This story and more in Tudor's latest letter to investors.
Our extraordinary times offer extraordinary opportunities, but as with most opportunities, there will be winners and losers.
Economies in the developed world find themselves with unemployment levels not seen since the Great Depression. The response from respective governments has been massive fiscal stimulus in conjunction with monetary easing. And now many of these governments, having exhausted all fiscal stimulus measures that are politically feasible, are about to embark on another round of quantitative easing. The Bank of England, the Bank of Japan and the US Federal Reserve have implemented, or are considering implementing, significant rounds of government securities purchases.
Will these measures actually succeed in lowering the chronically high levels of unemployment? Or are the unemployment problems of these countries so structural in nature that these policies will have only limited impact?
We’ve enlisted modeling and forecasting firm Macroeconomic Advisers, LLC to assist with answers to these questions. But, first, a story: About ten years ago I had an acute case of plantar fasciitis in the left foot, a condition in which the fascia, or the covering right beneath the skin, had become highly inflamed. I asked Pete Egoscue (egoscue.com), a renowned postural specialist but one without medical training, to take a look at my foot. Pete had, after all, healed a number of people I knew, including my wife. Because Pete was self-taught, I was a skeptic— as any good trader would be.
Pete said that he did not need to look at my foot because my foot was not the problem— a response that suggested I was dealing with a quack. But I was patient and continued to listen. He proceeded to explain that the pain in my left foot was the consequence of a structural, postural deficiency in my hip alignment. My right hip was rotated in such a fashion as to make the left side of my body do all the work and bear all the weight, culminating in the inflammation of my left foot. “The pain you feel in your left foot is just the symptom,” Pete said. “If you treat it symptomatically and ignore the structural issue, you will never solve the problem.” I did not immediately grasp the full meaning of his words, but I followed his prescription,and in a few days the pain was gone. Some time later I realized that those words were probably the wisest I have ever heard from any human being, and that they apply to more than just the human body.
The developed world, and the United States in particular, is suffering an economic malaise the likes of which we’ve seen only rarely in the last 100 years. Policy makers are searching for solutions, but they are too focused on the painful symptoms of unemployment to see the misshapen structure causing it. In so doing, they are presenting some of the more wonderful trading opportunities in quite some time: winners and losers.
The root cause of the unemployment woes is quite obvious. In the United States alone, in the last two decades, nearly six million jobs in manufacturing have been lost overseas. This equates to nearly four percentage points of the
current 9.7% US unemployment rate. As importantly, the migration of these jobs contributed to the most unsustainable economic imbalance in the world today—China’s persistent bilateral trade surplus with the United States. During the last decade, China accumulated almost $1.4 trillion of US debt and at least $2.3 trillion in global assets. These figures could grow to $3.8 trillion and $7 trillion, respectively, over the next decade if the current renminbi/US dollar (RMB/USD) exchange rate continues to be artificially suppressed from appreciating.
One entity owning this much debt of one debtor, let alone a foreign government, creates too much risk concentration, and has possibly repressed volatility for debtor and creditor alike. The risk may seem manageable now, but who knows what the nature and temperament of the Chinese and American leaders will be in ten years? Isn’t it possible that either side could weaponize financial imbalances to the detriment of domestic and global stability?
How did we get here? On January 1, 1994, China devalued its currency by 50% in a single day, and since then has experienced a manufacturing boom. After 15 years of impressive productivity gains relative to its trading partners,
though, it now resists the smallest appreciation. (The IMF implies the RMB could be as much as 30% undervalued taking 2000 as a base, but absolute purchasing power parity would argue that undervaluation is even greater—
possibly as much as 60%.) Clearly, there is a direct correlation between the six million manufacturing jobs lost in the US and the close to twelve million manufacturing jobs gained in China over the last two decades. Robert E. Scott, a
Senior International Economist and Director of International Programs at the Economic Policy Institute, estimates that the growing trade deficit with China, a partial consequence of the undervalued RMB, cost the US 2.4 million jobs
between 2001 and 2008 alone, the equivalent of 1.6% of the current unemployment rate.
As someone who has traded foreign exchange since 1980, I believe the RMB/USD rate is currently the single most important of all exchange rates. It not only drives the largest foreign trade relationship in the world, it also drives
virtually every other exchange rate globally. Dozens of other emerging market countries suppress their exchange rate against the US dollar because the RMB is effectively pegged to the dollar. And what is remarkable is the lack of any
concrete policy initiative in the US to change this. For several years, the US Treasury has threatened to name China as a currency manipulator 2 but has always found a basis for avoidance. Even if Treasury cited China, it would just set in motion more negotiations that would likely go nowhere. The lone serious attempt to impose a cost on China’s distortion of global financial markets this year was congressional action on the Currency Reform for Fair Trade Act, known as the Ryan Bill, which would allow US companies to file complaints against China’s currency policies with the Commerce Department, and would empower the Department to levy tariffs and countervailing duties on imports from China.
The Ryan Bill passed in the House of Representatives a few weeks ago by a vote of 348 to 79 but is stalled in the Senate. It drew immediate ire from the Chamber of Commerce as well as from eight former US Trade Representatives to China. But it was the very advocacy of the Chamber of Commerce and those Trade Representatives that led us to our current trade deficit. As Einstein said, “Problems cannot be solved by the same level of thinking that created them.”
That so many Americans continue to accept this suppression of a variety of exchange rates against the dollar is probably a function of the fact that for so long this suppression provided benefits such as cheap goods and cheap credit. In addition, for a while, manufacturing jobs seemed to be replaced by jobs in the service economy and construction industry without any economic disruption or any rise in the unemployment rate. However, the bursting of the credit bubble exposed the true structural decay that had occurred in the US economy. But, like zombies, many Americans still cling to the naive belief that we can return to the good times of the 90s and the earlier part of this decade, unable or unwilling to recognize that those high times were a debt-driven anomaly.
This delusion is fueled by a myriad of financial pundits who warn about the dangers of disrupting free trade. They are quick to point out that the Ryan Bill is contrary to rules of the World Trade Organization. Incredibly, in the WTO’s rules of governance, there is not one reference in any of its documents to the underlying bilateral exchange rate between two countries when trying to reconcile trade differences. It is like trying to referee a World Cup match with a
soccer ball that only the players can see. In the case of a controlled or manipulated exchange rate, it is patently unfair if the currency of one partner is grossly misaligned, as the RMB/USD rate is.
Any serious attempt to address the structural imbalance is met with a chorus of boos from financial industry pundits who rail against “protectionism.” In discussions involving the Ryan Bill, these pundits have few qualms with lobbing into the mix, like grenades, those most dangerous of words: “Trade War.” They often invoke the specter of Smoot-Hawley, the infamous US tariff act that triggered a trade war in which American exports and imports were slashed by half, leading a number of economists to argue that its passage contributed significantly to the Great Depression. But what they fail to see, or neglect to acknowledge, is that in modern times there never has been free trade with China; the US has already been in a trade war for nearly two decades; and it is the only time in this nation’s history it surrendered without ever firing a shot.
The United States lost six million jobs, indebted itself to China by $1.4 trillion, and received in return a host of consumer goods, many of which now reside in landfills across the country.
“Trade War” is a very dangerous phrase. Clearly, China and the US are commercial competitors and not enemies. There is no reason for “combat” in any sense of the term. The Chinese have set the RMB/USD peg artificially low
because they believed it was necessary in order to shift from an agrarian to an industrial-based economy. The United States also protected its nascent industrial sector when it did the same thing in the 19th century. Developing a significant export-oriented manufacturing base was part of an ambitious plan to relocate hundreds of millions of rural Chinese to cities where they could obtain manufacturing jobs and pursue a better life. It worked. China’s coasts now burst with export-dependent factories and cities. But now and going forward, China’s export strategy is completely unsustainable. In the intermediate term, much less the long term, it is becoming clear that the main buyer of China’s exports—the United States—can no longer foot the bill. A much better policy would be finding the right balance between domestic demand and exports through a stronger currency. Brazil did this brilliantly between 2005 and 2007. Their currency appreciated 34% against the dollar yet the economy grew 2% more than the prior
three years and above what was thought previously to be the speed limit. The incoming Chinese administration of 2012 will be forced to contend with a population that has been relocated and retrained for jobs that may one day
disappear, much as they did in the United States, all because China engaged in a futile attempt to avoid an inevitable re-equilibration of exchange rates. After all, one way or the other, the real US and Chinese exchange rate will find equilibrium– either through nominal movement or through relative inflation rates.
Just as the Chinese elite have become dangerously wed to an unsustainable export-driven manufacturing model, the US elite have become indifferent to mercantilist assaults on the global trade framework. In mid-September, when the Bank of Japan intervened to suppress the value of the yen against the dollar, there was no response from America’s political, financial and media leaders. While these interventions might have been understandable six years ago, when Japan’s economy was relatively less well off than that of the United States, they are far from necessary today: Japan has an unemployment rate that is half that of the United States and it still runs a trade surplus. Nonetheless, Japan intervened to protect its export industry, and the United States, incomprehensibly, responded with not even a whimper, let alone a bang.