On Inflation, China, and Being Humble

Worried about deflation? Yeah, me too. But, as I mentioned in a previous post, I’m even more worried about inflation. It may seem strange to worry about two diametrically opposite phenomena—deflation and inflation—at the same time. But that is the paradoxical mess in which we find ourselves.

The NYTimes editorial “The Printing Press Cure” put it this way:

Flooding the economy with freshly printed money may prevent a self-reinforcing downward spiral. But it may cause trouble long after the present danger has passed. One reason is that it could cause inflation later. In a worst-case scenario, inflation, or the fear of inflation, could dissuade foreign investors, who finance the United States’ debt, from buying and holding dollars. That, in turn, could provoke a disorderly decline in the currency, sending prices and interest rates sharply higher.

In a humorous, but frightening essay in the Wall Street Journal, James Grant said this about the looming dollar dilemma:

Economic commentators praised the central bank's determination to fight deflation -- that is, to reinstate inflation. All hands, including President-elect Obama, seemed to agree that wholesale money-printing was the answer to the nation's prayers.

One market, only, registered a protest. The Fed's declaration of inflationary intent knocked the dollar for a loop against gold and foreign currencies. In many different languages and from many time zones came the question, "Tell me, again, now that the dollar yields so little, why do we own it?"

Our troubles, over which we will certainly prevail, stem from a basic contradiction. The dollar is the world's currency, yet the Fed is America's central bank. Mr. Bernanke's remit is to promote low inflation, high employment and solvent finance -- in the 50 states. He wishes the Chinese well, of course, and the French and the Singaporeans and all the rest besides, but they don't pay his salary.

They do, however, buy the U.S. Treasury's bonds, which frames the emerging American dilemma. If the Fed is going to create boatloads of depreciating, non-yielding dollar bills, who will absorb them? Who will finance the Obama administration's looming titanic fiscal deficits? Who will finance America's annual surplus of consumption over production (after 25 more or less continuous years, almost a national trait)? Inflation is a kind of governmentally sanctioned white-collar crime. Every crime needs a dupe. Now that the Fed has announced its plan to deceive, where will it find its victims?

Everything, it seems, depends upon our Chinese creditors continuing the money-losing policy of financing our government’s deficit spending and bankrolling the shopping sprees of the debt-strapped American consumer. If they cease this seemingly foolish policy, then the dollar will turn into toilet paper and things will really fall apart. Worried yet?

But let’s not panic. The Chinese have good reason to continue to prop up our currency. They must keep the dollar strong and the American consumer strong so that all their export-oriented factories don’t go bankrupt all at once. They have to worry about a fragile social contract that exists between the government and all the former peasants who now work in those export-oriented factories. With mass unemployment caused by factory closings, social unrest in China would surely follow.

So, great! We’ve got the Chinese over a barrel. There is nothing like social unrest to concentrate the mind of a political leader! We can just print as much money as we like because the Chinese will continue to buy up all of our increasingly worthless paper dollars.

Not so fast. The Chinese are no dummies. They are well aware that the dollar is probably a doomed currency. They know its value will decline over time. The only question in their mind is: how soon and how quickly should the dollar depreciate? This is a very important question. The ideal scenario, for both China and the U.S., is that the decline will be slow and orderly. That way, the Chinese economy will have time to reorient industrial production away from exports to America and towards domestically consumed products (stuff Chinese consumers want to buy). Similarly, the American consumer and the American government will have time to change their profligate ways. We must become a nation of savers who live within our means, and our government must run a balanced budget.

But if the Chinese sense that America has no intention of undergoing these difficult adjustments (that is, if we just keep printing our way out of the hole), there will be great pressure on the Chinese government to cut the dollar loose despite the potential for political destabilization. That pressure is already building.

Gao Ziqing, the man who oversees $200 billion of China’s $2 trillion in dollar holdings, said as much in a fascinating interview in The Atlantic Monthly:

We have a PR department, which collects all the comments about us, from Chinese newspapers and the Web. Every night, I try to pick a time when I’m in a relatively good mood to read it, because most of the comments are very critical of us. Recently we increased our holdings in Blackstone a little bit. Now we’re increasing a little bit our holdings in Morgan Stanley, so as not to be diluted by the Japanese. People here hate it. They come out and say, “Why the hell are you trying to save those people? You are the representative of the poor people eating porridge, and you’re saving people eating shark fins!” It’s always that sort of thing.

He went on to offer this advice to Obama and the American people:

The simple truth today is that your economy is built on the global economy. And it’s built on the support, the gratuitous support, of a lot of countries. So why don’t you come over and … I won’t say kowtow [with a laugh], but at least, be nice to the countries that lend you money.

Talk to the Chinese! Talk to the Middle Easterners! And pull your troops back! Take the troops back, demobilize many of the troops, so that you can save some money rather than spending $2 billion every day on them. And then tell your people that you need to save, and come out with a long-term, sustainable financial policy.

The current conditions can’t go on. It is time for the new government, under Obama or even McCain, to really tell people: “Look, this is wartime, this is about the survival of our nation. It’s not about our supremacy in the world. Let’s not even talk about that any more. Let’s get down to the very basics of our livelihood.”

I have great admiration of American people. Creative, hard-working, trusting, and freedom-loving. But you have to have someone to tell you the truth. And then, start realizing it. And if you do it, just like what you did in the Second World War, then you’ll be great again!

If that happens, then of course—American power would still be there for at least as long as I am living. But many people are betting on the other side.

This, I think, is excellent advice. The printing presses eventually need to stop and we need to pull ourselves up by our bootstraps. The nation’s psychology needs to change. We must become more humble in our foreign policy and more sensitive to the point of view of others. And Obama needs to lead the way.

I am actually hopeful that America can work with the Chinese to pull this off. Even Thomas Friedman, who is as guilty as any American of believing in the fallacy of American exceptionalism, seems to understand that something fundamental needs to change. He has good advice in his most recent column:

We’re going to have to get out of this crisis the old-fashioned way: by digging inside ourselves and getting back to basics — improving U.S. productivity, saving more, studying harder and inventing more stuff to export. The days of phony prosperity — I borrow cheap money from China to build a house and then borrow on that house to buy cheap paintings from China to decorate my walls and everybody is a winner — are over.

What Friedman doesn’t say is that the government must do its part by cutting the budget for the military and conducting a less belligerent foreign policy. That will be a tough pill for many Americans to swallow. But the Chinese are watching. And the dollar hangs in the balance.