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hyenergix
02-08-11, 22:08
A good read on dysfunctional government. Sounds similar to our situation.


By Andy Xie (http://en.21cbh.com/author/?username=Andy_Xie)
http://en.21cbh.com/HTML/2011-8-1/1NMjU1XzIxMDY1Ng.html (http://en.21cbh.com/HTML/2011-8-1/1NMjU1XzIxMDY1Ng.html)

The DG Syndrome
01 Aug 2011


The messy fighting over increasing the debt ceiling for the US federal government raises the larger issue on the US's governance. By trying to score political points and forgetting its ramifications for the country as a whole, the various political factions show that they couldn't work together to solve the US's economic difficulties. Regardless what compromise they reach before August 2, which I believe they would, it wouldn't be close to what is necessary to stabilize the US's government's indebtedness. I believe that the US is heading towards a profound national crisis sometime in this decade.

The most important issue for China and other East Asian countries is their historical linkage to the dollar. Even though the dollar has been wobbly for nearly a decade, the region is still hanging onto it. The Fed's QE policy has caused dollar funds flooding the region. The governments here have chosen to mop up the dollar inflow and put the money back into the US treasury market. Basically, the region translates the Fed's policy in the short end of the interest rate curve into the long end. The US government and economy have benefited from the very low interest rates across the yield curve, despite the Fed's QE and the Federal government's massive deficit. East Asia is the back stop for the US's largesse.

East Asia has fallen into the trap for historical reasons. The WWII framed the political and economic order in the region. That order ties the region to the US economy and its currencies to the dollar. After the Bretton Woods system collapsed in 1971, East Asia has continued to embrace the old model with some modifications, such as managed exchange rate or dirty float. The determination to stay with the US is partly due to the competition between China and Japan and partly to lack of self confidence.

China and Japan don't get along. We need to live with this fact in our lifetime. So forget about an EU or euro type of mechanism here. EU and, later, euro happened because France and Germany believe they must work together regardless how much they dislike each other. China and Japan couldn't get there.

What's occurring in the US will finally force the region to ditch the dollar. The momentous change would be China floating its currency, possibly in five years. I never believed that China would float its currency in the foreseeable future, because its political system is averse to big change like that. The big change only happens when there is no other way. The relentless increase of the US's national debt is that force. The current system transfers the US's credit risk to China. When the Fed inflates away the dollar's value, China's wealth is destroyed too. If China's foreign assets (60% of 2011 GDP) go up in smoke, the resulting financial stability at home could cause political calamity.

When China floats its currency, its capital account will remain closed, I believe. The system would be similar to Taiwan's in the 1980s. It would be a managed float. Linking one's currency to the dollar is to stabilize the price for the US's consumers. The managed float will shift the goal post to China's competitors or input suppliers. As China moves up the value chain, Germany and Japan will increasingly become competitors. Hence, Rmb will link closer to euro and yen than the dollar.

Southeast Asian currencies may continue to be linked to the dollar. They hope to catch the industries that want to leave China for lower cost places. Their customers will mainly be American. Hence, they still have incentives to stay with the dollar. But, Northeast Asia economies like Korea and Taiwan will likely follow Rmb.

East Asia ditching the dollar may spell the end of the dollar era. Oil producers like the Gulf countries may remain big supporters for the dollar. Hence, the dollar's decline could be gradually. Its true end comes when East Asia and the Gulf countries shift oil pricing away from the dollar.

The Washington politicians don't know how much the dollar's status means to America. My back-of-the envelope calculation is half a trillionf dollars per annum with net present value equivalent to 100% of the US's GDP. East Asians work their butts off but have living standards far below the US's. One big reason is that they get a raw deal in trade due to their reliance on the dollar. When the dollar's dominant status is gone, the US's living standard will drop sharply, just like what occurred to the United Kingdom when the pound lost its dominance.

American politicians seem incapable of protecting such an important asset. The reason is the US has become a sharply divided society. A recent study suggests that the white population has average wealth 20 times the black population and 18 times the hispanic population. They obviously have fundamentally different views on what the government should do. Also, as baby boomers retire, they will vote for social security and medicare at any cost. As the US becomes so divided, no matter who get elected, the US government couldn't reach a compromise to solve the nation's problems.

The dysfunctional government syndrome (' the DG Syndrome') isn't just a US phenomenon. Take a look at Japan. The country suffered a 9.0 earthquake and massive tsunami. A big chunk of the country is no longer livable due to nuclear contamination. One would imagine that Japan would spring to reconstruction, at least quicker than after the 1994 Kobe earthquake. The reverse has happened. Japan's politics remains mired in quagmire.

Despite its stellar growth China just doesn't get a handle over its property bubble. This is such a puzzle. The consequences of a massive property are unfolding right before our eyes. Look at the US, Spain, Ireland, etc. This is live! But, so many government officials and 'experts' keep conjuring up reasons for China to tolerate the property bubble. Go back twenty years, Japan is such a scary example for any country that tolerates a property bubble too long. Why couldn't China get its acts together and stop the bubble? Anyone who says the government isn't powerful to do so is just lying. The system is just too divided due to various interest groups. It couldn't pull together to do something for the country as a whole.

European debt crisis is another reminder that its system is not capable of handling structural problems. It's been one year since the crisis began. Every rescue package since is kicking the can down the road. The politicians should be very smart people and know what they are doing. They couldn't give the right answer because, like the US, their voters have opposed interests. The system couldn't function properly.

Financial types usually judge if one is right or wrong on short-term market outcome. I have been deeply bearish since 2008, because worse than the crisis is not being able to deal with the crisis properly. The short-term painkillers like monetary and fiscal stimulus would improve things for the time being. Financial markets want to play. Such short-term improvement would cause the market to surge. I understood this and called for the market to perk up big in early 2009. Financial markets seem never tired of wave surfing. More short-term measures would produce similar outcome. When the Fed eases again, possibly beginning to talk about it in September, the markets will perk up again.

The political system that has governed the world since WWII seems incapable of handling the big structural forces today. Globalization, aging, and technology are producing a different world where the old interests must be sacrificed to produce a better world. Interest politics, unfortunately, cannot do that. One century ago, the world experienced technology and globalization shocks. The system then couldn't handle it either. It led to wars and revolutions. The necessary change came with so much destruction and blood.

I'm not predicting wars and revolutions for our time. Aging is a new and very powerful force. It is a deeply conservative force. Hence, revolution may not happen in most countries. But, it also means slower pace of change.
The world may be entering a period of permanent crisis.