February 25, 2004

The Conceit of Frictionless Adjustment II

My Angry Economist correspondent has continued in his errors. He declares " All that country A can do is say "thanks for the products" and move on" which is simply not true. There are lots of things that a country can do that are non-economic responses. They may be smart or dumb but it is simply incorrect to declare them inexistent. Country A (the US in this case) could:

1. Hold daily press conferences announcing how much the country B government is costing each country B citizen by selling below cost.
2. Impose a travel ban on various high ministers of country B government or impose travel documentation innovations that would drive the point home.
3. File a WTO complaint demanding market access.
4. Take direct physical action.

This last can be anything from a Godfather like severed horse head in the Chairman's bed to an imitation of Russia's style of communication with Eduard Shevardnadze (they blew up his limo and immediately sent a diplomat who remarked publicly on the fragility of some armored cars). Now I happen to believe that the last option would, most of the time, be criminally stupid. But this doesn't mean that it doesn't exist as a possibility any more than non-Westphalian war has not been a possibility since 1648. It was always there but until GW Bush invoked it, nobody much did it. If we were doing analysis of noneconomic responses and Country A was Russia, I would definitely put option 4 on the table because the Russian government probably will whether we game it or not.

Of the options I outline above, 1 and 2 are both entirely noneconomic and I would say worthy of serious study, 3 is a mixed political/economic response, and 4 is entirely noneconomic but almost certainly stupid.

Now on the issue of self-inflicted damage by way of dumping Treasury Notes, again, the problem is framed incorrectly as an economic one. A nation that dumps isn't somebody trying to make a profit. A nation that dumps in the way that I described is trying to wage asymmetric warfare.

How many shells, planes, and soldiers would be required to do net $1T in damage to the US (gross damage to US minus gross damage to the attacker)? Now how much would it cost you to do net $1T in damage to the US by dumping Treasuries (gross cost of Treasuries minus gross revenue in selling them)? If the second figure is smaller than the first, it makes sense to buy US debt instead of investing in your military. After that, you just need to figure out how many Treasuries it will take before you can send a diplomatic note to Washington to do X or we dump Y bonds on the market and pop your interest rates up 2 points every three months until you give in. They would calculate to a very fine point how much adjustment we can take in how short a time and be careful to be able to impose change on us past the point where the US can maintain social cohesion. The US could eventually get out of the trap but we would have to yield our interests as much as if we had lost a small war.

There is a further incentive to adopting this financial way of war. A bomb, once purchased, is a depreciating asset. It must be maintained, guarded, and will eventually go bad if not used. A Treasury Note is an appreciating asset. As it expires you make a small profit and just buy another one. So if you never get around to pulling the trigger, holding debt is superior to holding arms. It is an appreciating asset and doesn't make anybody else nervous. And if your target is blinded by narrow focus economists, it doesn't even make your target nervous.

Diversification is valuable. It's valuable for investors. It's valuable for borrowers too if you're big enough that you might be worth putting a credit squeeze on.

Posted by TMLutas at February 25, 2004 12:07 PM