Monday, March 30, 2009

From crony capitalism to geopolitical mercantilism?

Recently there have been many calls for bondholders and shareholders of troubled financials to bear the brunt of the crisis. As an example, John Hussman recently wrote:

Make no mistake - we are selling off our future and the future of our children to prevent the bondholders of U.S. financial corporations from taking losses. We are using public funds to protect the bondholders of some of the most mismanaged companies in the history of capitalism, instead of allowing them to take losses that should have been their own. All our policy makers have done to date has been to squander public funds to protect the full interests of corporate bondholders. Even Bear Stearns' bondholders can expect to get 100% of their money back, thanks to the generosity of Bernanke, Geithner and other bureaucrats eager to hand out the money of ordinary Americans.

Simon Johnson, former chief economist at the IMF, agreed with Hussman and others on the prescription for America’s ills. More telling, he wrote that United States is starting to look like a Third World country [emphasis mine]:

[T]o IMF officials, all of these crises looked depressingly similar. Each country, of course, needed a loan, but more than that, each needed to make big changes so that the loan could really work. Almost always, countries in crisis need to learn to live within their means after a period of excess—exports must be increased, and imports cut—and the goal is to do this without the most horrible of recessions. Naturally, the fund’s economists spend time figuring out the policies—budget, money supply, and the like—that make sense in this context. Yet the economic solution is seldom very hard to work out...

Typically, these countries are in a desperate economic situation for one simple reason—the powerful elites within them overreached in good times and took too many risks. Emerging-market governments and their private-sector allies commonly form a tight-knit—and, most of the time, genteel—oligarchy, running the country rather like a profit-seeking company in which they are the controlling shareholders. When a country like Indonesia or South Korea or Russia grows, so do the ambitions of its captains of industry. As masters of their mini-universe, these people make some investments that clearly benefit the broader economy, but they also start making bigger and riskier bets. They reckon—correctly, in most cases—that their political connections will allow them to push onto the government any substantial problems that arise.
He went on to say that:

Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government, such as preferential access to foreign currency, or maybe a nice tax break, or—here’s a classic Kremlin bailout technique—the assumption of private debt obligations by the government. Under duress, generosity toward old friends takes many innovative forms. Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk—at least until the riots grow too large.
During the Asian crisis, the Russian crisis and many other financial crises around the world in the last few decades, this state of affairs was described as crony capitalism. Today, does this sound like another country we know? Has Wall Street and its culture hijacked America?

The answer is clear. Let the bondholders and shareholders take the haircut so that we can get on with life.

However, life isn’t that simple. In a past post entitled China’s golden rule, I speculated that “Obama administration may be waiting for China to reduce its exposure to the debt of the latest U.S. financial institutions found lying near death’s door before it nationalizes them.” China, by virtue of the size of its reserves, is now able to strongly influence U.S. policy at many levels, including what happens at Treasury.

A recipe for social or economic disaster
If the world is determined to reflate the U.S. economy by propping up its financials and reviving the shadow banking system, then we will see a reflationary boom in the next cycle followed by a deflationary collapse. (It's not just the U.S., reflation and re-leveraging seems to the preferred solution everywhere.)

China's Age of Geopolitical Mercantilism
China is likely to emerge out of these series of crisis with much greater degree of geopolitical power. For China, we may be witnessing the Age of Geopolitical Mercantilism. At his blog, Fabius Maximus wrote that:

We can learn much from China’s evolution since WWII from rural backwater to major power.

Mao Tse-tung, On the Correct Handling of Contradictions Among the People, 27 February 1957:

When the rule of imperialism, feudalism and bureaucrat-capitalism was overthrown by the people, many were not clear as to where China was headed–to capitalism or socialism. Facts give the answer: Only socialism can save China. The socialist system has promoted the rapid development of the productive forces of our country–this is a fact that even our enemies abroad have had to acknowledge.

After Mao’s death, Deng Xiaopeng took control in 1979 and modified this: Only capitalism can save China!

After the fall of the Berlin in 1989 the remaining true believers said Only China can save socialism!

It’s now 2009, the western banks are burning, and everybody knows that only China can save capitalism!

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