The Frog and the Scorpion

There is a fable about a frog and a scorpion. The scorpion wants to cross a stream but can't swim so it asks a frog for a ride. The frog is reluctant knowing that the scorpion's sting would kill it. The scorpion points out that if it were to sting the frog it would drown. So the frog begins to ferry the scorpion across the stream. The scorpion stings the frog and both die. You could say it was in the nature of the beast.

In the midst of probably our worst economic crisis since the 1930's, we confront the consequences of having bought far more from overseas than we sold. The perennial deficits have been financed, as they are even today, by foreigners, especially governments, in effect exchanging their goods for US Treasury bonds. The US Treasury now pays interest on several trillion dollars of these bonds of which the largest single holder is China with 868 billion dollars worth. Japan is second with 721 billion dollars. As a holder of this extraordinary amount of US obligations, China is in the driver's seat, as it were. Should it cease buying US debt or, worse, choose to hold its reserves in other currencies, e.g. euros, the dollar would undoubtedly suffer a sharp decline in value against other currencies, US imports would be priced above the purchasing power of many if not most Americans and our world standing would be truly eroded.

The saving grace is that while we're the frog and the Chinese the scorpion hopefully they have a a far better perception of self interest. To keep the lid on social ferment and to maintain the near monopoly of power of the Communist Party, China needs an economic growth rate of a minimum of 8% annually. Historically it has achieved even higher rates of growth through massive increases of exports, becoming the world's largest exporter in the process. A world wide recession is already threatening China's ability to manage its domestic economy and for it to throw its financial weight around carelessly could well prove a disaster for all. We are in a form of "mutually assured destruction" that perhaps constrains untoward behavior for all parties.

In the intermediate to longer term the American propensity to consume without much thought to savings and to run large foreign exchange deficits year after year is not sustainable. Economic theory suggests that over time the dollar must decline in relative value to a level conducive to equilibrium in the balance of payments. As this occurs we will undoubtedly experience changes in consumption patterns as well as structural adjustments in the makeup of the national economy. As many are now commenting we may well be entering into a different and changed world.

The saving grace we've enjoyed for some decades has been the role of the US dollar as worldwide medium of exchange and holder of value of last resort. When in panic, foreigners tend to flee to the dollar. But the balance of economic power is shifting. The G-20 meeting held this month in Washington, DC, included in addition to the usual G-8 representatives, the presidents of China, Brazil, Mexico, South Africa and Indonesia as well as prime ministers from South Korea, India and Australia. In my view the locus of economic power has shifted from the Atlantic to the Pacific basin and the economic hegemony of the US will be challenged and most probably diminished in the years to come. Europe is already far less important now relative to the world economy than in the past and Japan is on track to follow. It's a new world out there!