Why US protectionism can not be the answer (page 1 of 2)

The other day, I received a three-page email from Klaus Bockstaller, who runs the Baring Emerging Europe Trust. I have to say that while I get at least 100 emails a day, the issues that Klaus raised, his thoughts, and the resulting questions were some of the most interesting and challenging that I have ever encountered. They have driven me along an illuminating path of reflection, and given rise to some interesting conclusions.

In essence, Klaus has the following theory. When, in the future, Western political leaders realize that the Bernanke-type monetary policies don't really work (or are doomed to fail, as I would put it), but lead to inflation and a depreciation of the dollar, they will increasingly pursue a policy of protectionism, which will buy the developed countries of the West some time and keep jobs from migrating to low-cost service providers, such as India, and more competitive manufacturing centers, such as we find in China, Vietnam, and Eastern European countries, among many others.

A sharply depreciating dollar and import duties will lift the price level in the US, but the disadvantage of higher domestic inflation could be partially offset if production and tradable services shifted back to the US.

The only remaining problem in this scenario (of depreciating dollars) would be oil. But, according to Klaus Bockstaller, the US has wisely taken steps to ensure that it will have sufficient supplies at reasonable prices in the future, vis-à-vis occupying Iraq.

Klaus concludes that while he agrees with me that the US is headed towards 'ein böses Ende' (disastrous eventual outcome), he nevertheless feels that a country like the US, whose money is 'the' reserve currency of the world, can, as Bernanke suggested not long ago, print money at practically zero cost.

If this policy does not work, however, Klaus suggests that the US can simply implement protectionist policies in order to postpone for quite some time the 'ultimate debacle'. If the US succeeds in putting off its problems for quite some time, then the equity markets could perform very well for a period.

While I fully agree with Klaus Bockstaller's basic presuppositions, I believe that the lease of life of economic policies that are designed to postpone problems, rather than to solve them - and to hurt competitors through competitive devaluations and protectionist measures - is far shorter than generally accepted. As Mao Tse Tung wrote during the struggle to 'liberate' China, 'a single spark can start a prairie fire.' Let me explain the reasons for my somewhat less sanguine views.

More than two years after the Fed began to ease aggressively, it is now becoming more obvious that the policy of aggressively driving down short-term rates has failed to produce any meaningful recovery. Consider, for instance, the booming housing industry. Given the red-hot conditions in this sector (don't forget that it is excessive credit growth that drives residential house inflation), one would assume that the furniture manufacturing industry would also be thriving.

But, not so! Industrial production for furniture and related products has been declining since 2000, while employment in this sector has totally collapsed. Why? Easy money has led to new capacities in the furniture industry - not in the US, but in Vietnam and in China, two countries from which the importing of furniture imports into the US are soaring.

So, it should already be obvious to US economic policymakers that in an environment of free trade and free capital flows, monetary policies can stimulate borrowings and spending in a high-cost country, but not capital spending and production, which, given a highly competitive situation, will naturally shift to the lowest-cost producers and lead to the ongoing wealth transfer to Asia via the US current account deficit.