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Prisoner’s Dilemma

Posted by Larry Doyle on January 26, 2009 6:35 PM |

Over the course of the last two decades, we have seen a massive increase in global trade in conjunction with a wide array of free trade agreements.

For those who do not track these agreements, two of the United States’ formal trade agreements are:

1. NAFTA: North American Free Trade Agreement
2. CAFTA: Central America Free Trade Agreement

As a country, we have formal trade agreements with certain nations but trade extensively around the world. For those who care to further explore the nature and extent of the U.S. trade agreements, you can do so at http://www.export.gov/fta/index.asp.

Our trade with China presents particular challenges. China has a significant level of quality control and worker safety issues. There are serious questions about Chinese abuse of human rights. On the foreign policy front, China is closely allied with states that sponsor terrorism, including Iran and Sudan. As a nation, we had very limited interaction with China until President Nixon engaged them during his tenure. In the late 1970s, we had a mere $2.5 billion in trade with this most populous country in the world. Fast forward and at the end of 2007, our level of trade topped $300 billion.

Our trade representatives have always been challenged in dealing with the Chinese, given the issues highlighted previously. That said, our administrations have increasingly viewed China as too big a market and too large a presence in world affairs not to engage. As our engagement with China has been facilitated by increasing levels of overall prosperity, how do we now economically engage the enigma that China represents during this downturn?

“In bad times everybody talks more about financial cooperation but the reality is that in bad times everyone wants to take care of himself first,” said Shi Yinhong, an international security professor at Renmin University in Beijing.

As I read that quote in a recent article in the International Herald Tribune, I was brought back to my Economics class, Social Welfare, and the study of “The Prisoners Dilemma.”

Without going into extensive economic analysis on this “dilemma,” in short it represents the choices a partner has, not knowing exactly how the other partner will act. While the partners would mutually benefit through cooperation, if one partner chooses to act in his own self-interest, the other partner is penalized if he does not also act in his self-interest. As a result, both partners are worse off by acting selfishly. Welcome to the world of global trade in 2009.

While promoting global trade and economic cooperation has not universally been accepted as being in our national interests, ultimately I do believe that in growing overall output worldwide we have the best chance to further our nation’s interests and well being. The challenge for us and for every country at this juncture is how to handle trade relationships during tough economic periods. Just as Professor Yinhong mentions, while collectively all nations in the world would benefit at this time through economic cooperation, it is highly likely that many and then most countries will choose their individual self-interests.

Where and how will this play out? By subtly promoting policies to devalue one’s currency, a country attempts to generate an advantage for its exports. How does that work? Very simply, as a currency declines in value, exports are cheaper because the devalued currency implies lower production costs. For example, if the U.S. dollar lost half its value with no change in the prices of our exports and all other currencies in the world remained unchanged in value, then our country would benefit by manufacturers’ increased production of goods. We are starting to see the pursuit of this very goal and the promotion of currency devaluation around the world.

That very scenario is the reason why newly confirmed Secretary of Treasury Tim Geithner remarked a few days ago that the Chinese were manipulating their currency. Geithner and plenty others do believe the Chinese have intentionally kept the yuan too low in value in order to promote exports and overall growth.
Geithner’s comments, in my opinion, were not a casual off the record assertion of a personal opinion, but rather an opening salvo by the Obama administration in the game of world trade circa 2009.
The stakes in this game are extraordinarily high. As we mentioned in our show on Sunday evening, foreign entities hold 49% of our government debt. The largest holder until recently was Japan, and as of September 2008 is now the People’s Republic of China. The following link highlights this fact: http://www.treas.gov/tic/mfh.txt.

As our deficit explodes, we are increasingly dependent on foreign funding. While this administration and every administration would never admit they would favor a weaker currency, especially at this time, believe me they would have no problem with it. A weaker currency not only may help promote growth in exports, it is also inflationary which our government would not mind in the face of the increased deficit. Again, they would never say that, but they would not mind it. In fact, every nation in the world right now would like to see a decline in their currency value for these same reasons.

While we sit in our cell wondering what to do and what our partner will do, the Chinese sit in their cell wondering the same thing. China has a whole set of its own issues given the cataclysmic dropoff in world trade. They are also pacing in their cell but they do so in the form of a totalitarian government which has no issues in repressing the rights of its citizens. Do we think they may act in our interest, by allowing their yuan to increase in value? Are they thinking there is no way our administration would run the risk of antagonizing the largest holder of our debt? Do the prospects of increased protectionism on our part also go through their mind?

The WSJ reported China’s Ministry of Commerce parry as “directing unsubstantiated criticism at China on the exchange-rate issue will only help U.S. protectionism and will not help toward a real solution to the issue.”

Increased protectionism along with increased taxes were the overriding factors that led our country into the Great Depression.

Welcome to the real world version of “The Prisoner’s Dilemma 2009.”

LD






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