By Chan Akya
Mark Twain quipped that the lack of money is the root of all evil. Humans are irrational, but societies are rarely so, until they choose to become extinct. Understanding the economic factors underpinning society helps us to appreciate the process of change better than an independent evaluation of all else.
In past articles, I have shown the impact of economic incentives in addressing terrorism, [1, 2] as a determinant of foreign policy [3] and as a guide to reconstruction [4]. An over-reliance on other factors, such as religion, human emotions, politics, nationalism, makes for interesting debate but usually ends up as an exercise in romanticism.
The success and decline of religions, as well as the failure of political systems such as communism, all hark back to economic factors. The ability to feed and care for adherents has too often been mistaken for spiritual success, in much the same way that religion can be blamed for entrenched inequality and poverty - for example, by its role in maintaining social strictures that in essence allowed vested interests to flourish in various countries. Communism collapsed not because it is a bad idea per se, but because the idea is inconsistent with cold economic realities.
Oldest profession
Even in the most basic of human activities, economic rationale rules. Women choose men based on their ability to provide economic security for their offspring and themselves. Men in turn choose women based on their own status in society, getting the women that best represent their position. This is why some old, rich men are with nubile members of the opposite sex. At the social level, this translates into a definition of success that allows many humans to make rational choices. In this environment, both men and women may choose alternative lifestyles when they fail to make the grade in their own societies.
Thus it is that the brothels of Manila are sustained by middle-class Westerners, most of whom are in effect frozen out of acceptable choices back home. Similarly, as evidenced during the rapid decline of the Soviet Union, a number of women failed to secure mates with adequate prospects for providing security. They were thus forced to accept alternative sources of sustenance, more popularly referred to as the world's oldest profession, although other types of the same business - mail-order brides, for example - also became common.
In turn, the observation that a society has failed when it exports its women as whores stands true, albeit for economic rather than any patently nationalist reasons. Whores get all the attention; a wider failure of Russia and the Eastern European countries is apparent from the number of maids, nurses and other menial laborers who have become available for the world economy.
What then can we make of the armies of people who are willing to sacrifice their lives in the name of religion? While an initial explanation can be found in the habitual irrationality of human behavior, one can also discern variations on the theme. American philosopher Abraham Maslow's hierarchy of needs explains much about what human beings hanker after, and suggests that more prosperous humans are likely to turn to more irrational pursuits. Perhaps this explains why most religious leaders I have encountered are corpulent - and this is an easy test for most of you. Think of your religious leaders, irrespective of which cloth they adhere to, and compare that mental picture with the social average.
That is not the full answer, though - as I observed elsewhere, many people turn to extremist political organizations such as the Maoists and al-Qaeda simply because of an absence of any economic opportunities. It is a proven fact that poor people are more easily radicalized than rich ones, for the simple reason that convincing people with nothing to lose that there is a potential upside to even the most hare-brained ideas is easier.
Extremist organizations are thought to compensate the families of suicide bombers, while Hezbollah even compensates its support base for material losses such as property in a bid to retain its popularity.
Social is economic
The relative prosperity of some against the deprivation of others has always provided grounds for human introspection. Social structures that evolved from such introspection have allowed the maintenance of vested economic interests. In ancient China, the Confucian ethic of subjecting one to a greater good reigned supreme.
It forced individuals to accept the jobs thrust upon them by society and, by denying opportunities for self-maximization, allowed the maintenance of the status quo. Even so, a number of regime changes effected through the history of China were at the behest of economic interest groups, in particular the trading community. Any emperor who could not guarantee safety and security for traders, or who dared to collect excessive taxes, found himself at the sharp end of a sword soon enough.
In India, introspection on the economic gaps gave rise to the much-reviled caste system. As a way of imposing fatalism on right-thinking individuals, the caste system is without parallel. It subjugated millions in the name of sins committed in a vague past life, with promises for advancement in the next. In effect, it served to keep the peasants quiet and acquiescent, and rarely changed in form until modern India became independent in the 20th century. Conquerors from other religions, including Islam and Christianity, simply failed to end the excesses of the caste system despite ruling India. The only reason for their reticence was economic, not religious.
Overestimating religion
Perhaps the greatest failure for the young and the romantic is to overestimate the power of religion in shaping society. Throughout history, religions have depended on the economic success of their societies, and indeed often claimed credit for prosperity as a way to expand the numbers of the faithful. Some of the first religious regime changes in the world came about in India, when Buddhism supplanted Hinduism as the religion of state, after its adoption by the Emperor Ashok.
It spread to the rest of Asia by trade rather than theological means, as traders paying taxes to Indian emperors slowly converted to Buddhism. In turn, they spread the religion for a purely selfish reason, as a way of enhancing the common interests that could help to avoid a trader cheating another. As you couldn't Google your prospective counterpart to check his reliability, the alternative "club membership" became religion. For much the same reasons, the caste system has continued to flourish in India despite a series of conquests by non-Hindu forces.
Away from Asia, the progress of Abrahamic religions depended on similar economic rationale. Bertrand Russell, writing about the adoption of Christianity by Constantine, notes:
The support of the Christians, as a single organized bloc, was to be obtained by favoring them. Whatever dislike of the Christians existed was unorganized and politically ineffective. Probably [Michael] Rostovtseff is right in holding that a large part of the army was Christian, and that this was what most influenced Constantine. However that may be, the Christians, while still a minority, had a kind of organization which was then new, though now common, and which gave them all the political influence of a pressure group to which no other pressure groups are opposed. This was the natural consequence of their virtual monopoly of zeal, and their zeal was an inheritance from the Jews.
In essence, the thrust of the argument is that the Emperor Constantine needed the Christians for his own selfish interests. Their unitary organization made it easier for him to implement social and economic changes, which helped to solidify his control over the Roman Empire, finally pushing his rival Licinius, whose persecution of the Christians sparked a revolt, into abdicating. Among his various reforms was the introduction of hereditary professions such as butchers and bakers, a nod to economic interests if there ever was one.
A few hundred years later, Islam's initial expansion was in turn fueled by a change of circumstances for the otherwise nomadic desert-dwelling Bedouin tribes. Joining up with Islamic armies was a way of employment, and offered an escape from the dreadful poverty of roaming around the desert looking for means of sustenance. Military successes provided access to trading wealth, and therefore enhanced prosperity at a stroke, in turn allowing the adoption of Islam as a self-fulfilling rationale. In modern times, increased prosperity in Saudi Arabia and Iran have allowed those countries to fund pet projects elsewhere, designed to further their own economic interests in the long run.
Civilizations and economics
Abrahamic religions, during their expansionary phase, always used their supposed superiority as an excuse for inflicting ills on their conquests. This was simply an extension of the rationale used for the caste system, in that people with better economic prospects just happened to have been born with an unfair advantage of belonging to the right caste, cult or religion. From a social perspective, religion certainly provided an answer for expanding economic girth.
As societies moved from addressing basic needs such as food and shelter to greater living standards, questions on the treatment of other human beings were common enough. In such cases, the overriding principle was to castigate the victims for following barbaric practices, or worshipping the wrong god. Thus, it could be explained, the essential role of the British in India was to convert the "copper-colored pagans" to Christianity, even if in practice the colonial authorities were more interested in plundering the country's wealth.
Within British society itself, greater economic prosperity was the greatest factor in helping to implement social changes. Despite laws outlawing slavery from many hundred years before, the practice flourished until the middle of the 18th century. The ability of society to outlaw the practice was greatly helped by the Industrial Revolution, which replaced human input with machines, allowing for an expansion in production without more costly manual and animal labor. In much the same way, the agrarian US south resisted the demands of the industrial Yankee north to end slavery, not because of religious or racist tendencies, but because the economics of their situation demanded the continued use of slaves.
Equally, enough industrialists in the north opposed the abolitionist movement because of its potential to affect their economic well-being. The history of civil rights in the US since then has depended much on continued economic growth. Universal suffrage both for women and for blacks was implemented under economic conditions that risked adverse results if the peace was not secured by implementing reforms.
If successful civilizations can be explained by economics, so can failures. A recent example is the collapse of support for the Taliban in Afghanistan in the 2000-01 period, well before the US invasion. The most important reason for the population to move toward the Taliban in the first place was the Afghan civil war in the 1992-96 period that pushed Afghans deeper into poverty. Thus their embrace of the Taliban was more about ensuring economic security than adopting strict religious practices. In the event, the Taliban failed to improve the lot of the average Afghan, because of their stubborn insistence on adopting Wahhabi practices such as severe restrictions on the role of women.
Such practices were all too common in Saudi Arabia, the main sponsor of the Taliban, but only because Saudi society did not need its women to work. The reliance on oil wealth rather than manufacturing allowed Saudi society to emerge as a classic closed one, but clearly its export to more open economies was not possible. Thus the trade-dependent Afghans simply could not afford the Taliban-inspired practices, inspiring support for anti-Taliban fighters. Tellingly, it is in urban areas such as Kabul and Jalalabad that the Taliban were first ousted, as cities have more diverse economies than the rural landscape.
So ...
I am confident that China will embrace political reforms, and India will greatly enhance its social reforms, simply because the supporting economic-growth rationale exists in both cases. Equally, I despair at the prospects for most Muslim countries because the absence of economic growth vastly increases the chances of their populations being radicalized, in turn pushing these societies deeper into poverty.
Peace, love and goodwill to all men; bah humbug. Show me the money, honey.
Notes
1. A capital alternative to terror, Asia Times Online, October 21.
2. Love your children, those little terrors, Asia Times Online, November 4.
3. Garfield with guns, Asia Times Online, September 2.
4. Economics and Bamiyan, Asia Times Online, December 9.
Friday, December 22, 2006
Thursday, December 14, 2006
Paulson, China and the turmoil beneath
By Henry C K Liu
US Treasury Secretary Henry Paulson, an expert on China with more than 70 business trips there as a private banker, is in China with six other cabinet members and the chairman of the Federal Reserve, Ben Bernanke, to discuss US-China trade relations.
The venue is the first meeting of a newly created semi-annual Strategic Economic Dialogue. Reflecting the growing relationship between the US and Chinese economies, this dialogue will occur at the highest official levels and is the first of its kind. It will provide an overarching framework for ongoing productive bilateral economic dialogues and future economic relations. It will examine long-term strategic issues, as well as provide coordination among the specialized continuing dialogues. The Strategic Economic Dialogue will also be a forum for discussing ways the United States and China can work together to address economic challenges and opportunities as responsible stakeholders in the international economic system.
The underlying issues
There is much that is dysfunctional and unsustainable in US-China economic relations. The unhappy situation is the natural result of inequitable terms of trade that have evolved over two decades, beginning with China's economic opening to the outside world in Deng Xiaoping's reform policy introduced in 1978. Since the end of World War II, the US has conducted foreign economic and trade policies on the basis that trade with the US is a favor the rich US economy grants to the poorer economies.
The conditions that render such an attitude operative have changed as the US, in an interdependent global economy, has become addicted to low-price imports to fuel its loose monetary policy based on dollar hegemony. The US economy now is dependent on foreign trade as much as, if not more than, the exporting economies. Victims of addiction are usually not in any position to dictate the terms of supply.
Trade deficit is in US national interest
A case can be made, although few in the United States are intellectually honest enough or politically courageous enough to make it, that a rising trade deficit is in the US national interest, just as a strong dollar is in the US national interest.
Dollar hegemony, a term that describes the effect of the US dollar, a fiat currency, assuming the unmerited role of the key reserve currency for international trade, enables the US to use its capital account surplus to fund its trade deficit. For this reason, a balanced trade with the rest of the world would dry up the capital account surplus and create serious structural problem for the US financial system that needs US$3 billion of net capital inflow a day to keep afloat.
Many in the US fear a new threat to the sustainability of US hegemony emerging in the form of excessive dependence on foreign capital and growing foreign debt. Former treasury secretary Lawrence Summers of the Bill Clinton administration observed that "there is something odd about the world's greatest power being the world's greatest debtor".
Actually, what is odd is US foreign debt being denominated in dollars, a fiat currency that the US and only the US can print at will. The United States is the only nation in the world whose foreign debt is denominated in its own currency. In that sense, the US has no real foreign debt as all its debts are sovereign debts payable in currency it can issue at will. The term "foreign debt" usually means debt denominated in foreign currencies. Such debts require the backing of adequate foreign reserves because the debtor governments cannot print foreign currencies and are therefore subject to risks of default on foreign currency loans. Foreign debts for the US, as they are denominated in dollars, are only sovereign debts held by foreigners. If foreigners holding US sovereign debt want to cash them in, the US can print as many dollars as it needs to satisfy them.
Therefore the US does not face risks of default on its foreign debts. This is what makes US sovereign debts relatively safe investments, as sovereign debts are not exposed to default risk, only foreign-exchange risk. The key behind the intrinsic value of the dollar is that dollars, and only dollars, are accepted by the US government for payment of taxes and all other governmental receipts. These characteristics, known as the State Theory of Money, make the dollar a political instrument exempted from rules that govern financial instruments.
A new approach to China
After his first major speech that signaled a new US economic approach to China, Paulson told the Financial Times on the eve of his first trip to China as treasury secretary (on September 22) that his message to China was: "We want you to succeed." Paulson said: "The United States has a huge stake in a prosperous, stable China - a China able and willing to play its part as a global economic leader." He said the US and China shared areas of economic interest, highlighting energy and the environment as two specific areas where the two nations should work together.
No doubt Paulson is sincere when he says what he recommends for China is in China's own interest within the context of neo-liberal ideology. Yet Paulson's formula for China is that the US wants China to succeed only on US terms. Paulson's approach is based on the assumption that neo-liberal economic reforms in China are "necessary to sustain its growth" despite heated policy debate now raging in Chinese policy circles on the desirability of such modes of growth. Paulson wants China to open up Chinese capital markets for "healthy competition" within the domestic financial system, so China can have a currency that is "freely tradable", despite a history of financial crises that befell economies with freely tradable currencies in recent decades.
Paulson warns Chinese officials that they underestimate - "at China's own peril" - the extent to which the currency issue is "viewed by their critics as a symbol of unfair competition", even though his own expert opinion differs from those held by such uninformed critics. Yet if such critical complaints are substantively groundless, any appeasement on them will only lead to further absurd demands to perpetuate their anti-China agenda, amounting to "if it's not one thing, it would be another". Free traders, of whom Paulson is one, should not tolerate political bias interfering with free trade.
Paulson calls on China to press ahead with liberalization across a broad front, including financial-sector reform, fiscal and regulatory policies to reduce excess savings, market-based macroeconomic management and enforcement of intellectual-property rights. "We are taking a comprehensive approach," he said. "We are collectively pulling it together." Paulson said China had become a lightning rod for fears about globalization, but insisted it is "manageable".
Paulson's neo-liberal message is music to some in China, particularly his fans in Tsinghua University, the bastion of neo-liberal supply-side economics in that country. These reformers would like to see US political pressure push the Chinese economy more toward capitalistic market economy, at a time when Rubinomics, a set of policies named after Robert Rubin, treasury secretary under Clinton, is forced on to the defensive by rising economic populism in the US and around the world. Chinese reformers are similarly put on the defensive by glaring defects of their export dominated economic policy, in the form of worsening income disparity, life-threatening environmental pollution, economic and developmental imbalances, erosion of national spirit and, worst of all, systemic corruption. China is not about to drive its economy further down any road that leads to an economic equivalent of a dangerous cliff merely to appease US ideological displeasure.
Chinese socialism
In an interview with US television journalist Mike Wallace on September 2, 1986, Deng Xiaoping, the architect of China's market reforms and opening-up policies, responded to a question on corruption and other obstacles to foreigners doing business in China:
Deng: I am aware of these things. They do exist. As we are new to doing business with the West, it is inevitable that we shall make some mistakes. I do understand the complaints of foreign investors. No one would come here and invest unless he got a return on his investment. We are taking effective measures to change the present state of affairs. I believe that these problems can be solved gradually. But when they are solved, new problems will arise and they, too, should be solved. As leaders, we have to get a clear picture of the problems and work out measures to solve them. There is also the question of educating the cadres.
Wallace: To get rich is glorious. That declaration by Chinese leaders to their people surprises many in the capitalist world. What does that have to do with communism?
Deng: We went through the Cultural Revolution. During the Cultural Revolution there was a view that poor communism was preferable to rich capitalism. After I resumed office in the central leadership in 1974 and 1975, I criticized that view. Because I did so, I was brought down again. Of course, there were other reasons too. I said to them that there was no such thing as poor communism. According to Marxism, communist society is based on material abundance. Only when there is material abundance can the principle of a communist society - that is, "from each according to his ability, to each according to his needs" - be applied. Socialism is the first stage of communism. Of course, it covers a very long historical period. The main task in the socialist stage is to develop the productive forces, keep increasing the material wealth of society, steadily improve the life of the people and create material conditions for the advent of a communist society ... There can be no communism with pauperism, or socialism with pauperism. So to get rich is no sin. However, what we mean by getting rich is different from what you mean. Wealth in a socialist society belongs to the people. To get rich in a socialist society means prosperity for the entire people. The principles of socialism are: first, development of production, and second, common prosperity. We permit some people and some regions to become prosperous first, for the purpose of achieving common prosperity faster. That is why our policy will not lead to polarization, to a situation where the rich get richer while the poor get poorer. To be frank, we shall not permit the emergence of a new bourgeoisie.
Deng's view of a socialist market economy during the transition phase from socialism to communism is still the national purpose of the People's Republic, despite the fact that Chinese economic policy has veered off course from Deng's original vision for the decade after the Tiananmen incident in 1989. The current leadership is moving to put economic policy back on the socialist path and to rein in the excesses of market economy and address the imbalances of development approaches that emphasize quantitative over qualitative performance.
China's 11th Five-Year Plan, the roadmap for the country's development in the next five years, will bring revolutionary changes, moving from the "get rich first" phase to the "common prosperity" phase so as to bridge the growing income and wealth disparity that threatens to polarize of society. That is a historic adjustment to the pattern of five-year plans since China changed its approach to economic and social development in the 1970s.
More than two decades after Deng's reform and opening-up policy, the per capita gross domestic product (GDP) had risen to only $1,700 in 2005 and is expected to reach only $3,000 in 2020. Even with a purchasing power parity of 4:1, Chinese 2005 per capita GDP was $6,800, still substantially below the US 2005 per capita GDP of $35,000. China is still, and will continue to be, a poor, developing country notwithstanding all the glister of highrise apartment towers and office skyscrapers in Shanghai.
China's rapid economic growth has also engendered new socio-political problems. The lowest-income families, comprising the bottom 10% of all families, owns less than 2% of all the private assets in the economy, while the highest-income families, or the top 10% of all the families, own over 40%. Chinese leaders have warned against extremes of poverty and wealth, rising unemployment and intensifying social conflict. "Common prosperity is not an unreachable goal, but the basic principle and pursuit of socialism," said President Hu Jintao.
The 11th Five-Year Plan recognizes that the single-minded quest for economic growth does not necessarily lead to sustainable economic development, and rejects unbalanced quantitative growth as the goal of development, putting importance instead on improvements in the quality of life. Chinese leaders have of late repeatedly criticized flawed concepts of economic growth, asserting that that the doctrine of "economic development as a focus" should not be misinterpreted as "speed at all costs". In the 11th Five-Year Plan, economic growth will be measured by "serving the people to improve their life quality", rather than GDP readings.
Foreign trade now accounts for more than 70% of China's economy as compared with 24% in the US economy. Frequent trade friction with China's trade partners have imposed high costs on the Chinese economy. China has become a major consumer of energy resources. International energy institutions predict that from 2002 to 2030 about 21% of the world's new demand for energy resources will come from China. In 2004, nearly 50% of the petroleum used in China was imported to feed the export sector. When it comes to energy consumption, China is merely the kitchen; the dining room is in the US.
Chinese planners are working to change the country's heavy reliance on foreign investment and resources to secure its national economy through energy and capital independence in the next five years.
The problem of social security is particularly serious in the countryside, where the medical-care system and welfare have been neglected and allowed to deteriorate in the past two decades. During the period from 1993 to 2003, the number of people with no access to medical insurance in the country increased from 900 million to 1 billion, with the percentage rising from 67.8% to 80.7%. The number in the urban areas rose from 96.53 million in 1993 to 300 million in 2003. And this is an economy that holds $1 trillion in foreign reserves.
In the next five years, China will place more emphasis on science and technology, education and health care in policy and investment. All rural children are expected to enjoy nine years of free education before 2010, which will reduce farmers' economic burden by 100 billion yuan ($12.37 billion) every year. The poor and the weak will get more protection and have improved access to social welfare. In all these policy objectives of socio-economic development, neo-liberal market fundamentalism has very little to contribute.
China trade is not unfair to US
Objectively, the case that Chinese trade with the US is unfair or damaging to the US is very weak. The fact is that the terms of US-China trade favors the US more than it does China. The US trade deficit with its flip-side capital account surplus does more for the US economy than for the Chinese economy.
Conventional wisdom mistakenly suggests that the US economy rests precariously on an unsustainable accumulation of debt, particularly foreign debt. Fueled by government profligacy and low private savings rates, the current account deficit and fiscal deficit, the US has become the world's largest debtor nation. But the US is a debtor nation with a difference, for all its debts are denominated in its own currency which the US can print at will.
The current-account deficit is created by the difference between what US residents spend on imports and what they earn from exports in a given year. This deficit now stands at almost 7% of GDP. Total net foreign liabilities are now approaching 25% of GDP. And China is now the top trade-surplus partner of the US as well as the top creditor to the US. While this means China has been shipping real wealth in the form of goods to the US in exchange for US dollars it cannot use at home, there is much talk among fear-mongering pundits and politicians of the danger of sudden unwillingness by investors abroad (read Chinese) to continue adding to their already large dollar assets. In this scenario, a panic will cause the dollar to sink, dollar interest rates to skyrocket, and the US economy to descend into crisis, dragging the rest of the world down with it.
But the prospect that this scenario will actually come to pass is nil. This is because economists fail to understand that the dollar, since was taken off gold backing, is no longer a financial instrument subject to market laws of supply and demand. Under dollar hegemony, the dollar is really a political instrument. When viewed as a political instrument, everything that Larry Summers considered odd about the dollar falls in place logically.
As long as the US is the world's dominant power and the US economy is the world's dominant economy in terms of both size and focus, and the dollar remains the key reserve currency for world trade, all other currencies are merely derivatives of the dollar. Derivatives contracts profit or lose with volatility, but such volatility does not threaten the dollar. The dollar will rise and fall within a range from its benchmark exchange rate, which is the rate the market has come to accept as normal at any given time.
Volatility in exchange rates is caused by complex factors, mostly technical, while the fundamentals of dollar hegemony anchor the dollar's base rate. The base rate changes only slowly over the long term, rising according to the quantity theory of money as related to the size of the world economy. When the world's debt and commodities are denominated in dollars that only the US can print, the US in essence owns all the financial wealth of the world. Foreign-held dollars are mere accounting technicalities of little real macro-consequence. In fact, the more dollars a foreigner holds, the more he/she becomes American. When China holds more than $1 trillion in foreign reserves, it is moving closer to become a US financial colony.
For those who spend dollars in their daily activities, such as US residents or most US transnational corporations, the exchange rate of the dollar is of little fundamental relevance. If import prices rise because of a fall in the dollar exchange rate, the Federal Reserve, the US central bank, will view it as inflation and raise dollar interest rates in response, thus pushing the exchange value of the dollar back up. The exporting economies will then devalue their currencies to reset the price of their exports in dollar terms, or subsidize it by other means such as lower wages from higher unemployment, or rebates of export taxes. This game goes on until fatigue sets in to stabilize the benchmark exchange rate.
US tax revenue is immune to fluctuations in changes in dollar exchange rates because it is denominated in dollars. US fiscal spending is also immune because it is also denominated in dollars. With a falling dollar, US imports prices will rise, forcing more purchases of domestically produced goods by US consumers and more US exports. But even the current account is immune because it is settled in dollars. What will happen is that the face value of the deficit will not change, only the actual volume of goods bought and sold will change. A fall in the current account deficit only means less dollars leaving the US as debt and less dollars returning as capital. As long as US geopolitical hegemony keep all key commodities denominated in dollars, no one who participates in the global economy can escape the dollar, much less dump it.
The US economy is being held up by dollar asset appreciation, which allows higher debt without changing the debt-to-equity ratio. There is a torrent of dollar creation by the Fed, but mostly by the growth of derivatives. This causes three phenomena:
1. More dollars to fund mergers and acquisitions, which, with increasingly lame antitrust regulation, create more efficient monopolies in the short term.
2. More dollar equity available to companies to enable them to carry more debt for expansion, which makes even distressed companies look temporarily healthy. 3. More dollars for investing outside the US to fund low-cost exports to the US.
As long as interest rates, the cost of the use of money within a time period, are lower than the rate of return on capital, the economy will expand by taking on debt. Consequently, corporate earnings will look strong as long as US consumers are willing to take on more debt, collateralized by the rising value of their assets, to keep consuming.
China has a problem with its export economy. It earns dollar income from its export sector but has yuan expenses in its domestic market. When the export sector dominates the Chinese economy, China is in essence shipping wealth to the US in exchange for a currency it cannot use at home. China has accumulated $1 trillion in foreign reserves, equivalent to its annual GDP, yet it does not have enough yuan-denominated money to alleviate widespread poverty, or to fund its social security obligation, or to pay for environmental restoration. A falling dollar will make China poorer because its income from trade is in dollars and its expenses at home are in yuan. This condition will remain until China requires payment for its exports in yuan and not in dollars.
All the factor inputs to the Chinese export sector are imported: capital, loans, energy, technology, design, machine tools, production lines, packaging, paper cartons, marketing, transportation and distribution systems. To its export sector China contributes only two underpriced factor inputs: labor and environmental pollution. Profits to China from the Chinese export sector come entirely from low wages and hidden-cost pollution. For the past few years China has been holding back its GDP by more than $200 billion every year, sending the earnings to finance US trade deficits, earnings from slave wages and toxic pollution.
What China needs is to reduce its dollar income and shift that income to yuan by selling more of its products in the domestic market. But the entire neo-liberal globalized trade is built on all exporting economies thinking that earning foreign exchange is a good thing.
In the US, the decline of labor and environmental inputs has been compensated by the increased use of variable inputs and capital. Debt enters into the US financial system from China and is re-exported as capital back to China. As for oil consumption, domestic consumption is 90% supplied from domestic sources. In China, imported oil feeds the export sector.
There is no way for China to diversify its foreign currency from dollar assets. The most China can do is slow the growth of its dollar holdings by cutting exports. Allotting new Chinese trade surpluses to other non-dollar currencies is merely enlarging the volume of dollar derivatives, an exercise in circular circuitry.
What China needs to do
What China needs to do is to keep export to the US at the same level as imports from the US. This is easily done. Every three months, as soon as exports to the US exceed import levels, exports are stopped until imports from the US catch up. No trade surplus, no new dollar foreign-exchange holdings. The surplus production is then sold in the domestic market to earn yuan revenue which then is recirculated as higher wages to sustain domestic purchasing power. Sovereign credit is used to finance the time gap between rising wages and domestic consumption and between corporate sales and rising employment to sustain full employment.
This will move the trade surplus/exchange rate monkey from China's back to the United States' back. Prices in the US will rise from a shortage of supply and dollar interest rates will rise to fight inflation. The Strategic Economic Dialogue team from Washington will beg China to stop this rational nonsense, and tell Senators Charles Schumer and Lindsey Graham, who are threatening legislation that would slap a 27.5% tariff on Chinese imports unless China allows the yuan to appreciate significantly (by 20%), to go fishing.
Trade is a game of market power. The US needs to recognize that the scale of market power is tilting toward China's side and that the US cannot make hegemonic demands from a position of weakness. The solution to the US trade dilemma lies in a reordering of US trade policy, not on the exchange value of the Chinese currency.
US geopolitical hegemony rests on an economy that is continually extending its lead in the innovation and application of new technology. It does not rest on what another country does nor does not do. The fact of the matter is that regardless of crybaby complaints of unfair Chinese trade practices, US-China trade still benefits the US more than it does China. A halt in US-China trade will do more damage to the US than to China. The dollar's role as the global monetary standard is not threatened, and the risk to US financial stability posed by large foreign liabilities are exaggerated. The US economy will adjust to a decline in the dollar and a rise in interest rates that will slow the growth of US consumption and retard its standard of living, but it will not fatally undermine the US economy.
The dislocations and inequities in the US economy both at home and overseas are caused by dollar hegemony, not by any foreign government trade policy. There is a mismatch between the democratic process in US politics and the dislocation in the US economy created by US-led globalization which no amount of China bashing can resolve.
Net international investment position
US external liabilities are denominated in its own currency, which remains the key global monetary standard. The net international investment position (NIIP), the value of foreign assets owned by US residents minus the value of US assets owned by non-residents, peaked at almost 13% of GDP in 1980. Up until 1989, the US was a creditor nation. But chronic current-account and fiscal deficits since then have given the United States the largest net liabilities in world history.
At the start of 2004, foreign claims on the US of $10.5 trillion exceeded US claims of $7.9 trillion abroad, with a negative NIIP of $2.6 trillion. In 2005, US NIIP was a negative $2.7 trillion or 21% of GDP, an increase of $333 billion over the previous year, or 21.6% of GDP. The largest share of this debt is in the form of foreigners holding US sovereign debt. Foreign holdings of US government securities reached $2.4 trillion in 2005, an increase of $215 billion compared to the previous year. The purchases of US government securities by foreign investors financed two-thirds of the increase in the net US international liabilities during 2005.
US interest payments on this massive debt held by foreigners and to foreign holders of US assets means that less money will be spent in the US. Annual US interest payments on that debt rose to $114 billion, which exceeded President George W Bush's proposed budget for education, training, employment, and social services in 2007 of $86 billion. Normally, these debt payments are the Achilles' heel of vulnerability as affected by any rise in interest rates. But what do foreign interest earners do with their dollar interest revenue? They reinvest it in more dollar assets, providing funds for US investors to buy foreign assets. A reduction in the US deficit will upset this circle of cash flow and cause financial problems in the US that can quickly translate into political problems for the sitting administration.
As a rule, a current account deficit, the broadest measure of the balance of trade in goods and services, must be financed through the sale of US assets to foreign investors and lenders. However, the $333 billion increase in the net US liability position in 2005 to a negative $792 billion was considerably smaller than the current account deficit of $210 billion for the year, largely because of a substantial increase in the value of foreign assets held by US investors. The market value of foreign stocks held by domestic investors alone increased $384 billion in 2005, much more than the $69 billion increase in the value of foreign holdings of US stocks. In other words, US assets are being swapped for foreign assets at a premium.
Foreign central banks sharply increased their holdings of US government securities in 2005, as they purchased dollar assets to keep the values of their currencies from rising against the dollar. China alone increased its holdings of foreign-exchange reserves by almost $210 billion in 2005. As a result, the real value of the US dollar gained 3.7% in 2005, despite growing trade deficits and the declining NIIP. A rise in the exchange value of the yuan against the dollar will mean less Chinese purchases of US sovereign debt. Does the US really think that is to its advantage?
NIIP is measured by two components: (1) direct investment, the value of domestic operations directly controlled by a foreign company; and (2) financial liabilities, the value of stocks, bonds, and bank deposits held overseas. At the start of 2004, foreign direct investment in the United States was $2.4 trillion, while US direct investment abroad was about $2.7 trillion. US-held foreign financial assets amounted to $5.1 trillion while foreign-held US financial assets amounted to $8.1 trillion, or 74% of GDP. The 2004 NIIP was a negative $3 trillion, about one third held by China alone. FDI to China in 2005 was only $72 billion, about 7% of its foreign reserves.
At the start of 2004, total US securities had a market value of $33.4 trillion, about 50% of the world total. Foreign investors held more than 38% of the $4 trillion in US Treasury bonds, but only 11% of the $6.1 trillion in agency bonds (such as those issued by the Federal National Mortgage Association, or Fannie Mae, and the Federal Home Loan Mortgage Corp, or Freddie Mac); 23% of the $6.5 trillion in corporate bonds; and 11% of the $15.5 trillion in equities outstanding. These foreign liabilities are the result of a string of current account deficits that have grown from 1.5% of GDP in the mid-1990s to 7% of GDP, about $805 billion, in 2005. Economists at the Organization for Economic Cooperation and Development estimate that ongoing deficits of 3% of GDP would bring the US NIIP to negative 40% of GDP by 2010, and that it would eventually stabilize at around negative 63%. If the deficit remains at today's level, they foresee the NIIP growing to negative 50% of GDP by 2010 and eventually to negative 100%.
Yet future dollar depreciation and market adjustments in interest rates and asset prices will likely check the negative increase of the NIIP. Dollar depreciation against the euro and the yen in 2002, 2003 and 2004 kept the NIIP flat despite rising current account deficits. Under dollar hegemony, chronic US current-account deficits reflect strong economic fundamentals rather than fatal structural flaws. The problem with US trade policy is not economic but political fallouts from unbalanced dislocations such as income disparity and sector-related job loss.
Three ways to look at the trade deficit
A trade-oriented approach views US current-account deficits as byproducts of robust economic growth, reinforced by an overvalued dollar and the US economy's structural import bias. In this view, the US has a stubborn current-account deficit because it grows both faster and with more efficiency than its trading partners and spends a disproportionate share of its growing income on imported goods and services to further accelerate its economic development paid for with debt denominated in dollars that the US can print at will.
A related perspective blames low domestic saving for the danger of trade deficits, fearing that a sudden reluctance by foreigners to continue exporting their excess savings to the US would send the US economy into financial crisis. But US saving is stronger than government statistics show. Capital gains on equities, retirement plans, and home market values even after the current correction, which add up to 20% of GDP, are excluded from measurements of personal savings. The national account also excludes "intangible" investment: spending on knowledge-creating activities such as on-the-job training, new-product development and testing, design and development, and managerial time spent on workplace organization. Economists at the National Bureau of Economic Research estimate that intangible investment grew rapidly during the 1990s and is now at least as large as physical investment in plant and equipment: more than $1 trillion per year, or 10% of GDP. Consequently, the size and growth rate of the US economy have been seriously underestimated by the neglect of stealth saving.
A third approach to the current-account deficit focuses on the growth and composition of global wealth. In this framework, international capital movements drive the current-account balance, rather than vice versa. With the US economy expected to grow faster than Europe's and Japan's over the next several decades and wealth growing rapidly in Asia, especially in China and India, foreign wealth will continue to flock to US financial markets. This could generate a sequence of US deficits as high as 5% of GDP, causing the NIIP to balloon. But such an increase would not mean an end to the foreign appetite for US assets; NIIP ratios that appear dangerously high relative to US GDP would still be sustainable because of the rapid growth of global wealth. The only obstacle is political restrictions put on foreign acquisition of US assets.
US financial markets have stayed strong even as the financing of the US deficit shifts from private investors to foreign central banks. From 2000 to 2003, the official institutional share of investment inflows rose from 4% to 30%. A large percentage of the $1.3 trillion in Asian government foreign exchange reserves is in US assets. Central banks now claim about 12% of total foreign-owned assets in the United States, including more than $1 trillion in Treasury and agency securities. Official inflows from Asia will likely continue for the foreseeable future, keeping US interest rates from rising too fast and choking off investment. Yet the US phobia against government ownership (versus private ownership) will eventually make this trend a political problem.
Senator Schumer charges China with pursuing a "mercantilist" development strategy of undervalued exchange rates to support export-led growth at the expense of the US. This is uninformed grandstanding because mercantilism has to do with gold-backed specie current, not a fiat currency such as the dollar. Under dollar hegemony, China must continue to finance US imports of its exports, since the US is its largest market and a major source of inward direct investment. Only a fundamental transformation in China's development and growth strategy could undermine these unequal terms of trade, an unlikely prospect as long as Chinese policymakers remain under the toxic spell of snake-oil neo-liberalism. The biggest threat to US hegemony stems not from the sentiments of foreign investors, but from protectionism and isolationism at home.
For China, US protectionism will force it to turn from export toward domestic development. Mao Zedong said that bad things could be turned into good things. Such a shift will shift China from its slippery path to a comprador mode of development back onto the track of economic self-determination.
Strategic economic dialogue
Since assuming office on July 3, Secretary Paulson has put together a "strategic economic dialogue" that began in September. A key to the success of this potentially highly useful dialogue is to not to push China in the direction as a cheap-labor colony of the US, but to allow China to develop as a powerful engine of growth for Asia and the global economy. To do that China must be weaned from its current addiction to labor-intensive export and redirect its energy toward domestic development not from foreign capital but with sovereign credit. Only a vibrant Chinese economy that trades with the US as an equal partner can set the US free from the ironic problem that dollar hegemony has created for its economy.
Congresswoman Nancy Pelosi, the California Democrat who is to serve as Speaker of the House next year and who has earned a string of misguided anti-China medals during her political career, has already signaled a tougher line on China, raising the stakes for the treasury secretary. "Many of us in the Congress will be watching closely for tangible results from Secretary Paulson's trip," Pelosi said through a spokesman, asserting that the Bush administration's policies on China have generally been ineffective across the board. The tangible results, if they come to pass, will be a hard landing for the US economy. The incoming Speaker needs to understand that US-China trade is a key factor behind this Goldilocks US economy.
In his first speech, Paulson said: "These challenges are made even more difficult by the fact that within China, as in the US, there are loud voices espousing anti-reform, protectionist sentiment. In China this resistance stems from a number of factors including that the benefits of this economic expansion have been spread unevenly among its citizens and that some influential people have never fully embraced the need to open up the Chinese economy to competition. This protectionist sentiment is evidenced by increasing levels of public discontent, demonstrations, and anti-reform articles written by prominent academics."
The wealth and income gap
The widening gap between the richest and poorest US residents had not been the focus of attention by anyone in the Bush administration until Paulson's appointment. He sees it as a long-term economic policy challenge. Paulson appears to attempt to re-frame the policy debate on this fundamental issue as a solution to the trade problem. The trade problem is rooted in global income inequality which is a problem that the US cannot solve without first addressing its domestic income inequality.
The wealth gap is a fixture of the industrialization phase of US economic history but relative income equality has been the dynamo of the US consumer economy. "Fordism" put the US on the road to rising industrial wages to create the US middle class out of factory workers and allow the US economy to overtake its older European competitors. The two World Wars gave US workers income growth that consistently outstripped inflation and allowed productivity growth to sustain spectacular growth of consumer demand, a key component in the success of the US economy.
Market capitalism naturally produces income disparity and polarization that leads to recurrent economic crises. To correct this structural flaw, the nation adopted an income policy. Income redistribution has been the tradition of the US tax regime since the New Deal. With the onset of eight years of supply-side "Reaganomics", followed by another eight years of neo-liberal "Rubinomics" under Clinton, whom orthodox liberal Democrats accuse as being the best Republican president in history, inequality has been growing in US society to fuel a vibrant economy. While the Republicans adopted a new income policy to redistribute income upward with the watering down of the progressive income tax, the neo-liberal Clinton Democrats used outsourcing in a globalized market economy to keep US wages from rising, and built a fiscal surplus by starving social spending. The result has been to expand the globalized economy at the expense of the US domestic economy.
For the past two decades, two-party democracy has failed to provide alternative choices in economic policy for the US electorate. And outsourcing is not the only factor driving US wages down: even as average worker productivity within the US has surged, average hourly earnings have stagnated, while the nation's economic elites have prospered with astronomical levels of income. New sectors such as high tech, information technology and financial services operate on the model of low salaries and high stock options. Even for investors, the trend has been to favor equity appreciation over dividend income. Neo-liberal economist seem to have forgotten the basic rule in finance: Income is all. Economic growth without income is a fantasy.
Income disparity has now reached obscene levels. Capital One Financial chief executive officer Richard Fairbank exercised 3.6 million options for gains of nearly $250 million, on which he paid tax on the lower capital-gain rate rather the income-tax rate. His personal take exceeded the annual corporate profits of more than half of the Fortune 1000 companies, including Goodyear Tire & Rubber, Reebok and Pier One. Median pay among chief executives running most of the United States' 100 largest companies soared 25% to $17.9 million in 2005, dwarfing the 3.1% average gain by typical US workers. And Congress is in the midst of a passionate debate over raising the minimum wage from the current $5.15 an hour to $7.25 an hour in 2009 in three steps, with opponents to the proposed bill claiming that such a raise would destroy the US economy. The idea of indexing the minimum wage to inflation is considered a legislative non-starter.
US corporate earnings are at an all-time high because wages have been stagnant. Corporations are overflowing with cash but they refuse to pass it on to their workers. Instead, corporations adopt share buy-back schemes, using the surplus cash to raise the market value of the stocks.
To his credit, Paulson is the first treasury secretary in recent history to focus on the inequality problem. In his first major speech as secretary, Paulson said: "Amid this country's strong economic expansion, many Americans simply aren't feeling the benefits. Their increases in wages are being eaten up by high energy prices and rising health-care costs, among others." Paulson gave notice that this issue will be a priority in his agenda to restructure the US economy.
A Federal Reserve survey shows that between 2001 and 2004, the median income of US workers with post-secondary degrees barely budged, rising from $72,300 to $73,000, after adjusting for inflation. The Clinton administration did almost nothing to advance the interests of organized labor, or working people more generally. Union membership continued its long decline during the Clinton presidency, standing at 13.5% of the total workforce when he left office. A paper co-authored by Rubin observed: "Prosperity has neither trickled down nor rippled outward. Between 1973 and 2003, real GDP per capita in the United States increased 73%, while real median hourly compensation rose only 13%."
New populism against Rubinomics
A new wave of economic populism is surging along with Democratic victory at the polls. Yet these new populists seem to target foreign trade exclusively, not realizing that the imbalance in trade is the result rather than the cause of the new age of economic inequality, the fountainhead of which originated in US domestic policy. If Paulson really wants to deal with the problem of persistent US trade deficits, the solution lies not in Beijing, but at home in the US.
The new populists argue that the trade pacts beginning with the North American Free Trade Agreement (NAFTA) and continuing through the various World Trade Organization (WTO) negotiations have failed to protect workers' rights to organize unions and thus raise wages in the low-wage countries. Instead, wages in high-wage countries have continued to stagnate or drift downward in real purchasing power. They also insist not only on an increase in the minimum wage but on tying it to the cost of living so that future inflation will not erode its real value, as it has in the past.
Just as the neo-conservatives have hijacked foreign policy in the Bush administration, the neo-liberal Clinton wing of the Democratic Party hijacked the party's economic policies. The Clinton neo-liberals imported the Republican ideology that the economy could achieve sustained growth only if markets were allowed to operate unregulated around the globe. Treating labor as a captured constituency, the Clinton administration vigorously supported free trade agreements like NAFTA and agreed to China's admission into the WTO, to expand the global economy at the expense of the US domestic economy, along with half-hearted promises of worker retraining and other safety-net measures that Clinton's balanced budget could not fund. The adverse effects of Rubinomics were masked by a temporary burst of unsustainable economic prosperity caused by corporate and consumer debt.
The new populists want an alternative to Rubinomics, one that register growths by the income received by the middle class. They argue that the national income has increasingly flowed disproportionately into corporate profit and the rich. They call for a review of US-led globalization and for new terms of trade that do not put the cost of economic expansion entirely on the chronic poor, the newly poor and the powerless both domestically and globally. They call for government regulation in the terms of trade to distribute the benefits more equitably.
The free traders accuse the new populists of being protectionists. Rubin admits that globalization has not brought job security or rising incomes to US workers and that as the global economy expands to benefit the US in general, it does so at the expense of shrinking the US middle class's share of the economic pie. Yet Rubinomists stick to the worn-out Margaret Thatcher claim of TINA (there is no alternative), arguing that regulating trade and imposing market restrictions would be self-defeating.
There are now enough historical data to question the false claim of benefits of financial globalization, which has brought about monetary and financial crises around the world every few years. The emergence of unregulated capital, debt and currency markets has prevented governments around the world from effectively using sovereign credit to finance domestic development, and forced all nations to distort their economies toward over-reliance on exports for dollars and to compete by joining the race to the bottom on wages and environmental abuse.
And it is not clear that Rubinomics was really responsible for economic growth of the 1990s. Historical data suggest that the information revolution greatly improved productivity even in economies insulated from Rubinomics, such as China and India. A more balanced US economic policy away from maximization of profits might have let that productivity burst lift the global economy into a higher plane without the distortions that are haunting it now. The free market does not know best. Left undirected, a free market will race ahead at unsafe speed toward accidents waiting to happen.
In his 2003 book In an Uncertain World, Rubin admits: "In retrospect, the effect of the Clinton economic plan on business and consumer confidence may have been even more important than the effect on interest rates." Business investment during the Clinton boom years was not exceptionally vigorous. It was the brain-power-intensive information revolution that helped trigger big gains in productivity and growth despite a low capital input compared with earlier capital-intensive cycles, such as the railroad age.
The 1997 Economic Report of the President released in February, five months before the 1997 Asian financial crisis, predicted that growth would average a meager 2.2% over the next four years. The actual growth rate turned out to be 3.9%. A case can be made that the high growth rate was the result of the Fed's monetary easing in response to the Asian financial crises that started on July 2, 1997, in Thailand and whirled around Asia like a tornado. When contagion hit Wall Street in October, the Fed did what no other central bank could do. It printed dollars to provide liquidity to the US banking system to not only contain the crisis, but also to allow US banks to buy up distressed Asian assets at fire-sale prices. It was a clear example of how dollar hegemony works.
Rubinomics is a doctrine of aggressive trade liberalization paid for by squeezing domestic and foreign workers while balancing the fiscal budget at home by cutting social programs to avoid the need for raising taxes progressively. The Clinton federal surplus came directly from the pockets of workers. Yet Rubin has said publicly that he understands that income inequality, both domestic and around the world, will produce a political backlash at the core that threatens the neo-liberal trading system, even the stability of capitalistic democracy. Rubin acknowledges the ill-effect of globalization on US wages, which takes on political significance when the squeeze shifts from just the poor who seldom vote, to the politically active middle class. The favoritism of government policy toward the rich, particularly the tax structure, has become so embarrassingly obscene that even the super-rich such as Warren Buffet complain about its unfairness.
Rubin has launched the Hamilton Project, a policy group of like-minded economists and financiers who are developing ameliorative measures to aid the threatened workforce and to create a broader political constituency that will defend the trading system against populist backlash. Yet how can one defend a system that creates wealth by making the majority poor? It is not possible to deify Mammon, the demon of the love of money.
The populist tidal wave may well build up to a tsunami. As outsourcing moves up the skill ladder, threatening the job security of not just assembly-line workers, but highly educated, resourceful and active workers in high tech, information technology, medicine and finance, the democratic process will turn against neo-liberal globalization. The backlash can turn ugly, mixing xenophobia with anti-Semitism.
The neo-conservative Weekly Standard observes correctly that wages have been stagnant because the increases in compensation have been eaten up by soaring health-care costs. Yet both neo-conservatives and conservatives oppose universal health care as socialist. The Weekly Standard proposes "outsourcing health-care services to cheaper foreign countries where highly qualified medical professionals working with the latest equipment only charge less than a fraction of the fees in the US. Some corporations have already started doing this, and the results so far have been very positive." The American Medical Association, the conservative trade lobby for doctors, will soon join the march against globalization.
Neo-conservatives defend globalization
Globalization is being defended by neo-conservatives, who are strange bedfellows of neo-liberals. The Weekly Standard wades in: "It is estimated that of the 28 Democrats who beat GOP [Grand Old Party, ie Republican] House incumbents on election day, 22 are unabashed protectionists, with five being pragmatic protectionists. All six losing GOP senators were free traders. Even free trader Jim Jeffords of Vermont is being replaced by the reliably anti-globalization Bernie Sanders. There is a new scent in the air, and if you're not convinced, consider the life and times of Lou Dobbs. The CNN television host suffered for years from flat ratings as the young upstart Fox News regularly cleaned his clock. Then Dobbs began pounding the anti-globalization theme, night after night bemoaning the American jobs lost to foreign competition. His ratings suddenly shot up by more than a third."
Free trade still has one reliable defender: the presidential veto that the Democrats do not have the vote to override for the next two years.
A false debate
Yet the debate on globalization is between two extremes rather than seeking solutions. International trade is very desirable if it augments domestic development. Unfortunately, in the past two decades, international trade has turned itself into an inhibitor of domestic development. This is because the destructiveness of dollar hegemony, which forces all economies to suppress domestic wages and development to compete for exports to earn dollars that cannot be used at home.
What is needed is a new international finance architecture that allows export payments to be denominated in the exporting country's currency so that domestic development can be financed with sovereign credit without having to resort to importing foreign capital. Concurrently, growth needs to be measured not in terms of how many workers are laid off from mergers and acquisition in the name of efficiency, but by how many new jobs are created by improving productivity with new technology. A corporate-tax regime should be introduced to discourage obscene profits so that earnings can be channeled more equitably back into wages to stimulate consumer demand to reduce overcapacity in the economy.
These are the issues that Paulson and his team should be exploring with their Chinese counterparts in the "strategic economic dialogue" to develop a symbiotic trade relationship between the two major economies that will augment urgently needed domestic development. There is no sense in kicking around dead-horse issues like exchange rates and intellectual-property rights.
Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com.
(Copyright 2006 Asia Times Online Ltd. All rights reserved. )
US Treasury Secretary Henry Paulson, an expert on China with more than 70 business trips there as a private banker, is in China with six other cabinet members and the chairman of the Federal Reserve, Ben Bernanke, to discuss US-China trade relations.
The venue is the first meeting of a newly created semi-annual Strategic Economic Dialogue. Reflecting the growing relationship between the US and Chinese economies, this dialogue will occur at the highest official levels and is the first of its kind. It will provide an overarching framework for ongoing productive bilateral economic dialogues and future economic relations. It will examine long-term strategic issues, as well as provide coordination among the specialized continuing dialogues. The Strategic Economic Dialogue will also be a forum for discussing ways the United States and China can work together to address economic challenges and opportunities as responsible stakeholders in the international economic system.
The underlying issues
There is much that is dysfunctional and unsustainable in US-China economic relations. The unhappy situation is the natural result of inequitable terms of trade that have evolved over two decades, beginning with China's economic opening to the outside world in Deng Xiaoping's reform policy introduced in 1978. Since the end of World War II, the US has conducted foreign economic and trade policies on the basis that trade with the US is a favor the rich US economy grants to the poorer economies.
The conditions that render such an attitude operative have changed as the US, in an interdependent global economy, has become addicted to low-price imports to fuel its loose monetary policy based on dollar hegemony. The US economy now is dependent on foreign trade as much as, if not more than, the exporting economies. Victims of addiction are usually not in any position to dictate the terms of supply.
Trade deficit is in US national interest
A case can be made, although few in the United States are intellectually honest enough or politically courageous enough to make it, that a rising trade deficit is in the US national interest, just as a strong dollar is in the US national interest.
Dollar hegemony, a term that describes the effect of the US dollar, a fiat currency, assuming the unmerited role of the key reserve currency for international trade, enables the US to use its capital account surplus to fund its trade deficit. For this reason, a balanced trade with the rest of the world would dry up the capital account surplus and create serious structural problem for the US financial system that needs US$3 billion of net capital inflow a day to keep afloat.
Many in the US fear a new threat to the sustainability of US hegemony emerging in the form of excessive dependence on foreign capital and growing foreign debt. Former treasury secretary Lawrence Summers of the Bill Clinton administration observed that "there is something odd about the world's greatest power being the world's greatest debtor".
Actually, what is odd is US foreign debt being denominated in dollars, a fiat currency that the US and only the US can print at will. The United States is the only nation in the world whose foreign debt is denominated in its own currency. In that sense, the US has no real foreign debt as all its debts are sovereign debts payable in currency it can issue at will. The term "foreign debt" usually means debt denominated in foreign currencies. Such debts require the backing of adequate foreign reserves because the debtor governments cannot print foreign currencies and are therefore subject to risks of default on foreign currency loans. Foreign debts for the US, as they are denominated in dollars, are only sovereign debts held by foreigners. If foreigners holding US sovereign debt want to cash them in, the US can print as many dollars as it needs to satisfy them.
Therefore the US does not face risks of default on its foreign debts. This is what makes US sovereign debts relatively safe investments, as sovereign debts are not exposed to default risk, only foreign-exchange risk. The key behind the intrinsic value of the dollar is that dollars, and only dollars, are accepted by the US government for payment of taxes and all other governmental receipts. These characteristics, known as the State Theory of Money, make the dollar a political instrument exempted from rules that govern financial instruments.
A new approach to China
After his first major speech that signaled a new US economic approach to China, Paulson told the Financial Times on the eve of his first trip to China as treasury secretary (on September 22) that his message to China was: "We want you to succeed." Paulson said: "The United States has a huge stake in a prosperous, stable China - a China able and willing to play its part as a global economic leader." He said the US and China shared areas of economic interest, highlighting energy and the environment as two specific areas where the two nations should work together.
No doubt Paulson is sincere when he says what he recommends for China is in China's own interest within the context of neo-liberal ideology. Yet Paulson's formula for China is that the US wants China to succeed only on US terms. Paulson's approach is based on the assumption that neo-liberal economic reforms in China are "necessary to sustain its growth" despite heated policy debate now raging in Chinese policy circles on the desirability of such modes of growth. Paulson wants China to open up Chinese capital markets for "healthy competition" within the domestic financial system, so China can have a currency that is "freely tradable", despite a history of financial crises that befell economies with freely tradable currencies in recent decades.
Paulson warns Chinese officials that they underestimate - "at China's own peril" - the extent to which the currency issue is "viewed by their critics as a symbol of unfair competition", even though his own expert opinion differs from those held by such uninformed critics. Yet if such critical complaints are substantively groundless, any appeasement on them will only lead to further absurd demands to perpetuate their anti-China agenda, amounting to "if it's not one thing, it would be another". Free traders, of whom Paulson is one, should not tolerate political bias interfering with free trade.
Paulson calls on China to press ahead with liberalization across a broad front, including financial-sector reform, fiscal and regulatory policies to reduce excess savings, market-based macroeconomic management and enforcement of intellectual-property rights. "We are taking a comprehensive approach," he said. "We are collectively pulling it together." Paulson said China had become a lightning rod for fears about globalization, but insisted it is "manageable".
Paulson's neo-liberal message is music to some in China, particularly his fans in Tsinghua University, the bastion of neo-liberal supply-side economics in that country. These reformers would like to see US political pressure push the Chinese economy more toward capitalistic market economy, at a time when Rubinomics, a set of policies named after Robert Rubin, treasury secretary under Clinton, is forced on to the defensive by rising economic populism in the US and around the world. Chinese reformers are similarly put on the defensive by glaring defects of their export dominated economic policy, in the form of worsening income disparity, life-threatening environmental pollution, economic and developmental imbalances, erosion of national spirit and, worst of all, systemic corruption. China is not about to drive its economy further down any road that leads to an economic equivalent of a dangerous cliff merely to appease US ideological displeasure.
Chinese socialism
In an interview with US television journalist Mike Wallace on September 2, 1986, Deng Xiaoping, the architect of China's market reforms and opening-up policies, responded to a question on corruption and other obstacles to foreigners doing business in China:
Deng: I am aware of these things. They do exist. As we are new to doing business with the West, it is inevitable that we shall make some mistakes. I do understand the complaints of foreign investors. No one would come here and invest unless he got a return on his investment. We are taking effective measures to change the present state of affairs. I believe that these problems can be solved gradually. But when they are solved, new problems will arise and they, too, should be solved. As leaders, we have to get a clear picture of the problems and work out measures to solve them. There is also the question of educating the cadres.
Wallace: To get rich is glorious. That declaration by Chinese leaders to their people surprises many in the capitalist world. What does that have to do with communism?
Deng: We went through the Cultural Revolution. During the Cultural Revolution there was a view that poor communism was preferable to rich capitalism. After I resumed office in the central leadership in 1974 and 1975, I criticized that view. Because I did so, I was brought down again. Of course, there were other reasons too. I said to them that there was no such thing as poor communism. According to Marxism, communist society is based on material abundance. Only when there is material abundance can the principle of a communist society - that is, "from each according to his ability, to each according to his needs" - be applied. Socialism is the first stage of communism. Of course, it covers a very long historical period. The main task in the socialist stage is to develop the productive forces, keep increasing the material wealth of society, steadily improve the life of the people and create material conditions for the advent of a communist society ... There can be no communism with pauperism, or socialism with pauperism. So to get rich is no sin. However, what we mean by getting rich is different from what you mean. Wealth in a socialist society belongs to the people. To get rich in a socialist society means prosperity for the entire people. The principles of socialism are: first, development of production, and second, common prosperity. We permit some people and some regions to become prosperous first, for the purpose of achieving common prosperity faster. That is why our policy will not lead to polarization, to a situation where the rich get richer while the poor get poorer. To be frank, we shall not permit the emergence of a new bourgeoisie.
Deng's view of a socialist market economy during the transition phase from socialism to communism is still the national purpose of the People's Republic, despite the fact that Chinese economic policy has veered off course from Deng's original vision for the decade after the Tiananmen incident in 1989. The current leadership is moving to put economic policy back on the socialist path and to rein in the excesses of market economy and address the imbalances of development approaches that emphasize quantitative over qualitative performance.
China's 11th Five-Year Plan, the roadmap for the country's development in the next five years, will bring revolutionary changes, moving from the "get rich first" phase to the "common prosperity" phase so as to bridge the growing income and wealth disparity that threatens to polarize of society. That is a historic adjustment to the pattern of five-year plans since China changed its approach to economic and social development in the 1970s.
More than two decades after Deng's reform and opening-up policy, the per capita gross domestic product (GDP) had risen to only $1,700 in 2005 and is expected to reach only $3,000 in 2020. Even with a purchasing power parity of 4:1, Chinese 2005 per capita GDP was $6,800, still substantially below the US 2005 per capita GDP of $35,000. China is still, and will continue to be, a poor, developing country notwithstanding all the glister of highrise apartment towers and office skyscrapers in Shanghai.
China's rapid economic growth has also engendered new socio-political problems. The lowest-income families, comprising the bottom 10% of all families, owns less than 2% of all the private assets in the economy, while the highest-income families, or the top 10% of all the families, own over 40%. Chinese leaders have warned against extremes of poverty and wealth, rising unemployment and intensifying social conflict. "Common prosperity is not an unreachable goal, but the basic principle and pursuit of socialism," said President Hu Jintao.
The 11th Five-Year Plan recognizes that the single-minded quest for economic growth does not necessarily lead to sustainable economic development, and rejects unbalanced quantitative growth as the goal of development, putting importance instead on improvements in the quality of life. Chinese leaders have of late repeatedly criticized flawed concepts of economic growth, asserting that that the doctrine of "economic development as a focus" should not be misinterpreted as "speed at all costs". In the 11th Five-Year Plan, economic growth will be measured by "serving the people to improve their life quality", rather than GDP readings.
Foreign trade now accounts for more than 70% of China's economy as compared with 24% in the US economy. Frequent trade friction with China's trade partners have imposed high costs on the Chinese economy. China has become a major consumer of energy resources. International energy institutions predict that from 2002 to 2030 about 21% of the world's new demand for energy resources will come from China. In 2004, nearly 50% of the petroleum used in China was imported to feed the export sector. When it comes to energy consumption, China is merely the kitchen; the dining room is in the US.
Chinese planners are working to change the country's heavy reliance on foreign investment and resources to secure its national economy through energy and capital independence in the next five years.
The problem of social security is particularly serious in the countryside, where the medical-care system and welfare have been neglected and allowed to deteriorate in the past two decades. During the period from 1993 to 2003, the number of people with no access to medical insurance in the country increased from 900 million to 1 billion, with the percentage rising from 67.8% to 80.7%. The number in the urban areas rose from 96.53 million in 1993 to 300 million in 2003. And this is an economy that holds $1 trillion in foreign reserves.
In the next five years, China will place more emphasis on science and technology, education and health care in policy and investment. All rural children are expected to enjoy nine years of free education before 2010, which will reduce farmers' economic burden by 100 billion yuan ($12.37 billion) every year. The poor and the weak will get more protection and have improved access to social welfare. In all these policy objectives of socio-economic development, neo-liberal market fundamentalism has very little to contribute.
China trade is not unfair to US
Objectively, the case that Chinese trade with the US is unfair or damaging to the US is very weak. The fact is that the terms of US-China trade favors the US more than it does China. The US trade deficit with its flip-side capital account surplus does more for the US economy than for the Chinese economy.
Conventional wisdom mistakenly suggests that the US economy rests precariously on an unsustainable accumulation of debt, particularly foreign debt. Fueled by government profligacy and low private savings rates, the current account deficit and fiscal deficit, the US has become the world's largest debtor nation. But the US is a debtor nation with a difference, for all its debts are denominated in its own currency which the US can print at will.
The current-account deficit is created by the difference between what US residents spend on imports and what they earn from exports in a given year. This deficit now stands at almost 7% of GDP. Total net foreign liabilities are now approaching 25% of GDP. And China is now the top trade-surplus partner of the US as well as the top creditor to the US. While this means China has been shipping real wealth in the form of goods to the US in exchange for US dollars it cannot use at home, there is much talk among fear-mongering pundits and politicians of the danger of sudden unwillingness by investors abroad (read Chinese) to continue adding to their already large dollar assets. In this scenario, a panic will cause the dollar to sink, dollar interest rates to skyrocket, and the US economy to descend into crisis, dragging the rest of the world down with it.
But the prospect that this scenario will actually come to pass is nil. This is because economists fail to understand that the dollar, since was taken off gold backing, is no longer a financial instrument subject to market laws of supply and demand. Under dollar hegemony, the dollar is really a political instrument. When viewed as a political instrument, everything that Larry Summers considered odd about the dollar falls in place logically.
As long as the US is the world's dominant power and the US economy is the world's dominant economy in terms of both size and focus, and the dollar remains the key reserve currency for world trade, all other currencies are merely derivatives of the dollar. Derivatives contracts profit or lose with volatility, but such volatility does not threaten the dollar. The dollar will rise and fall within a range from its benchmark exchange rate, which is the rate the market has come to accept as normal at any given time.
Volatility in exchange rates is caused by complex factors, mostly technical, while the fundamentals of dollar hegemony anchor the dollar's base rate. The base rate changes only slowly over the long term, rising according to the quantity theory of money as related to the size of the world economy. When the world's debt and commodities are denominated in dollars that only the US can print, the US in essence owns all the financial wealth of the world. Foreign-held dollars are mere accounting technicalities of little real macro-consequence. In fact, the more dollars a foreigner holds, the more he/she becomes American. When China holds more than $1 trillion in foreign reserves, it is moving closer to become a US financial colony.
For those who spend dollars in their daily activities, such as US residents or most US transnational corporations, the exchange rate of the dollar is of little fundamental relevance. If import prices rise because of a fall in the dollar exchange rate, the Federal Reserve, the US central bank, will view it as inflation and raise dollar interest rates in response, thus pushing the exchange value of the dollar back up. The exporting economies will then devalue their currencies to reset the price of their exports in dollar terms, or subsidize it by other means such as lower wages from higher unemployment, or rebates of export taxes. This game goes on until fatigue sets in to stabilize the benchmark exchange rate.
US tax revenue is immune to fluctuations in changes in dollar exchange rates because it is denominated in dollars. US fiscal spending is also immune because it is also denominated in dollars. With a falling dollar, US imports prices will rise, forcing more purchases of domestically produced goods by US consumers and more US exports. But even the current account is immune because it is settled in dollars. What will happen is that the face value of the deficit will not change, only the actual volume of goods bought and sold will change. A fall in the current account deficit only means less dollars leaving the US as debt and less dollars returning as capital. As long as US geopolitical hegemony keep all key commodities denominated in dollars, no one who participates in the global economy can escape the dollar, much less dump it.
The US economy is being held up by dollar asset appreciation, which allows higher debt without changing the debt-to-equity ratio. There is a torrent of dollar creation by the Fed, but mostly by the growth of derivatives. This causes three phenomena:
1. More dollars to fund mergers and acquisitions, which, with increasingly lame antitrust regulation, create more efficient monopolies in the short term.
2. More dollar equity available to companies to enable them to carry more debt for expansion, which makes even distressed companies look temporarily healthy. 3. More dollars for investing outside the US to fund low-cost exports to the US.
As long as interest rates, the cost of the use of money within a time period, are lower than the rate of return on capital, the economy will expand by taking on debt. Consequently, corporate earnings will look strong as long as US consumers are willing to take on more debt, collateralized by the rising value of their assets, to keep consuming.
China has a problem with its export economy. It earns dollar income from its export sector but has yuan expenses in its domestic market. When the export sector dominates the Chinese economy, China is in essence shipping wealth to the US in exchange for a currency it cannot use at home. China has accumulated $1 trillion in foreign reserves, equivalent to its annual GDP, yet it does not have enough yuan-denominated money to alleviate widespread poverty, or to fund its social security obligation, or to pay for environmental restoration. A falling dollar will make China poorer because its income from trade is in dollars and its expenses at home are in yuan. This condition will remain until China requires payment for its exports in yuan and not in dollars.
All the factor inputs to the Chinese export sector are imported: capital, loans, energy, technology, design, machine tools, production lines, packaging, paper cartons, marketing, transportation and distribution systems. To its export sector China contributes only two underpriced factor inputs: labor and environmental pollution. Profits to China from the Chinese export sector come entirely from low wages and hidden-cost pollution. For the past few years China has been holding back its GDP by more than $200 billion every year, sending the earnings to finance US trade deficits, earnings from slave wages and toxic pollution.
What China needs is to reduce its dollar income and shift that income to yuan by selling more of its products in the domestic market. But the entire neo-liberal globalized trade is built on all exporting economies thinking that earning foreign exchange is a good thing.
In the US, the decline of labor and environmental inputs has been compensated by the increased use of variable inputs and capital. Debt enters into the US financial system from China and is re-exported as capital back to China. As for oil consumption, domestic consumption is 90% supplied from domestic sources. In China, imported oil feeds the export sector.
There is no way for China to diversify its foreign currency from dollar assets. The most China can do is slow the growth of its dollar holdings by cutting exports. Allotting new Chinese trade surpluses to other non-dollar currencies is merely enlarging the volume of dollar derivatives, an exercise in circular circuitry.
What China needs to do
What China needs to do is to keep export to the US at the same level as imports from the US. This is easily done. Every three months, as soon as exports to the US exceed import levels, exports are stopped until imports from the US catch up. No trade surplus, no new dollar foreign-exchange holdings. The surplus production is then sold in the domestic market to earn yuan revenue which then is recirculated as higher wages to sustain domestic purchasing power. Sovereign credit is used to finance the time gap between rising wages and domestic consumption and between corporate sales and rising employment to sustain full employment.
This will move the trade surplus/exchange rate monkey from China's back to the United States' back. Prices in the US will rise from a shortage of supply and dollar interest rates will rise to fight inflation. The Strategic Economic Dialogue team from Washington will beg China to stop this rational nonsense, and tell Senators Charles Schumer and Lindsey Graham, who are threatening legislation that would slap a 27.5% tariff on Chinese imports unless China allows the yuan to appreciate significantly (by 20%), to go fishing.
Trade is a game of market power. The US needs to recognize that the scale of market power is tilting toward China's side and that the US cannot make hegemonic demands from a position of weakness. The solution to the US trade dilemma lies in a reordering of US trade policy, not on the exchange value of the Chinese currency.
US geopolitical hegemony rests on an economy that is continually extending its lead in the innovation and application of new technology. It does not rest on what another country does nor does not do. The fact of the matter is that regardless of crybaby complaints of unfair Chinese trade practices, US-China trade still benefits the US more than it does China. A halt in US-China trade will do more damage to the US than to China. The dollar's role as the global monetary standard is not threatened, and the risk to US financial stability posed by large foreign liabilities are exaggerated. The US economy will adjust to a decline in the dollar and a rise in interest rates that will slow the growth of US consumption and retard its standard of living, but it will not fatally undermine the US economy.
The dislocations and inequities in the US economy both at home and overseas are caused by dollar hegemony, not by any foreign government trade policy. There is a mismatch between the democratic process in US politics and the dislocation in the US economy created by US-led globalization which no amount of China bashing can resolve.
Net international investment position
US external liabilities are denominated in its own currency, which remains the key global monetary standard. The net international investment position (NIIP), the value of foreign assets owned by US residents minus the value of US assets owned by non-residents, peaked at almost 13% of GDP in 1980. Up until 1989, the US was a creditor nation. But chronic current-account and fiscal deficits since then have given the United States the largest net liabilities in world history.
At the start of 2004, foreign claims on the US of $10.5 trillion exceeded US claims of $7.9 trillion abroad, with a negative NIIP of $2.6 trillion. In 2005, US NIIP was a negative $2.7 trillion or 21% of GDP, an increase of $333 billion over the previous year, or 21.6% of GDP. The largest share of this debt is in the form of foreigners holding US sovereign debt. Foreign holdings of US government securities reached $2.4 trillion in 2005, an increase of $215 billion compared to the previous year. The purchases of US government securities by foreign investors financed two-thirds of the increase in the net US international liabilities during 2005.
US interest payments on this massive debt held by foreigners and to foreign holders of US assets means that less money will be spent in the US. Annual US interest payments on that debt rose to $114 billion, which exceeded President George W Bush's proposed budget for education, training, employment, and social services in 2007 of $86 billion. Normally, these debt payments are the Achilles' heel of vulnerability as affected by any rise in interest rates. But what do foreign interest earners do with their dollar interest revenue? They reinvest it in more dollar assets, providing funds for US investors to buy foreign assets. A reduction in the US deficit will upset this circle of cash flow and cause financial problems in the US that can quickly translate into political problems for the sitting administration.
As a rule, a current account deficit, the broadest measure of the balance of trade in goods and services, must be financed through the sale of US assets to foreign investors and lenders. However, the $333 billion increase in the net US liability position in 2005 to a negative $792 billion was considerably smaller than the current account deficit of $210 billion for the year, largely because of a substantial increase in the value of foreign assets held by US investors. The market value of foreign stocks held by domestic investors alone increased $384 billion in 2005, much more than the $69 billion increase in the value of foreign holdings of US stocks. In other words, US assets are being swapped for foreign assets at a premium.
Foreign central banks sharply increased their holdings of US government securities in 2005, as they purchased dollar assets to keep the values of their currencies from rising against the dollar. China alone increased its holdings of foreign-exchange reserves by almost $210 billion in 2005. As a result, the real value of the US dollar gained 3.7% in 2005, despite growing trade deficits and the declining NIIP. A rise in the exchange value of the yuan against the dollar will mean less Chinese purchases of US sovereign debt. Does the US really think that is to its advantage?
NIIP is measured by two components: (1) direct investment, the value of domestic operations directly controlled by a foreign company; and (2) financial liabilities, the value of stocks, bonds, and bank deposits held overseas. At the start of 2004, foreign direct investment in the United States was $2.4 trillion, while US direct investment abroad was about $2.7 trillion. US-held foreign financial assets amounted to $5.1 trillion while foreign-held US financial assets amounted to $8.1 trillion, or 74% of GDP. The 2004 NIIP was a negative $3 trillion, about one third held by China alone. FDI to China in 2005 was only $72 billion, about 7% of its foreign reserves.
At the start of 2004, total US securities had a market value of $33.4 trillion, about 50% of the world total. Foreign investors held more than 38% of the $4 trillion in US Treasury bonds, but only 11% of the $6.1 trillion in agency bonds (such as those issued by the Federal National Mortgage Association, or Fannie Mae, and the Federal Home Loan Mortgage Corp, or Freddie Mac); 23% of the $6.5 trillion in corporate bonds; and 11% of the $15.5 trillion in equities outstanding. These foreign liabilities are the result of a string of current account deficits that have grown from 1.5% of GDP in the mid-1990s to 7% of GDP, about $805 billion, in 2005. Economists at the Organization for Economic Cooperation and Development estimate that ongoing deficits of 3% of GDP would bring the US NIIP to negative 40% of GDP by 2010, and that it would eventually stabilize at around negative 63%. If the deficit remains at today's level, they foresee the NIIP growing to negative 50% of GDP by 2010 and eventually to negative 100%.
Yet future dollar depreciation and market adjustments in interest rates and asset prices will likely check the negative increase of the NIIP. Dollar depreciation against the euro and the yen in 2002, 2003 and 2004 kept the NIIP flat despite rising current account deficits. Under dollar hegemony, chronic US current-account deficits reflect strong economic fundamentals rather than fatal structural flaws. The problem with US trade policy is not economic but political fallouts from unbalanced dislocations such as income disparity and sector-related job loss.
Three ways to look at the trade deficit
A trade-oriented approach views US current-account deficits as byproducts of robust economic growth, reinforced by an overvalued dollar and the US economy's structural import bias. In this view, the US has a stubborn current-account deficit because it grows both faster and with more efficiency than its trading partners and spends a disproportionate share of its growing income on imported goods and services to further accelerate its economic development paid for with debt denominated in dollars that the US can print at will.
A related perspective blames low domestic saving for the danger of trade deficits, fearing that a sudden reluctance by foreigners to continue exporting their excess savings to the US would send the US economy into financial crisis. But US saving is stronger than government statistics show. Capital gains on equities, retirement plans, and home market values even after the current correction, which add up to 20% of GDP, are excluded from measurements of personal savings. The national account also excludes "intangible" investment: spending on knowledge-creating activities such as on-the-job training, new-product development and testing, design and development, and managerial time spent on workplace organization. Economists at the National Bureau of Economic Research estimate that intangible investment grew rapidly during the 1990s and is now at least as large as physical investment in plant and equipment: more than $1 trillion per year, or 10% of GDP. Consequently, the size and growth rate of the US economy have been seriously underestimated by the neglect of stealth saving.
A third approach to the current-account deficit focuses on the growth and composition of global wealth. In this framework, international capital movements drive the current-account balance, rather than vice versa. With the US economy expected to grow faster than Europe's and Japan's over the next several decades and wealth growing rapidly in Asia, especially in China and India, foreign wealth will continue to flock to US financial markets. This could generate a sequence of US deficits as high as 5% of GDP, causing the NIIP to balloon. But such an increase would not mean an end to the foreign appetite for US assets; NIIP ratios that appear dangerously high relative to US GDP would still be sustainable because of the rapid growth of global wealth. The only obstacle is political restrictions put on foreign acquisition of US assets.
US financial markets have stayed strong even as the financing of the US deficit shifts from private investors to foreign central banks. From 2000 to 2003, the official institutional share of investment inflows rose from 4% to 30%. A large percentage of the $1.3 trillion in Asian government foreign exchange reserves is in US assets. Central banks now claim about 12% of total foreign-owned assets in the United States, including more than $1 trillion in Treasury and agency securities. Official inflows from Asia will likely continue for the foreseeable future, keeping US interest rates from rising too fast and choking off investment. Yet the US phobia against government ownership (versus private ownership) will eventually make this trend a political problem.
Senator Schumer charges China with pursuing a "mercantilist" development strategy of undervalued exchange rates to support export-led growth at the expense of the US. This is uninformed grandstanding because mercantilism has to do with gold-backed specie current, not a fiat currency such as the dollar. Under dollar hegemony, China must continue to finance US imports of its exports, since the US is its largest market and a major source of inward direct investment. Only a fundamental transformation in China's development and growth strategy could undermine these unequal terms of trade, an unlikely prospect as long as Chinese policymakers remain under the toxic spell of snake-oil neo-liberalism. The biggest threat to US hegemony stems not from the sentiments of foreign investors, but from protectionism and isolationism at home.
For China, US protectionism will force it to turn from export toward domestic development. Mao Zedong said that bad things could be turned into good things. Such a shift will shift China from its slippery path to a comprador mode of development back onto the track of economic self-determination.
Strategic economic dialogue
Since assuming office on July 3, Secretary Paulson has put together a "strategic economic dialogue" that began in September. A key to the success of this potentially highly useful dialogue is to not to push China in the direction as a cheap-labor colony of the US, but to allow China to develop as a powerful engine of growth for Asia and the global economy. To do that China must be weaned from its current addiction to labor-intensive export and redirect its energy toward domestic development not from foreign capital but with sovereign credit. Only a vibrant Chinese economy that trades with the US as an equal partner can set the US free from the ironic problem that dollar hegemony has created for its economy.
Congresswoman Nancy Pelosi, the California Democrat who is to serve as Speaker of the House next year and who has earned a string of misguided anti-China medals during her political career, has already signaled a tougher line on China, raising the stakes for the treasury secretary. "Many of us in the Congress will be watching closely for tangible results from Secretary Paulson's trip," Pelosi said through a spokesman, asserting that the Bush administration's policies on China have generally been ineffective across the board. The tangible results, if they come to pass, will be a hard landing for the US economy. The incoming Speaker needs to understand that US-China trade is a key factor behind this Goldilocks US economy.
In his first speech, Paulson said: "These challenges are made even more difficult by the fact that within China, as in the US, there are loud voices espousing anti-reform, protectionist sentiment. In China this resistance stems from a number of factors including that the benefits of this economic expansion have been spread unevenly among its citizens and that some influential people have never fully embraced the need to open up the Chinese economy to competition. This protectionist sentiment is evidenced by increasing levels of public discontent, demonstrations, and anti-reform articles written by prominent academics."
The wealth and income gap
The widening gap between the richest and poorest US residents had not been the focus of attention by anyone in the Bush administration until Paulson's appointment. He sees it as a long-term economic policy challenge. Paulson appears to attempt to re-frame the policy debate on this fundamental issue as a solution to the trade problem. The trade problem is rooted in global income inequality which is a problem that the US cannot solve without first addressing its domestic income inequality.
The wealth gap is a fixture of the industrialization phase of US economic history but relative income equality has been the dynamo of the US consumer economy. "Fordism" put the US on the road to rising industrial wages to create the US middle class out of factory workers and allow the US economy to overtake its older European competitors. The two World Wars gave US workers income growth that consistently outstripped inflation and allowed productivity growth to sustain spectacular growth of consumer demand, a key component in the success of the US economy.
Market capitalism naturally produces income disparity and polarization that leads to recurrent economic crises. To correct this structural flaw, the nation adopted an income policy. Income redistribution has been the tradition of the US tax regime since the New Deal. With the onset of eight years of supply-side "Reaganomics", followed by another eight years of neo-liberal "Rubinomics" under Clinton, whom orthodox liberal Democrats accuse as being the best Republican president in history, inequality has been growing in US society to fuel a vibrant economy. While the Republicans adopted a new income policy to redistribute income upward with the watering down of the progressive income tax, the neo-liberal Clinton Democrats used outsourcing in a globalized market economy to keep US wages from rising, and built a fiscal surplus by starving social spending. The result has been to expand the globalized economy at the expense of the US domestic economy.
For the past two decades, two-party democracy has failed to provide alternative choices in economic policy for the US electorate. And outsourcing is not the only factor driving US wages down: even as average worker productivity within the US has surged, average hourly earnings have stagnated, while the nation's economic elites have prospered with astronomical levels of income. New sectors such as high tech, information technology and financial services operate on the model of low salaries and high stock options. Even for investors, the trend has been to favor equity appreciation over dividend income. Neo-liberal economist seem to have forgotten the basic rule in finance: Income is all. Economic growth without income is a fantasy.
Income disparity has now reached obscene levels. Capital One Financial chief executive officer Richard Fairbank exercised 3.6 million options for gains of nearly $250 million, on which he paid tax on the lower capital-gain rate rather the income-tax rate. His personal take exceeded the annual corporate profits of more than half of the Fortune 1000 companies, including Goodyear Tire & Rubber, Reebok and Pier One. Median pay among chief executives running most of the United States' 100 largest companies soared 25% to $17.9 million in 2005, dwarfing the 3.1% average gain by typical US workers. And Congress is in the midst of a passionate debate over raising the minimum wage from the current $5.15 an hour to $7.25 an hour in 2009 in three steps, with opponents to the proposed bill claiming that such a raise would destroy the US economy. The idea of indexing the minimum wage to inflation is considered a legislative non-starter.
US corporate earnings are at an all-time high because wages have been stagnant. Corporations are overflowing with cash but they refuse to pass it on to their workers. Instead, corporations adopt share buy-back schemes, using the surplus cash to raise the market value of the stocks.
To his credit, Paulson is the first treasury secretary in recent history to focus on the inequality problem. In his first major speech as secretary, Paulson said: "Amid this country's strong economic expansion, many Americans simply aren't feeling the benefits. Their increases in wages are being eaten up by high energy prices and rising health-care costs, among others." Paulson gave notice that this issue will be a priority in his agenda to restructure the US economy.
A Federal Reserve survey shows that between 2001 and 2004, the median income of US workers with post-secondary degrees barely budged, rising from $72,300 to $73,000, after adjusting for inflation. The Clinton administration did almost nothing to advance the interests of organized labor, or working people more generally. Union membership continued its long decline during the Clinton presidency, standing at 13.5% of the total workforce when he left office. A paper co-authored by Rubin observed: "Prosperity has neither trickled down nor rippled outward. Between 1973 and 2003, real GDP per capita in the United States increased 73%, while real median hourly compensation rose only 13%."
New populism against Rubinomics
A new wave of economic populism is surging along with Democratic victory at the polls. Yet these new populists seem to target foreign trade exclusively, not realizing that the imbalance in trade is the result rather than the cause of the new age of economic inequality, the fountainhead of which originated in US domestic policy. If Paulson really wants to deal with the problem of persistent US trade deficits, the solution lies not in Beijing, but at home in the US.
The new populists argue that the trade pacts beginning with the North American Free Trade Agreement (NAFTA) and continuing through the various World Trade Organization (WTO) negotiations have failed to protect workers' rights to organize unions and thus raise wages in the low-wage countries. Instead, wages in high-wage countries have continued to stagnate or drift downward in real purchasing power. They also insist not only on an increase in the minimum wage but on tying it to the cost of living so that future inflation will not erode its real value, as it has in the past.
Just as the neo-conservatives have hijacked foreign policy in the Bush administration, the neo-liberal Clinton wing of the Democratic Party hijacked the party's economic policies. The Clinton neo-liberals imported the Republican ideology that the economy could achieve sustained growth only if markets were allowed to operate unregulated around the globe. Treating labor as a captured constituency, the Clinton administration vigorously supported free trade agreements like NAFTA and agreed to China's admission into the WTO, to expand the global economy at the expense of the US domestic economy, along with half-hearted promises of worker retraining and other safety-net measures that Clinton's balanced budget could not fund. The adverse effects of Rubinomics were masked by a temporary burst of unsustainable economic prosperity caused by corporate and consumer debt.
The new populists want an alternative to Rubinomics, one that register growths by the income received by the middle class. They argue that the national income has increasingly flowed disproportionately into corporate profit and the rich. They call for a review of US-led globalization and for new terms of trade that do not put the cost of economic expansion entirely on the chronic poor, the newly poor and the powerless both domestically and globally. They call for government regulation in the terms of trade to distribute the benefits more equitably.
The free traders accuse the new populists of being protectionists. Rubin admits that globalization has not brought job security or rising incomes to US workers and that as the global economy expands to benefit the US in general, it does so at the expense of shrinking the US middle class's share of the economic pie. Yet Rubinomists stick to the worn-out Margaret Thatcher claim of TINA (there is no alternative), arguing that regulating trade and imposing market restrictions would be self-defeating.
There are now enough historical data to question the false claim of benefits of financial globalization, which has brought about monetary and financial crises around the world every few years. The emergence of unregulated capital, debt and currency markets has prevented governments around the world from effectively using sovereign credit to finance domestic development, and forced all nations to distort their economies toward over-reliance on exports for dollars and to compete by joining the race to the bottom on wages and environmental abuse.
And it is not clear that Rubinomics was really responsible for economic growth of the 1990s. Historical data suggest that the information revolution greatly improved productivity even in economies insulated from Rubinomics, such as China and India. A more balanced US economic policy away from maximization of profits might have let that productivity burst lift the global economy into a higher plane without the distortions that are haunting it now. The free market does not know best. Left undirected, a free market will race ahead at unsafe speed toward accidents waiting to happen.
In his 2003 book In an Uncertain World, Rubin admits: "In retrospect, the effect of the Clinton economic plan on business and consumer confidence may have been even more important than the effect on interest rates." Business investment during the Clinton boom years was not exceptionally vigorous. It was the brain-power-intensive information revolution that helped trigger big gains in productivity and growth despite a low capital input compared with earlier capital-intensive cycles, such as the railroad age.
The 1997 Economic Report of the President released in February, five months before the 1997 Asian financial crisis, predicted that growth would average a meager 2.2% over the next four years. The actual growth rate turned out to be 3.9%. A case can be made that the high growth rate was the result of the Fed's monetary easing in response to the Asian financial crises that started on July 2, 1997, in Thailand and whirled around Asia like a tornado. When contagion hit Wall Street in October, the Fed did what no other central bank could do. It printed dollars to provide liquidity to the US banking system to not only contain the crisis, but also to allow US banks to buy up distressed Asian assets at fire-sale prices. It was a clear example of how dollar hegemony works.
Rubinomics is a doctrine of aggressive trade liberalization paid for by squeezing domestic and foreign workers while balancing the fiscal budget at home by cutting social programs to avoid the need for raising taxes progressively. The Clinton federal surplus came directly from the pockets of workers. Yet Rubin has said publicly that he understands that income inequality, both domestic and around the world, will produce a political backlash at the core that threatens the neo-liberal trading system, even the stability of capitalistic democracy. Rubin acknowledges the ill-effect of globalization on US wages, which takes on political significance when the squeeze shifts from just the poor who seldom vote, to the politically active middle class. The favoritism of government policy toward the rich, particularly the tax structure, has become so embarrassingly obscene that even the super-rich such as Warren Buffet complain about its unfairness.
Rubin has launched the Hamilton Project, a policy group of like-minded economists and financiers who are developing ameliorative measures to aid the threatened workforce and to create a broader political constituency that will defend the trading system against populist backlash. Yet how can one defend a system that creates wealth by making the majority poor? It is not possible to deify Mammon, the demon of the love of money.
The populist tidal wave may well build up to a tsunami. As outsourcing moves up the skill ladder, threatening the job security of not just assembly-line workers, but highly educated, resourceful and active workers in high tech, information technology, medicine and finance, the democratic process will turn against neo-liberal globalization. The backlash can turn ugly, mixing xenophobia with anti-Semitism.
The neo-conservative Weekly Standard observes correctly that wages have been stagnant because the increases in compensation have been eaten up by soaring health-care costs. Yet both neo-conservatives and conservatives oppose universal health care as socialist. The Weekly Standard proposes "outsourcing health-care services to cheaper foreign countries where highly qualified medical professionals working with the latest equipment only charge less than a fraction of the fees in the US. Some corporations have already started doing this, and the results so far have been very positive." The American Medical Association, the conservative trade lobby for doctors, will soon join the march against globalization.
Neo-conservatives defend globalization
Globalization is being defended by neo-conservatives, who are strange bedfellows of neo-liberals. The Weekly Standard wades in: "It is estimated that of the 28 Democrats who beat GOP [Grand Old Party, ie Republican] House incumbents on election day, 22 are unabashed protectionists, with five being pragmatic protectionists. All six losing GOP senators were free traders. Even free trader Jim Jeffords of Vermont is being replaced by the reliably anti-globalization Bernie Sanders. There is a new scent in the air, and if you're not convinced, consider the life and times of Lou Dobbs. The CNN television host suffered for years from flat ratings as the young upstart Fox News regularly cleaned his clock. Then Dobbs began pounding the anti-globalization theme, night after night bemoaning the American jobs lost to foreign competition. His ratings suddenly shot up by more than a third."
Free trade still has one reliable defender: the presidential veto that the Democrats do not have the vote to override for the next two years.
A false debate
Yet the debate on globalization is between two extremes rather than seeking solutions. International trade is very desirable if it augments domestic development. Unfortunately, in the past two decades, international trade has turned itself into an inhibitor of domestic development. This is because the destructiveness of dollar hegemony, which forces all economies to suppress domestic wages and development to compete for exports to earn dollars that cannot be used at home.
What is needed is a new international finance architecture that allows export payments to be denominated in the exporting country's currency so that domestic development can be financed with sovereign credit without having to resort to importing foreign capital. Concurrently, growth needs to be measured not in terms of how many workers are laid off from mergers and acquisition in the name of efficiency, but by how many new jobs are created by improving productivity with new technology. A corporate-tax regime should be introduced to discourage obscene profits so that earnings can be channeled more equitably back into wages to stimulate consumer demand to reduce overcapacity in the economy.
These are the issues that Paulson and his team should be exploring with their Chinese counterparts in the "strategic economic dialogue" to develop a symbiotic trade relationship between the two major economies that will augment urgently needed domestic development. There is no sense in kicking around dead-horse issues like exchange rates and intellectual-property rights.
Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com.
(Copyright 2006 Asia Times Online Ltd. All rights reserved. )
Saturday, December 2, 2006
Feral cats, beware
By Chan Akya
With the US government firmly on the back foot in Iraq and President George W Bush rendered a lame duck by a Democratic Congress, the end of the American century is approaching rather faster than previously expected. [1] My characterization of the United States as Garfield may have been too gentle in the context of what is likely to happen going forward, when the cat becomes feral. The death of any superpower usually carries with it a combination of military and economic defeats and, as with the Soviet Union's demise in the 1990s, America's decline will prove equally cruel.
Iraq has descended into a civil war in recent weeks, as a feckless US military attempts to recover lost ground with the same failed tactics of the past few years. Albert Einstein defined insanity as doing the same thing over and over again but expecting a different result. Bush, reeling from stunning losses in mid-term elections, had to fire defense chief Donald Rumsfeld, but has since failed to signal any changes in strategy. The matter may not be entirely up to him as insurgents and terrorists, sensing a potential shift in US strategy, have stepped up their attacks to record levels. This makes an early US exit not only more likely, but also more ignominious.
For a people imbued with a sense of infallibility, this turn of events would be nothing short of a catastrophic reality check. As with the end of the Vietnam conflict, it might take 10 years or more for any resurgence in national optimism in the US. The difference is that this time around, putative successors are much better positioned to inherit the mantle of superpowers.
Echoes elsewhere
The impact of a significant foreign-policy setback is hardly minor for any economy, and will be quite marked for the US economy. A decline in government spending on the "military-industrial complex" would reduce profits for many US companies, especially the ones that tend to fund policymakers or send their executives into politics.
The downward adjustment of such sectors would, however, pale in comparison to the impact of reduced optimism at the top level. Simply put, US consumers would be less likely to spend on new houses, cars or home improvements. The notion of "keeping up with the Joneses", which underpins vast swaths of the US economy, would operate in reverse under such circumstances, with people cutting their spending in competition.
Financial markets are already signaling the possibility that the US confronts a recession at home, as the US dollar has declined sharply in recent days. While the prestige factor mentioned above is only part of the story, the other part is the likely monetary easing that makes the currency less attractive going forward. Stock markets have also seen a wobble in recent days.
The immediate impact of a decline in the US economy is of course negative for exporting countries, including China, Japan and pretty much the whole Middle East. However, to the extent that China and India continue to build their infrastructure, and allow their currencies to appreciate against the US dollar, one can expect increased consumption from these countries to take up the slack created by the US decline. The worst-positioned countries are those that do most of their business with the US today, namely those in Latin America.
Some financial commentators have pointed out that a falling US dollar is good for the country's exports. This might be the case when a country produces anything that others want to buy, but that's largely not the case with the US. In a previous article, [2] I wrote:
The US has lost its competitive edge in manufacturing ... The simple fact is that after the Cold War ended, US innovation stopped dead in its tracks. Evaluate the engineering aspects of any American car, and you are likely to walk away completely unimpressed. A six-liter engine used by US car companies produces the same power as an engine half that size from the Germans, and one-third of the size by the Japanese (tuned, admittedly). Leave out engineering, and simple design dynamics don't work either - Detroit has not produced a single desirable car in the past decade.
The United States came to the forefront of righting human-rights wrongs such as racism, but only when its economic prosperity was threatened by the status quo. Now, America's lost competitiveness in manufacturing comes alongside its declining demographics (when keeping immigrants out of calculations), and rising threats from the likes of India and China in all areas of the global economy that it currently dominates. In this high-pressure economic environment, rising geopolitical risks argue for an unwelcome acceleration of the country's transition. Much like a worker who becomes a wife-beater when threatened with losing his job, the US lashes out, with its anger directed toward garnering any resource advantage that it can to lengthen its reign at the top.
As I pointed out then, the US is unlikely to go quietly into the night. It will attempt to lash out at the rest of the world, particularly at its potential successors - the Eurozone, Russia and China.[3] Of these, the Eurozone has neither the military nor social mandate to pose a strategic counterbalance to the US. This leaves Russia and China to consider. I have already written about the latter in the aforementioned article, concluding that China would make necessary accommodations to its currency and economic policy to avoid confrontation with the US. Russia's role, though, is more intriguing.
Russia's sinister game
That President Vladimir Putin has stepped up his great Asian game comes as no surprise in the context described above. To a large extent, his strategy has been shaped by the impact of a dying Soviet Union on the national psyche, something that he has personally mourned more than once. A shameful withdrawal of the US from Iraq guarantees a strong role for his country in the immediate aftermath, particularly given the proximity of concerns with Iran, whose potential to disturb southern Russian regions has never been doubted in Moscow.
The assassinations of various dissidents, including journalist Anna Politkovskaya and former KGB spy Alexander Litvinenko, show a return to the "bad old days" of the KGB under Josef Stalin and Leonid Brezhnev, while apparent intransigence on energy businesses show that the Kremlin is keen to maximize every advantage it perceives. What this means for Putin himself is a matter of much conjecture, but it seems a fairly safe bet that he will not slide into oblivion quite as easily as president Boris Yeltsin did.
At the logical extreme, one can expect that Russia will hold Europe hostage with its gas supplies, while increasing its shrill behavior on world forums against US interests. This would in turn cause the US to dial back its old suspicions on Russia. The nomination of Robert Gates (of "Mikhail Gorbachev is a fraud" fame) as US defense secretary makes it ever more likely that the US would prefer to pick battles with known enemies, particularly one that appears to be so willing to become recognized once again as the strategic counterbalance to the US.
The only event that could derail this train would be a large terrorist attack on Russia, perhaps mounted by Chechen Muslims. [4] Similarly, a bigger attack on the US may make Americans more amenable to concessions for the Russians, making any conflict escalation unlikely.
Over the longer term, though, Russia's tilt toward regaining the Soviet Union's lost dominance is ill-conceived for both historical and demographic reasons. However, it provides just enough breathing room for China to emerge fully into the limelight. For this reason, more than anything else, China's foreign policy in the next few months is likely to "encourage" adventurism on the part of the Russians, while playing lip service to the United States.
Notes
1. Garfield with guns, Asia Times Online, September 2.
2. In-Sen!, Asia Times Online, September 16.
3. China's four-play, Asia Times Online, November 11.
4. It is interesting to note that Alexander Litvinenko alleged that it was the KGB rather than the Chechens who bombed Moscow apartment buildings.
(Copyright 2006 Asia Times Online Ltd. All rights reserved.)
With the US government firmly on the back foot in Iraq and President George W Bush rendered a lame duck by a Democratic Congress, the end of the American century is approaching rather faster than previously expected. [1] My characterization of the United States as Garfield may have been too gentle in the context of what is likely to happen going forward, when the cat becomes feral. The death of any superpower usually carries with it a combination of military and economic defeats and, as with the Soviet Union's demise in the 1990s, America's decline will prove equally cruel.
Iraq has descended into a civil war in recent weeks, as a feckless US military attempts to recover lost ground with the same failed tactics of the past few years. Albert Einstein defined insanity as doing the same thing over and over again but expecting a different result. Bush, reeling from stunning losses in mid-term elections, had to fire defense chief Donald Rumsfeld, but has since failed to signal any changes in strategy. The matter may not be entirely up to him as insurgents and terrorists, sensing a potential shift in US strategy, have stepped up their attacks to record levels. This makes an early US exit not only more likely, but also more ignominious.
For a people imbued with a sense of infallibility, this turn of events would be nothing short of a catastrophic reality check. As with the end of the Vietnam conflict, it might take 10 years or more for any resurgence in national optimism in the US. The difference is that this time around, putative successors are much better positioned to inherit the mantle of superpowers.
Echoes elsewhere
The impact of a significant foreign-policy setback is hardly minor for any economy, and will be quite marked for the US economy. A decline in government spending on the "military-industrial complex" would reduce profits for many US companies, especially the ones that tend to fund policymakers or send their executives into politics.
The downward adjustment of such sectors would, however, pale in comparison to the impact of reduced optimism at the top level. Simply put, US consumers would be less likely to spend on new houses, cars or home improvements. The notion of "keeping up with the Joneses", which underpins vast swaths of the US economy, would operate in reverse under such circumstances, with people cutting their spending in competition.
Financial markets are already signaling the possibility that the US confronts a recession at home, as the US dollar has declined sharply in recent days. While the prestige factor mentioned above is only part of the story, the other part is the likely monetary easing that makes the currency less attractive going forward. Stock markets have also seen a wobble in recent days.
The immediate impact of a decline in the US economy is of course negative for exporting countries, including China, Japan and pretty much the whole Middle East. However, to the extent that China and India continue to build their infrastructure, and allow their currencies to appreciate against the US dollar, one can expect increased consumption from these countries to take up the slack created by the US decline. The worst-positioned countries are those that do most of their business with the US today, namely those in Latin America.
Some financial commentators have pointed out that a falling US dollar is good for the country's exports. This might be the case when a country produces anything that others want to buy, but that's largely not the case with the US. In a previous article, [2] I wrote:
The US has lost its competitive edge in manufacturing ... The simple fact is that after the Cold War ended, US innovation stopped dead in its tracks. Evaluate the engineering aspects of any American car, and you are likely to walk away completely unimpressed. A six-liter engine used by US car companies produces the same power as an engine half that size from the Germans, and one-third of the size by the Japanese (tuned, admittedly). Leave out engineering, and simple design dynamics don't work either - Detroit has not produced a single desirable car in the past decade.
The United States came to the forefront of righting human-rights wrongs such as racism, but only when its economic prosperity was threatened by the status quo. Now, America's lost competitiveness in manufacturing comes alongside its declining demographics (when keeping immigrants out of calculations), and rising threats from the likes of India and China in all areas of the global economy that it currently dominates. In this high-pressure economic environment, rising geopolitical risks argue for an unwelcome acceleration of the country's transition. Much like a worker who becomes a wife-beater when threatened with losing his job, the US lashes out, with its anger directed toward garnering any resource advantage that it can to lengthen its reign at the top.
As I pointed out then, the US is unlikely to go quietly into the night. It will attempt to lash out at the rest of the world, particularly at its potential successors - the Eurozone, Russia and China.[3] Of these, the Eurozone has neither the military nor social mandate to pose a strategic counterbalance to the US. This leaves Russia and China to consider. I have already written about the latter in the aforementioned article, concluding that China would make necessary accommodations to its currency and economic policy to avoid confrontation with the US. Russia's role, though, is more intriguing.
Russia's sinister game
That President Vladimir Putin has stepped up his great Asian game comes as no surprise in the context described above. To a large extent, his strategy has been shaped by the impact of a dying Soviet Union on the national psyche, something that he has personally mourned more than once. A shameful withdrawal of the US from Iraq guarantees a strong role for his country in the immediate aftermath, particularly given the proximity of concerns with Iran, whose potential to disturb southern Russian regions has never been doubted in Moscow.
The assassinations of various dissidents, including journalist Anna Politkovskaya and former KGB spy Alexander Litvinenko, show a return to the "bad old days" of the KGB under Josef Stalin and Leonid Brezhnev, while apparent intransigence on energy businesses show that the Kremlin is keen to maximize every advantage it perceives. What this means for Putin himself is a matter of much conjecture, but it seems a fairly safe bet that he will not slide into oblivion quite as easily as president Boris Yeltsin did.
At the logical extreme, one can expect that Russia will hold Europe hostage with its gas supplies, while increasing its shrill behavior on world forums against US interests. This would in turn cause the US to dial back its old suspicions on Russia. The nomination of Robert Gates (of "Mikhail Gorbachev is a fraud" fame) as US defense secretary makes it ever more likely that the US would prefer to pick battles with known enemies, particularly one that appears to be so willing to become recognized once again as the strategic counterbalance to the US.
The only event that could derail this train would be a large terrorist attack on Russia, perhaps mounted by Chechen Muslims. [4] Similarly, a bigger attack on the US may make Americans more amenable to concessions for the Russians, making any conflict escalation unlikely.
Over the longer term, though, Russia's tilt toward regaining the Soviet Union's lost dominance is ill-conceived for both historical and demographic reasons. However, it provides just enough breathing room for China to emerge fully into the limelight. For this reason, more than anything else, China's foreign policy in the next few months is likely to "encourage" adventurism on the part of the Russians, while playing lip service to the United States.
Notes
1. Garfield with guns, Asia Times Online, September 2.
2. In-Sen!, Asia Times Online, September 16.
3. China's four-play, Asia Times Online, November 11.
4. It is interesting to note that Alexander Litvinenko alleged that it was the KGB rather than the Chechens who bombed Moscow apartment buildings.
(Copyright 2006 Asia Times Online Ltd. All rights reserved.)
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