Thursday, July 28, 2011

Europe, China, Economic Instability, and National Security

Europe, China, economics and national security are a lot to cram into one title. And it is a lot to cover in a few pages of text, but Mark Blyth pulls it off in an article in Foreign Affairs: China’s European Shopping Spree? The subtitle is more explanatory: How Austerity in the EU Creates Investment Opportunities for Beijing. Blyth’s plot might be summarized as “The eurozone is headed for a crash followed by fire sale prices on assets, and guess who is walking around with the thickest wallet in the world?”

Blyth sets the stage by pointing out that China has been sending out emissaries to be friendly and supportive of Europe in its time of need. He also points out that China has $3 trillion of assets in US dollars.

“If China were to buy only half of all outstanding Greek sovereign debt (a bargain at around $220 billion, a fraction of China's dollar assets), it would not only resolve the eurozone crisis and add to Chinese prestige but it would help give Beijing the sort of reserve asset that it needs to diversify its holdings out of dollars.”

Obviously china will act in its own self-interest, so there must be more at stake in the future.

“For one, China probably has as little faith in the EU's ability to solve its debt crisis over the long run as do the rest of the world's financial markets, more bailouts notwithstanding. But another answer is possible -- one that links the 2008 financial crisis and the 2011 European bond market crisis to a possible Chinese end run around the 2007 Foreign Investment and National Security Act. This U.S. law makes it hard for China to diversify out of its $3 trillion-plus holdings of U.S. dollars and buy sensitive U.S. assets such as aerospace, technology, and defense-related companies.”

“As a result of the unintended consequences of U.S. and European actions in financial markets, there is now the possibility that....China could buy such sensitive assets from Europe, at fire-sale prices.”

The simplest solution to the eurozone crisis is, and always has been, for the European Central Bank (ECB) to buy up the debt that Greece (and others) cannot handle. But the ECB was never given that kind of authority or resources. Instead, such a move would have to be financed by the wealthier countries to support those in trouble. Since democracies are unwieldy beasts, such approval is unlikely. The best that has been done thus far is to lend more money to the debt-ridden countries.

The only options for a country like Greece are default or austerity. Default would be a disaster for everyone, while austerity is only a disaster for the country on which it is imposed. Therefore we have austerity. Blyth, who will be publishing soon a book titled Austerity: The History of a Dangerous Idea, believes such a path is doomed to fail.

“Austerity is a form of internal deflation through government cuts that reduces wages, prices, and public spending to restore the external financial balance. Such a system of financial adjustment was tried before, from 1870 to around 1914: the gold standard. It, too, was based upon deflating domestic wages and prices in order to bring a national economy into balance with its external financial position, as the eurozone is demanding of its periphery states today.”

“But such regimes have a fatal flaw: they cannot work in democracies because electorates
have a strong incentive to vote against imposing austerity measures, and instead seek to pass the costs of deflation on to the bondholders.”

Banks are aware of this dynamic, so it is in their interest to encourage severe and immediate austerity measures to protect their assets. The countries most able to help financially, Germany and France, are also those whose banks are holding a majority of the Greek debt. They cannot help Greece without hurting their own banks. And when banks get in trouble, their debts usually end up being transferred to the national debt ledger. So the counties take the least immediately painful path available and make Greece suffer the consequences.

“Notwithstanding the latest bailout, Greece today can never grow its economy fast enough to pay back what it owes, and new borrowings serve only to add debt to debt. Simply piling on more austerity measures cannot work, since voters are likely to reject such a regime at some point, triggering a default.”

This ‘inevitable” default will be disastrous.

“....if one of these periphery states (Greece, Ireland, or Portugal) were to default on its debt, the crisis would soon spread to the large EU states. Holders of periphery debt would try to stem their losses by dumping good assets in order to cover their bad exposures, as happened in the U.S. market in 2007 and 2008. This would create a financial contagion in the form of a bank run through the bond market, which would end up back on the balance sheets of the biggest core European banks: the banks with all those periphery exposures. This would be a disaster for Europe and would at the very least require expensive bank recapitalizations, which already bloated state budgets can ill afford.”

Banks around the world hold pieces of these debts as well. The economy of the US and many other nations would be affected by the economic damage in Europe. The path to China and national security lies in the fact that Europe currently has limits imposed on what can be sold to China, but no good way of enforcing them. Blyth fears that China will take advantage of the situation by using its immense reserves to purchase from Europe the sensitive technologies and capabilities that it cannot obtain from the US.

If this seems a bit convoluted, it is, and Blyth recognizes that. He has chosen to use an extreme example to garner our attention to problems about which we should be spending more time worrying.

“This scenario may seem far-fetched, but it is possible. It also suggests a few things to think about: that the global financial system is more fragile and more interconnected than often understood, that financial fragility may be more of a national security issue than often thought, and that pursuing austerity in a democracy may not be the solution that policymakers think it is.”

“Regardless of whether China's rise to dominance is distant or close, Western powers have not helped themselves by turning their financial systems into a generator of unintended consequences that may prove to be very bad for the United States and Europe, and very good for China.”

If Blyth’s concerns about national security do not particularly distress you, the notion that a country like Greece, an economic afterthought, could bring down the world economy should. The similarity between the accumulation of bad debt by European financial institutions now, and bad debt generated by US financial institutions a few years ago is troubling. Equally troubling is the realization that nothing much has changed in the interim.

Blyth is correct in pointing out that one way or another, China stands to be a big winner. It just has to bid its time until our financiers are again shown to be greedy fools.

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