Tuesday, June 2, 2009

Mr. Geithner Goes to China

Making promises and offering advice:

Geithner renewed pledges that the Obama administration would cut its huge fiscal deficits and promised "very disciplined" future spending, possibly including reintroduction of pay-as-you-go budget rules instead of nonstop borrowing.

I don't doubt that the Obama administration would impose austerity on the American public if it could, but the fact is, they need to win elections. Seniors vote, and when boomers retire, they are going to vote a lot. Furthermore, cutting the safety net turns the U.S. consumer into the proverbial 'Asian' consumer. There will be some attempted cutbacks in entitlements, but they will be politically impossible - in my opinion - without new sources of tax revenue to create the perception of a shared burden. Wealthy private interests have the clout and hostility to avoid substantial new taxation, and a rumored VAT tax might be as regressive to consumption as austerity. These political 'obstacles' mean that the U.S. is going to be running large deficits for the foreseeable future.

"In China ... growth that is sustainable will require a very substantial shift from external to domestic demand."

To that end, Geithner said a more flexible exchange-rate regime for the yuan, which would almost certainly see the value of the Chinese currency rise against the dollar, was particularly important because it would spur more Chinese demand.

During an economic slowdown, this is not going to happen in any substantive way. China needs to employ people first and foremost, and a rising yuan would damage their most labor intensive industries.

Geithner offered U.S. backing for a higher-profile role for China in running global institutions including the IMF -- a controversial proposition since it raises the sensitive issue of reducing Europe's voting share in the global lender.

This is also not going to happen in a substantive way. Continental Europe has enough votes now to constitute a veto, and they are not going to give up their sway in the IMF, along with its sizeable gold holdings.

What's more likely is that Quantitative Easing, and an escalating debt-to-GDP ratio, are going to result in some type of de facto devaluing of the dollar. There are a number of scenarios for this, including increased core inflation, speculative inflation in commodities, or a decline relative to other currencies. Moderate devaluation against other currencies would be beneficial to the U.S export sector, and would reduce domestic unemployment.

There is the real potential of significant devaluation, which would not only damage China's reserve holdings, but lead to a more severe global financial crisis.

Stimulus has bought time, but not much else as of yet.

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