2008/01/20

Broken dikes take away predictability

I've already expressed my belief that economic health and power of nations is a very important variable for defense policy - also in the future.

Well, I've got an economic science background (but I'm no expert on financial markets - the goods markets are so much more important and interesting), this comes handy as I attempted to understand the impact of the recent crisis and overall situation on the future decades.

This is of course a rather hopeless endeavor - even federal banks don't have the economist brainpower to produce reliable forecasts. But forecasts by educated people are usually wrong because of additional factors that they missed - not so often because of a wrong interpretation of the known factors.
In short: Shit happens, it's worth an attempt.

So first let's remember the overall situation:

- The USA has been partially de-industrialized in the past decades.
- This was one reason for a huge trade deficit for many years and a huge net external debt today
- The USA has a huge public debt, as do most old industrialized nations (China doesn't)
- China, Japan, several oil states and several EU nations incl. especially Germany have strongly positive trade balances
- since the breakdown of the Bretton-Woods system the US-$ was leading reserve currency
- the previous factor allowed the U.S. Federal Reserve Bank to print money and export it almost without fearing inflation (and so it did, partially financing the trade and public deficits this way)

Amidst such a situation came the recent banking sector crisis. Every macro-economist knew that the old situation was not sustainable and that the trade balances had to change sometime. Well, this didn't happen the pleasant way.
The banking sector crisis undermined the trust into banks which couldn't be tolerated by the Fed. So the Fed helped the banking sector with "cheap" money. That led to inflation expectations for the US-$, which weakened the $ against Euro, Rinminbi and Yen.

And the dikes broke in the midst of the storm tide.

The dollar weakness and inflation expectations are difficult to turn around, and it's very enticing for decision makers not to intervene at all (against these trends).

Why should high inflation and weak dollar be fought by U.S. authorities? They reduce the value of the external and public debts. Even poor private households that have too many debts can be happy about it if their debt has fixed interest rates. Especially the weak dollar has its advantages, while the inflation's advantages will be canceled by quickly adjusted expectations.

But the devaluing of the debts is not the only nice thing: The exchange rates ruin the competitiveness even of otherwise superior foreign companies - and motivate investments in the USA and thereby a re-industrialization of the country.

This is certainly no nice option - and it won't gain new friends. Europeans and East Asians will be pissed off by the purchasing power loss of their savings and the (unfair) price advantage of American factories.

Otherwise - why should the U.S. American political leadership go the hard route and work against inflation and pay back huge debts if they can have it so easily?
It's basically a trade-off between trust, friendship, respect, prestige - and economic health.

In either scenario we'll see drastic changes in the geo-strategic situation in about fifteen years.

Forget about what's fact today if you think about the distant future.


Sven Ortmann

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