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Will Obama Play The Japan Card?

David Smick founded International Economy magazine three decades ago, hoping to occupy what Larry Summers called the "space between Henry Kissinger kind of stuff--geopolitics and negotiations--and Martin Feldstein stuff--regressions and models." His The World is Curved: Hidden Dangers to the Global Economy has stood out as an unusually lucid guide to the chaos and is being read closely by central bankers, senior political figures, and successful entrepreneurs across the globe. We asked him for advice on one of the key challenges of the current crisis, America's policy toward China and Japan.

TNR: Who's in power in the China-America relationship?

David Smick: I think the incoming Obama administration is spending too much time worrying about the Chinese. ... Now, I'm looking at it as Tim Geithner--I wouldn't be taking on the Chinese stuff. I figure the Chinese are going to repatriate capital anyway. I do not believe the numbers coming out of China--they are probably a lot worse. If you look at energy usage, and container shipping activity coming from some of the emerging markets that export some of the raw materials to China, everything has come to a standstill. ... I looked back at the three great periods of social disruption in post-war China--the Great Leap Forward in the late 1950s, the Cultural Revolution, and Tiananmen Square. Growth in the previous four or so quarters dropped from anywhere from the 10 to 12 percent range to the 4 to 5 percent range, which is exactly what's happening in China now. It was 11.8 percent a year ago, and now most Hong Kong analysts are talking in the fives, and the government even says it's 6.8 percent. Anything below 8 is recession, and anything below 6 is considered catastrophic. If you look at electrical usage, you could make the case that China is growing at 1 percent. Nobody knows. ... The point is this: There is going to be a temptation to repatriate capital....

I have a lot of friends in China saying that something in the last two or three weeks has changed. ... The financial bubble there has burst, but that's not the important bubble to me. It's the social and political bubble. ... The big issue for me will be they'll start to repatriate capital. It'll be a natural thing, to drop cash from helicopters, to buy off as much as they can. They're going to do whatever they can to maintain power.

So what should Tim Geithner do?

I think the relationship that matters for Timmy Geithner is his relationship with the Japanese finance minister. If you look at Japan right now, they have lost control of the foreign exchange markets, of the yen. The yen is soaring because Japanese savers, who tended to be the Japanese housewives, have for years been buying high-yielding foreign bonds. Now, the rest of the world is slashing interest rates. U.S. rates, for example, are now closer to Japanese levels. So foreign bonds don't have as much attraction. Surprise, surprise--money is being repatriated in massive fashion back to Japan. It is sending the yen through the roof. You are having the entire export-geared corporate sector in collapse. Even Toyota is ailing for the first time in 70 years. And, unlike other countries, Japan is starting from mediocre level of growth--they are dropping like a stone.

There is a potential deal to be had. Obama may not want to play, for political reasons, the Japan card, but eventually he will have to play it. The deal is this: The Japanese agree to buy large amounts of U.S. securities and other financial assets, and we look away the other way on a coordinated effort to weaken the yen. ... I don't see any other way out, given the size of what's going to be at least a $2 trillion bank bailout effort, and a $1 trillion stimulus package in the U.S. We are going to have to finance this somehow.

--Sahil Mahtani