China has been integrated tightly into the globalization scheme already. Due to the sheer size of population China's tie-in with the global economy is bound to have enormous effects. Since the emergence from the disastrous "The Great Cultural Revolution" of Chairman Mao, China had gradually opened its market for outside capitals on one hand and had steadily devaluated its currency, Yuan, against US Dollar. By 1987 the exchange rate was around 3.7 Yuan per US Dollar; the rate was rigidly maintained at 1 Yuan = 1 US Dollar through Chairman Mao's era. In this early stage only some Hong Kong capitals ventured in and moved some light manufacturing facilities into southern China. It was after 1989's Tieanman square incidents, thanks to the lack of economic sanction from USA and the persistence of the leader Tang to open Chinese market and to devaluate Chinese Yuan further, China has been boosted rapidly by a unique force called "Taiwan Merchants" into the global market and has become an indispensable part of the global economy.
To understand the evolution of Chinese economy, we must look into the
evolution of Taiwan first, since Taiwan's developement model, which we
call "Taiwan model", is the forerunner of what to come in China. The majority
of residents of Taiwan, called "native Taiwanese people" are immigrants
from Fujin provice of China; the real natives of Taiwan are aboriginals
and are small in numbers. Near the end of the ninteenth century Taiwan
was given to Japan by the Imperial China after it lost a war with Japan
and Taiwan had stayed as a colony of Japan for nearly half a century. Taiwan
has returned to the rule of China only after the defeat of Japan in The
World War II. After the return to the rule of China, the native Taiwanese
people had an uprising for self-rule and was supressed by force. When the
Chinese nationalists was defeated by the communists, the nationalists under
the leadership of Chiang Kai Sheik retreated to Taiwan and ruled Taiwan
for four decades with martial laws and authoritative governance. During
the colonial rule of Japan, Taiwan escaped the turmoil of China,
the revolution, the fall of the Imperial China, the war lords, the invasion
of Japan and the World War II, and the civil war between the nationalists
and the communists. During that stretch of peaceful period of nearly 50
years the infrastructure of Taiwan has advanced much more than the mainland
China, the literacy rate among Taiwanese people is quite high and many
of them speak Japanese, but Taiwan mainly remained as an agricultural society
producing large amount of rice and abundant varieties of fruits due to
its semitropical weather. After the dream of a quick counter attack and
the return to mainland China faded, Nationalists Government in Taiwan under
the push of Chiang Kai Shek's son, Chiang Ching Kuo, has started to take
policies to industrialize Taiwan. By that time the industrialization of
Japan after the war has advanced rapidly, the wage level in Japan has risen
steadily and the concern abount environment has awaken. Those factors made
Japanese industries wanting to outsource their lowest level manufacturing
capabilities overseas. Taiwan thus has become the natural candidate, a
familiar and friendly place for many Japanese, for that purpose. Japanese
capital and know-how, combined with cheap labor and lax environmental control
of Taiwan, has created a powerful proxy manufacturing center of Japan in
Taiwan. The products from Taiwan have never meant to be reimported to Japan,
but are exclusively earmarked to be exported to USA. Serving as the proxy
exporter of Japan, the underutilized Taiwan labor resource has awakened
and has produced large amounts of goods. This rush of production can be
considered as creating a huge amount of consumption power; a large portion
of this newly created consumption power has been exported to USA to support
the consumption boom there, but a portion of that consumption power has
been retained in Taiwan to push it rapidly up the economic ladder. However,
as Taiwan industrialized as a proxy exporter of Japan, the wage level and
the environmental polution have raisen. With this wage pressure and the
gradual tightening of environmental control, manufacturers in Taiwan has
wanted to migrate to somewhere with cheaper labor and lax environmental
control, now the familiar senario of globalization. After the death of
Chiang Ching Kuo, Lee Tung Huei, a native Taiwanese, became the president.
He has pushed democratization of Taiwan, whereas listened to the demand
of business circle of Taiwan to open the door for Taiwanese industries
to invest in China. The rush of Taiwanese industries to move their manufacturing
facilities to China has thus started, creating the phrase, "Taiwan Merchants",
to describe those Taiwanese manufacturers of gold-rush mentality. That
is why the made-in-Taiwan products dominated USA market were suddenly replaced
by made-in-China products (same varieties but with much more in quantity)
without any outcry since the manufactures of those made-in-China goods
are more or less the same as of those made-in-Taiwan goods. Panicked by
the rapid hollowing of Taiwan's manufacturing capabilities, Taiwanese Government
has been trying to slow down this hollowing process, whereas Taiwan's focus
has shifted from the already lost low tech industries to higher tech sectors
like PC mother boards, memory chips, LCD screens and plasma screens. However,
as long as the focus of Taiwan's business world is just export, then any
industry, whether low tech or high tech, has no reason not to move to China
to take advantage of cheap and abundant labor source and comparatively
lax environmental control to lower their production costs. Ironically,
if China abandons its military threat against Taiwan, the rush for most
of merchaints in Taiwan to become "Taiwan Merchants" is irresistable and
the complete hollowing of Taiwan's industry is unavoidable. At that point
it will be "Taiwan Merchants" banging on Taiwanese Government to abandon
Taiwan's western style democracy and to reunite with China. If Taiwanese
Government can negotiate cleverly with China and shore up its still shabby
financial sector during this reunification process, Taiwan can probably
become a tax heaven and a resort for the new riches of eastern China. If
that happens, Taiwan may even see its real estate prices and the
stock prices of its shell companies (all their manufacturing facilities
will be moved to China by that time) skyrocket.
Now returning to the economic evolution of China: With the help of "Taiwan Merchants" China is rapidly advancing to become the factory of the world. As the Chinese fever rises, manufacturers of USA are also joining the bandwagon of "Taiwan Merchants" to outsource their manufacturing facilities to China. As the vast underutilized Chinese labor resource is employed as the trenmendous export engine, enormous amount of goods and thus the consumption power are produced. The major fraction of this consumption power is exported to USA to support an unpreceedent "borrow and spend" consumption boom which is still continuing today. But a significant portion of the newly created consumption power, as was the case for Taiwan, is retained within China and is fueling an emerging consumption boom and prosperity in China. However, China is still a developing country and by definition is resource inefficient when it comes to the economic growth. This means that the boom in China that is based on USA trade deficit requires substantial natural resource to sustain, and this hungry for natural resource from China has fired up the global prices of commodities. The higher natural resource prices is going to intensify inflation rates of the whole world and will damp the consumption boom in USA. Without this natural damping mechanism, relying on the huge
pool of underutilized labor source, USA can run an unlimited "borrow and spend" consumption boom by letting its trade deficit to grow without any bound, and USA will rapidly plunge into the phase of a jobless "virtual society" as depicted in Article 7 .
With this natural damping mechanism, higher inflation and higher interest rate period will cap the consumption boom in USA and the growth of US trade deficit will stagnate. In such a period China's export engine also will be hit. If China can not compensate the slow down of its export engine by domestic spending, then China's thirst for global natural resource will ease, the global commodity prices will weaken, the world inflation rate will fall, and the ground for another global economic boom based on renewed US trade deficit expansion will be laid. If China succeeds in firing up its domestic consumption during the mean years of its export engine, then Chinese economy can continue its strong growth, China's thirst for global natural resource will continue, the global inflation rate will be sustained at a rather high level, and USA will experience a prolonged period of stagflation. If the export engine of China is suddenly interrupted, for example, if Japan suddenly stops to support US Dollar through its currency market manipulation, if military confrontation erupts across Taiwan strait, or if some unforeseen political turmoil occures within China, USA will be deprived the source to borrow and spend, US economy will sink into a deep recession, and the Pacific Rim economy built around China's export engine will also crash to the ground.
There are some regularities emerging in the global housing markets.
For the developed economic entities with high wage levels, the spending
happy societies, and especially big borrowers through trade deficit like
U.S.A. and UK are seeing robust housing markets. Resource rich countries
like Canada and Australia are also experiencing housing booms thanks to
the sharp rise of prices of raw materials. However, for the countries and
economic entities woth high labor costs and the insistence to run trade
surpluses, consumption have fallen and so are the housing prices; in this
category Japan is the most notable, but Hong Kong, Taiwan and Singapore
are also experiencing similar housing malaise as Japan exactly due to their
misdirected currency policies to artificially supress their own currencies
to boost exports, thus exporting away their own consumption power to trade
deficit countries. Even Germany can be considered belong to the latter
group, since due to the weak Euro Germany has maintained a very high level
of trade surplus and a stagnated consumer spending. The situations in developing
countries, which enjoy large amount of foreign investments and low labor
costs, are quite divergent. In the societies, like China, that has successefully
translated foreign investment and strong export into higher economic growth,
housing booms ensured. However, for the ones that foreign investments and
exports have failed to lift living standards, housing boom is nowhere to
be seen, like Mexico and Latin America in general.
Many in the investment and economic circles blame the high oil prices
on various factors like the unrest in Iraq, the uncertainty in the Yukos
situation, and even on some faceless futures market speculators. However,
before relegating the responsibility of higher oil prices to those noneconomic
events, we need to look at the situation of supply and demand in the global
oil market as the free market economic basics teaches us. Currently the
global oil output is about 82 million barrels a day with zero extra capacity
to serve as the cushion for some unexpected emergencies, and the global
demand of oil is also about 82 million barrels a day. If the normal equilibrium
is to have the extra capacity of a few million barrels a day to serve as
a cushion, then the price of oil will stay high or go even higher until
either the global demand comes down (means the global economic growth rate
needs to come down) or some new production capcity emerges to restore the
cushion of a few million barrels a day of idled capacity. Since new
production capacities are not so easy to pop up no matter how hard we wish
for them, we should expect that the high, or even higher, oil prices will
continue until it breaks the back of the too robust global demand; it may
take the form of penalizing those Americans who want to drive ever larger
and gas guzzling SUVs and military style vehicles until they cry out for
pain and give up their gas guzzlers, or it may curtail the desire of many
newly rich Chinese middle class to enjoy the freedom of automobile through
sticker shocks of gasoline price, or both. Considering the recent drop
of gasoline price in USA on the face of steadily rising crude oil price,
it seems that the price of oil needs to go substantially higher from todays
level in order to have the effect of curtailing the demand for oil and
for the oil market to reach a new equilibrium.
In the second quarter of 2004 the economic growth rate of USA has suddenly slowed down to 3.0% in real GDP from four plus percent growth rates of previous two quarters. The drop of GDP growth rate is maily due to the slow down of consumer spending. Many analysts and economists have immediately pointed their finger at the high crude oil price as the cause. Some argue that high oil price acts like an extra tax on consumers and has prevented them to spend. However, this argument is logically fraud. High oil prices will only force consumers to spend less on non-oil related goods but more on oil related products. The total amount of consumer spending should not be affected since the buying of oil related products are also counted in the overall consumer spending. More thoughful analysts argue that high oil prices has affected consumer psychology and thus has retarded the consumer spending. However, consumer confidence surveys through the second quarter and even in July have not picked up any slack in their confidence. The actual data are also not showing any direct correlation between the consumer spending and the crude oild prices. In the following we list quarterly percentage changes in the real personal consumption and the crude oil price, starting from the third quarter of 2003:
(3Q2003, real personal consumption +5.0%, crude oil price +15%)
(4Q2003, real personal consumption +3.6%, crude oil price +7%)
(1Q2004, real personal consumption +4.1%, crude oil price +47%)
(2Q2004, real personal consumption +1.0%, crude oil price +42%).
It is clear that there is no clear direct correlation between the crude oil price changes and the changes in the personal consumption. A more meaningful correlation between the personal consumption and the stock prices can be observed from the data. Monthly close of Dow Jones Industrial Average (DJIA) is used as the monthly indicator of the stock market, and three month average is taken as the stock market valuation of the quarter. The data are listed in the following:
(3Q2003, real personal consumption +5.0%, DJIA +24.5%)
(4Q2003, real personal consumption +3.6%, DJIA +30.2%)
(1Q2004, real personal consumption +4.1%, DJIA +18.6%)
(2Q2004, real personal consumption +1.0%, DJIA -7.4%).
DJIA has started to be anti-correlated to the prices of crude oil since the second quarter of 2004, but not before that time. The data show clearly that US consumers rather synchronize their consumption with the stock prices rather than on other indicators like interest rates, crude oil prices and so on. Other indicators can only influence consumer behavior indirectly by first influencing the prices of stocks. If the stock prices continue its downward path in the third quarter of 2004, we can expect another dismal showing of US real personal consumption.
In Comment 11, we have discussed the observation that US consumers are
synchronizing their spending with the ups and downs of the stock market,
and thus have caused the real personal consumption to grow a dismal 1.0%
in the second quarter when the stock market, gauged by Dow Industrial Average,
retreated around 7%. In recent decades personal wealth of US consumers
is tied to stocks more and more. Though consumers who do active stock trading
are the minority, majority have their pension funds tied into stocks. With
the bitter experience of the burst of bubble in the early 21st century
and seeing their pension savings suffered a noticealbe dent, it is natural
for US consumers to be supersensitive to the ups and downs of the stock
market. However, this kind of emphasis on the stock prices by US consumers
will create the possibility of a dangerous economic down spiral. Stock
markets are forward looking instruments, with players constantly trying
to gauge the future performance of the economy that will naturally be reflected
to the profitability of the underlying corporations. After the June consumer
spending report and the personal consumption figure in the second quarter
GDP report have confirmed the poor performance of consumer spending, stock
market naturally took a further hit. This additional pull back of stocks
probably has cooled the spending of US consumers further, and when July
consumer spending report comes out at the late August, stock market may
stage another drop, cooling consumer spending in September more, and so
on into a death spiral. Without this unexpected influence of stock market
performance, we have been projecting a gradual slow down of US economic
growth rate, like 3.5% in the second half of 2004, 3.0% in the first half
of 2005 and 2.0% or below for the second half of 2005. With this new attitude
of US consumers to tie their spending to the ups and downs of stock markets,
the gradual slow down of economic growth rate may turn into a full scale
recession, and thus deserve our close attention.
In Sept. 2, 2004 issue of Wall Street Journal an article in "Capital Market" has touched upon the topic of the possible catastrophy for stocks and bonds due to the coming demographic change in USA. The article has presented the counter arguments from optimists who claim that the calamity is just an imagination of alarmists and the selling pressure claimed by the alarmists will not happen. However, the argument of optimists contains a logical flaw, and the whole topic deserves a close examination.
Since baby boomer generation has entered the labor market, US working age population has increased rapidly for many years. The baby boomer generation will retire soon. This will create a situation in USA that the rate of retiring people will be higher than the rate of increase of the working age population. It is well known that younger workers are more apt to hold stocks as their assets, and when people retire, they tend to liquidate their stock holdings and convert them into readily spendable cash. The alarmists claim that the stellar performance of US stock markets during the past half century is mainly the result of the rapidly increasing working age population and their tendency to hold stocks. Now this demographic trend is changing and massive liquidation of stocks and bonds is going to happen when baby boomers retire, and thus the ultimate calamity will hit the markets. The optimists as quoted by the Wall Street Journal article claim that the retirees are not necessarily going to liquidate their portfolios at the time of their retirement, so the calamity is just a fantacy. However, the argument of the optimists contains a logical flaw. Retirees may not liquidate their stock portfolios right away, but they will certainly do so as they approach their death beds. Suppose that the average life span after the retirement is 15 years, then the argument of the optimists only postpone the calamity by at most 15 years. The alrmists are claiming that the calamity will hit in 2023 in a sudden death form, and the optimists' argument is only modifying that prediction and turn it into a slow water torture type agony that can last a decade or more from 2023. Is that kind of calamity really going to happen, and is there anyway to avoid the disaster? It is certainly an interesting question to study.
Let us use Dow Jones Industrial Average (DJIA) as the representation
of US stock markets. During the past half century DJIA has risen 30 times.
During the first forty years, from 1955 to 1995, DJIA moved up 10
times, a respectable performance. From 1995 to 2000 DJIA moved up 3 times,
a real explosion upward. If DJIA had moved with the rate as from
1995 to 2000 during the first 40 years, it whould have moved up like 1000
times! This respectable achievement of US stock market is not just due
to the increased working age population, but is also due to the trend that
US workers invest larger and larger portion of their assets in stocks,
either invested actively by workers themselves or passively through their
pension funds. There is also an additional factor of foreign money involved
indirectly in boosting US stock prices. The foreign money scheme works
as follows. As US runs huge trade deficits, US Dollar is handed over to
foreigners. Those trade deficit dollars are eventually bought up by foreign
governments, especially by Japanese Government, as they manipulate the
currency market to keep Dollar strong in order to sustain their trade surplus.
Japanese Government uses the acquired dollars to buy US treasuries. This
means that some institutions are selling US treasuries to Japanese Government.
When those institutions receive cash for their US treasuries, they have
little choice but to invest the cash in stocks, thus fanning the stock
market boom further. This foreign money phenomena is especially acute after
1995 when Japanese Government has started an all out currency market manipulation
to boost Dollar and supress Yen; that is the reason why since 1995 US stock
markets have exploded upward, and when US trade deficits have retreated
somewhat at the latter half of 2000, the stock market bubble have burst.
As the baby boomers retire, massive (in the order of several hundred billion
dollars to over five hundred dollars a year) liquidation of stock portfolios
is unavoidable. However, this massive selling of stocks can be absorbed
by increased holding of stocks by working age population, by the step up
indirect foreign government purchase as mentioned above, or both. The current
suggestion to partially privatize the social security and let individuals
manage their social security retiremnet account and to invest in stocks
is a clear ploy to induce working age population to hold more stocks and
thus may cancel out a certain portion of the massive selling due to the
retiring baby boomers. As for the foreign buying, Japanese Government has
already demonstrated that it is willing to pour 400 billion dollars into
US treasuries a year. If Japanese Government just increases that amount
by a few hundred billion dollars a year, then its indirect buying will
be enough to absorb the remaining portion of baby boomer selling. We believe
that the calamity mentioned here are avoidable since US Government will
do its best to induce individuals to hold more and more stocks and will
persuade Japanese Government to continue to do the massive dollar buying
in order to cancel out the unavoidable massive selling by retiring baby
boomers. If US Government succeeds in those two fronts, then what is going
to happen to US stock markets? If the inducement of individuals to hold
more stocks come before 2023 and Japanese Government continues to buy Dollar
as they are doing presently, US stock markets will stage a strong rally
first. When the massive selling by retiring baby boomers become the reality,
then the gains will be quickly erased and stock markets will enter a prolonged
stagnation period, that is, stock prices will neither rise nor fall, say
for ten years or more until either individuals get tired of holding stocks
without any capital gains or Japanese Government refuses to buy any more
dollars. If either one of the senarios becomes true, then and only then
US stocks will suffer a catastrophic fall as alrmists are claiming.
At the time that US Dollar is rapidly falling against Euro and Yen, all kinds of rumors and myths are flooding the financial markets. It is essential that we understand what are the realities and what are just fantacies.
Many think that a sharp fall of Dollar will immediately be translated into higher interest rates and crashing stock prices, because they equate the falling Dollar to the withdraw of foreign capital from US markets. This notion, of course, is false as pointed out in Comment 4, titled "What is capital flow?" Currency market is an auction market. Any Dollar sold must be matched with an equal amount of Dollar bought. Dollar will fall when the sellers are more aggressive than the buyers, but the total amount of Dollar in circulation will not change at all. Let us call the Dollar sold "the old Dollar" and the Dollar bought "the new Dollar". How the falling Dollar will affect stock market depends on where the old Dollar comes out of and where the new Dollar will go into. If the old Dollar is withdrawn from the stock market whereas the new Dollar only goes into the mnoney market funds, then of course stock prices will be adversely affected. However, if the old Dollar comes out of the money market funds but the new Dollar is deployed into the stock markets, then the falling Dollar will be translated into higher stock prices. In average the movement of Dollar will not cause any immediate lasting effect on stock prices. For example, the sharp devaluation of Dollar in early 1985 did not prevent a bubble like upward explosion of US stocks in 1987, and the twin falls of Dollar in 1998 and 1999 did not hinder the formation of the dot com bubble until late 2000 and early 2001.
Reading the previous paragraph, one may ask then what is the worry about the falling Dollar; is it really only US oversea's travellers will be adversely affected and everything else is rosy as many financial spin-doctors on news media try to convince us? As presented in the studies of actual data in various papers posted in this website, the significant movement of Dollar will be translated into the ebbs and flows of US trade deficit with roughly two years of delay. Today's falling Dollar means that in 2007 the expansion of US trade decifit will be slowed. Rapid expansion of trade deficits was the driving force of both the Reagan era and Clinton era prosperities, and the shrinkage of trade decifits had triggered economic recession during the Senior Bush era and again in the manifestation of the burst of the dot com bubble in late 2000. Thus today's falling Dollar implies a substantial economic slowdown in 2007. If Dollar should collapse here, then the 2007 slowdown will turn into a full fledged recession. Stock markets are usually not so far sighted, so the adverse reaction in stocks will come mostly in the latter half of 2006. Until then stock markets may suffer a lasting effect due to other reasons, but not due to the falling Dollar. Stock markets may suffer a temporary set back immediately following a sharp fall of Dollar due to the psychological panick of market players, but the set back will most likely be reversed soon due to the deployment of the new Dollar to pick up the depressed stocks until the time when the trade deficit really shrinks, the inflow of foreign capital actually slows and then stock markets will enter into a lasting bear trend.
There are substantial amount of talks of China reducing its Dollar holdings, and such talks immediately unnerve currency market traders and financial market participants alike. If we study the structure of Chinese economic reality and the intention of Chinese Government with regard to the value of Yuan, then we will know that no way Chinese Government can reduce the amount of its Dollar holdings at all; it rather must increase the amount of its Dollar holdings steadily if it wants to peg Yuan to Dollar or allow Yuan only to appreciate a very modest amount, say like around 10%. The driving force of Chinese economic growth is ironically the Dollar buying operation of Chinese Government. Those Dollars to be sold for Yuan are coming from outside investments to set up factories to product goods to be exported to USA, from multinational companies investing in China aiming at one billion strong Chinese consumers, Hong Kong and Taiwan money intended for real estate speculations, and the repartriate of money by former Chinese emigrants, Hong Kong and Taiwan residents wanting to engage in the currency speculation waiting for Yuan to appreciate. At the stage of falling Dollar it is pointless to distinguish the long term investment money from the so called hot money that is just deposited into domestic Chinese banks and waiting for Yuan to appreciate, since the Chinese banks will not let those hot money deposited in their branches sit idle; they will lend those hot money to Chinese local Government entities to build power plants, steel and aluminium production facilities or just real estate developements. Thus so called hot money is spuring Chinese economic growth just as the long term investments from outside. If Chinese Government wants to trim its Dollar holdings, the most direct way is to scale back its Dollar buying. But then Yuan will appreciate sharply (like 100% to 200%). How about buying Dollar at current rate, but shift Dollar holding to other currencies like Euro and Yen? If Chinese Government does that, Euro and Yen will appreciate vs. Dollar and Yuan sharply. Even if European Central Bank and Japanese Government allow such actions, the pressure on Yuan to revaluate will become untolerable and Chinese Government will discover soon that it needs to buy back much more Dollar than the Dollar it has divested earlier just in order to keep wild gyrations of Yuan under control and Chinese economy not wrecked. Thus we believe that the talks of Chinese Government to reduce its Dollar holdings, are just talks but not practical at all.
As discussed in the previous paragraph the fate of Dollar and the long
term effect on the global economy is not in the hands of China. However,
the fate of Dollar depends how Japanese Government will react when the
line of 100 Yen/Dollar is approached. Japan plays a dominant role in the
globalization scheme as the major provider of international capital with
its huge trade surplus. This continuously large trade surplus of Japan
is sustained by the relentless currency market manipulation of Japanese
Government to keep Yen weak and Dollar strong. Japan's zero interest rate
policy is just another face of this weak Yen strategy. However, the instigators
of this weak Yen policy have totally misjudged the reality of the consumption
pattern in Japan. Average Japanese retire early and the social security
system of Japan is far from ideal. Thus Japanese public needs to rely on
their savings and the interests generated by their savings to suplement
the expense of supporting their long life span after their retirement.
Under this kind of circumstance zero interest rate is like a poison. It
has immediately vanquished Japanese demand of consumption, and ushered
in the prolonged period of deflation in spite of the fact that the amount
of consumable goods in Japan has also plunged due to the weak imports and
strong exports, the effect of weak Yen. This self inflicted economic hardship
has temporarily pushed Japan into a third world like condition with abundant
idled labor resource so that increased exports will reempoy a part of those
unemployed and create a temporary rebound of its economy; that is the condition
that Japanese economy is in today. Under this kind of environment, to let
Dollar fall and Yen rise probably is the prerequisit for Japanese economy
to return to the normal condition and to grow near its potential growth
rate around 2% a year. However, this kind of reversal of decade long artificially
weak Yen policy is very difficult for the financial bureaucrats of Japan
to swallow; they will certainly try to intervene in the currency market
to weaken Yen again. Adding on to this picture we must consider the political
reality about the relation between USA and Japan. When Japan started to
manipulate the currency market ten years ago to weaken Yen and push up
Dollar, it was done with the full consent of USA under the Clinton administration.
This time around the current Bush administration understands fully the
enormous danger of the unsustainable US trade deficit; it also understands
that the only way to cap US trade deficit is to let Dollar fall to its
natural level. That is the reason why US Government is opposing other governments,
especially Japanese Government, to continue to intervene in the currency
market, and is trying to guide Dollar to fall gradually. That is probably
also the reason why Japanese Government let Yen move through important
price levels of 110 Yen/Dollar and 105 Yen/Dollar without any action. However,
the level of 100 Yen/Dollar can be quite different. If Yen rise above that
level, it can quickly rise toward the all time high record of 80 Yen/Dollar,
and Dollar will be experiencing a crash, not a gradual fall. We believe
that US Government will ask Japanese Government to intervene when Yen tries
to rise above 100 Yen/Dollar level, Dollar will have a modest bounce, then
fall later again and eventually break through 100 Yen/Dollar line in not
very distant future. This kind of gradual fall of Dollar will cap US current
account deficit to around 5% of GDP, but will not cause the deficit to
shrink significantly. Thus the external debt of USA will accumulate steadily
and will eventually approach the total assests of USA, creating a condition
called "bankrupcy". In the meanwhile we must watch closely the delicate
dance of US Government and Japanese Government around this line drawn in
the sand, the 100 Yen/Dollar line.
A bill is pending in US Senate to impose 20 plus percentage of import taxes on all Chinese imports unless Chinese Yuan is upwardly revaluated by a similar amount. This bill is sponsored jointly by Democratic and Republican Senators and was introduced about a year ago. The consideration of the bill has been suspended to give US Government time to persuade Chinese Government about the revaluation of Yuan. However, after one year of fruitless attempt by US Government to talk up Yuan, this bill seems to regain the focus and has a good chance to be enacted into the law in 2005, especially under the changed environments among US and international economic policy makers. The school of economists who have pushed for free trade at any cost is forced to argue that the loss of US jobs to developing worlds like China is good for US economy, and is ridiculed in front of the public opinion. Even the Federal R eserve Chairman, Alan Greenspan, has changed his tone. He was reiterating that the large US trade deficit will be taken care of painlessly by "free markets". Now he is issuing a warning about the unsustainability of this enormous US trade deficit and wants currencies to float freely without government intervention to rebalance this imbalance in the globalization scheme. This, of course, means that Chinese Yuan must move up sharply, and US Government apparently shares this view. Only a handful of large Chinese good importers want to keep Chinese Yuan weak so that they can continue to reap huge profits through the import of inexpensive Chinese made goods. In the international front, Japanese Government is most eager to see the upward revaluation of Chinese Yuan, and Europe is not far behind. If Chinese Yuan continues to be pegged to US Dollar, and if US Dollar falls sharply against Japanese Yen, then Chinese Yuan will also experience a sharp devaluation against Japanese Yen and within a short period a large number of Japanese manufacturing jobs will flow to China. To prevent this kind of disaster to happen, Japanese Government will have no choice but to continue to manipulate the currency market with whatever amount of money necessary to support the value of Dollar. The amount required for such manipulation will escalate steadily; from near 400 billion dollar buying last time to one trillion dollar buying soon, then to two trillion dollar buying and so on with no end in sight. Under such consideration, we believe that the above mentioned bill will not encounter any strong resistance domestically nor internationally, and will probably be passed or Chinese Government gives in and revaluate Yuan by a satisfactory amount.
Let us analyze the effect of this 20 plus percentage import tax against Chinese made goods. The reason that multinational manufacturers shift their production lines to China is to take advantage of inexpensive labor cost and the lax environmental and regulatory controls over there. The raw materials and the components for those goods for the reexport to USA are mostly imported into China. The raw materials are, of course, imported from various resource-producing contries, and the components are imported from Japan, Taiwan, South Korea and other places. The added value by China to those Chinese made goods is usually only a fraction of the final price that the goods command when they pass US customs. This 20 plus percentage import tax under proposal will not only tax the portion that China contribues, but will also tax all the raw material and components went into those goods but not contributed by China. Thus this proposed import tax will cause a very sever blow to Chinese made goods, and China will see a sharp curtailment of its exports. Low profit margin goods like textiles probably will be wiped out over night, and those jumped on the China band wagon to expand their textile investments in China will see heavy financial losses. The high margin electronic goods probably will withstand the shock better than the low profit margin goods. As China's export industry is hurt, the capital inflow to China will slow down. Since Chinese economic growth is so dependent on exports to USA and the capital inflow, Chinese economy will experience a major slump if that import tax is enacted. How will this import tax impact US economy? We should note that the indispensable part of the globalization scheme is Japan, and to a lesser part Taiwan and Europe; they are the source of global capitals in the form of their chronicle trade surpluses without the matching capital inflow. Without those capitals US consumers can not borrow and spend, and the whole globalization scheme will just collapse. China is not an indispensable link in this globalization scheme. If goods made in China become not cost effective, the manufacturers will simply move their production facilities to other developing countries like India, Indonesia, Vietnam and so on. Some production of high tech goods will probably return to places like Taiwan, Hong Kong, Singapore, South Korea and even some back to Japan. If we look into the price of a Chinese made garment sold in US department stores, say a dress costing $50, the cost when this garment passes US custom is probably like $5 or below. The 20 plus percentage import tax will only increase the over all price of this garment by about $1.25 out of the price of $50, that is, to increase the price by 2.5%. Thus this 20 plus percentage import tax will not drive up US inflation in any significant way and the intermediate term impact on US economy is minor and temporary.
The long term effect of this import tax on the global financial market is more difficult to analyze. First we must project how Chinese Yuan will move after the imposition of the import tax. If Chinese Government insists on the currency peg, and foreign capital stops to flow into China, it may need to buy back Yuan by relinquishing a portion of its vast dollar reserve to prevent the fall of Yuan. This kind of action will prolong the negative effect of the import tax on Chinese economy. If Chinese Government lets Yuan float without intervention, Yuan will fall against Dollar and the negative effect of the import tax will be nullified graduately until China becomes competitive again as a manufacturing base even with the import tax. However, if Chinese Government tries to freeze the value of Yuan vs. Dollar at that lower level, then the whole history will repeat itself to no one's benefit. If Chinese Government stops to get involved in the currency market manipulation after Chinese competitive power is resumed, then it is the role of a free currency market to self regulate the trade balance, and future conflict between China and USA can be avoided. If Chinese Government tries to retaliate against the import tax by liquidating its dollar holding for Japanese Yen and Euro, the situation quickly becomes very complicated. This kind of action certainly will push Dollar sharply lower against Yen and Euro. If nothing is done, Chinese Yuan will also devaluate sharply against those currencies and China can shift its vast exports to Japan and Europe. In those places the mobility of labor is much worse than in USA. When massive imports from China hit, it will simply push the economies of Japan and Europe into a deep recession, and they will not hesitate to follow the foot step of USA to impose similar import tax against Chinese made goods. This means that China will be isolated from the globalization scheme, whereas US trade deficit will be curbed followed by an economic recession caused by the shrinking trade deficit, that is, US consumers will have less to borrow and thus less to consume. On the other hand if Japan and Europe decides to buy the dollar that Chinese Government releases in the phase of retaliation, whole thing will evolve slowly. US can continue to run huge trade deficits by importing from developing countries other than China, and Japan and Europe will continue to run large trade surpluses. What happens to China under that senario? If Chinese Government still wants to keep the peg, then Yuan will be suspended along with Dollar, and the recovery of Chinese economy and the shift of Chinese export to Japan and Europe will be slow. If Chinese Government retaliate, Japan and Europe come in to support Dollar from a sharp fall, and then Chinese Government let Yuan to float freely without further intervention, then Yuan will fall faster against Dollar than the case of no intervention by Japan and Europe on the behalf of Dollar. In any event once such an import tax is enacted and Chinese exports is curtailed, it will take a draconian effort to reassure multinational companies that China can be a viable export base to USA again. We should also note that if the 20 plus percentage import tax is insufficient to curb the exports from China, the rate of the tax can be arbitrary increased until it really bites and the above arguments become relevant.
What if Chinese Government act before the bill and let Yuan to float up, say by 20 plus percentage points? In that case the effect will be minor than the import tax since only the portion contributed by China in those exported goods will be effected. However, the problem of this approach is that the amount of revaluation of Yuan must be large enough to cause Chinese exports to USA stop growing; this, if happens, will also cause a slump in Chinese economy. If the amount of revaluation is not large enough and Chinese exports to USA does not level off, then the bill of concern will come back sooner or later.
In summary we believe that the show down about the valuation of Chinese Yuan is unavoidable and it will come sooner than many in the markets tend to believe.
There are a group of economic entities which are determined to supress the value of their currencies versus US Dollar so that they can enjoy a large amount of exports to The United States of America. This is their only economic policy and the obsession of their economic policy makers. Those economic entities must continuously buy and hold Dollar, if not by their private parties, then by their governments. It does not matter whether they hold those Dollar in the form of US Government treasuries, US agency debts like the ones issued by Government chartered mortgage companies, US corporate bonds, stocks of US corporations, real estates located within USA, or takeover US companies as a whole, those activities are equivalent to lend to US consumers to help US consumers to sustain their borrow and spend boom. Only exception is to hoard Dollar bills and store them in warehouses; this kind of activities will take those Dollar out of circulation and does not amount to the lending to US consumers for spending. Those economic entities not only cannot afford to sell their Dollar holdings, but must continue to buy Dollar when there are selling presuures of Dollar against their currencies in the market, since if those governments sell Dollar for other currencies or do not counter the desire of the currency market to sell Dollar for their own currency by buying up those Dollar, their currencies will appreciate against Dollar, and their only economic policy will be ruined. Those economic entities include Japan, China, Taiwan, South Korea and so on.
Oil rich parties like Russia, and Middleeast countries do not care whether their currencies appreciate against Dollar or not. In the general environment that Dollar inevitably will fall against other major currencies due to the unsustainable US trade deficits, it is advantageous for thoes entities to diversify their foreign currency reserves away from Dollar into gold, Euro and Yen. Other weak economic entities which are bothered by the falling value of their currencies against Dollar should also hold appreciating currencies and gold as their foreign currency reserves to help their teetering currencies.
Recently there have been rumors that China will refrain from holding more Dollar, or it may sell Dollar outright for Euro or Yen. Then there have been erroneous rumors that South Korea has been selling Dollar, and then so has been Taiwan, causing one day turmoil in the global markets. We can be assured that those rumored parties are exactly those parties that are not capable to stop buying Dollar, left alone of selling any Dollar holdings since their economic policity makers cannot think of anything other than supress their own currencies to boost their exports. Only economic novices will dance with those false rumors. However, the arguments here does not mean that those parties bound to Dollar will and can sustain their Dollar buying forever since lending money to US consumers for consumption in the form of their trade surplus and US trade deficit inevitably means to put their own consumers in an austerity mode. It will be the day of reconing for Dollar and for this globalization monster when those parties are not capable of buying more Dollar; then the whole world will enter into a great depression. Fortunately the time for such a global crisis is still not on the horizon. It may come within a decade, or may come after a few decades. If such a crisis does not come and Dollar buying can be sustained for a very long time, then a situation called "globalization utopia"(for US consumers) as discussed in Article No. 7 of this website will become the reality.
The Federal Reserve System of The United States of America (FED) has been raising short term interest rates in a measured manner since the middle of 2004 under the pretence to damp the risk of inflation. However, in the monthly reported inflation statistics there is no sign of any pending inflation threat. The long term interest rates is moving sideways during this period of rising short term interest rates, implying that the financial market is not anticipating any significant increase in the inflation rate as far as the eye can see. Many are thus confused about the whole picture of interest rate environment. Why does FED insist on raising short term interest rates in spite of the absence of any inflation threat? Why the long term interest rates do not move up in tandem with the short term interest rates? Once we understand the ins and outs of the current global economic environment, we will see the clear logic behind the disparate movements of the short term and the long term interest rates. In a simple phrase, the behavior of the interest rates is just reflecting the value of Dollar and the run away trade deficit of The United States of America.
We have been claiming persistently that the robust economic growth of America in the globalization age is due to the wanton expansion of personal consumption. The rapid expansion of consumption in America is the direct result of the runaway trade deficit. The runaway trade deficit, in turn, is due to the overly inflated value of US Dollar. Up to the middle of 2004, the inflated Dollar is supported by the massive dollar buying operations of the governments of Pacific Rim countries. However, the last episode of such dollar buying has shocked economic observers. In the span of 10 months, from the middle of 2003 to the spring of 2004, Japanese Government alone has bought 380 billion dollars just to prevent the collapse of Dollar against Japnese Yen. If adding the amount of dollars bought by the governments of China, Taiwan, South Korea, Hong Kong and Singapore, the total sum will surpass 700 billion dollars. It is also during that dollar buying frenzy, the first public skepticism has been voiced in Japan in a rather bizarre fashion. An adult comic strip (called "manga" in Japanese) has portrayed the dollar buying operation as a conspiracy of America to keep Japan poor and America rich. The "mango" has caught Japanese public's attention and has forced the minister of finance to openly deny the existence of such a conspiracy in front of the members of Japanese Diet (see article No.8 on this website for the account of this episode). When the next wave of dollar selling comes, it is certain that Pacific Rim countries need to buy up more than one trillion dollars in order to avoid a total collapse of Dollar. Whether or not such a massive dollar buying operation is politically feasible becomes naturally the biggest worry to all that are concerned about the matter. Though FED is officially pushing a rosy view that such a total collapse of Dollar will only correct US trade imbalance but will not induce any serious economic hardship, it is obvious that FED does not dare to test its own rosy senario by letting Dollar collapse in the next wave of dollar selling. Thus it becomes essential to postpone the onset of the next dollar selling frenzy that is sure to come. Then what can be done to prevent an outright Dollar collapse? For US Government to buy up those unwanted dollars is simply not possible, since in order to buy those dollars US Government needs to pay for them with Euros, Yens, Yuans, Taiwan Dollars, Korean Wons, and Hong Kong Dollars that US Goverment is not able to print. Only method left to support Dollar and not let it to test dangerous break-points is for FED to raise short term interest rates, and that is exactly what FED is doing since the middle of 2004. The logic behind this approach is that the rising short term interest rates in America will keep Dollar to move sideways within a band. If Dollar tests the lower limit of the band, then Pacific Rim governments, like Japanese Government, will come in with a moderate dollar buying operation to push Dollar back into the band. The amount of dollars needed to be bought in this scheme will be much less than the case if FED does not raise short term interest rates. Thus the day of reckoning of Dollar can be postponed.
Long term interest rates move according to inflation outlooks. In the past FED raised short term interest rates only to combat the real inflation threats. That is why the long term interest rates have always followed the raising short term interest rates and have moved up accordingly. However, this time the short term interest rates are raised to support Dollar. When Dollar is suspended at an inflated level, America continues to run larger and larger trade deficits. Running large trade deficits is like importing deflation. That is why America's inflation rate has been kept at a very low level in spite of run away consumption, and thus there is no reason for the long term interest rates to make any significant move. This means that the yield curve will flatten out more and more as the short term interest rates rise.
The current approach to use rising short term interest rates to support Dollar has its limits. For the next year or so this measured rise will bring short term interest rates to the range of about 5%, the so called "neutral" zone. As Dollar is suspended at this highly inflated level, America's trade deficits will continue to explode, and thus the selling pressure of Dollar will build up continuously. This means that FED must keep raising short term interest rates beyond the "neutral" zone for a period as far as the eye can see in order to prevent Dollar to collapse. What is FED going to tell American people about the need to raise short term interest rates beyond 5% level without any visible inflation risk? There is already a movement in America to force FED to target inflation rate. The motivation of this movement is obvious. If FED is forced to target inflation rate, then FED cannot raise short term interest rates if there is no inflation! Even if FED concedes at that time that the reason to raise short term interest rates is not to fight inflation but to support Dollar, the critics of FED will use FED's own words to attack FED. They will say that to let Dollar collapse is a win-win strategy. Since on one hand the cllapse of Dollar will wipe out America's trade deficit and bring jobs back to America without significant economic pain as FED itself is claiming, and on the other hand the collapse of Dollar will make the rise of short term interest rates unnecessary; also the collapse of Dollar will finally release the Pacific Rim countries from the bondage of complusive dollar buying. Is the collapse of Dollar really so benign as FED is claiming? We totally disagree with FED about this point. We believe that when Dollar finally collapses, an economic tsunami will be triggered and will wipe out the global economy, but the discussion of this critical issue will be defered to another writing at another date.
Some analysts believe that the United States of America (abbreviated as America) is treading a dangerous path by running "twin deficits"--the government budget deficit and the trade deficit. We have maintained that the trade deficit is the bane of America but the government budget deficit has only a secondary importance to the health of American economy. The natural result of relentless expansion of the trade deficit is the steady growth of the gap between domestic demand of credits from the government and the private sector combined and the credits available from domestic savings; the exploding gap is filled by the exploding trade deficit that is nothing but the borrowings from foreigners. We believe that America is already on the road of no return toward an eventual economic crash due to its wanton addiction to the expansion of the trade deficit. The crash of the American economy will bring down the economies of many other countries, large and small, and will mark the end of globalization, as we know it. However, there are opposing views. The commentary by David Malpase titled "Running on Empty?", published in the Wall Street Journal (March 29, 2005, page A16) is a typical example of such views. The author claims that the domestic savings rate is meaningless. His magic number to gauge the health of American economy is the net asset value of America. Most of that consists the home owners' equity in residential houses and the value of stocks held in the hands of American citizens. According to the tabulation of the Federal Reserve Board, this magic number has reached a new peak of about 65 trillion dollars and is growing rapidly. Since the magic number of America is growing much faster than the magic numbers of Europe and the Asian Pacific Rim countries as a whole, the author declares that the American economy will overwhelm all the other economic entities in the world soon, and thus America is ascending to an economic paradise. The purpose of this comment is to analyze Malpase's view and show that the so-called "magic number" is artificially adjustable so that it does not have any relevance to the health of a real economy. The thing to watch is still the trade deficit that will lead the American economy into a black hole.
We start our analysis by considering the following mathematical game:
Let us consider a subdivision that consists of 100 similar houses. We assume that each household has four members and an annual income of $100,000. The market value of each house is $300,000. For the sake of simplicity, we also assume that not a single household has any mortgage on its house outstanding. The total homeowner's equities for the whole subdivision is thus $300,000 x 100 = 30 million dollars.
Now suppose 10 households want to sell their houses and move away. An economic wizard among the remaining 90 households fears that the sell of 10 houses in a not so robust housing market may depress the market value of each house in the subdivision and thus reduce the total homeowners' equity of the subdivision; if the fear of the wizard should become the reality, the magic number tabulated by the Federal Reserve Board will naturally be reduced accordingly. The wizard proposes the following scheme to the other 89 households that will remain in the subdivision.
For the game to proceed up to Step 10, there must be an unrealistic assumption that the mortgage banker who grants all the mortgages is just a dumb computer; the computer will grant a mortgage automatically as long as the sum of the new mortgage and all the outstanding old mortgages on a house does not exceed the market value of the house at the time of the mortgage application. Actually at any step in the above table, the total amount of mortgage obligation outstanding on a house never exceeds the market value of the house at the end of the preceding step, so there is no problem for the dumb mortgage banker to let the game proceed up to Step 10. We will postpone the consideration of a more realistic situation to the next paragraph and consider first the case of this dumb mortgage banker and what is going to happen at the end of this game. At the end of Step 10, the fund will own all 100 houses. It has an outstanding mortgage obligation of around 12 billion dollars. Assuming a mortgage interest rate of 6%, the fund must pay 720 million dollars of mortgage interest a year. The fund has 2.145 billion dollars of cash retained from its most recently taken-out mortgage. Assuming that the 10 steps have proceeded so quickly that the cash retained at each step are still in the hands of the fund to maximize its cash position, the retained cash totals to 3.681 billion dollars. Assuming that the fund can invest the cash on hand with 6% return, a very optimistic assumption for the fund, the fund will have an investment income of 221 million dollars a year. Even with this highly inflated price per house, the rental income from each house should be expected to be just around $30,000 a year per house, the typical rental rate when the market value of a house was only $300,000. Thus the yearly rental income of the fund is only 3 million dollars. The fund will face about 500 million-dollar shortages in cash flow a year. This means that within 5 years the fund will be bankrupted and the dumb mortgage banker will sustain a loss of 9 billion dollars! When the mortgage banker possesses those houses and sells them at the real market value, about $300,000 per house, then the contribution of this subdivision to the magic number tabulated at the Federal Reserve Board will plunge from around 38 billion dollars back to the original 30 million dollars. The real winners of this game are the households that sold their houses to the fund. The ten households that sold their houses to the fund at Step 10 are, of course, the biggest winners; each one of them will net a windfall of about 430 million dollars! Among the old-fashion circle, this game is known as a variation of the “pyramid”; every financial “pyramid” will eventually collapse. The modern name of this game is a variation of “leveraged buyout”.
Real mortgage bankers are, of course, smarter than the dumb computer. They will scrutinize the cash flow of each mortgage borrower. For example, at the end of Step 3 the total sum of the outstanding mortgage of each household is about $750,000. With a mortgage interest rate of 6%, each household must pay $45,000 a year as the mortgage interest. Since each household has an annual income of $100,000, the burden of the mortgage interest, though heavy, is still sustainable. Therefore, a reasonable mortgage banker will allow the game to proceed up to Step 3. However, Step 4 is a different story. At the end of Step 4, each household's outstanding mortgage amount will be about 1.68 million dollars; this means that the mortgage interest for a year will be $100,800; it will exceed the annual income of the household. Thus we must assume that the game will be stopped at Step 3. Let us look into the financial situation at the end of Step 3. First, the fund has assumed mortgages totaled $10,920,000, so it must pay $655,200 a year as the mortgage interest. It retained cash from Step 3 and Step 2 totaled $3,276,000 that can generate an investment income of $196,560 a year. The rental income from 30 houses, $30,000 per house, will amount to $900,000 a year. Thus the fund will have a positive cash flow of $441,360 a year to cover maintenances and other costs required to run the rental properties. This means that the fund can keep going forever. The situation of each of the remaining households has been discussed already; the remaining households are also not in danger of default. Who are the winners if the game ends at Step 3? The mortgage bankers are some of the winners. Before the game they generated no business from the subdivision. At the end of Step 3 they have a mortgage of 63 million dollars outstanding, and the mortgages are not in danger of default. Those who rely on the “magic number” are also winners since the total homeowners' equity for the subdivision is inflated to 214 million dollars from the original 30 million dollars, and this jump will naturally be reflected in the “magic number” tabulated by The Federal Reserve Board. The real winners are the households that sold their houses to the fund. The ten households that sold their houses at Step 3 will see a windfall of about 2.3 million dollars each. The ten households that sold their houses to the fund at Step 2 have a windfall of about 1.1 million dollars per household, and the first ten households that sold their houses to the fund have a windfall of $330,000 per household. The losers are the remaining 70 households at the end of Step 3. They will suffer the diminished cash flow for next 30 years, the duration of their mortgages. In other words, the future consumption power of those 70 poor households is transferred to the 30 exiting households as the current consumption power. Thus the current GDP will be boosted by current consumption but the future GDP will decrease due to the poor future consumption of 70 losing households. It should also be noted that liquidation of the fund is not a desirable option for the remaining 70 households. If the fund is liquidated, the 30 houses in the hand of the fun can be sold at only around $300,000 a piece. Thus the liquidation of the fund will not generate much return for those 70 households. On the other hand, those households not only must continue to pay the same amount of mortgage interests, but also will see the market value of their houses plunge back to $300,000 a piece; they will have a negative homeowner’s equity. They are better off letting the fund continue and keep the market value of each house suspended at a highly inflated level.
Readers may question whether the game, even stopped at Step 3, has any relevance to the actual situation in America. Any homeowners who have made aggressive mortgage refinancing are unwittingly participating in the game, especially those who have used the money generated by the new mortgage less the old mortgage for personal spending. They are active participants in this game. Since money flows, their money spent will flow to someone else’s pocket, and this someone else will buy houses to boost the prices of houses. Thus, the original homeowner that did the aggressive refinancing can do the aggressive refinancing again to sustain the chain of the game. Those that carelessly take a new mortgage with larger mortgage interest payments than their original mortgage interest payment or rely on adjustable-rate mortgages to improve their cash flows will see their future cash flow strained as mortgage interest rate rise, just like the 70 poor losing households in the game.
Based on the above analysis we do not believe the “magic number” tabulated by the Federal Reserve Board can serve as a meaningful measure to gauge the health of the American economy. The focus is still on the exploding American trade deficit and the unavoidable collapse of the US dollar. The question is still whether the collapse of the US dollar will trigger a worldwide depression that we believe is inevitable, or whether the event will be benign as some researchers of the Federal Reserve Board are claiming. As mentioned in Comment 17, the discussion of that crucial issue will be postponed to another future article or comment.
The 2005 ACM International Collegiate Programming Contest sponsored by IBM was held recently at Shanghai Jiao Tong University. ACM stands for "Association for Computing Machinery". The competition, with its long history and prestige, is viewed as a barometer to gauge the level of computer programming skills in various geographic regions around the world. The world final invites the top one or two teams from each regional division to participate; about 80 teams compete in the world final. In 2005 there were no American teams in the top tier medal winners. There were 4 American teams in the ranked list. Usually colleges from rank 1 to about rank 12 are medal winners, and below that down to about rank 30 they are just said to be in the ranked list. To understand the meaning of this result, the statistics of past American performance are tabulated below; the first number is the number of American teams that have received medals, and the second number is the number of American teams in the ranked list:
The spectacular boom and bust cycles of science and technology in America is nothing new.
However, the severity and the duration of the most recent bust of American high tech industry
is unprecedented. To understand this high tech trouble in America thoroughly we will first
review the historical busts of science and technology in America in the latter half of
the 20th century.
The first incident was the sudden collapse of the ivory world of mathematics, physics and chemistry at the end of the 1960's. That bust followed the government-sponsored overproduction of Ph.D's in those fields after the "Sputnick shock". Many surplus Ph.D's in math and physics, utilizing their peripheral skills in the then-emerging field of computer programming, sustained their living by entering into weapons research and telecommunications. Some of them have switched to Wall Street and spearheaded the explosion of the financial derivative markets, to the horror of many economic analysts who fear an oncoming collapse of the global financial system due to the gigantic and interwoven net of derivatives. Many chemistry Ph.D's hid their higher degrees and became lab-technicians in pharmatheutical companies and medical labs. The effect of that boom and bust in America's basic science is still felt today. Generations of bright young American kids have been avoiding those basic sciences like the plague; it is no wonder that the calls of politicians to beef up basic math and science skills in the secondary education system have been met with a yawn, since the general public has a longer memory and is smarter than politicians acknowledge.
The second example is the demise of American video game pioneers. Video games were a purely American invention at the time when inexpensive home computers and game machines became available. After some enthusiastic years, American youths tired of those games. As a result, most American video game companies went under and disappeared from the landscape due to the lack of further support from Wall Street. However, loyal game players and banks in Japan persisted through the hot and cold, thick and thin days and sustained Japanese video game companies. When American consumers reawoke to the frenzy of Pacman, the only major players in the video game industry were Japanese. Many years later, the software giant Microsoft has tried to reestablish a foothold in the video game market through the Xbox. Though this bust cannot be compared in scale with other busts to be considered here, it is a good example how moody American consumers and shortsighted American financial markets combined have turned gold into dust and sent American ingenuity to foreigners free of charge.
The bust of the computer science industry in the early 90's is a memorable one. Many experienced computer scientists were laid off under the pressure of "corporate downsizing", prompting a joke that says, "the career of a computer scientist ends at age 40." This bust was soon forgotten as the tech and Internet boom of the mid to late 90's took hold. However, a sizable number of foreign-educated and foreign-born but American-trained computer scientists, scared by the massive layoffs in the field, returned to their native countries and nurtured new tech powerhouses in the Asian Pacific region. Under this moveback tide, Taiwan has emerged as a significant high tech center. Afterwards, Taiwan's high tech industry began to increasingly migrate to China, putting China on the map as an emerging tech giant and soon also a military giant. On the other hand, Indian-born computer scientists have returned to India to sow the seeds of Indian high tech industries. It is rather ironic that China and India are now talking about cooperating to dominate the global high tech landscape and eventually to put American high tech industries into a dust bin.
The current high tech bust started at the burst of the bubble around 2000 and 2001. Many tech companies vanished, and a massive number of computer experts lost their jobs. The surviving high tech companies, trying not to repeat the folly of the early 90's, desperately held on to their experienced talent but laid off younger talent with less experience and less seniority in order to survive. This trend of laying off younger workers has quickly snowballed to the situation that many newly graduated computer scientists cannot find jobs in the field. This disastrous message then is swiftly passed down the age ladder, and now bright young American talents not only consider computer related field as a taboo but also shy away from science and engineering as a whole. This ill effect is already showing up in the high tech education of America, and most likely is the cause of American teams' sorry showing in the 2005 ACM international competition. This trend is going to get worse for many generations to come. As young American tech talent dries up, high tech companies in America will increasingly be attracted by higher quality and lower cost foreign high tech talents to move high tech jobs to foreign soil. Thus, a vicious cycle will develop, and eventually most American high tech jobs will leave the land with only a hollow memory left in America.
It is important to point out that the computer-related high tech industries are still youthful. Many more developments will lead to continuous and substantial changes in our daily lives and improvements in how corporations operate and how governments are run. Unfortunately, these future developments with very large economic rewards will be increasingly done outside of America as the crisis in America's high tech education deepens.
We have attempted to write a comment with the above title, but ended up with a full length article. It is posted as Article 6 with the same title.