Sunday, December 4, 2011

Time for Redemption: Don't Blame The Oriental Land

This article of mine was published in Hindu Business Line on November 19 ( link ) , posting it here on the blog with some additions.

The world is steadily but surely moving towards an era of trade wars and protectionism. With the controversial bill to punish China over its currency having been approved by the Senate, the Sino-US tensions have moved up by a few notches.

When there is dis-illusionment among the masses and the protestors are on the streets it’s rather easy to put the blame for one’s precarious state of affairs on a distant foregin land and it’s government.

The reality is that it’s not the Chinese policies but the policies of the US itself that has been responsible the nations huge indebtedness, joblessness and high Current Account Deficits.

Ever since 1980s the US financial sector has been in trouble for some reason or the other, be it the tequilla crisis, LTCM, Asian crisis, the subprime crisis and now ofcourse the sovereign debt crisis and everytime the response of the US government (infact most Western governments for that matter) has been pretty predictable; transferring of the bank’s bad debts onto its own balance sheet thereby increasing the soveregin debt load and the Central Bank happily monetizing a part of it.

The problem with money printing and issuing sovereign guarantees is that it never increases the wealth of the society; money is a store of value for an individual but for the society as a whole it is just a medium to transfer wealth from one person to the other or more broadly from one sector of the economy to another. As a result of the government’s and Central Bank’s fire fighting exercises over the  last three decades, everytime the financial sector was saved capital was transferred from the manufacturing and other prodcutive sectors of the US economy and given to the financial sector.

Chart a

Chart b

 As one can see from the graphs above; that thanks to the government bailouts and Fed money printing the bloated financial sector sucked resources from every other sector of the economy specially the manufacturing sector. Even here a large part of what is actually accounted for as the contribution of financial sector to the US GDP is the non productive activity of flipping around assets and derivatives and generating a fee income. One can only fathom of the numbers considering the 700 trillion dollars market with a daily turnover of as much as 40 trillion (globally). As also seen from the graph, for all the GDP contribution that the financial sector makes to the US economy its contribution to job creation has been paltry to say the least.

Had all these dollars that were generated to save the defunct financial sector botteled up inside the US, the CPI levels would have exploded; instead it was because the Oriental land came to its rescue by happily servicing the US citizens with cheaper goods due to its lower labour cost and cheaper currency that the US was able to maintain its mojo.

The symbiotic relationship wherein the Chinese sold their goods and services for US dollar and then recycycled them back to US by buying up the treasury bonds is what gave the US government the ability to run its various social welfare programs and ofcourse save the banks every now and then.

Chart c
As can be seen from the graph, post 2007 with the bailouts having become bigger, the fiscal deficits have outgrown the Current Account Deficits forcing the Fed to intervene with it’s massive QE programs.

It’s not the weaker Chinese yuan that is the reason for US woes, the trouble lies with the government and the Fed “Put” on the US financial sector that has led to serious mis-allocation of capital. Infact the only reason why the bloated financial sector which has taken away the productive jobs but has still not managed to completely take away the purchasing power from the US citizens thereby draining the vitality of the average US household is because of the cheaper Chinese goods for which the cheaper yuan has a big role to play.

A bill in the US senate is required to be passed, but not against the Chinese currency manipulation rather against the Fed and government’s policy towards what they term as “Too Big To Fail”.


Jagdish said...

Great article Himanshu!
I have a couple of questions regarding US:
1) even after a lot of money printing (QE), inflation has not seemed to increase significantly. What is the reason ? (increasing population, stabilizing housing, money outflow)
2) When will the exponentially rising sovereign debt going to be a problem ?

Stochastic Process said...

Hey Jagdish,

Firstly, the metrics they use for inflation is tempered using some subjective modifications. For e.g. let's say the cost of IPAD2 is same as that of then IPAD1, the BLS (agency that calculates the inflation numbers) would assume that since IPAD2 is better than IPAD1 so even though the cost is same but adjusting for the technological advancement it is cheaper. Why they do this.. well because social security is linked to the inflation rate.
So inflation is certainly higher than they report but yes not exorbitantly high the reason is that the dollars that they print go to China(and other countries)to pay for the imports. The Chinese then in order to peg their exchange rate recycle them back to US and buy up their treasuries. So the money supply created is going into financial assets and not in real economy as of now.

The answer to your second question is difficult, however as a general observation from history.. whenever the government debt exceeds 5 times its revenues even a couple of percentage movement in interest rates can lead to a sovereign debt problem. So by this count not only countries of Europe but also Japan, US, UK are in that zone. Probably Europe is the start and then from there this problem goes to these other countries as historically sovereign defaults have occured in clusters. BTW, sovereign debt situation in India is also not very good.. the only thing that was/is saving it has/had been high growth rate.

Jagdish said...

Thanks for the great answers !