Losers and Winners on the Ides of March

They weren't kidding about the Ides of March.

LOSERS. This is a day for losers.

Japan. With the 9.0 earthquake (about as big as they come) and the 30-foot tsunami that followed, Japan got walloped. Now, the rising risk of reactor fuel meltdown has the Japanese nation turning to its nuclear industry and asking, "Et tu?"

Industrialized World. Japan is deeply integrated into the world economy, as an exporter and importer. The ramifications of the soon-to-come earthquake-driven recession there affect crucial industries around the globe, including electronics, automotive, insurance (obviously), petroleum, and banking. With China slowing its economy to rein in inflation, Europe turning to austerity as it struggles with its currency crisis, and America getting by on the methadone of Federal Reserve easy, easy money, there's not a whole lot of horsepower in the international economy to pick up the slack left by Japan. The stock markets are starting to figure this out.

Nuclear Power Industry. While some Japanese nuclear power plant workers may, in effect, be committing hara kiri trying to contain meltdown risk, nuclear power projects worldwide are being curtailed and cut. When you play around with stuff that has real potential for destruction, no amount of engineering can guarantee safety. That's true of nuclear energy, and it's also true of financial derivatives.

Libyan Rebels. With the world's attention diverted to East Asia, the Libyan rebels' chances for resupply and a no-fly zone from other nations are fading rapidly. The U.S. buys little or no Libyan oil, and has no vital national interest there. Britain and France were quick to advocate a no-fly zone, but they know that only the U.S. Navy has the resources and power to actually impose one. That means America would have to bear the burdens and take the casualties. The U.S. government is clearly stalling for time--its demand for UN authorization is a transparent pretext for delay. Maybe the Obama administration knows something it can't really share with the rest of us, yet. Things in the Persian Gulf may be worse than the news services have reported. Saudi Arabian troops have rolled (in unmarked vehicles) into Bahrain, in order to help the Bahraini government stay in control. Things in the Persian Gulf could be deteriorating, and the U.S. military may have to keep its powder dry in order to retain the option to play a role there, where the U.S. has a large vested interest.

Barack Obama. The President hesitated to join up with the Libyan rebels, and they now think he has a secret pact with Gaddafi. Obama has called on Gaddafi to cede power and leave Libya, so Gaddafi knows that Obama isn't on his side. No matter who wins in Libya, America and Obama lose. The Japanese nuclear crisis has blown up Obama's nuclear power policies, and a recession in Japan could put pressure on the administration to apply more fiscal stimulus (i.e., engage in more deficit spending, which isn't exactly politically trendy these days). The perhaps not well publicized unrest in Bahrain and Saudi Arabia, along with a deteriorating situation in Yemen, put the Obama administration in the position of wanting to side with oppressive monarchs in order to protect U.S. interests. Even if these monarchs survive, America's already compromised image in the Arab world will suffer.

Republicans. International events are taking front page news coverage away from Republicans and their domestically-focused agenda. They can't easily criticize President Obama's foreign policy, which is strikingly similar to George W. Bush's. They may have to settle for appearances on Dancing With the Stars.



WINNERS. Even in ugly situations, there are winners. That's why you find the most cynical of stock market speculators swarming into select parts of the market when a crisis hits.

Natural Gas and Shale Oil. The NIMBY style controversies over fracking may seem manageable in light of massive radiation releases from Japanese nuclear power plants. Natural gas and shale oil might have to be repriced to cover the costs of reimbursing people damaged by fracking. But the stuff is found in plenitude in these United States, and will surely be a growing source of energy in the future.

Coal. It's not beloved by environmentalists and mining it leaves ugly scars on the land. But America has massive coal reserves and will surely turn more and more to them in the future. Long term, alternative/renewable energy sources may begin to play a major role in America, but for the short and medium term, coal will be definitely be a part of our lives.

Oil Producers. Oil producers, like Venezuela, Russia, Nigeria and Canada, see their fortunes rise. Too bad not all of them are friendly to America.

Iran. Iran gets a win-win here: increased revenues from rising oil prices and more opportunity from the Arab uprising to stir up Shiite co-religionists on the Arabian peninsula.

China and Taiwan. As Japan's economy struggles, Chinese and Taiwanese companies will get a chance to get into high value-added product lines the Japanese have dominated. Semiconductors and high tech automotive components are obvious targets. Look for Chinese automobile companies to try to move up their deadlines for introducing their products to America.

The 21st Century Global Economics Experiment

Not since the days of the Cold War has there been such a clash of national economics policies. The UK has made an abrupt U-turn away from deficit spending, embracing the hair shirt of austerity. Elsewhere in Europe, big spending EU governments have followed suit, although not with the fervor of true believers. Keynesian economics may be disproved, or not.

America is caught in political crosscurrents, with fiscal policy stifled by a prairie fire of populism. The Federal Reserve is the only show in town, and the financial markets believe the Fed will put on a dazzling performance. Stock, commodities and bond valuations all presume that the Fed is going to walk into the joint and be a real big spender. Monetary policy is at the plate, and no one is on deck. The Austrian school of economics may be disproved, or not.

In China, an ad hoc amalgam of state controlled enterprise and fiercely capitalistic forces has propelled the Chinese economy into a meteoric rise. The Communist Party in China has craftily exploited market forces to raise living standards, thereby legitimizing its continued control while it gradually jettisons a failed ideology. The Chinese are wittingly or unwittingly recreating an updated version of dynastic China, where government played a large role in the economy but allowed private trade and commerce to spark growth. Imperial China was for over 1,000 years the wealthiest nation in the world, so this model has a history of success. If China continues its upward trajectory, free market ideologues may be discombobulated. Or not, if the heavy hand of state control of the economy and political freedoms smothers the individual initiative needed for lasting prosperity.

Since economists can't conduct controlled experiments, the world today is about as good as it gets for students of comparative economics. Ten or twenty years from now, tentative conclusions might be possible. Or not, since nothing in economics is ever truly resolved. Schools of thought mostly go in and out of fashion.

But what if they're all wrong? What if austerity in the Old World produces stagnation or even recession? What if the Fed's forthcoming liquidity dump fails? The financial system already has a trillion dollars of unused liquidity on deposit at Federal Reserve banks. More liquidity is likely to be just the proverbial push on a string, while stagnation continues. And what if China's real estate and credit bubbles burst, pushing China into the stagnation experienced by Japan and now America? With China's severe demographic problem of too many old and not enough young, any slowdown in China's growth could upset the entire apple cart the government is trying to push along.

If all models and all schools of thought are wrong, we have a problem. There wouldn't be any credible paradigm in which to find solutions. We might find ourselves mired in slumps and malaise, with struggling to muddle through the only strategy. But Americans are good at muddling. Every major crisis in American history, from the Revolution to the Civil War to World War II to the Cold War, was a painful muddle. Even if all the economists are confounded, Americans can still have faith in themselves, and that's always proven to be enough.

Currency Exchange Rates: Playing Musical Chairs with Fire

Currency exchange rates have been much in the news as President Obama makes his first visit to China. The dollar is sinking, and China has ensured that its yuan falls in tandem with the dollar. Other nations, disadvantaged by the drop in two of the most important currencies in the world, complain vociferously. The U.S. government proclaims a strong dollar policy, and then looks away as the dollar continues to fall. The Chinese government scolds the U.S. government, which lectures back.

The currency markets are different from other markets. They don't just consist of private buyers and sellers. Governments also get involved, and generally do so for political and macro-economic reasons. Since nothing is as unpredictable as politics, currency exchange rates can move in ways that seem seriously out of whack.

To make things worse, currency exchange fluctuations are, at best, a zero-sum game. One currency's gain comes at the expense of other currencies, and resulting trade imbalances have a similar effect on the nations issuing the currencies. Only today, it's worse than that. Two powerful nations--America and China--rely on policies that may produce near term gains for them but potential longer term losses for everyone. The currency markets may now be a negative sum game.

For decades, China has linked the yuan to the dollar. Thirty years ago, the rate was about 8 yuan to the dollar. Today, it's around 6.8 yuan to the dollar. By contrast, the Japanese yen has tripled in value against the dollar during the same time period. The yuan has never been fully convertible into other currencies, as China has sought to prevent the rapid inflows and outflows of foreign capital that have bedeviled the development of other Third World nations. Considering the devastation wreaked in Asia by the 1997-98 financial crisis, one would have to concede that the Chinese have a point. They aren't unvarnished capitalists, and won't allow markets to operate freely simply as a matter of principle. They utilize market forces pragmatically, mixing in government dictat whenever they believe Adam Smith's invisible hand may be a little shaky. By holding the the yuan relatively steady against the dollar, they ensure pricing stability for their exports to dollar bloc nations (i.e., nations that use the dollar or maintain currency stability against the dollar, including the U.S. and, at times, various nations in Latin America). Chinese manufacturers could largely ignore the complexities and costs of currency fluctuations and commit to low, fixed prices to buyers abroad.

China's fixed exchange rate did much to make China a dominant exporter. But it had to take a lot of dollars in exchange--ultimately trillions of dollars. These were mostly invested in U.S. Treasury securities and American mortgage-backed securities (on which the Chinese have already taken nasty losses resulting from the mortgage crisis). Now, as the dollar falls in value, China loses more money on these assets. Hence, China's scoldings to the U.S. government to get its house in order and prop up the greenback.

The U.S. government in turn has countered that China is itself responsible for this dilemma, having created the trade imbalance that resulted in its enormous dollar holdings. The U.S. government would have China restructure its economy to focus on domestic consumption, and reduce exports to take pressure off the dollar.

However, neither government is doing much to change the status quo. China's government has launched a major stimulus program to forestall economic slowdown, with much of its spending directed at building infrastructure. These are wise expenditures for a developing nation, but they do little to promote domestic consumption. The Chinese are among the world's most frugal people, because they have no other choice. China has no Social Security system. Most Chinese have no pensions; the pensions that exist are meager. The health insurance that was part of Communist China's iron rice bowl has disappeared along with sales of Chairman Mao's little red book. The Chinese save because it's the only way they can have health care and a half-way decent retirement. The Chinese government has done nothing to alter this dynamic. Since China needs about 8% economic growth every year simply to keep up with population growth, it has no choice except to keep exporting. And to do that, it has to keep its currency stable against the dollar.

The U.S. government has responded to America's economic crisis primarily by borrowing and printing dollars--shiploads of dollars. Pushed by the forces of a lot of supply and not so much demand, the dollar has not surprisingly fallen in value. Euro bloc nations have grumbled about the rise of the Euro, especially export-dependent Germany. Several smaller Asian exporting nations have recently been buying dollars in order to defend their currencies. Oil exporters, like Russia and the OPEC nations, have complained of losses in their holdings of dollar-denominated assets and hinted at pricing oil in a basket of currencies to free themselves of dollar risk. In short, the U.S. government's primary response to the economic crisis has imposed losses on the rest of the world.

The flood of the cheap money being pumped out by the Fed has fueled the "carry trade," in which speculators borrow dollars at extremely low interest rates, convert them into currencies where interest rates are higher (such as in much of Asia) and invest overseas for those higher returns. This outflow of dollars is stimulating economic activity in other nations, and appears to be creating asset bubbles in Asia. While other nations don't mind a touch of stimulus courtesy of the Fed, many in Asia have vivid and disturbing memories of the Asian financial crisis of 1997-98, when asset bubbles fueled by inflows of foreign capital burst painfully and caused severe recessions.

There is little sign that the U.S. government intends to pull its stimulus back. The Fed has made clear its intention to maintain zero interest rates as far into the future as one can foresee. The carry trade will expand and perhaps even explode--in a time of slow economic recovery, it's one of the very few ways to make fast money. China will complain and lecture, but won't change the exchange rate of the yuan by much, because it needs continued access to American markets. Other exporting nations will grumble and defend their currencies with little likelihood of long term success. Oil exporters and other holders of dollars (including China and Japan) will take more losses on their dollar reserves, as there is no other currency or asset into which they can easily transfer their wealth.

American and Chinese expediency have created dangerous dynamics in the world economy. America can win only if other nations continue to fund its gigantic deficits and tolerate its uncontrolled printing of dollars by taking losses as the dollar falls. China can win only if it continues to export to America and hope that other nations will help it fund America's deficits while they become more vulnerable to Chinese exports themselves. The rest of the world is scrambling to figure out how to limit its losses and avoid being blown up by carry trade asset bubbles. Everyone, one way or another, is trying to shift their economic problems to other nations, a process that won't have a happy ending. This is starting to look like a game of musical chairs where the limited number of chairs is diminishing and all could end up net losers. If, somehow, the people running these nations would stop playing a children's game.