Dow 14,000: So What?

What does Dow Jones Industrial Average at 14,000 mean?  Not much, when you consider that it's to a large degree the product of the Fed's unremitting money printing policy.  A "value" achieved through government policies, rather than market forces, has little intrinsic value.  Witness the real estate markets of 2007-08:  decades of government subsidies through the mortgage markets, tax laws and Federal Reserve monetary laxity puffed up home values until they exploded in our faces.  Comparable subsidies (like quantitative easing) and more easy Fed money can do the same to financial assets. 

Right now, retail money has started flowing into stocks again.  That's deemed by many market pros to be a sign of an impending market peak.  If you want to get in and out of the market--i.e., trade it as if it were an asset bubble--there may be some greater fools who would buy from you.  That is, if you act quickly enough.  But investor, beware.  The Fed is making an enormous bet right now:  that enough monetary stimulus will somehow revive the economy to the point that it will independently resume sustained growth and return to full employment.  That such will occur is unusually uncertain.  Aside from the fact that economic revival has been painfully slow even with all the printed money, one has the sneaking suspicion that the Fed has quietly placed a side bet that its easy money policy would push down the value of the dollar enough that America might export its way to prosperity.  But other export-centric nations are fighting back.  Japan has effectively undermined the independence of its central bank in order to push the yen down. China has stopped levitating the renminbi. And the Germans are starting to grouse audibly about the revival of the Euro.  Currency wars tend to take on the look and feel of a circular firing squad, and the major economies of the world are charging their muskets.

The Weird and Unknown From the U.S. Credit Rating Downgrade

We learned in a big way during the 2008 financial crisis that what we don't know can really hurt us. That would still be true today, after S&P lowered America's credit rating from AAA to AA+. We also know that weird stuff happens when the financial markets get a tummy ache. They seem likely to be queasy from the downgrade when the markets open tomorrow. The weird and unknown may surface soon.

Complex Trading. Major banks and hedge funds frequently trade esoteric investments in multi-investment positions involving U.S. Treasuries as hedges or otherwise. Quite often, these market players embrace leverage in playing this game, since it boosts potential profits. The downgrade shouldn't have come as a complete surprise, since the rating agencies have been loudly frowning at the U.S. debt situation for several months now. But the downgrade's timing was uncertain and its impact uncertain. Complex trading positions may become unhinged for unanticipated reasons. These large institutional traders may find their positions exposed, or may receive unexpected demands for collateral from brokers or counterparties, and then struggle to keep things on an even keel. If so, that could prove unsettling for the markets, especially if the exposures from such trading are directly or indirectly concentrated in one or two companies, a la AIG circa 2008. The reform of the derivatives market has proceeded slowly, if at all, and regulators likely have no idea if there exists the potential for another meltdown. So all we can do is wait and see what happens. If there is another AIG lurking out there, expect very bad consequences.

Housing Market Hassles. Fannie Mae and Freddie Mac provide almost all the financing in the residential real estate markets, primarily because their debts are effectively 100% guaranteed by the U.S. government. It's logical to expect that Fannie and Freddie will be downgraded, since their sugar daddy was just downgraded. This could make mortgage loans harder to get. Not necessarily because interest rates would rise, because the U.S. Treasury downgrade could trigger a flight to safety that ironically would increase demand for U.S. Treasuries (there being few alternatives). But a Fan/Fred downgrade would make it harder to find investors for the mortgage backed securities that Fan/Fred backed loans go into. Investors in those securities are the true source of liquidity for the mortgage market, and may demand higher quality borrowers than current already stringent credit standards require. The housing market could slip on yet another banana peel in its path.

Chinese Communists Strengthened. China's Communist government has been coming under increasing domestic political pressure, because of rising unemployment, poor protection of consumers, sporadic protection of the environment, corruption and co-optation by China's capitalist plutocracy. The S&P downgrade of U.S. Treasuries, however, highlights the fundamental strength of the Chinese economy and its levitating currency, the yuan. That makes the Communist government look good, at a time when it needed some positive spin. Of course, S&P wasn't trying to influence internal Chinese politics. But the law of unintended consequences is the supreme authority in the world of finance.

Obama-Boehner in 2012? Increased factionalism in both political parties is stretching current party delineations close to the breaking point. The Republican Party is held hostage by a limited number of Tea Party ideologues. Respected mainstream conservative voices have labeled Tea Partiers "hobbits, " which, albeit an affront to hobbits, captures the fantastical quality of the thinking on the far right. At the same time, the fissure between President Obama and liberal Democrats has been outed. Emotions are red hot. Ralph Nader publicly, and likely others nonpublicly, predict a primaries challenge to President Obama next year. No one is naming names yet. The most obvious challenger, Secretary of State Hillary Clinton, has publicly said she isn't running for elective office again. Neither a liberal left agenda, nor a Tea Party-style conservative platform, will win the White House in 2012. Both Obama and Boehner know that. Their problems with their parties will increase, because the debt ceiling deal creates a bipartisan committee to squabble more about deficit reduction, giving all factions many opportunities for further raucousness. With so many shouting past each other instead of having a dialogue, the conditions for a realignment of parties are ripening. It's impossible that Obama and Boehner would actually team up to run in 2012. But the pressures for a functioning U.S. government come from powerful forces in the financial markets and the economy. We're no longer debating political philosophy or ideology over beer and pretzels or coffee and Danish. Lots of jobs, careers, wealth, and retirements are on the line. The will of the people is for a functioning government, and ambitious politicians will find a way to give them one. Current party alignments may be endangered.

The Fed and Foreign Policy

The Fed's easy money policies have spurred inflation and rising real estate prices in China. China's informal link of the yuan to the dollar in effect imports U.S. monetary policy into China. Even though the slack in the U.S. economy from the Great Recession has held prices down here, the red hot Chinese economy reacted to excess liquidity by pushing up prices there.

The Chinese have a deep fear of inflation, having experienced far worse in their four millenia of existence as a civilization than anything Americans have seen. They're imposing monetary constraints, and even resorting to price controls. The Fed is meeting this Tuesday and Wednesday, and is expected to continue running its money printing press at full throttle. With its inflationary implications for the yuan, the Fed's current stance provides China a reason to de-link the yuan from the dollar. Once the yuan is de-linked, China can regain control of its own monetary policies.

The dissatisfaction of Chinese consumers with inflation has much more influence on Beijing's thinking than all the haranguing of the U.S. and European governments. Thus, the yuan is edging up in value, and is becoming more freely tradeable in international currency markets. Its continued rise against the dollar can be expected, albeit at a carefully managed rate. Among other things, a rising yuan makes it easier for China to buy oil and other commodities traded in dollars. Greater Chinese demand would push up the dollar-denominated price of those commodities.

This will be a mixed bag for America. As the yuan rises, U.S. exports to China may increase, creating jobs here. But a falling dollar also means a loss of buying power. America imports a lot from China, and as the yuan rises, those imports become more expensive. Cheaper substitutes may be available in some instances--Southeast and South Asia offer lower cost alternatives for manufacturing clothes. But the manufacture of high tech components that go into computers, cell phones, PDAs, tablet computers and what not can't easily be shifted to new suppliers. And rising oil and other commodities prices have obvious implications for American consumers. A rising yuan, bottom line, means falling wealth levels in America.

It may be that the Fed intends to engineer a drop in the dollar's value. That would be one way it can discharge its statutory mandate to foster full employment. America's wealth levels during the past decade were puffed up by the profligate borrowing that funded the nation's consumption. Debt-fueled "prosperity" can't go on indefinitely, and America's wealth was at risk for a fall.

As the dollar drops against the yuan, the Chinese government will take losses on its vast portfolio of dollar-denominated investments. It would likely be willing to take these losses in order to hold inflation in check and keep its citizens from becoming overly restive.

Many Americans would consider jobs for some of the unemployed at the expense of less buying power for all to be a fair trade. High unemployment has many social costs, ranging from increased government spending to discouraging consumption to familial distress and breakdowns. Fair or not, however, as the yuan rises, American living standards could be squeezed.

Unintended Consequences of Monetary Policy

Today's news reported that China's foreign exchange reserves have risen to $2.85 trillion (yes, trillion, not billion), an increase of 20% over the past year. This is almost triple the next highest amount of foreign reserves held by a central bank (Japan, at $1.04 trillion). At the same time, China's trade balance narrowed over the past year. In other words, China's increased holdings of foreign reserves don't come from a net increase in exports.

Many commentators blame China's low exchange rate for the yuan, which it depresses in order to protect its exporters. But if net exports aren't increasing, something else is going on. A prime suspect is the carry trade, in which speculators borrow dollars made cheap by the Fed's easy money policies and convert them into yuan in order to profit from China's rising interest rates. The dichotomy in interest rates between China (high) and America (low) gives capital the incentive to flee the U.S. for higher returns in China. The fact that China has recently loosened trading restrictions in the yuan, allowing it to be traded in Hong Kong and now the U.S., only makes such capital flight easier. The Chinese central bank will levitate rates further in order to combat accelerating inflation in China, so the disparity with America will only increase.

China's high interest rate/low yuan exchange rate strategy exacerbates economic imbalance. The high rates will predictably draw in foreign capital, and the low exchange rate for the yuan will only aggravate the phenomenon by making it cheap in forex terms to buy high interest rate yuan obligations. But the Federal Reserve's easy money policy heightens incentives for speculators to invest the dollars it's printing in China rather than America. Such a capital outflow would help explain why inflation has been so low in the U.S., notwithstanding the Fed's 'round the clock money printing operation. Capital outflow detracts from whatever stimulus effect the Fed's quantitative easing program might have. Although unintended, QE is boosting China's forex reserves. The Chinese want to eat their cake and have it, too. So does the Fed, hoping that printing money will spur growth without inflation. But it isn't spurring much growth, and is producing inflation in China. That does nobody much good.

Monetary policy is heightening the imbalance between China and America. The Fed doesn't intend this, and the Chinese surely recognize the dangers as well. But China can't turn on a dime away from an export driven economy, and the Fed clearly will persist in QE come hell or high water. So we shouldn't expect things to change much in the foreseeable future.

Still Searching for the Gold Standard

Contrary to popular belief, the gold standard lives on. Not as a linkage of paper currency to a precious metal, but as the human search for certainty in the value of currency. And the results today are as convoluted as earlier experiences with the gold standard.

The gold standard--making a unit of a paper currency convertible into a fixed amount of gold--was used first and foremost to provide assurance against uncontrolled printing of money and the inflation that could follow. Such inflation could be created by whoever issued the paper money--be it a bank or a government--and gold convertibility was seen as stabilizing the value of the currency.

Gold, however, doesn't ensure absolute certainty of value. When large amounts of gold become available (from mining or other sources), price inflation can result. The Spanish conquest of much of Central and South America in the 1500s resulted in massive amounts of Aztec and Incan gold and silver flowing to Spain. Price inflation followed, even though Spain used gold and silver currency.

Gold as a reserve for paper currencies has not always provided a foundation for stability. In the 1930s, central banks protecting the gold standard acted too conservatively to combat the growing economic depression. In doing so, they may have aggravated the deflation that resulted from the stock market crash and accompanying economic downturn, which in turn hindered recovery from the depression. Eventually, the U.S. and other nations had to devalue their currencies to help foster recovery. What happened here was that the nation issuing the currency had gone into a depression and the real world value of its currency had correspondingly fallen. The conversion value of its currency into gold had not changed, so the currency was overvalued and deflation ensued. Ultimately, the gold standard did not prevent paper currencies from falling in value because paper currencies takes their true value from the economic strength of the issuing nation.

Gold can serve as a currency because people think it's valuable and accept it as a medium of exchange. The same is true for anything people accept as valuable--tobacco, cotton, deer skins, beaver pelts, sea shells, and American cigarettes all have served as currency at various times and in various places.

People want their currency to be stable. It doesn't really matter what is used as currency. Most currency today consists of electronic entries in computer systems. But people believe these little bits and bytes of data have value, so they accept them as a medium of exchange.

What hasn't changed from the days of the traditional gold standard is the desire for certainty. And that's the problem. The Euro bloc, in which 16 nations have adopted the Euro as a common currency, is simply a reincarnation of the gold standard. By adopting the same currency, issued by a central bank that supposedly must limit its responsibilities to maintaining the value of that currency, the Euro bloc nations hope for an island of stability in the raging seas of the currency markets. But these nations can't reach Avalon unless all members row their oars together and pull their own weight. That hasn't been happening and the ship is foundering.

China and other nations that link the values of their currencies to the U.S. dollar also seek to create a latter day gold standard. Although now a distant memory, there was a time (the 1970s and 1980s) when the dollar was seen in some parts of the world as rock solid. In the Soviet Union and Communist China, U.S. currency was coveted and hoarded, while local currencies were regarded with suspicion and disdain (China has a long history of currency inflation). As China integrated market forces into its economy, it linked its currency to the dollar, not as an export weapon so much as an anchor against inflation. Some Latin American nations that struggled with inflation did the same thing at various times. (Most notable among these were Argentina and Mexico.)

China's dollar link was crucial to its ability to grow. It removed the risks of currency fluctuations, encouraging American businesses to invest in China. The Chinese very much wanted American investment in order to obtain American know how and technology. The intellectual capital gained by China from American (and other foreign) investment leveraged its rate of growth. On its own, China could never have achieved prosperity as quickly as it did.

Of course, as China grew, its currency became more valuable in relation to the dollar and China's dollar link conferred an exporting advantage that is now essential to its economic model. Despite increasing inflation and foreign political pressure, the Chinese want to protect their exporters, because they don't have internal markets to substitute for the export markets they would lose from a stronger yuan. To combat inflation, the Chinese have employed alternatives, such as higher reserve requirements for their banks, price controls, consumer subsidies and sales from state food reserves (the latter a tradition from the days of dynastic China).

Americans shouldn't think that their own government isn't implicated in China's search for a contemporary gold standard. The U.S. government was for a time quiescent about China's exchange rate policies in order to encourage China to ally itself with America against the Soviets, and to open up China to U.S. investment. Moreover, the inflow of inexpensive Chinese goods has helped keep inflation low in America, which in turn permitted low interest rates and booming real estate values. Okay, so not everything turned out wonderfully, but the 2008 financial crisis wasn't the fault of the Chinese. Indeed, they lost money investing in American mortgage-backed securities.

In spite of the financial turmoil of the past three years, Europeans and Asians still cling to their gold standards, looking for certainty in the value of currencies. Gold standards can have short term benefits. Long term, economic conditions change and so do currency values. The squabbles of the Euro bloc over bailouts, quantitative easing, haircuts for creditors and the growing disquiet of German taxpayers, are a struggle over who will bear the costs of maintaining Europe's latter day gold standard. China's accumulation of a vast hoard of U.S. debt securities (and their attendant investment risks), along with the fiscal costs of consumer subsidies and state-owned food stocks, are China's costs of maintaining its 21st Century gold standard.

The gold standard protects savers, investors and creditors. Pure fiat currencies tend to favor borrowers and spenders. Thus creditor nations prefer a gold standard. Borrowing nations argue for free-floating currency rates. A gold standard doesn't necessarily favor exporters--they are better off or not depending on where the exchange or conversion rate is set. The Euro bloc includes both creditor nations and borrowing nations; hence the conflicts that may yet cause the Euro to collapse. The dollar bloc similarly includes creditor nations and borrowing nations; its tensions, too, are palpable.

Ultimately, there is no permanent gold standard or other absolute reservoir of value. The never-ending quest for certainty is trumped by the incessant process of change, mutation and evolution in the economy. (See http://blogger.uncleleosden.com/2010/06/what-if-economy-is-creature.html.) But the process of human advancement can be said to be a long struggle for certainty. Deliverance from the vicissitudes of hunting and gathering, the extremes of the weather, the unpredictability of farming, the dangers of aggressive peoples, the horrors of plagues and other deadly illnesses, the volatility of the business cycle, and the capriciousness of financial markets all underlie the imperative for human advancement. All the bug-eyed, rifle-cleaning, ridge-dwelling, fringe group wackos panting for the gold standard can wipe the drool from the sides of their mouths and rest easy. It's alive and kicking, and will continue to bedevil central banks, high ranking government officials, policy makers, business executives, and the rest of us as far into the future as one can see.

So What the Heck is China Up To?

The Chinese central bank raised interest rates today, signaling a slowdown in the growth of China's economy. Financial markets in the rest of the world took the news badly. The U.S. markets dropped 1.5 %.

China's government moved to cool down a blistering economy, driven by fear of inflation and a bubble in its real estate market. Must be tough to have such problems--economic growth that's too fast, rapidly rising asset values. Oddly perhaps, these problems stem from the U.S. Federal Reserve's easy money monetary policy. Because the Chinese yuan is tied to the dollar at a more or less fixed exchange rate, U.S. monetary policy flows through to China and becomes China's de facto monetary policy. The flood of liquidity from the Fed has had limited stimulative effect in America because of the slack in the U.S. economy. But China's economy is much more taut and easy money makes things happen in China.

Just as America's monetary policy becomes China's, so does China's monetary policy become America's. The dollar rose in the currency markets, and interest rates in the U.S. Treasuries market moved up, seemingly in sympathy with the Chinese move.

Logically, if the Chinese government wanted better control over the Chinese economy, it would de-link the yuan from the dollar and rid China of the Fed's easy money policies. Why hasn't it? With all the international outcry over the relatively weak yuan, the Chinese would garner brownie points with many other nations if they did so. And Chinese manufacturers could probably cover much or all of the cost increases resulting from a rising yuan by squeezing more productivity out of their facilities and employees. The Japanese faced the same challenge with a rising yen in the 1970s and 1980s. They quite successfully increased productivity and protected their export industries.

While the Chinese central bank, unlike the U.S. Fed, does not issue statements explaining its actions, a glance at the tea leaves suggests an explanation. China holds trillions of dollars of investments denominated in dollars--U.S. Treasuries, mortgage-backed investments and other paper. De-linking the yuan from the dollar, and the resulting fall in the dollar, could impose hundreds of billions of dollars of investment losses on the Chinese. Even though China is no longer expanding its dollar exposure, and instead buying Euro denominated investments, it remains stuck in a bear hug with the dollar and must protect the value of the dollar. By raising its own interest rates, it raises the value of the dollar, offsetting some of the dollar's recent weakness.

The underlying source of all this angst, sturm and drang is China's trade surplus. Whether denominated in dollars, Euros or whatever, China maintains a large and persistent trade surplus with the rest of the world. By all indications, it intends to maintain this trade surplus, even though Chinese leaders pay lip service to the notion of increasing domestic consumption. Much of the outside world perceives China's trade surplus as economic aggression, and reciprocates with disapproval, at a minimum. But China, the world's oldest continuous civilization, hasn't survived 4,000 years by poking everyone else in the eye with a sharp stick. So what the heck are they up to?

China has a severe demographic problem. It doesn't have enough young people to support all the older Chinese who will be retiring in the next few decades. With an already enormous population of 1.3 billion relying on its limited resources, China can't add enough young people, either through births or immigration, to satisfy its needs. By saving enormous amounts of money denominated in key foreign currencies like the dollar and Euro, China acquires the ability to purchase resources from other nations to support its old folks. It can draw on the productive capacity of younger people elsewhere in the world by purchasing the goods they produce. Without a large stash of foreign currency, however, China could have a difficult time supporting its retirees through imports. It would have to export Chinese goods in order to acquire the necessary foreign exchange, and its ability to do so ten, twenty, thirty or more years from now is unpredictable. By stashing away foreign currency now, while it has a trade advantage, it builds up a reservoir on which to draw later.

What does this mean for the future? That America will be closely connected to China for a long time, and very possibly on terms not highly favorable to America. But the good news is that eventually, when China needs to import goods to support its elderly, it will logically look to spend many of its dollars in the country that issues them.

Japan's Yen Intervention: A Trade Skirmish?

The Japanese central bank has unilaterally stepped into the currency markets and bought U.S. dollars in an effort to lower the value of the yen and push up the dollar. It appears to have increased the dollar by about 1%. In economic terms, this intervention is similar to a 1% across-the-board tariff on all U.S. goods imported into Japan. Conversely, it creates a 1% price cut on all Japanese goods imported into the U.S.

While American consumers wouldn't mind a 1% price cut, this intervention could export some of Japan's unemployment to the U.S. American workers making products that compete with now cheaper Japanese goods may face a greater risk of layoffs and reduced income.

The Japanese government apparently had hoped for international support for its intervention. It got none. Everyone's hurting and no one wants to take someone else's unemployment.

There was no public reaction from the U.S. government to the Japanese intervention. A 1% shift in currency valuations is small from a medium to long term perspective, and could easily shift back within a few days from now in today's volatile currency markets. The U.S Treasury has its hands full squabbling with the Chinese about the valuation of the yuan, and probably doesn't want to fight on two fronts simultaneously.

The yen is rising because it's becoming more valuable. One reason is that the Chinese government has been buying yen denominated assets in order to diversify away from the dollar. The Chinese are killing two birds because this diversification is also likely to weaken the dollar. Because the Chinese yuan is still essentially tied to the dollar, when the dollar sinks, so does the yuan. The Chinese tack allows them to maintain approximate parity with the dollar while gaining a trade advantage over the Japanese.

By intervening, the Japanese central bank is in effect riposting with a two birds with one stone tactic of its own. Pushing the dollar up also pushes up the yuan against the yen, thereby recovering some of the trade advantage the Chinese have gotten lately.

Next week, the Federal Reserve will meet again and perhaps give more guidance on the extent of the quantitative easing (read, printing of money) it has in mind for the foreseeable future. The more the Fed quantitatively eases, the lower the dollar will fall in the currency markets. The Japanese may perceive this as aimed at them, even though it isn't. They might respond with more intervention.

With economies around the world slowing and governments too leveraged for much more stimulus spending, currency manipulations are a deceptively cheap and easy way to improve a nation's prospects. The problem is that one nation's gains come at the expense of other nations. When they all start to maneuver their currencies around, they wittingly or unwittingly form a circular firing squad aiming inward. Things weren't pretty when that happened in the 1930s and they wouldn't be pretty if it happened again.

How the Chinese Yuan Re-valuation Will Affect the U.S. Real Estate Market

The re-valuation of the yuan recently announced by the Chinese government has implications for the balance of trade, capital flows into China, and political relations between the U.S. and the People's Republic. What seems to have gone unnoticed is the consequence of this re-valuation for the U.S. real estate market.

As the dollar falls in relation to the yuan, it will make less and less sense for the Chinese to lend to America. They would need interest rates that covered not only lending costs and risks, but also currency risk in an environment where the yuan will almost surely rise. Current low U.S. mortgage rates, a boon to buyers who are financially qualified, are like cold pizza to lenders. And the Federal Reserve appears dead set on keeping interest rates low, lower and even lower. During much of the past decade or so, the Chinese were big buyers of American mortgage-backed investments. The mortgage crisis cooled their jets big time. Even though the secondary market for mortgages today consists almost entirely of U.S. government guaranteed investments, currency risks will make the flow of funds from China less unpredictable. It's true that Europe and the Euro don't, at the moment, provide China with attractive alternatives to the dollar. But China is working on boosting domestic demand and building an internally focused economy. Over time, it will demand fewer dollars and Euros, and provide less real estate financing in the States.

The excess inventory from foreclosures, short sales and the like will be a drag on the real estate market for years. The shrinkage of foreign credit due to the falling dollar will add to the stagnation. We'd better hope the falling dollar gives U.S. exports one helluva jump start, because it will probably tighten up an already parsimonious mortgage market.

Winners and Losers from the Yuan Re-valuation

Winners

China cleverly announced its decision to permit its currency, the yuan, to float more widely and gradually move higher against the dollar shortly before the G-7 and G-20 meetings. It took away the biggest gripe other nations had about it, and leveraged its ability to lecture them about their failings. The Chinese, who are heavily invested in both dollar and Euro denominated assets, have much to say about the profligacy of the West, and much to gain if Western nations get their financial houses in order. The re-valuation was begun just as China is turning to building domestic consumer demand in order to lessen its dependence on exports to the West. It's no accident Chinese authorities didn't interfere when workers at Honda and Toyota plants in China went on strike. Higher wages in China will boost domestic demand. (Henry Ford did something similar in 1914 when he first began paying workers the then astonishing wage of $5 a day.)

China in the long term will win from the re-valuation of the yuan. Its manufacturers will seek to become more efficient and cost effective in order to preserve their export markets. Given China's indisputable prowess in manufacturing, expect many of them to succeed. The same thing happened with Japan. In the early 1970s, the yen traded at over 300 to the dollar. Despite various Japanese government measures to keep the yen down, it rose to the low 200s per dollar by the end of the 1970s. But Japan kept running a trade surplus with the U.S. because its manufacturers continued to improve (and in some cases move their factories to lower cost countries in Asia, but this still helped Japan maintain a surplus with America). In the 1980s, the yen stubbornly remained around the low 200s until a 1985 international agreement called the Plaza Accord led to its devaluation into the low 100s. Nevertheless, Japan's trade surplus with the U.S. remained sizable. It remains sizable to this day (over $44 billion in 2009), even though the yen now trades around 90 to the dollar. Japan's exporters still work hard to improve efficiency and quality. The Chinese will do the same, and their likely success will preserve many export markets. Efficiency improvements will also help them to seize market share in China's growing domestic markets, reducing opportunities for America and other nations to export to China.

Mexico and other low cost manufacturers will also win. America's now chastened consumers, who have rediscovered the virtues of saving, will resist higher prices. As China's prices rise, American retailers will seek out alternative inexpensive sources of supply. These will almost always be in other foreign nations with low labor costs.

Currency traders at big banks, hedge funds and elsewhere will have more opportunities with a more flexible yuan. Traders like volatility, because price movements, whether they are up or down, create larger profit opportunities than stable exchange rates. Big banks will also profit from selling derivatives products to hedge or speculate in the value of the yuan.


Losers

The United States could easily end up on the short end of the stick. A higher yuan will improve American industry's ability to export to China. But long term success is far from certain, as Chinese manufacturers will fight back by vigorously improving their capabilities. America's failure to achieve a trade balance with Japan after the yen more than tripled in value over 30 years is sobering. America needs to concentrate its resources on developing products and services other wealthy nations want to buy. Its last couple of decades of growth have been financed by foreigners purchasing American debt, and that's a trend that won't last. A big recent American innovation, social networking sites, may be fun, and popular overseas as well as here. But these sites are not noticeably profitable, and won't add much to our national income. Investment in basic research and development, bio tech and high tech should be favored. We don't need more financial engineering. We need more science-based engineering. Long term economic growth can't rest on the hoped-for continued escalation of real estate or any other asset. It should come from making things other people want to buy.

EU nations are also likely losers. The still unfolding sovereign debt crisis reveals that Western Europe, like America, used debt instead of productive capability to foster "prosperity." Europe is less innovative than America, and its prospects for growth are correspondingly lower. (EU per capita income is already about 30% lower than America's and Europeans should worry about whether or not that comparison will worsen.) As the rising yuan strengthens China, and American industry seeks to riposte, Europe will be caught in the cross-fire. Germany, with its famed discipline, might maintain relative parity. But the rest of Europe may have to rely increasingly on the quaintness of its tourist sites to pay the bills.

Political Winners

While we've been focusing on economics, the yuan re-valuation eases tensions between America and China, and makes it easier for them to work together on common problems. China wants to become wealthier and stronger. But it would not want America to become weaker. America is the world's police officer, and is taking the brunt of the load of dealing with international nut cases like North Korea's Communist government and the radicals in power in Iran. If the U.S. were to weaken and reduce its level of engagement in Asia, China would be stuck with a lot of nasty problems. The Chinese benefit economically from a prosperous South Korea, so they'd have the primary burden of constraining the loonies in Pyongyang, a job now largely performed by the U.S. troops on the 38th parallel. The Chinese would also have to greatly increase their involvement in the Middle East, a crucial source of petroleum for them and many of their Asian trading partners. The U.S., at great cost in lives and money, currently ensures a steady outflow of oil from the Middle East. And the U.S. war against Islamic radicalism in Afghanistan and elsewhere suits China's purposes. The same radicalism has seeped into the Muslim populations of Chinese Central Asia, creating unrest and occasional violence. The Chinese know they would become a primary target if America withdrew from the field of fire. America, in turn, needs China's cooperation with its many problems in Asia and elsewhere. Thus, both nations are political winners from the yuan re-valuation.

China Bails as Germany Declines to Bail. Will America Bail?

The Chinese government is conducting stress tests on over 1,000 Chinese companies to ascertain how a rise in the value of China's currency, the yuan, would affect them. See http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ahhhMkrA.A.I. This happens at a time when the U.S. and other countries have complained about the strength of the yuan. Members of Congress have threatened to take action against China (although given Congress' record of alacrity on legislative initiatives recently, the Chinese would hardly be quivering in their shoes).

Nevertheless, it is potentially significant that China's government is scoping out the impact of re-valuing the yuan upwards. Americans and other non-Chinese shouldn't delude themselves that their complaints have much to do with China's apparent inclination to re-value. China's economic policies are driven by internal concerns. While the Chinese government hardly is a paragon of transparency, there's probably an overriding reason why China might now re-value the yuan. It has no good investments outside of China for future trade surpluses. The dollar, overall, has dropped during the last decade and can be expected to keep sinking. The Euro is suddenly looking shaky, with the recent surge of EU sovereign debt problems, hinky national accounting systems and preposterous posturing substituting for a solution. The yen offers low-yields and doesn't have attractive long term prospects, not with Japan's massive government debt.

The yuan, by contrast, is likely to be a good investment. Although there is currently a bubbly froth in China's real estate and credit markets (sound familiar?), the People's Republic remains on an upward long term trajectory. By raising the value of the yuan, the Chinese government reduces China's trade imbalances and the cash surplus it needs to recirculate to other countries. U.S. imports to China may rise, although you can bet China's government intends to encourage Chinese companies to redirect their attentions to domestic markets. Throughout the last 30 years of modernization, the Chinese have quietly made a priority of economic self-reliance, encouraging Chinese companies to improve technological applications and productive efficiency, with the goal of competing against and ultimately supplanting foreign companies selling in China. If the yuan is re-valued upward, China's push for self-sufficiency will intensify, and probably enjoy considerable success. Then, the Chinese government will look smart for investing in the yuan and bailing on the currencies of stagnating foreign nations.

Meanwhile, back at the ranch, the EU is starting to look less unified. The French have stepped forward and argued for an explicit bailout of Greece. The Germans, no doubt irked by the fact that France's gallantry would be funded by Germany's wealth, have intimated that perhaps Greece should depart the EU in order to pursue other opportunities (or something to that effect). On a subliminal level, it's disquieting to see France and Germany disagreeing over a nation in the Balkans. At least this time, neither stormtroopers nor poilus are on the alert.

Nevertheless, the Europeans seem to be drifting back toward the dynamics of continental relations in the early part of the preceding century, when nations seemed simply to misunderstand where their neighbors were coming from. France's President, Nicholas Sarkozy, by proposing a concrete bailout plan for Greece, was inviting Germany's Chancellor, Angela Merkel, to commit political suicide. Seeing as how Merkel worked her way up the political ladder to become Germany's first female chancellor, self-immolation isn't likely to be in her playbook. While the French electorate is surely applauding Sarkozy's efforts to allocate some of Germany's wealth to Greece, Germany's electorate will only encourage Merkel to flip Sarkozy a pelican, or something like that. This isn't likely to end in a cozy circle with everyone roasting marshmellows and singing Kumbaya.

Greece has threatened to go to the IMF for assistance if the EU doesn't soon come up with a concrete bailout plan. The Germans shrugged. Without German participation, there will be no EU bailout plan because France and other pro-bailout nations have only the courage of Germany's convictions.

Thus, it may pass that Greece goes to the IMF. That's when Greek prime minister George Papandreou's quiet visit with President Obama last week may acquire greater significance. While next to nothing has been said publicly about the purpose and outcome of that meeting, it wouldn't be a surprise to see an American contribution to the IMF not long after Greece applies for help. After all, doughboys and GIs twice went over there to solve Europe's problems. Greenbacks may have to make the same trip soon.