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US-China Relations in the Era of the Fiscal Cliff

In the coming months, all foreign policy initiatives of the new White House will be constrained by somber domestic realities.

In the past – from the Carter and Reagan years to the Clinton and Bush years – the sharp rhetoric of the presidential campaigns has been replaced by more pragmatic policies after the elections. Much of the same will take place in the near future as well.

However, there are two important caveats. None of those post-1980 campaigns occurred against the background of a severe global economic stagnation. Nor were those elections followed by years, possibly a decade of difficult fiscal adjustment in the West.

In 2008, the presidential election brought no real change in Washington. Today, the economic headwinds can no longer be deferred.

In 2008, the United States voted for change. In the next four years, change will be forced upon voters in America.

U.S. Fiscal Cliff

In mid-September, U.S. Federal Reserve said it would engage in open-ended purchases of $40 billion of mortgage debt a month and hold the federal funds rate near zero, “at least through mid-2015.”

Bernanke’s third round of quantitative easing was motivated by great concern over the impending U.S. fiscal cliff, which includes converging threats of unemployment, Bush tax cuts, a huge debt burden, and cuts in defense and non-defense outlays.

What’s even worse is that there is little bipartisan consensus on the appropriate ways to tackle the fiscal cliff.

Today, the U.S. unemployment rate is 7.9%, which translates to 12.3 million Americans.  More than 40% of these are long-term unemployed. The problem is that the current emergency federal unemployment insurance is scheduled to expire on December 31, 2012. In the coming weeks, the most vulnerable workers in America will be effectively captive of Washington’s deficit deals.

The U.S. fiscal drag also includes the issue of the Bush tax cuts, which will account for more than 40% of the $18 trillion in debt that America will owe under current policies, in the course of the next decade. Republicans believe these cuts will encourage the wealthy to employ more Americans, even in the absence of historical evidence. In turn, Democrats would prefer to support primarily middle-class households with these tax cuts, which should eventually expire.

Further, the fiscal cliff involves ‘sequester’; that is, substantial cuts of defense and non-defense outlays. Most Democrats accept cuts in Pentagon, but oppose intensively cuts in non-defense outlays. Most Republicans could live with cuts in non-defense spending, but will fight cuts in defense outlays.

Most importantly, the fiscal cliff includes the U.S. debt burden, which has now soared to almost $16.2 trillion. That is $2 trillion more than in August 2011, when Washington lost its historical triple-A rating. In the short-term, Washington needs a new debt ceiling, again. But what it needs even more urgently is a credible, bipartisan and medium-term fiscal adjustment program.

In the absence of such a plan, new credit rating downgrades in the United States would contribute to increasing volatility, which could spread to the Eurozone– and to emerging Asia which currently drives global growth.

Washington’s Good Cop/Bad Cop Policy Toward China

According to polls, nine of ten Americans chose the new U.S. president on the basis of four priority issues: jobs, budget deficit, health care and social security. China did not figure in this list directly; indirectly it did. Its role as the scapegoat was evident in the 2010 mid-term elections and the 2012 presidential elections.

During the campaigns, neither candidate was eager to speak about the post-election economic challenges in America. But occasionally both resorted to China bashing. The political dilemma is that, in the aftermath of the election, not every promise can be reversed in America; nor can every threat be ignored in China.

As the Democratic and Republican campaigns demonstrated, the two parties support the Obama administration’s strategic pivot toward Asia Pacific, which includes efforts for a new regional trade pact that does not involve China and which has already contributed to escalating rearmament in the region.

If the U.S. regional approach is perceived as a “bad cop” posture in China, the administration’s U.S.-China Strategic and Economic Dialogue (S&ED) plays the role of the “good cop,” focusing on a wide range of bilateral, economic, strategic and security issues between both countries.

In the past, the Obama administration has brought trade cases against China at nearly twice the rate of the Bush administration. In the future, trade friction is likely to increase and spill more into innovation policies, intellectual property rights, and security issues – as evidenced by the recent Congressional hearings against Chinese telecom equipment companies Huawei and ZTE.

Some excesses could be avoided by expanding and refocusing the S&ED more strongly onto issues of foreign direct investment (FDI). After all, America has much to gain from increasing Chinese FDI in the U.S., while China needs America’s advanced technologies and know-how.

In the past, the Obama administration has promoted the Trans-Pacific Partnership (TPP), which excludes China. Now China is about to join talks to create the Regional Comprehensive Economic Partnership (RCEP), which excludes the United States.

In the short-term, these two huge trade blocs could prove exclusive and contribute to trade friction in Asia Pacific. But in a positive scenario, and with patience and perspective, the two could converge in the long-term.

The Critical Margin

President Obama may have an economic plan against the fiscal cliff, but it will be constrained by Washington’s political gridlock, which is now worse than ever before.

With his second term, Obama will need to develop a bipartisan compromise. That is the ultimate balancing act. The problem is that, in a negative scenario, it could alienate both the Republican opposition and the Democratic left.

How bad could the post-election aftermath get in America? Theoretically, a potentially severe contraction in the fiscal deficit could shave off more than 4% of U.S. GDP in 2013. In practice, and if reason prevails, the hit would reduce growth by some 1%.

However, taking into consideration the fact that U.S. growth is likely to remain around 1-2% in 2013, the impact could halt growth. That’s the benign scenario. In a disruptive scenario, U.S. stagnation could turn recessionary, which would deepen and prolong the Eurozone turmoil at the worst possible moment, while transmitting the contagion effect to Asia.

In the world economy, the United States remains the critical margin. As a result, the outcome of America’s fiscal cliff will either facilitate a way out of the deepening stagnation – or pave way to a new abyss.

The political struggle over America’s economic future has only begun. The hardest days are still ahead.

(Slightly modified from the original, published by China-US Focus, Nov 9, 2012)

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Dan Steinbock

Dr Dan Steinbock is a recognized expert of the multipolar world. He focuses on international business, international relations, investment and risk among the major advanced economies (G7) and large emerging economies (BRICS and beyond). In addition to his advisory activities (www.differencegroup.net), he is affiliated with major US universities as well as international think-tanks, such as India China and America Institute (USA), Shanghai Institutes for International Studies (China) and EU Center (Singapore).

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