This week I had the opportunity together with other local scholars to meet with Chinese trade officials visiting Washington DC to discuss the economic crisis. Commerce Minister Chen Deming’s article in the WSJ about the rise of protectionism includes some points raised in the discussion. Other topics for discussion include the following questions for which I offer some observations.

1. Recently, some U.S. macroeconomic indices have improved. Does this mean the hardest time has passed and the economic stimulus package, to some extent, has taken effect? How about the recovery prospect of US economy? What industry or sector will be the primary backbone of the future US economic development?

That some economic indicators have stopped their freefall or turned around is a good sign. As many observers suggest though, these data probably indicate a slowing of the decline at this stage rather than a reversal. Complete economic recovery will probably not return until after many episodes of improvement followed by episodes of worsening. Optimism will be replaced by pessimism many times over.

Complete recovery will surely come eventually … it always has in the past regardless of the nature of the crisis. What no one can answer is how long that recovery will take. An important element to sustained recovery though is a return to the general belief that the financial sector is sound. As long as the banks remain mired in bad debt, a return to normalcy will not occur. The financial system is like a lubricant that greases the economic engine. We learned from the Japan experience that if the financial sector remains gridlocked, no amount of fiscal stimulus matters.

It is unlikely that the fiscal stimulus plans have had much effect since very little spending would have actually occurred yet. Disbursements to agencies may have occurred but not the actual spending. The only way the fiscal stimulus could have such an immediate effect is if it raises confidence substantially. I am doubtful that it has.

As for which industry will lead the recovery that is hard to answer, especially if it is a market-led recovery. However, the nature of industry may change if government interventions are substantial. For example, subsidies to clean technologies will surely inspire rapid growth in those industries as businesses seek government handouts.

2. Will the current crisis change the US economic pattern of low-saving and high-consumption dramatically? What effect will the crisis have on the US economy in the long run?

Much depends on the length of the recession. If the recession lasts a year to 18 months and is followed by a rapid recovery, savings and consumption rates may quickly return to previous levels. However, if the recession lasts longer, or if the recovery is slow, then changing behavior in the short-term may become habitual. This is what happened to the generation that lived through the Great Depression; many remained frugal for the rest of their lives.

3. What effect will the financial crisis have on the globalization process and the pattern of international trade? For developing countries, especially those emerging economies, how will the crisis influence their economic development pattern? What lessons are there? Will the east-Asia-US supply chain be impacted?

This too depends on how deep the recession is and how long the crisis lasts. If unemployment rises to double digits in the US and around the world, protectionist pressures will grow rapidly. Already governments, including the US, are engaged in what has been called “murky protectionism;” that is, measures like industry bailouts, subsidies, increased antidumping and safeguards actions, among other things. Some of these measures are WTO-consistent, but some are questionable. If unemployment rises a lot more, the measures may become less WTO-consistent and trade disputes and verbal wars may develop.

Protectionism is always popular to jobless individuals eager to find someone else to blame, and politicians feed on these sentiments. Luckily we have a WTO in place today and thus the world should be more resilient to protectionist pressures than they were during the Great Depression. It was encouraging to hear Ambassador Kirk express support for continuation of the Doha discussions. Despite this though, I expect the Obama administration to be ambivalent about freer trade. Fundamentally they are more inclined to support workers over management. Thus while they will continue to say they want to maintain free markets, I worry that they will be more inclined to support “fairness,” which in most instances means protections for industries and their workers.

Supply chains will be disrupted around the world if protectionist measures grow. One way to prevent protection from getting out of hand is to try to keep the disputes out of the popular press. The more public the discussion, the more it will fan the flames of populist sentiment. In this light it was helpful that the US last week refrained from charging China with currency manipulation. Perhaps, now discussions regarding exchange rate policy can be done more quietly in diplomatic circles, rather than being played out in the press.

Of course, when charges against other countries do make it into the press it is necessary for countries to defend themselves. Fortunately, disputes can be adjudicated through the WTO DSB. Although this process is lengthy and has some important shortcomings, restrained use of the process can help support the agreement and perhaps keep countries from drifting too far from the core WTO principles.

4. The expansion of the virtual economy is considered one of the major causes of the current crisis. Therefore, will manufacturing “returning home” became popular again in some developed countries?

Returning manufacturing home will reduce the efficiencies that were achieved in the pre-crisis years. Admittedly, it fuels popular sentiment because it can create the appearance of saving jobs. Nonetheless, the main problem is that a greater level of less efficient employment in the short run can generate a lower standard of living in the longer run.

One thing I believe we need is better education in the US and around the world about how free markets work. In a free market, sectors are larger or smaller on the basis of comparative advantage. While some patterns may appear, any attempt to create “appropriate patterns” is contrary to the free market and should be avoided.

5. What influence will the financial crisis have on the international monetary system? Will there be some changes? Under the current international political regime, how should governments supervise and regulate financial operations across the world? Will the US dollar be impacted as the world currency? Is there any possibility of depreciation of US dollar and inflation after the Fed took such monetary policies as quantitative easing and treasury securities repurchasing?

The expansion of the US money supply and the fiscal stimulus plan raises very serious concerns about future inflation. I think the main problem involves lags in policy. At the onset of the crisis last fall the velocity of money in the economy fell quickly. The circular flow of money from sales to wages to spending is lower now partially because households have lost jobs or are worried about future job losses, because households have lost an enormous amount of portfolio and home wealth, and because banks are only lending to the very best credit risks. In response the US Fed has pumped an enormous amount of money into the economy. At the same time the fiscal stimulus bill has passed but the spending itself will take place with a lag over several years. Only a small amount will be disbursed in the next few months. Because of this drop in velocity though the main worry now is deflation not inflation.

However, deflation can quickly turn into inflation. If the banks turn out to be reasonably sound, if home values stop falling, and if the stock markets rebound a bit more and remain stable, then consumer confidence will return swiftly and with it the velocity of money could increase rapidly. But if all that happens just when the main fiscal stimulus spending occurs in 6 months or a year, and if the stock of money remains high, then the only outlet for the pressure will be an increase in prices. Inflation may ignite with a vengeance. The FED would surely respond to this with a rapid decrease in the money supply. However, because of the lag in monetary effectiveness it could take many 12-18 months before the drop in money catches up to the change in the economy. In the meantime inflation could be severe.

Although US recovery will be good for the world and would help assure the US dollar remains the currency of choice in international transactions, at the same time a rapid dollar inflation reduces international desires to hold dollars. Additionally, large US government budget deficits raise concerns about the safety of US treasuries. Of course, the US will pay back its debt, but if that debt is paid back with lower valued dollars, it will lose its attractiveness.

These things may reduce international demand for the dollar for use as an international currency. However, the diminution of dollar primacy would also require the rise of a viable alternative. At this stage there are no obvious candidates.

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