2014-02-27

The Logic of Strategy: Yuan Devaluation and the Road to Trade War

There's an excellent post for anyone interested in China: Review of “The Rise of China vs. The Logic of Strategy” by Edward Luttwak. I just finished the book and I don't think I can add much to that complete and thorough review. Read through it to get an idea of the arguments put forth in Luttwak's book, plus a summary of all the players.

If you're lazy, the quick and dirty summary can best be given by a comparison with Germany and England prior to WWI, with China as Germany and the USA as England. Germany was the up and coming power and had surpassed England economically, culturally and academically. What got Britain very nervous was Germany's decision to build a large navy. England responded with a new ship, the dreadnought, and with a diplomatic flurry to move enemies into the neutral or friendly category. The result is well-known: although eclipsed in many areas, British superiority in diplomacy and war defeated Germany twice.

China's rise was similarly peaceful, but China's aggressive military buildup and claims to South China Sea territory have all of the surrounding nations on alert. Due to the advent of nuclear weapons, logic dictates that total war will be avoided in Asia. However, the U.S. and a group of allies could effectively deter Chinese aggression in the Pacific, and even though the U.S. has not sought out a coalition, Chinese aggression has pushed Southeast Asian nations (and even Mongolia) into the arms of the U.S. Finally, due to its size and the desire to avoid an outright conflict, the United States has a very powerful weapon if it can overcome the free trade ideology: economic policies designed to slow China's economic growth. Using economic policy, the U.S. could deliver an effective blow to Chinese growth that will keep its military from exceeding U.S. capabilities without requiring a massive buildup in military spending, a policy which would further slow GDP growth in China. If the U.S. and regional economies prefer U.S. influence in the region to that of Chinese influence (and putting aside all ideology, the distant hegemon remains more attractive than the near), they can choose a path of slower economic growth designed to keep China from becoming the dominant power.

The reason for this policy is not a U.S. desire to keep China from rising. Instead, it is China's increasingly aggressive policies in the region that make neighbors nervous. China makes claims to territory based on very loose evidence, such as a map from hundreds of years ago. Using the same logic, Italy could claim all the land formerly held by the Roman Empire or Sri Lanka can claim India (one example given by Luttwak). No one would fear a claim by Italy or Sri Lanka, but imagine Italy was among the fastest growing economies in the world, rapidly building up its military capabilities and it was openly making bold claims to territory. Everyone in Europe, North Africa and the Middle East would be nervous.

There's a talk by Luttwak on the topic of his book:



The "logic of strategy" coincides with social mood and current events. Protectionism is on the rise due to economic factors tied to declining social mood, but Luttwak's book adds a geostrategic grounding for protectionism as part of an economic cold war in the Pacific designed to restrain China's ambitions. Luttwak doesn't delve into economics in his book, but it is very easy for me to imagine the path to protectionism.

There are three U.S. China policies according to Luttwak. The first is the Pro-China Treasury Department. This wing also represents the capture of American government by Wall Street and the financial industry: Treasury doesn't care about manufacturing and pursues a China policy solely almost aimed at profits for Wall Street. The Treasury also represents the idea of free-trade as ideology. Manufacturers have almost no voice in American policy these days.

Next is the State Department, which confronts China in Asia. The State Department is mainly concerned with the "Asia Pivot." It was not U.S. policy to encircle China by forging closer alliances with Southeast Asian nations, rather China's own aggressive posturing pushed these nations into proactive efforts to attract the United States. There are areas where the U.S. was proactive though, such as working to strengthen ties with India.

Finally, there is the national defense establishment. They view China as potentially the main enemy of the future, though this is as of yet undecided. China is a cyber threat and potential military threat. The Defense Department is involved with strengthening regional military ties, such as the naval visits to Vietnam.

Prediction

The protectionists are ever so slowly gaining the upper hand thanks in part to negative social mood. 2008-2009 will probably mark the peak moment for Wall Street and the Treasury Department, even though there is as yet no sign of it in Washington. Changes can be seen in the form of issues such as immigration, which has turned the grassroots of the conservative movement against the Chamber of Commerce and large corporations (due to an attack initiated by the latter against the former). This has pushed the Overton window of acceptable debate among conservatives who can now take shots at big business. There is also the growing libertarian faction pulled together by Ron Paul that supports his son, Rand Paul, that consistently attacks the Federal Reserve and Wall Street. Put it together and it is not hard to envision an anti-Wall Street, pro-manufacturing political consensus emerging. This will cut across party lines, with manufacturing unions pulling in Democratic support if there are specific bills to vote on.

There are also the academic attacks on free trade. Australian economist Steve Keen discusses the work of Dani Rodrick in 1,000,000 economists can be wrong: the free trade fallacies - See more at: http://www.debtdeflation.com/blogs/2011/09/30/1000000-economists-can-be-wrong-the-free-trade-fallacies/.
But there is an obvious fallacy to this neat and plausible argument: To effect specialisation, England has to shift labour and capital from wine to cloth (and Portugal has to do the opposite). Arguably labour can be retrained—a vigneron can become a machinist—but how do you convert wine press into a spinning jenny?

The obvious answer is that you don't. Instead, you sell the wine press and buy a spinning jenny with the proceeds. But because of the introduction of trade, the price of wine in England would have fallen, so that the sale price of the wine press will also fall (economists have modified Ricardo's model to introduce curves where Ricardo had straight lines, so that total specialisation is no longer required and there would still be some wine production in England under the "new" model of Free Trade), while the price of spinning jennies will have risen, given the new export market to Portugal. Some capital is necessarily destroyed by the opening up of trade and it applies in reverse in Portugal as well.

Since capital is destroyed when trade is liberalised, the watertight argument that trade necessarily improves material welfare springs a leak. If economics were a real science, this real-world complication to Ricardo's argument would be considered, but it has never been seriously addressed.

Ricardo also assumed that British businessmen wouldn't uproot their life and open a factory in Portugal. As the real life modern example of free trade has shown, thanks in part to modern travel and telecommunications, that is exactly what happens. Not only does the factory close in America, but the capital follows it to China. Instead of building a new industry in the United States, the entire manufacturing sector is hollowed out. There are small diverse benefits to lower consumer goods prices, but the vast bulk of the gains go to two groups: workers in the destination country such as China, and to the holders of capital, which are mainly the nation's wealthiest citizens. The nation's capital base is sold off or relocated, with the profits going to the top. The median male income is flat since the 1970s in the U.S., with trade playing a huge role (along with the increase in labor supply from immigration and feminism, both of which also benefit the wealthiest Americans who own most of the capital).

With a growing economic case against free trade, a shift in social mood making anti-free trade opinion more popular, plus the loss of political support for the financial sector, free trade will become a centerpiece issue in American politics. The trigger will be one of two factors. One is economic. China's credit bubble isn't going to slowly ride off into the sunset. There will be pain, it is only a matter of where it lands. The path of least resistance is devaluation of the yuan, something I have been looking for here for several years now due to the growth in credit. A target of ¥8 to $1 is a reasonable ballpark figure, with ¥10 to 1 not unbelievable given the rise of the shadow banking sector. The actual number isn't as important as the size of the devaluation: it will likely be large and set off the anti-China arguments that have been growing in the United States. The left and right have their beef with China's economic policies and the right has provided the main rhetorical cover for business. When that goes, there will be a bipartisan push for policies that counteract China's "predatory" currency policies. A Chinese devaluation could be the trigger.

The second factor is geopolitical. Do take the time to read the lengthy review linked above, and/or watch the video. Luttwak's main point is that China cannot simultaneously build up its economy and influence at the same time it builds up its military, and not run into resistance from surrounding states. He cites the Chinese policy on the island disputes as the case in point: instead of increasing China's power in the region, it has pushed Vietnam, the Philippines, Japan and Indonesia into the arms of the United States. An anti-China coalition is building up due to each nation following the logic of China's inevitable rise in power along with the perception of an increasingly aggressive China. China has "tipped its hand" so to speak and these nations are moving preemptively. Due to the nuclear arsenal of the United States and China (to say nothing of Russia's interest in the region), there isn't going to be a major war for survival. This reduces the options for confrontation, with one of the most powerful being economic. If there is a minor military confrontation that is too large to be ignored, the most politically acceptable response will be economic.

Either the economic or the geopolitical event can happen first then, but in time, the two will be seen as inseparable. Once events move in this direction, the logic to continue down the path is compelling.

Anyone can run GDP numbers for the U.S. and China. One simple calculator is here: Catching the eagle. The default is 7.1% GDP growth, 4% inflation and 2.9% yuan appreciation for China. For the U.S., 2.4% GDP growth and 1.4% inflation. With these numbers, China's economy overtakes the U.S. in 2019. If growth is more like the 4% that Marc Faber believes (and the debt growth/gdp growth ratio suggests is correct), China overtakes the U.S. in 2022. Lowering that GDP growth to the 3% low end forecast of Michael Pettis adds one year, to 2023. However, take down the inflation number (due to credit deflation) or factor in a devaluation of the yuan, and China quickly falls behind the U.S. and can "never" catch up. See: China may not overtake America this century after all.

The ultimate containment strategy for the U.S. and regional partners (who all have access to U.S. markets) then, is an economic strategy. Yes, these nations will suffer slower growth, but they will retain their sovereignty. For East Asian nations, a distant hegemon is better than the near one with an appetite for your territory.

Whichever path is chosen, the economic and geostrategic paths will line up. An economic crisis in China will add the economic component to the emerging geostrategic China policy. A geostrategic decision to confront China economically would set in motion an economic crisis that would propel the strategy forward since China would respond in kind. The decision to halt rare earth exports to Japan and the widespread anti-Japanese riots of recent years already show how China will respond. A major confrontation from the U.S. would require an even larger policy response. Luttwak lays out some possible policy choices, starting with small ones such as banning technology transfers in a limited area such a military or telecom. I fully expect that were a Chinese crisis and devaluation to accompany another recession in the United States, the push for tariffs would find a bipartisan majority in the House and Senate.

Yuan devaluation is inevitable as soon as China enters a serious financial crisis. If the government refused to devalue, the nation would go through a 1930s style deflationary Great Depression. China is unlikely to allow the market to take the yuan lower in a panic collapse like a replay of 1997. At some point, it would announce a large devaluation designed to end the selling and the crisis. This will be called a political act in the United States (those who understand the economics will nonetheless spot the political opportunity) and the political push for protectionist policies will be too attractive to be ignored. The United States will retaliate with sanctions and the world will follow. This will put even more pressure on the Chinese economy and lead to a massive rise in nationalist sentiment (either that or anti-CCP sentiment, so expect the CCP to redirect it into nationalism). A chill wind will blow across the Pacific that will last a generation or more.

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