason China succumbs to US pressure and it causes another Asian Currency Crisis that benefits the US short-term, the repercussions down the road for the US will be more severe than if we just pay the piper and let the economic cycle take care of itself right here right now. The best course of action for China is to stall, hoping that a sustained slowdown in the US cuts US consumption to more manageable levels. Prolonging US asset bubbles is not in anyone's best interests. We are in this mess in the first place because Greenspan and the FED thought they could "beat the cycle" and "stimulate jobs" with 1% interest rates. The FED did not "beat the cycle" and certainly did not produce any jobs to speak of either. Further attempts to "beat the cycle" would just add more fat to the US consumer debt problem.

China should call the US's bluff, stand pat, and let the cycle play itself out. Exhaustion will eventually get the US housing bubble if these repeated hikes from the FED do not get take their toll first. Once housing goes the US will quickly fall into a recession, and that will be that. It's always taken a recession to cure global mal-investments of this order and this time will not be different. The best long-term solution is the one that no one seems willing to accept: A hard US consumer-led recession right now.

It seems increasingly likely to me that the choice is not recession now or recession later, but recession now or depression later.

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