POWER STRUGGLE: First part

Nations seek for power and resources. Without the latter they cannot survive, their economical and social system would come to a halt. There used to be a time where these struggles were fought by armies and long wars. Today, things changed, there are still wars, but the struggle for power and resources is more subtle. States secure contracts allowing them to access certain resources of certain countries. Some help others to build up infrastructure with the ulterior motive to later use these infrastructures to extract and dispatch raw materials and finished goods. To open the newspaper means to read about the obvious power struggles. It is to see Iran seeking for nuclear weapons, China refusing to cut emissions to boost local economy and the US keeping interest rates low to help exports (what’s Europe doing??).

Bill Emmott, the former editor of The Economist, published a book in which he predicts that the power struggle between China, India and Japan will shape our next decade, more than an eventual conflict between China and the US. Most of the time, it is true, people tend to neglect the rivalry between those three countries and accordingly the potential geopolitical consequences. People talk of “Asia” and forget that the continent is far from being “united” in the way Europe is. We are talking about a continent where India, China and Japan seek for the first place in terms of economical and political power, but where Russia, Korea, Singapore and other states also wish to have a word…not to forget Australia and New Zealand that seek for greater influence in the region as well.

China won’t be able to keep growing without resistance from India and Japan. Neither of these countries will keep on watching without intervening. Ties to South-East Asian countries are in that logic especially important, because representing future markets and strategic positions, thus Japan finances, for instance, the construction of the Ho-Chi-Minh City subway (Vietnam). A defense agreement with Australia is also meant to strengthen Japan’s position within Asia. But is that really going to help? China is now crucial for the United States, who else would buy their government debt? In order to finance the recovery and two wars, the one in Afghanistan and the other on in Iraq, they need to raise funds. Without China that recovery would hardly be manageable. But of course, admitting that would be equal to political suicide.

The United States depend therefore to a certain degree on China. In case China would expand its political ties in a more violent manner, would the US intervene? Would they protect Taiwan for instance? Many would say “yes” and think “hopefully” but we can no longer be so sure. In order to intervene, they would need to raise more funds to pay for that defense. Tax payers would not like to see their money wasted in wars, thus raising taxes would be rather unpopular. If the US would still decide to intervene, China could sell of their foreign reserves thus creating oversupply of dollars on the markets which would eventually lead to a sharp decline of the dollar’s value. The USD would collapse and become worthless and no one would like to invest in USD denominated assets. Would the US risk such a thing? Investors would pure out of the country and invest their funds into more secure places, such as Europe. But Europe cannot stay neutral, probably…or can it? By staying neutral, Europe would encourage China to proceed with the aggressive extension. This cannot be in the interest of the European countries because next victim could easily be Europe itself. Thus, Europe needs to stand on the US side just to secure US support once China tries to tackle European territory.

The Japanese reliance on US help in case of a military conflict is declining which demonstrates the agreement with Australia. It is a move towards a more diversified defense pact and shows that Japan is aware of the fading American power. In 2005 and 06, the Bush administration also opened the door to a new partnership in Asia: with India. The new collaboration for civil nuclear energy with India proves that the US is aware of the threat that China might become too mighty and thus unpredictable.

China can, however, not afford to make an aggressive move because it does rely on the United States and Europe as a market for its own goods and it also needs the technology and know-how. Thus, a Chinese attack is not an issue. But the simple thought of the immense power it could potentially have might frighten and should lead us to consider whether our political system is prepared for those future conflicts. The Lisbon treaty is now enacted and Europe has a new political leadership with a permanent president and a person responsible for foreign relations. Europe, however, still speaks with 27 voices when it comes to foreign policy which is not suitable for the geopolitical conflicts of the 21^st century where only a strong union with clear and unchallenged leadership can pose as a real opposition to an emerging, power seeking, China. The transformation, from a loose federal construct to a strong federal state, might be the only solution to keep a high profile during the next decades.

The hope that China might anyways collapse due to potential social conflicts is a dangerous thought. The idea that only democracy survives is naïve due to the fact that China has never been a democracy, as most of Asian states in their history, and it never seemed to bother its population. As soon as the Chinese peasants were unhappy with their leadership, they replaced it using a revolution but only to implement a new kingdom, to set up a new dynasty. Thus, even though the dictatorship in China might not last forever, it will probably be replaced by something similar.

The information policy of the country shows that its leaders are aware of this threat of “revolution” and it might lead to the conclusion that the leaders are not as much in control as they would wish to be. Official statistics can hardly be trusted, a UBS economist, tried to calculate the real GDP growth rates from 1980 till today and found a less attractive picture, corresponding more a rollercoaster ride. The so praised sharp GDP growth rate increase between 2005 and 2008 might, for instance, have been rather stable instead. Another interesting fact about the official GDP rate is the 2005 figure. Official growth rate was 10.4%. China is divided into 31 regions (22 provinces, 5 autonomous regions and 4 municipalities). Of these 31 regions, 29 reported higher growth rates than the national one, only two (Hainan and Yunnan) were below national average. Everyone above average?

This might make us laugh but can also be a serious threat. First of all these figures are not so much aimed at outsiders as they are aimed at their own population. Keeping good news in and bad news out of the newspapers is a measure to reduce the possibility of social unrest. The problem for outsiders is that we do not know for sure how big China really is. Probably smaller, probably bigger…

And while we hope that China will eventually fall over its own shoes, the Chinese are silently conquering Africa. They promise not to intervene in local conflicts and invest huge sums of money to secure natural resources. To a certain degree the African nations to benefit from such investments, some however don’t. But the leadership does most of the time benefit and what is more important to keep relations intact? Chinese leaders have understood that future geopolitical challenges cannot depend on moral and that those who insist too much on certain values will be the future losers. Some claim that China needs to be a more responsible player if it wishes to implement itself on a global basis. But that would mean that responsible means an alignment to western values or to a certain set of predefined values that might not be the ones China would defend. Certainly, it is important to safe human lives and to help poorer people, but the efforts of Western countries in Africa have been rather unsuccessful as well.

It is probably not the best solution to forget about those values and rush into Africa, as it happened during the colonization, to secure raw materials. But it is probably good to think about the future challenges and to determine where do we stand? How can we act and what should we do? There is no easy answer.

Where will Russia stand in the future? Having closer ties to Iran and neighbors it will probably expand its political influence in the Middle East and Eastern Europe. Closer ties with China might provide it with a big client for its natural gas. But China does not need Russia as much as Russia needs China. Thus, turning it’s solely attention to China would be a mistake from Russia. Closer ties to Western Europe, a friendlier relationship would be of more benefit but that is not going to happen in the near future. The Russian president has even offered a defense plan where Russia would have a veto right for new NATO members in Easter Europe. That offer will most certainly be declined by the NATO states but demonstrates that Russia is not aware of the potential benefits of a European-Russian partnership. The most likely scenario is therefore that Russia becomes a second league player, having some influence on regional issues but not being able to talk on a worldwide basis.

The most common discussion during a crisis is how to stimulate the economy in order to pass the recession or crisis. Even if economic theory considers a crisis as a necessary evil in order to readjust certain parts of the economy and to enable a fresh start, most of the people dislike these periods and politicians do their best to restore confidence.

However, most of the political action targets businesses. Thanks to subsidies governments ask companies to not lay-off part of their workforce and support those companies in international trades. Temporary tax cuts or cash-injections are part of that "treatment". The goal is to encourage companies to invest further.

But do these measures tackle the right problem? Where is the real problem during a slump? It is not quite the businesses that are the trouble makers here but consumers are. They lose their confidence and spend less. Consumption decreases due to their lack of confidence. Due to this, companies sell fewer goods and services. Selling fewer goods means that they need to cut their costs in order to stay profitable. This means that they will decrease the production volume (fewer orders to suppliers, lower energy consumption, need of fewer workers to produce goods...) and hold back any investment plans. This postponement hits some more suppliers (for instance construction companies or machinery suppliers).

Helping the companies is certainly a good thing to do and makes sense politically speaking because it is always good to know that the industry is happy with the current government. This will potentially safe jobs in the future and make re-election of the government more likely.

But still, it doesn't tackle the issue of consumer spending. How can a government influence consumer spending? You might think of taxes and it is surely the easiest way to influence the amount of money the taxpayer has in his or her pocket. Today, income tax is based on our income (seems logic). By simply lowering the income tax, we would add some incentives to spend more money. But this is not enough.

Let's consider a completely new approach to income tax. Let us call it the savings tax. Instead of taking the tax from the disposable income, the government would base the tax on the income that has not been spent. That means, if a household has spent all of their income, they would not pay (saving or income) taxes. If they decide not to spend all of their money, the tax would be based on the amount that has not been spent. Does that mean that people have no longer the right to put money aside? No, of course not, they can put as much money aside as they wish, but they have to pay taxes on it.

A few things should be exempt from the savings tax though. Putting money aside for the retirement is a good thing and should be supported. Thus a special account will be created where each person can put as much money on as they wish. This money will not be taxed but can only be used for a special (and authorized) purpose, such as retirement. Certain kind of spending can also be supported. If a household spends a certain amount per month or year on education or culture, they have a lower tax on their savings. This encourages people to consider their spending and use more for child education.

The system does therefore not penalize savings that have been made for a legitimate purpose and encourages people to spend all their money. There are few incentives to save. The state would recover from the loss of the income tax revenue by collecting more money from corporate taxes (thanks to higher EBITs) and VAT.

Inflation vs deflation

We are currently facing a heated debate whether we have a risk of deflation or inflation. Not that this is a passionate subject for most of the people but it might well influence our future – especially our purchasing power. What do we know about these two? We know that deflation is that kind of thing which the Japanese have been facing for a decade or so already. Do they seem unhappy? When they travel around and block our inner cities with their tourist busses they all seem quite happy. What about inflation? That’s that kind of stuff which is going on in Zimbabwe: the government issued on January 16th a ZWD 100 trillion bill. You can be a millionaire so quickly!!

The problem is that, as a citizen of one of these countries or as a corporation, we do not really think that this is funny. Why? Because if we receive a bill of LCY[1] 100 and some days it is only worth 90 we are rather pissed. This is inflation. Inflation makes things more expensive and thus we can buy less with our 100. Deflation is more complicated. Consider that you are the head of XYZ Inc. and that you want to make an investment in Yokohama. Today that investment costs you JPY100, tomorrow probably JPY90. What will you do? Yeah right, you’d probably wait. But the thing is that once the investment would cost JPY90 today it would cost JPY80 tomorrow, so you keep on waiting. That’s pretty embarrassing for the country because suddenly no one is investing because prices are falling. It is a vicious circle because for prices to rise again, someone would need to invest. But because no one does so prices keep on falling.

So to keep it simple, inflation is caused because too many people are spending too much money and deflation is that too many people are not spending anything. Thanks to globalization all this becomes somewhat complicated. Investors can transfer funds from place A to place B quite easily. Inflation is low in Japan, the Central Bank lowered interest rates to 0 and thus investors enter the market to take on a credit and invest it in a country with a higher inflation such as the US a couple of years ago. The difference they made was their gain. The trade is called a carry trade. Normally the exchange rate is going to prevent that kind of trade from happening but exchange rates are not always free-floating which gives place to arbitrage opportunities.

Are we now facing deflation or inflation? What should the Central Banks policy be?

According to some inflation can only be caused when consumers are spending more nominal dollars. They argue that the state has so far been reluctant to pure money to consumers’ pockets and thus the risk of inflation is low. The state funds consist basically in guarantees meaning that there is most of the time no exchange of cash. Consequently, there can not be inflation. They argue that the bigger threat is deflation. Consumers stop spending, companies stop investing, employment rises and a downward pressure on prices is exerted.

If the crisis continues and recession deepens, deflation becomes a real threat. Drying liquidity causes deflation, money is hold back by consumers as well as lenders. Mr. Bernanke said in 2002 that a healthy banking system is the best defense against deflation. The banks now being in a shaky situation, the economy can no longer rely on that defense. Thus the risk of deflation increased significantly.
All also depends on the currency. If the LCY is getting stronger, import prices are decreasing which adds deflationary pressure on prices.

Today, the money-in-circulation is not so much of a problem because so far the consumers are careful and lenders are keeping their money. According to an article published in the Wall Street Journal, the M1 aggregate rose so far by 10%. The biggest problem comes from the bank reserves. Banks now have huge reserves enabling them to make new loans. The question is now how quickly do the banks make these loans? Consider that banks are hungry for new business and make loans quickly in order to have higher returns. Money-in-circulation skyrockets and creates inflation. The phenomenon is even intensified by the low demand – due to high unemployment and low investments - and high supply of money.

Some more factors do enter into the inflation figure: commodity prices. Commodities are the basic element of all products. If commodity prices rise – what they are doing again since May – product prices might follow. Why do commodity prices rise? So far analysts expect the Asian economies, especially China, to recover from the crisis. According to Chinese newspapers, Chinese industrial production rose by 8.9% in May. This is a sign that the economy is recovering but especially an indication that Chinese manufacturers are starting again to import raw materials which pushes up prices again.

Gold price which is usually considered as an indicator for inflation has been pretty volatile during the recent weeks probably indicating that investors are considering the risk of inflation. Inflation indexed bonds also start pricing in an increase of inflation. Especially the 10yr bonds are showing some sensitivity to that issue (they currently price in an inflation of 2%).
It is therefore probably safer to say that there will be inflation. Not now but in the next years and if the Central Banks do not take the necessary steps – such as reducing the money-in-circulation by increasing the reserve requirements for banks – we might see a strong and persistent inflation. This damages parts of our economy. For sure it would be unwise to say that deflation is not going to happen but the chances that we enter a deflationary cycle are pretty low. Finally everything depends on the
[1] LCY = Local Currency ; FCY = Foreign Currency