Finance

By Dan Blumenthal

Overall, Obama's Asia policy has been largely driven by events and domestic priorities rather than by an overarching strategic vision. The Obama team had to closely coordinate with China on financial matters in response to the financial crisis. Passing a cap and trade bill at home means that we need China to sign up to a global climate change pact; Americans will chafe at a costly bill if the world's largest carbon emitters do not agree to carbon reductions.

The Obama team attempted a new policy on Burma. The idea is to find a way to engage the military junta which would strengthen relations with the Association of Southeast Asian Nations, of which Burma is a member. But the policy change has been overtaken by events.

Aung San Suu Kyi was unfairly punished when an American swam across a lake to her residence. And the junta began a new round of repression, as its leaders jail and harass political opponents in the run up to their 2010 "elections." Obama could not radically shift Burma policy. Rather, adjustments to our relations with ASEAN and Burma have been only marginal. There has been some more contact with the junta. And as part of the broader attempt to build stronger relations with Southeast Asia, the administration signed the Treaty of Amity and Cooperation (TAC). These and visits to Southeast Asia by Secretary Clinton and her deputy, Jim Steinberg, demonstrate a desire to deepen American engagement with that region. It is unlikely that engaging Burma or signing the TAC will increase America's regional influence.

Surprise?

There are several Obama Asia policies that have been surprising. On a positive note, the Obama team has given much greater attention to the Japan alliance than I had expected. Secretary Clinton's first stop in Asia was in Tokyo, which eased Japanese concerns that they were in for another round of "Japan passing." Since the Democratic Party of Japan took over last September, Obama officials have visited Japan frequently to get a sense of how to deal with a party that has never before governed. The Obama team should be commended for trying to find its way with this inexperienced and eclectic ruling coalition.

Constructive Criticism?

Other policies should give us pause. For example, Obama is sticking to his campaign promises on trade, which means we have no trade policy. The Korea-U.S. Free Trade Agreement has been collecting dust in the Congress. The rest of the region, however, is not standing still. China seems to sign a trade agreement a minute and South Korea is moving forward on an FTA with the EU. If this continues, not only will our economy be disadvantaged, but our regional leadership will also suffer. While the Obama administration has done a fine job showing up to Asian multilateral meetings, without new trade proposals it has shown up empty handed.

A second troubling policy is the absence of any agenda on Taiwan. The Obama team was effusive in its praise of President Ma when he was elected in March 2008 and they applaud his attempts to ease tensions with the Mainland. The Taiwan president is doing what he thinks Washington wants - easing cross Strait tensions. But there was an implicit bargain with Taiwan that we are not upholding. We were supposed to strengthen Ma's hand by strengthening our ties to Taiwan. The Obama team is not helping Ma.  We have not sold any arms to Taiwan even as China has continued its arms buildup across the Strait. And Obama has no plans of yet to deepen economic ties as Taiwan goes forward with a China FTA.

Third, the bluntness with which the team has downplayed China's miserable human rights record is an unfortunate break with past administrations' practices. Secretary Clinton announced that she would deemphasize human rights concerns on her first trip to China. This was followed by the president's refusal to meet with the Dalai Lama when the Tibetan spiritual leader was in Washington last month. The administration has also been silent on Uighur repression and will not meet with Uighur leader Rebiya Kadeer. It does not help either country for us to pretend that we are indifferent about Chinese respect for human rights, when in reality we have a huge stake in China's political liberalization.

Overall, despite a regular barrage of criticism by Candidate Obama directed at President Bush for his supposed neglect of Asia (never a fair criticism), the Obama team has not wowed the region with new ideas or lavished it with attention. During Bush's first year, his administration had offered the largest arms package ever to Taiwan, was well on its way to substantially upgrading ties with Japan, and was negotiating a diplomatic breakthrough with India of historical significance. Then-U.S. Trade Representative Bob Zoellick was negotiating free trade agreements with Singapore, Australia, and Korea.

The criticism of the Bush administration was that it was "distracted" by the war on terror. The Obama team is learning that fighting a war saps a nation's energy and attention. Now in office, the Obama team can see that the threat from Islamic extremism is very real. The Obama team may have really believed that they could "fix" Afghanistan, disengage from Iraq, and then move on to "re-engaging" the rest of the world.

As Obama is learning, it is not so easy to "move on" when you are at war. No president can disconnect a major foreign policy issue such as war from other foreign policy issues. Asians have a stake in America's Afghanistan policy. A loss in Afghanistan would have stark consequences, as friend and foe alike would question our resolve, and Islamic extremism would rear its head again in Southeast Asia.

Prediction?

Obama's Asia team must be finding that during wartime, presidential attention is the scarcest of commodities. Obama has no choice but to focus on "the wars we are in," often at the expense of the Obama team's hopes for a grand "re-engagement" with Asia.

Win McNamee/Getty Images

The U.S. dollar enjoys a privileged position in the world. The federal government can print up the little slips of green paper and exchange them for barrels of oil or digital cameras. That trick is not unique to the United States; almost all countries print money and spend it at home. The difference is that the dollar can be so easily spent abroad and that foreigners are so willing to hold on to large quantities of those little slips of papers, instead of trading them back in for American-made goods. This raises the question: Is the dollar likely to be replaced as the world's reserve currency?

There have certainly been similar shifts in the past. Some time in the first half of the last century, the dollar took over the exalted position long held by the British pound. Nor are the questions about the dollar's status as a reserve currency merely conservative fantasies aimed at stirring doubts about President Obama's leadership. As with so many other things, this idea was made in China. Alarmed by his country's exposure to a potential slide in the dollar, the head of China's central bank floated the idea of a global currency to replace the dollar. The Russians liked the idea. The United Nations and the IMF were intrigued.

If we're to hold auditions for a new dominant global currency, we can start by considering the job description. We're really looking for three things in an aspiring new currency:

1. It must be widely traded.
2. It must be linked to deep and open capital markets.
3. It must provide a stable store of value.

The dollar excels on the first two counts. Given the size of the U.S. economy, the dollar has a broader reach than any other currency. U.S. capital markets (bonds, stocks) feature enormous trading volumes; that means that a government wishing to adjust its reserve position by selling Treasury bonds generally need not worry about whether it can unload them.

The dollar concerns stem from fears about U.S. fiscal incontinence. The Obama administration often deflects such concerns by arguing that it is necessary to run large deficits in a time of economic crisis. This conflates the short-term and long-term deficit problems. The administration declared early on that America's fiscal position was unsustainable because of burgeoning entitlement costs, especially in health care.  Yet the plans under consideration would likely increase overall health spending while raising the government's share of costs. Nor has the administration earned much credibility for its promises to offset costs.  The situation beyond health care does not look much brighter.

Runaway deficits can spiral out of control and have frequently ended in bouts of serious inflation, as governments print money to cover costs. That directly undermines the currency's role as a store of value. Inflation means that those green slips of paper buy less tomorrow than they do today.

Hence, the search for a successor to the dollar. But a review of the serious applicants suggests the dollar's position is secure, at least for a while.

At the front of the line is the euro. It already accounts for almost 30 percent of global reserve holdings, compared to the dollar's roughly 60 percent. The euro zone certainly has the economic size to be a viable contender. But the recent crisis has shown up some serious weaknesses in the currency. First, there was the question of how the euro zone would deal with bank failures, as in Ireland and Iceland. The European Central Bank does not have the full panoply of powers enjoyed by U.S. federal bank overseers. Europe also faces its own deficit problems, exacerbated by the fact that some members are more profligate than others.

In line behind the euro are the British pound and the Japanese yen. The economies are smaller, but still large enough to be contenders. Yet British debt problems are even more serious than those in the United States. Japan's fiscal problems are severe as well, offset only by that country's great propensity to save.

Beyond the yen and the pound, we come to the long shots, such as the Chinese yuan or the Brazilian real. For all its eagerness, China is disqualified because it does not have an open capital account (the opposite of deep capital markets; good luck unloading those RMB bonds). Brazil recently got a small taste of what it is like to be a favored currency and started running in the other direction. After the real appreciated 36 percent against the dollar this year, the Brazilians decided to start taxing investment flows.

So who's left? Just the imaginary currencies. These are artificial constructs like the IMF's SDR (special drawing rights). It's not widely traded; there are no deep SDR capital markets; nor are there any special guarantees about its prospects as a store of value. It has gained a following because it seems to offer an escape from all the failings of the other currencies. In fact, the SDR is nothing more than a basket of those very currencies.

So the dollar's reign looks likely to continue for a while. It's not a very resounding victory -- champion because everyone else fell over -- but a win is a win, as the cliché goes. It does beg the question: is it a win? Has the U.S. benefited from the dollar's special role? More particularly, what do the dollar's role and value mean for U.S. foreign policy?

That will be the subject of the next and last post in this series.

By Phil Levy

The Pittsburgh G-20 meetings concluded with a call for strong, sustainable, and balanced global growth. Countries were going to get their acts together, to shape up, to mend their ways. And if they don't? What if they just go with their own domestic political imperatives? Then someone will call them out, the leaders said.

But who? The International Monetary Fund, perhaps. After a meeting of finance ministers, the AP reported:

Four governments -- including the United States and China -- renewed promises to enact policies aimed at rebalancing global trade.

They said an orderly reduction in the U.S. trade deficit and trade surpluses in Asia would benefit the world by defusing protectionist trade action...

"It was agreed that a rebalancing of domestic demand growth across economies would be key to reducing imbalances...," said the statement, issued on behalf of the group by the IMF.

China pledged to take steps to increase domestic demand, deepen financial reforms and increase the flexibility of its currency, a step long demanded by the United States and other industrialized nations.

Wait! This story is from April 2007, on the eve of the global financial crisis. (Plus ça change...). That meeting followed a 2006 agreement that the IMF would adopt a new surveillance system to identify misaligned exchange rates. The surveillance program essentially came to naught. This ineffectiveness was not due to any analytical weakness on the part of the good folks at the IMF. It turned out, rather, that big countries like the United States and China dislike being publicly criticized.

Of course, smaller nations share this distaste for criticism, but they usually have no choice. The IMF has leverage when it lends money. When a nation like Hungary or Iceland finds itself in serious trouble, it must accept IMF policy prescriptions along with the cash. The bitter memories of this cash/criticism combo from the Asian financial crisis of the late 1990s help explain why Asian countries have built up such substantial piles of exchange reserves; they want to ensure they are not in that position again.

Why should the IMF or World Bank care, though? Why not just call it the way they see it and let the big countries deal with their own bruised egos? Because the big countries are the IMF and World Bank. The leaders of the bank and fund spend their days reporting to boards of executive directors, seeking the boards' approval for all they do. These institutions are not like the U.N. General Assembly -- one country, one vote -- the executive directors' votes are roughly weighted according to the economic heft of the countries they represent.

This creates a dynamic that played out this week in Istanbul, where the bank and fund are holding their fall meetings. According to the Financial Times, World Bank President Robert Zoellick asked his governing council for an infusion of $5 billion. Without it, he said,

"[A]s we start to get towards the middle of next year we are going to start to face some serious constraints and we would have to ration..." He said uncertainty over future financing capacity was already affecting bank work with developing countries.

Developing nations voiced unanimous support for a capital increase.

But developing nations are not the ones paying the bills. Zoellick faced a much more skeptical reception from the British, the French, the Japanese, and the Americans. It is the major donors to which any bank president is beholden. This dependence did not stop Zoellick from making a relatively forthright speech about global imbalances last week at the Johns Hopkins School of Advanced International Studies, but the FT pictured him yesterday with his head in his hands.

The independence deficit of the IMF and World Bank is serious, but perhaps not the most significant obstacle to achieving global rebalancing through coordinated reform. Even if Bob Zoellick launched the kind of scathing critique of which he's certainly capable, it would not suffice to bring serious cuts to U.S. federal deficits or to prompt revaluation of the Chinese currency. President Obama's political prospects depend heavily on delivering a costly expansion of health-care coverage. The Chinese leadership's legitimacy rests heavily on maintaining employment in the manufacturing sector. In each case, the domestic political stakes are far too high to be overcome by global opinion, no matter how blunt.

Change will come, of course. But it will be through average American voters worrying about borrowing from their grandchildren, or from average Chinese worried about the value of their massive dollar holdings. Right now, even if the IMF or the World Bank were to call out, those key constituencies aren't listening.

Win McNamee/Getty Images

By Phil Levy

This week's budget sketch from the Obama administration has stirred lots of partisan debate: A liberal dream come true! A conservative nightmare! For all of its occasional tedium, one of the nice aspects of economics is that markets often let you keep score in real time. And markets seem to be sending an unambiguous signal that the U.S. economy is now headed in the wrong direction.

At the heart of the debate, President Obama believes that massive spending and borrowing will ultimately strengthen the country. He regards the new proposals in health care, education, and energy as investments. Critics counter that these massive programs will bankrupt the country.

A first temptation is to look to the stock market for a verdict, and the stock market did not seem pleased. It has shown a tendency to swoon with almost every landmark moment of this administration. But supporters of the administration have argued that the stock market is too focused on the short term, that it is driven by other factors, that the market is more of a moodring than a carefully reasoned verdict. 

Fortunately, there are other markets that give a cleaner reaction. In particular, one can look at the government bond market, which is now giving the Obama plan a decided thumbs-down. The interest rate on the 10-year U.S. Government Treasury note helps set borrowing rates for corporations and households. It is not the very short term rate that the Fed has pushed near zero. It covers the same time frame that the Obama administration has now picked for its budget outlook. Unlike the stock market, there are no questions of dividend cuts, consumer fads, new competition, or management failures to muddy the picture.

This clarity led to the classic James Carville quote from early in the Clinton administration: "I used to think if there was reincarnation, I wanted to comeback as the President or the Pope or a .400 baseball hitter, but now I want to come back as the bond market. You can intimidate everybody."

A bond investor need only consider a few particular risks. There is the risk of inflation, which cuts into the spending power of the dollars investors receive later on. For foreign investors, there is the risk of a falling dollar, since they will ultimately need to convert their bond returns back into their own currency. Then there is the risk of default. That has been an important consideration for shaky businesses and emerging market basket cases, but not for a country like the United States. Until now.

In November and December, as investors panicked worldwide and rushed to the safety of U.S. government bonds, the interest rate on 10-year government bonds plunged to near 2 percent. From a low on December 30, the rate has rocketed back up to over 3 percent today, reflecting a sharp drop in the value of bonds. This is not because the rest of the world has solved its problems.

An even clearer negative verdict on Obama's approach comes from the much-maligned market for credit default swaps. These swaps function like insurance contracts that pay off if a borrower fails to make good. That insurance gets more expensive when the likelihood of default increases. The idea of a U.S. government default has recently gone from "unthinkable" to close to 10 percent over the next five years. 

So what is scaring the bond traders? Perhaps they spent last weekend reading a timely report by the distinguished economists Alan Auerbach (UC-Berkeley) and Bill Gale (Brookings). The upshot is that the United States has serious long-term fiscal challenges, between the downturn, an aging population, and major entitlement programs. None of the options for getting out of the mess looked particularly palatable. And that was before the president spoke of an extra trillion dollars for health care.

Despite claims of a new realism, the administration's budget is loaded with optimism. It assumes the economy will have a quicker and more vigorous recovery than most private forecasters predict. It assumes that individuals won't change their behavior much to avoid new, higher tax rates. It assumes that sacred cows such as mortgage interest deductibility and agricultural subsidies are ready to be made into hamburgers. And even with all this optimism, the administration predicts red ink as far as the eye can see.

Meanwhile the administration is trying to pretend the crises in the financial and housing sectors will go away on their own. Although a storm is already raging, the administration is not setting much aside for a rainy day. The IMF recently predicted potential bank sector write-downs of $2.2 trillion globally, perhaps half of that in the United States. Nouriel Roubini (NYU) suggests $3.6 trillion. Any such loss would leave the administration with a choice: borrow even more to fill the holes, or watch tax revenue shrivel up as the financial sector crumbles and the economy asphyxiates. If they continue to borrow, at some point we will test the limits of the world's willingness to lend and call into question America's status as a financial safehaven. Higher interest rates will then make a bad situation worse.

I can't say for certain that this is what is scaring the bond market. But I know it's what's scaring me.