Confusion is a word we have invented for an order which is not yet understood.

Henry Miller (1891 - 1980)

What to do with China?

Let’s face it, the financial crisis is nothing but confusing.  But if you want to see complete and utter confusion, take a look at how the Obama administration is dealing with China.  On January 23, Obama’s soon to be Treasury Secretary, Timothy Geithner, accused the Chinese of “manipulating their currency”.  Basically Geithner scolded the Chinese for keeping its currency artificially low, spurring domestic employment and exports, and then increasing their foreign exchange reserves by buying U.S. treasury securities with the proceeds.

However one month later, Obama’s Secretary of State, Hillary Clinton, traveled to Beijing and all but begged the Chinese government not to sell their U.S. Treasury securities and to please, please, continue to buy them in the future.

China has become the world’s largest foreign holder of U.S. treasury securities, with $780 billion of the $3.1 trillion in U.S. treasury securities held by foreign interests.  The U.S. needs China to finance their stimulus packages but China themselves are going to have to finance their own stimulus package.  China, however, is sitting on the world’s largest stash of cash, with $2 trillion in foreign exchange reserves.

Some think the financial crisis is signaling the end of the American Empire, and with it the end of the U.S. dollar’s reign as the world’s reserve currency.  The fact is, however,  that while the credibility of the U.S. dollar is at risk, conditions are not yet right for a run on the dollar.  The mere prospect of an Obama administration implementing better foreign and domestic policies is enough to postpone a massive liquidation of U.S. dollars by foreign investors.  I believe the seemingly contradictory policy statements of Clinton and Geithner, are in fact a reflection of a coordinated Obama strategy.  The dollar lost 15% to the yen and 40% to the euro over the 8 years that Bush pretended to be following a strong dollar policy.  Obama comes from the Paul Volker school of, “a country is stronger with a strong currency, not weaker”, and so he is just more believable than Bush when promoting a strong dollar.  There is a lot of deflationary pressure with the unwinding of leverage around the world, but I suspect Obama would support a Federal Reserve decision to start raising interest rates if inflation was on the horizon.  While Obama’s policies and stimulus will cost plenty, his withdrawal from Iraq will save the U.S. Treasury plenty.  The Nobel-prize winning economist, Joseph Stiglitz, has estimated that the Iraq war will have cost U.S. taxpayers $3 trillion dollars.  At the very least, Obama is moving America in a new direction.

The dollar is in jeopardy, not because the Federal Reserve is keeping interest rates low in the face of inflation, but because of the “twin deficits” (current account and fiscal), that the U.S. has allowed to balloon.  In this era of globalization, a country’s current account is a vital barometer of its economy.  When a country spends and invests more than its domestic income and savings, it has to fund the deficit with large inflows of foreign capital.  The U.S. consumer has been the driving force of much of the world’s economy, but this consumption has occurred on borrowed money.  The International Monetary Fund (IMF) expects the U.S. to have a current account deficit of $615 billion in 2008, while China will have a current account surplus of $386 billion.  Could the renminbi be the world’s reserve currency of the future?

The other crucial deficit affecting the dollar is the U.S. fiscal deficit.  This deficit is likely to reach $2 trillion in 2009, before dropping to $1.5 trillion in 2010.  Again, this deficit has to be financed mostly by non-residents, and while the world community is likely to bet on Obama in the short term, a protracted failure of U.S. policies will result in a flight from the American currency.

The pressure on Obama is immense.  By the end of his first term we should know if the reign of the American Empire will continue or be replaced by regional financial powers (China, Russia, Brazil, South Africa, Iran), and a much diminished role for the American dollar.  If there is the perception that the U.S. is falling into the abyss, the first sign of the dollar’s collapse may come from discussions in the Gulf countries revolving around revaluing their crude oil sales based on a basket of currencies.  A lot of very smart people are betting against the dollar  (Nouriel Roubini, Jim Rogers, Nassim Taleb), but I believe the U.S. will have one more kick at the can.  This optimism can be explained in two words - Chu and Varmus.  Huh! That’s right Chu and Varmas.  When Obama named Steven Chu as his Energy Secretary and Harold Varmus as his co-chair of the Council of Advisors on Science and Technology, he signaled that the U.S. government was going to embrace science and technology to get us out of this mess.  The two Nobel prize laureates are a reflection of Obama’s intelligence.  Obama is smart enough to get technology leaders into policy making positions and to lead us in a new direction.  My belief is that he will do the same in finance and foreign policy.

Those that think we are in for a prolonged (some say 10 year) deep recession/depression, don’t understand the speed at which the global economy now works.  Policy decisions, good and bad, that played out over years during the depression of the 1930’s, now would play out in a matter of days.  Let’s hope this fact is good news for Barack Obama and the American dollar.