“American senators could vote this week to slap tariffs of 27.5% on all Chinese goods, amid a rising clamor of protectionist anger on Capitol Hill.

“The sponsors of the so-called Schumer-Graham bill were in Beijing last week — Chuck Schumer’s first official trip overseas in 25 years — to press home the message that China’s cheap currency gives it an unfair advantage over the Americans. Schumer, a Democrat who represents New York, and his Republican co-sponsor, Lindsey Graham of South Carolina, have been promised a vote on the measure by the end of March…

“The United States ran a trade deficit of more than $200 billion with China last year, as shoppers sucked in low-cost consumer goods from the fast-growing economy. Like Japan in the ’80s, China is the target of protectionist rhetoric…

“Schumer and Graham will hold talks with colleagues in Congress to decide whether to press their bill to a vote. ‘The jury’s out,’ Schumer said. ‘We’re going to make a decision next week. We’re not saying yes, we’re not saying no.’”

You are not saying yes and you are not saying no? So what exactly are you saying? That this may or may not be a bluff?

Let’s backtrack a bit and look at statements made by China on March 13. China Daily is reporting, “Renminbi Reform on Sound Track”:

“China will reform its foreign exchange system in an orderly way and will not bend to pressure from the United States to float the yuan, said Zhou Xiaochuan, governor of the People’s Bank of China.

“China has its ‘own principles’ to carry out its exchange rate reform and the current rate is appropriate, Zhou told reporters at the sideline of the annual session of National People’s Congress on Saturday…

“U.S. Treasury Secretary John Snow again urged China to float its exchange rate on Friday. There are reports that he is under mounting pressure from the U.S. lawmakers to label China a currency manipulator in a report due in April. U.S. President George W. Bush also said that he would adopt further movement to press China to appreciate its currency soon…

“Premier Wen Jiabao said in this year’s government report that China will improve the system of managed floating foreign currency exchange rates and keep the renminbi exchange rate basically stable at an appropriate and balanced level.”

No Currency Changes

A tougher stance yet was announced by the Chinese premier in “China: No More Plans for Currency Changes”:

“Premier Says China Has No Plans for More Administrative Changes to Currency’s Value

“Premier Wen Jiabao said Tuesday that China sees no need for further one-time administrative changes in the exchange rate of its currency following a decision last July to drop its direct link to the dollar.

“‘There will be no more surprises,’ Wen said at a news conference.

“‘It is no longer necessary for us to take a one-off administrative means to affect the movement of the renminbi either upward or downward,’ he said.”

I suppose those statements should be clear enough, but that did not stop two U.S. senators from parading to China on a fool’s mission to attempt to persuade China to float the RMB or repeg it substantially higher. The threat is a 27.5% tariff on goods coming from China.

Supposedly, this will bring jobs back to America. At 20-1 or 15-1 wage differentials, it will not do anything of the kind, but it will plunge the United States headlong into a recession. A recession is headed our way anyway, but such nonsense would, of course, make it worse.

Smoot-Hawley and Xenophobia

Phillip Swagel of the American Enterprise Institute said that unless Schumer drew back from the brink this week, he could become known as the Smoot of the 21st century: “He would go down in history as the man who crashed the U.S. economy.” He said the anti-China senators were likely to “declare victory,” having delivered their message to the Chinese in person.

Wikipedia discusses Smoot-Hawley and its effect on the Great Depression.

“I think we’re riding a wave of xenophobia,” says William Reinsch, president of the National Foreign Trade Council, a pro-trade group.

One thing I would like to emphasize is that trade wars, protectionism, and repudiation of credit excesses are all hallmarks of deflationary, not inflationary, times, as the following chart shows.

The Kondratieff Cycle

Global Tripwires

In “Tripwires,” Stephen Roach of Morgan Stanley had this to say:

“Investors are nearly unanimous these days in dismissing the mounting economic and political tensions of an unbalanced world — arguing that it is in everyone’s best interest to keep the game going. The retort of increasingly smug U.S. fund managers is typically something along the lines of, ‘What else are the Chinese going to buy — euros?’

“At the same time, I worry about an even more treacherous aspect of the endgame. An earlier era of globalization was brought to a tragic end by two world wars in the first half of the 20th century. While history rarely repeats itself, the rhymes never cease to amaze me…

“Nation-specific rivalries have given way to threats coming from the amorphous terrorist ranks. Add in the current tensions associated with widening income disparities, real wage stagnation in developed countries, and the growing outbreak of trade frictions and protectionism, and today’s world looks far from secure. The tripwires of globalization are now being set.”

In “From Beijing to Dubai,” Roach writes:

“My travel schedule is planned months in advance. It was only by happenstance that I found myself in both Beijing and Dubai this past week — two of the more recent flashpoints in a U.S.-led pushback against globalization. What I found in both cities unsettled me — disappointment and frustration over America’s attitude toward two of its major providers of foreign capital. The feedback from Beijing and Dubai is that this image is going rapidly from bad to worse — something a saving-short U.S. economy can ill afford.

“China is deeply troubled over the outright hostility from an increasingly xenophobic US Congress. The Chinese don’t believe that U.S. politicians appreciate the potential risks that still lurk in this transitional economy. Instead, they are pressuring China as if it were operating from a position of much greater strength. China remains very much a tale of two economies — a booming coastal region and a lagging interior. Most in Washington view China from the lenses of Beijing and Shanghai, and conclude that these two thriving metropolises personify the emergence of a powerful and mighty nation. What they don’t realize is that only 100 kilometers away from either city lurks a China that has changed very little in the past thousand years. Yes, 560 million Chinese now live in urban centers around the country, although probably less than half these city dwellers have seen meaningful improvement in their standard of living over the past 30 years. Meanwhile, the rural population of some 745 million Chinese still tries to get by on $1-2 per day.

“When I pointed this out to Sens. Graham, Coburn, and Schumer in Beijing, Senator Schumer said, ‘I understand the structural point, but China still has to give.’

“The editorialist in me says, if Washington – or, for that matter, beleaguered U.S. manufacturers — really wants China to give, then it needs to make that argument from a position of a macro strength and boost America’s national saving rate. Until, or unless, that happens, U.S.-led China bashing is nothing short of political hypocrisy.

“In Dubai, I was met by a similar sense of consternation. Fresh from the wounds of the rejected Dubai Ports World transaction, several major private equity investors in the UAE were blunt in expressing their sudden loss of appetite for U.S. assets.

“In the broad scheme of things, Dubai is a small player in the world of international finance. But to the extent that the Dubai backlash is emblematic of similar distaste from other Middle East investors — hardly idle conjecture, in my view — the repercussion cannot be minimized. Net foreign direct investment into the United States hit $128 billion in 2005 — an increase of $22 billion from the inflows of 2004. If that trend now starts to reverse course, America’s already daunting current-account financing problem will only get worse.

“From Beijing to Dubai, there is a growing undercurrent of economic anti-Americanism. The irony of it all is truly extraordinary: The United States has the greatest external deficit in the history of the world, and is now sending increasingly negative signals to two of its most generous providers of foreign capital — China and the Middle East. The United States has been extraordinarily lucky to finance its massive current account deficit on extremely attractive terms. If its lenders now start to push back, those terms could change quickly — with adverse consequences for the dollar, real long-term U.S. interest rates, and overly indebted American consumers. The slope is getting slipperier, and Washington could care less.”

The Bluff Is Admitted

When I am researching a piece like this, I often gather material over the course of several weeks or even longer. I had been working on this “bluff theme” since mid-March. so I was especially pleased to find “Inside the China Debate” by Roach:

“For me, the highlight of the annual China Development Forum always comes at the end of the gathering — the traditional meeting with the premier. Sometimes, this exchange is tightly scripted, but at other times, it offers considerable food for thought. This was one of the latter examples. In a freewheeling response to intense questioning from the assembled group of outside experts, Premier Wen Jiabao left little doubt of the strong resolve of the Chinese leadership in facing a series of daunting challenges in the years ahead…

“[In response to the last question of the meeting by Steve Roach about 'Globalization and Mistrust: The U.S.-China Relationship at Risk'], the premier was especially animated and intense in framing his response. ‘China views this relationship as very important,’ he said, ‘and takes these risks very seriously.’ He was emphatic in re-emphasizing the limited role that foreign exchange policy could play in tempering the U.S. saving shortfall and related trade imbalance — in effect, implying no major change in the RMB exchange rate. At the end of his discourse, he leaned forward, looked me straight in the eye, and stated with great emphasis, ‘You can take this message back to the American people: It is unfair to make China a scapegoat for structural problems facing the U.S. economy.’

“Three Senators in Beijing

“The next morning, as luck would have it, I had the opportunity over breakfast to run Premier Wen’s comment by three U.S. politicians who just happened to be in town — Sens. Schumer, Graham, and Coburn… Schumer and Graham, of course, are co-sponsors of a bill (S. 295) that would impose 27.5% tariffs on all Chinese imports into the United States unless there was an RMB currency revaluation of a like amount. They were steeped with confidence that this bill had overwhelming support in the Senate and most likely comparable support in the House. And since it played to the angst of middle-class U.S. wage earners, they did not expect the first veto of a politically weakened President Bush to be exercised on this issue.

“Chuck Schumer is a very smart and savvy man. He is using the bully pulpit of a prominent politician to put so much pressure on China that it will have no choice other than to give. Nor does he have much doubt that this approach will work. ‘This is exactly what I did in Japan in 1986,’ he said — apparently the last time he was in Asia. ‘It worked in Japan and it will work in China…’

“In the end, Schumer doesn’t want tariffs — he wants to go down in history as the man who made China blink. But he is perfectly prepared to play high-stakes political poker in order to achieve this objective. So is the rest of the U.S. Congress. The big risk is that China calls Washington’s bluff and the two parties start to stumble down the very slippery slope of trade frictions and protectionism…

“‘I care deeply about the loss of U.S. manufacturing jobs to China,’ [said Schumer]. ‘If I am successful in cutting our trade deficit with the Chinese, not only will those jobs come back home, but I will have succeeded in boosting U.S. saving and cutting excess consumption. My bill can do all that and more.’ I am rarely speechless, but at that point, I started to choke on a huge bite of watermelon. ‘Let me get this straight,’ I gasped, ‘tariffs will boost saving?’ Too late — he was already off to face the ever-present battery of cameras and microphones.”

Going “All In”

That article had me laughing out loud. Not only do we see that the actions of Schumer are a bluff, but he openly admitted in public that he was indeed bluffing. Somehow, he expects it to work. Why? What kind of arrogance is that?

This is tantamount to flipping over your hole cards in a game of Texas Hold ‘Em and disclosing to the table that you hold the two of clubs and the seven of diamonds. (To non-poker players, an unmatched 2-7 is the worst start one could have. If you had such a poor hand, you would not show your cards and then brag that you were going to win the pot.)

China, not America, is holding the cards here. The United States has 2-7 and China has paired aces. Is China supposed to fold? The problem goes beyond bluffing, however; it shows arrogance and unwillingness to admit what the real problem is. The real problem that no one wants to hear about is rampant spending by the U.S. Congress and an administration that sees nothing wrong with blowing $500 billion in Iraq attempting to be the world’s policeman. The irony, as Roach points out, is that China and others are lending us money at very favorable terms, but we are complaining that the terms are “too favorable.”

The danger, of course, is that Congress does go “All In” and passes such a bill. Would President Bush sign it? Would Congress be dumb enough to override that veto?

Another Bluff?

We have talked about this before, but there is one more bluff that is worth a second look at this time. In “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” Ben Bernanke states:

“The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation…

“If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation…

“In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption, and hence to prices. Even if households decided not to increase consumption but instead rebalanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money.”

I think Bernanke is going to regret that speech for the rest of his life. That said, the important questions are:

1. Was that an ill-advised bluff of some kind, or was Bernanke really serious?
2. If he was serious, will the rest of the Fed go along with it?

The Greenspan Put

On March 16, 2006, Federal Reserve Board Governor Donald Kohn said, “Fed won’t act to preserve high home prices”:

“‘Greenspan put’ theory doesn’t stand scrutiny

“The Federal Reserve has no intention of preserving all of the recent gains in home price values, said Federal Reserve Board Governor Donald Kohn on Thursday.

“‘If real estate prices begin to erode, homeowners should not expect to see all the gains of recent years preserved by monetary policy actions,’ Kohn said in a speech prepared for delivery to a European Central Bank forum in Frankfurt, Germany.

“In his remarks, Kohn attacked the popular ‘Greenspan put’ theory that Fed policy would always protect investors from sharp asset market drops while doing nothing to restrain these markets when prices rise.

“‘This argument strikes me as a misreading of history,’ Kohn said.

‘Conventional policy as practiced by the Federal Reserve has not insulated investors from downside risk,’ he said.

It seems to me that Kohn has a poor memory. The Greenspan Fed has injected money into every scare (real or imagined) during his entire tenure: The Long Term Capital Management crisis; a nonexistent Y2K scare; and the bursting of the Nasdaq bubble, in which interest rates were slashed to 1% to “make sure ‘it’ doesn’t happen here” are just three examples.

The most important question now is this: Is Kohn bluffing (hoping to smoothly talk down housing prices without crashing them), is Bernanke bluffing, or are they both somehow bluffing? Interestingly enough, Bernanke might go so far out of his way to prove that he is an “inflation fighter” that he exacerbates the deflationary debt trap he is clearly in. Regardless of who is bluffing whom, the pot size is now enormous and the entire U.S. economy is at stake. Does anyone have any chips left, or are they all in the pot? Perhaps there is room left for one more raise. We will find out soon enough, but if protectionism kicks in, there will not be any winners in this game. Everyone will lose.

Mike Shedlock ~ “Mish”
March 27, 2006

Outrageous Bluffs was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The Kondratieff Cycle

Let’s take a step back. Inquiring Mish readers just might be wondering who was Nikolai Dmyitriyevich Kondratieff (1892-1938)?

K-Cycle theory should more than explain Greeenspan’s conundrum. Indeed, one should expect Treasuries to perform well in both autumn (disinflation) and winter (deflation) as interest rates fall. Junk bonds should perform extremely well in autumn, but debt will destroy them in winter.

Right now, I look for corporate spreads to start and keep widening. As the risk of default widens in K-winter, we should soon see some of the effects. Indeed, we have already seen this to a limited extent with the downgrade of GM’s debt to junk status and the resultant widening of GM yields versus Treasuries. In general, the widening of corporate spreads versus Treasuries in conjunction with the flattening action in Treasuries as the curve nears inversion is not a good sign for stocks or the economy.

That conundrum (they seem to be everywhere you look these days) will probably be resolved as stocks start plunging when the Fed pauses or cuts rates. Indeed, stock market bulls cannot have it both ways, with rising interest rates seen as a sign of a good economy and falling rates seen as being good for stocks simply because they are falling.

Some think we are in a prolonged period of inflation, or even hyperinflation. I disagree. I do not believe the K-Cycle can be defeated. Postponed, yes; defeated, no. Greenspan managed to postpone the inevitable by slashing interest rates to 1%, which fueled the biggest housing bubble the world has ever seen, not only in the United States, but in Britain, Australia, and other places. All he has accomplished is to create bigger and bigger bubbles that will ultimately be deflated away.

Hyperinflationists will have you thinking the K-Cycle can be defeated or that seasonal stages can be skipped. I do not wish to repeat myself. If you missed my previous two articles challenging hyperinflationist Jim Puplava (challenges that still have not been adequately replied to…)

Where we are in the cycle is extremely important to stock, bond, and commodity traders. Treasuries and bonds in general will get hurt in spring and devastated in summer. Stocks typically get hammered in summer and winter. Commodities tend to do well in spring and summer.

Given that K-Cycle seasons are fairly long events, and given the stock market run-ups in the United States for 20 or so years up to 2000 and falling stock and land prices in Japan for the past 20 or so years, it seems to me to be totally preposterous that America has undergone deflation in one quick drop from 2000-2002.

A closer look at debt levels should be convincing enough. In K-winter, debt levels and excesses should be purged. Instead, we are seeing bigger and bigger bubbles and higher and higher debt levels as people plow more and more into housing.

That is why I am confident that Greenspan delayed the K-Cycle, instead of defeating it. In effect, we have just experienced what I think of as a false spring. We have only just begun winter, but some would have you believe that spring has arrived. Do not fall for it.

The biggest clue as to where we are in the cycle should be readily apparent from all of the protectionist talk spewing forth from Washington, D.C.  Indeed, it was the current protectionist talk in Washington threatening 27.5% tariffs against China, as well as threats to label China a “currency manipulator,” that was the biggest factor in deciding exactly where to place that arrow on the opening chart.

The Kondratieff Cycle: Additional Clues

Enquiring Mish readers just might be wondering if there are any additional clues. Indeed, there are.

In addition, I believe steel prices are a clue. Steel prices have collapsed this year. I do not think we would see that in K-spring.

Finally, the Baltic Dry shipping index has been plunging like a rock. That index reflects shipping costs for various commodities. It would not be behaving like a yo-yo if this were really spring. The FinData Web site lets you pick a time frame in which to analyze shipping rates. I suggest looking at a duration of about five years or so. It shows what I believe to be false spring.

In theory, oil prices should be declining in K-winter. So what’s up with that? That conundrum is resolved by the knowledge that oil is subject to geopolitical issues, as well as peak oil concerns. K-winter cannot stop prices from rising in situations in which the commodity is simply running out and/or situations in which world tensions and terrorism prevent supplies from reaching the market. Oil is affected by both. Indeed, Iraq is pumping less oil now than before Bush invaded.

Also note that commodities might be tricky in general, because Japan should just about be coming out of K-winter and China (being a command, as opposed to a market, economy) does not follow the K-Cycle exactly.

Taking all of the above into consideration, the great preponderance of evidence is that this is indeed a false spring, and sometime soon, Mr. Groundhog (aka the typical consumer and house flipper) will indeed be frightened by his own shadow and go scurrying back into very prolonged winter hiding. The economic consequences of this are not likely to be pretty.

The Kondratieff Cycle: Six Points from Bill Gross

Bond guru Bill Gross provides a list of his main points in a well-written article entitled “Fire!”:

“1. The current, rather mild U.S. recovery has been driven by asset appreciation/consumption, and not employment or capex growth.

“2. Future growth is dependent on additional asset appreciation in real estate and stocks if Asia continues to absorb much of our investment and many of our jobs.

“3. Recent asset appreciation has been set ablaze by several fiscal/monetary pumps… with five-year real rates being the central driver/gasoline can.

“4. Tax cuts are a thing of the past and five-year TIPS yields can theoretically decline only 60 basis points or so more.

“5. The reason why intermediate/long TIPS have an interest rate floor is that if we approach potential deflation, investors risk losing money on a government-guaranteed investment. The same concept applies to homes, stocks, and other inflation-adjusting assets without government guarantees.

“6. The Fed may soon be out of fuel, despite hints of Bernanke-style helicopter money. Stocks and houses are already at low yields and high prices reflective of European economies nearing Japan-style liquidity traps.”

He continues:

“If the asset pumps run dry and the kerosene cans empty, the inevitable path of the U.S. economy will reflect slow growth at best, and recession as a realistic alternative. Inflation then would return to low 1% levels in the ensuing years and be pressing the deflationary crossover line. Nominal Treasury paper would enter the 3-4% zone for 10-year maturities, and lower still for shorter intermediates. Such an analysis argues for capturing yield via duration extension now, in the face of admittedly artificially low current yields. If Rome burns, long maturity bonds will rule the day, and that day may come sooner than many imagine possible.”

I do believe that long-term investors can follow Bill Gross and comfortably hold Treasuries. Short-term players may note that the capitulation of Bill Gross, as well as Stephen Roach, could mark a temporary bottom in Treasury yields.

The Kondratieff Cycle: The Kondratieff Cycle was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.