And another thing ...

The interdependence of macro variables is so complicated that I have no idea how to keep all of it in your head at once. Tim Duy has some interesting reflections on the current imbalances.

Consider that the current account deficit will need to correct by some mixture of import compression and export expansion. The weaker Dollar encourages that correction, but Dollar-pegs prevent the full adjustment. But where currency adjustment fails, commodity price adjustment steps in as, for example, higher transportation costs support import competing industries. Indeed, we are learning that cheap oil, not just cheap wages abroad, was the critical force supporting offshoring of US production.

It's interesting to think about the effect of higher oil prices as a national rebalancing mechanism. It both cuts into your real consumption, and at the same time, by making imports that have to cross an ocean more expensive, shifts the mix of the consumption towards domestic producers. He continues on to the punch line:

I have long maintained that this adjustment should be characterized by weak consumption growth but better-than-expected business activity overall, particularly in export and import-competing industries. Effectively, the US is offshoring some of its weakness. The combination should be something that consumers clearly associate with recession, but with better than expected output, especially when policy stimulus is added to the mix. This is very much like the current environment, a recession that still lacks a single quarter of negative GDP growth. But the level of stimulus is starting to look excessive, and supporting a more inflationary environment than anticipated.

How long can this process continue? As long as global policymakers are willing to support it. Indeed, it is almost of a game of chicken, with US and emerging market policy makers on a collision course, neither wanting to accept the adjustment, a greater reliance on internal balance, necessitated by excessive US consumption.

Thinking about this, it seems to me that the Chinese are seriously fucked. They get caught on both ends of this bargain, as they too have to fork over more for oil and food, at exactly the same time as their exports become less competitive -- and they don't have any domestic demand to fall back on like the US. They can either continue to try to export, pile up dollars, let new direct investment come in (remember, they are accumulating reserves even faster than they can export) and simply accept the inflation this causes -- or they can revalue. Right now they are choosing option A (most of the world is choosing option A actually, not just the Chinese) -- exporting, putting up with the speculative inflows, recycling these into dollars as best they can, and just swallowing the resulting inflation. The fact that they're willing to do this is what is keeping the US afloat, but China must be paying the price for it in terms of bubble-like mis-allocations of these inflows. The whole thing looks like a positive feedback loop between Chinese fixed investment and commodity prices, with US monetary policy intervening in the middle and providing the juju to keep it going. If the fall of the Chinese property and stock markets, and the rise in inflation are any indication, we are at the last stages of this bubble.

The best way out of this for the US is for China to just accept that inflation. This would mean accepting lower export competitiveness, raising wages, and resigning themselves to the value of their dollar hoard in real Chinese terms going down. It would probably contribute to US inflation, and it would tend to keep commodity prices high. All of which would set up the conditions Duy describes in the US, which is really our easiest way out of the debt overhang from the Bush Binge, despite the fact that it may feel unpleasant for all involved.

On the other hand, in order to finally control inflation, they might raise rates and let their currency depreciate. It would have to be a sudden depreciation of course (say 20% in one go), to avoid people speculating on the currency. This destroys their competitiveness immediately, but does at least halt some of the speculation. It makes their pile of dollars worth a lot less, and the knock-on effects of that may be worse for the US, given that such an obvious policy failure might be accompanied by a remedy that makes it even worse -- namely diversifying out of dollars, or simply not adding so many new ones to the hoard. This should drive up US rates, and would probably tip the whole world into recession/depression.