The Year Of Rebalancing

Patrick Doherty

January 06, 2006

It started last night, East Coast time. I was reading the Financial Times website when the headline that should have come last year finally emerged. "China Signals Reserve Switch Away From Dollar." That, friends and countrymen, is a bell that tolls for the American economy.

You might have been confused by the concerted efforts of the White House to "talk up the economy," such as Treasury Secretary John Snow's statement, yesterday, that, "the U.S. economy is the picture of economic health and we remain, as the president often notes, the economic envy of the world." It appears that this current White House campaign is an effort to fix the economic intelligence to the facts. This time, however, the data is not classified.

Today's column by Morgan Stanley Chief Economist Stephen Roach paints the real economic landscape facing America:

It is quite possible that we’re being too analytical in attempting to discern why it all went so well on the global macro front in 2005.  It may simply be that the stars were in near perfect alignment, enabling the world to buy an extra year of time.  I think the odds are low that an unbalanced world economy will continue to draw support from such a favorable constellation of forces.  Reversals are possible on three fronts -- the liquidity cycle, the US property market, or the dollar.  Shifts in any one of these areas could well be enough to transform the global outcome from benign to malign.  The interplay between these forces could be especially lethal.

He goes on:

Nor should these potential adjustments be treated in isolation from one another.  If, for example, the dollar goes and real interest rates are bid up in response, adjustments to the US housing market will undoubtedly be more severe.  Under those circumstances, overly-indebted American consumers will then be squeezed by higher debt-servicing expenses.  If, on the other hand, the US housing market simply falls under its own weight -- a distinct possibility given the major overhangs in property values in many segments of the nation -- the hit on wealth-dependent consumption and GDP growth could then be a major negative for the dollar.  ...  And, of course, if the American consumer fades for any reason, the impacts on the rest of the world would be especially acute.

Re-enter the Chinese statement from last night. What did the Chinese actually do? Here's the lead paragraph from the FT article:

China indicated on Thursday it could begin to diversify its rapidly growing foreign exchange reserves away from the US dollar and government bonds – a potential shift with significant implications for global financial and commodity markets.

What this all means is that the American economy is hanging on the precipice of a major economic disruption. That disruption is rooted in a number of policy decisions both here at home, such as the Fed's decision to ease the pain of the 2001 stock market crash by transferring the Internet bubble into the housing market and the Bush administration's decision to crank up the federal deficits in a cynical move to increase political power (tax cuts) and force cuts in entitlements, like Social Security.

The Chinese are to blame, too, for their economic grand strategy of developing a communist export machine that poured hundreds of billions of dollars into foreign exchange reserves rather than building out a sustainable domestic market. Yesterday's announcement seems to suggest that the Chinese government is in a position to manage the domestic effects of a global economic downturn, but that the risk of being lashed to the irresponsible economic managers of the Bush administration is just too much.

But Democrats are far from innocent. In his article in today's TomPaine.com, Democrats' Silent Spring , economist Thomas Palley  writes that elite Democrat and Republican economic policy advisers are nearly indistinguishable, due to their common acceptance of the basic tenets of Milton Friedman's laissez faire economic theories. Indeed, while Palley discusses more domestic economics in his article, it was this common belief in "free trade" and market deregulation held by Clinton-era economists that gave the Chinese strategy a foothold and allowed the Internet bubble to go on unimpeded, respectively. Bush certainly made it worse, but Clinton, Sperling, Summers and Rubin got the game started.

My constant theme here in Uncommon Sense is that Democrats need to focus on macroeconomic and national security strategies, progressive strategies and shed their reflexive desire to call for a bigger and better safety net or, equally frustrating, just saying "No" to whatever Bush comes out with.

Now, the Chinese have done us a favor. There's nothing like the ticking of an economic time bomb to concentrate the mind.