They've Got Us by the...Assets

Recently a good friend voiced a slightly altered version of the above phrase during a discussion of the Chinese government preference for US dollars. No she didn’t use the plural form of a word defined by Webster’s as “a round object that is hit or thrown or kicked in games”. She’s not that kind of girl. She was referring to the Chinese accumulation of US Treasury and Agency debt, but it now appears that the Chinese government is looking to diversify beyond the fixed income asset class. The Chinese government is rumored to be forming an investment fund, called the National Foreign Exchange Investment Company, to invest in other asset classes. The fund will be used for mergers and acquisitions of overseas businesses, energy assets, and equities.

With holdings of $1 trillion in reserves, it seems logical that the Chinese will look to invest some of the $200 billion the fund is expected to be seeded with initially to buy the stock of US companies. Why sell dollars and drive down the value of the fixed income allocation? That might seem like good news for investors in US stocks, but it should also send a bit of a chill down the spine of every stockholder. What exactly are the Chinese up to? Are they just looking to diversify as any prudent investor would or are they after something else? Since I’m writing this, it should be obvious that I believe they have another agenda.

I don’t know if the Chinese government has a long term plan to dominate the world like some James Bond villain, but their mercantilist impulses have consequences for the US economy and sovereignty. The number of grandstanding, populist politicians demanding that the Chinese revalue their currency up against the dollar grows by the day. These economic ewoks believe our trade deficit with China will magically disappear if only the Chinese will allow the Yuan to appreciate. And everyone knows that the trade balance is the vital sign that signals economic health…right? Well, not exactly.

Since 1976, the US has run a trade deficit every single year. The only times we have seen an improvement in the trade balance is during recession. So if eliminating the trade deficit is the path to economic nirvana, we just need a really good recession and our problems will be over. And a recession, or worse, is exactly what we would get if the politicians have their way. Senators Schumer (D, NY) and Graham (R, SC) (economic idiocy is apparently the only area of true bipartisan agreement) have previously introduced a bill that would levy tariffs of 27.5% on Chinese goods unless the Chinese take steps to “correct” the undervalued Yuan. Somehow these two intellectual giants have determined the exact amount by which the Yuan is undervalued.

I find it highly unlikely that the Chinese would just accept such a high tariff barrier and they don’t have to. As my friend said, they have us by the….Treasuries. Enact tariffs and the likely Chinese response would be a fire sale of US dollar denominated bonds. And there are a lot of excess dollars in the world. Furthermore, the rise in the price of Chinese goods would not be a good thing for the US economy. In case Senators Schumer and Graham haven’t noticed, those flat screen TVs the Chinese manufacture get sold in places like Best Buy and Circuit City. What do the honorable gentlemen have against the pimply faced gadget geeks that work the aisles of Best Buy? What about US companies manufacturing in China? Do the politicians really believe that if we raise the Yuan, that these US companies will relocate all their manufacturing back to the good old USA? I’ve got news for them; a 27.5% increase in wages in China will not be nearly enough to equalize things from the perspective of a manufacturer.

And let’s just suppose that the Chinese are magnanimous and actually do revalue the Yuan. Would it have the effect that Schumer and Graham assume? I don’t think so. The Chinese are primarily assemblers of products and thus import the parts for the products they assemble. They also must import raw materials such as oil. So if the Yuan is revalued up, what would be the effect? Probably not much. Their input costs would go down thus increasing their profit margins and allowing them to absorb most of the presumed rise in price for the final goods sold here in the US. The economic effect would likely be negligible and the trade deficit would be little better than it is now. And the Chinese would have a stronger currency with which to buy US equities and other assets. I’m really having trouble finding a positive here.

So what are the Chinese doing? While we are distracted with Iraq and North Korea, they are waging a kind of stealth economic war against us. Our politicians are doing exactly what the Chinese want them to do. By demanding a rise in the Yuan, US politicians will provide the Chinese with additional purchasing power to gain the assets they need to further their leverage over the US economy. Add say $500 billion in equities to their Treasury holdings and they will have a measure of control over our economy with which everyone should be uncomfortable. If they decide to move on Taiwan, we’ll have a choice of economic suicide or letting the Chinese have their “renegade” province back. I suspect the American public will choose flat screen TVs over defending Taiwan.

The good news is that we don’t have to let this happen. We are in this situation because of our own policy mistakes, not because of the Chinese. The primary cause of the situation is a monetary policy that attempts to control $US money supply without acknowledging the existence of or the need to control asset inflation. Globalization has the effect of holding down US consumer inflation by importing cheap manufactured goods from, ironically, countries like China which have much lower wage costs. The Fed, seeing no consumer inflation, assumes that they have control over the global supply of dollars. The asset inflation that we see all around us is ignored. Greenspan spoke of the conundrum of low long term interest rates and Bernanke talks of a global savings glut. What they apparently won’t acknowledge is that the cause can be found by looking in the mirror. There is no global savings glut; there is a global US Dollar glut.

Lousy monetary policy has been exacerbated in recent years by equally lousy fiscal policy. Inflation affects politicians too. The excess supply of dollars allows us to spend billions in Iraq even while politicians compete to see who can try to stuff the budget with the most egregious pork barrel project. Tax receipts rise as capital gains are realized from the asset inflation and spending rises even faster. I guess the politicians believe that if the Chinese are willing to loan us the money, they should find a way to spend it.

The answer to ending the Chinese influence on our economy will not be found in simple policy prescriptions like currency devaluation and import tariffs. The solution is found in a monetary policy that anchors the dollar to a true price indicator (that includes asset prices) and a fiscal policy that supports growth while controlling government spending. Until that happens, the Chinese will continue to further their grip on our….assets.

Coming Next: In my next essay, I’ll discuss the asset inflation that is the result of the excessive money creation of the Central Banks of the world.