Posts Tagged ‘stimulus’

Why bailouts and ‘stimulus’ crutch will screw up the US economy even more?

Wednesday, August 31st, 2011

August is the most volatile month in the global financial market since the GFC. We had a near default of the US government (see What will happen if Uncle Sam does not raise the debt ceiling?), followed by the downgrade of the US government debt by S&P. On top of that, there’s worries about a double dip recession in the US and fears that the Europe sovereign debt crisis can cause a financial earthquake that can rival the panic triggered by the fall of Lehman Brothers in 2008.

Regarding the raising of the US debt ceiling, we have some things to say. President Obama said that if the US government’s debt ceiling is not raised, the US government will default on its debt. Dear readers, do you see what message the US is sending with this simple statement? Basically, he is saying that if the US is not allowed to borrow more money, they are going to default on the money already owed. In other words, they need to borrow more money to repay the monies (plus interests) that they are currently owing. As China is the biggest lender to the US, this is basically telling them that if they don’t lend more money to the US, they can kiss their existing money goodbye.

If a private citizen comes to the point that he has to borrow more money to repay the ones already owed, it is no-brainer that he is on his way to bankruptcy! As we wrote back in October 2008 at? America?s balance sheet,

To make it easier for you to understand these colossal numbers, imagine owing $200,000 and earning $3640 per year on your job (that is, optimistically assuming that the economy can grow at 2% per year)! In other words, the earnings per year are only 1.82% of the total outstanding debt, which is far below the rate of price inflation. Based on market rate of interests (i.e. the long-term bond yield), the earnings will not be enough to even cover the interest payments.

So, the US government is in the same situation! Unless the US can? somehow create miraculous economic growth that will result in miraculous growth in tax receipts of the US government, the amount that the US government is going to owe will go up exponentially! And no, unlike private citizens, austerity measures will not solve the problem. Why? Thanks to the GFC, the government spent BIG on bailouts and ‘stimulus’ that does not stimulate, resulting in the government becoming a big part of the economy. So, slashing government spending will shrink the economy, which in turn will shrink tax receipts. As we wrote in August 2009 at Will governments be forced to exit from ?stimulus??,

In fact, the word ?stimulus? is the most misleading word in economics lexicon because it conveys the idea of a surgeon ?stimulating? a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch. The longer the economy leans on the government crutch, the more dependent it will be on the government. Eventually, the government will become the economy. For those who haven?t already, we encourage you to read Preserving jobs at all costs leads to economic stagnation and Are governments mad with ?stimulating??.

Do you see why we oppose ‘stimulus’ spending and bailouts in 2008? The government is going to have a colossal funding challenge in the first place (see Is the GFC the final crisis?). Spending big money in bailouts and ‘stimulus’ crutch is going to make the government the economy. Once the government becomes the economy, austerity measures becomes out of question. If austerity is out of question, then debt repayment becomes out of question. If debt repayment becomes out of question (i.e. default), then printing money is the only option. Yes, the US government can print money because the debt that they owe is denominated in their own currency.

Now, back to the real world. What are we hearing about the US economy today? We are hearing market chatter about a double-dip recession in the US. Bernanke had announced that he is going to keep short-term interest rates at zero for the next two years. There are talk about the coming lost-decade for the US where the economy will stagnate for the next 10 years.

Do you see the implication for this dismal forecast?

If we are right, the 2008 GFC is nothing compared to the coming US government debt crisis. That is why the message in our book, How to buy and invest in physical gold and silver bullion is so urgent and important.

Keep up spending- Who?s right? Europe or America?

Thursday, July 1st, 2010

Sometime last year, we were discussing with someone in the finance ?industry? about the possibility of a double-dip recession. Back then, the mainstream assumption was that government spending will somehow ?stimulate? the private-sector of the economy. But we argued that this assumption was simply incorrect. As we wrote in August 2009 at Will governments be forced to exit from ?stimulus??,

In fact, the word ?stimulus? is the most misleading word in economics lexicon because it conveys the idea of a surgeon ?stimulating? a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch.

Based on this faulty assumption, the financial market?s expectation is that the worst of the GFC is well and truly over and that the global economy will return to ?trend growth.? But as we wrote in January 2009 at Soft landing hope built on faulty framework assumptions,

Built into the blinkers of the mainstream neo-classical economic framework, the assumption is that the economy is like an elastic band that will spring back to its previous un-stretched state of ?equilibrium? after being stretched by external ?shocks? (e.g. global financial crisis). For those who studied economics at university, you will realise that the phrase ?external shock? is often used in the text-books to describe phenomena that are beyond the scope of economic model. Furthermore, you will find that your text-book are full of simultaneous equations, which implies some sort of ?equilibrium? has to unquestionably happen.

Today, there is a lot of talk in the financial markets about the threat of a double-dip recession. The expected (assumed is the more accurate word) recovery in the United States seems to be stalling. China is enacting policies to slow growth. Europe is mired in sovereign debt problems.

But for you, our dear readers, all these should not come as a surprise. As we already wrote in March this year at Black Swans lurking because Uncle Sam has less margin for error,

If the right word is used (e.g. ‘crutch,’ ‘prop up’) to describe the counter-productive government policies of spend, spend and spend, then it will do wonders to increase the economic IQ of the masses (see Are governments mad with ?stimulating??). Consider this very simple chain a logic:

  1. Someone is falling.
  2. You place a crutch to prevent him from falling.

Isn’t it plain common sense to see that once you remove the crutch, that person will crumble? From this, it follows that government crutch (‘stimulus’) lifts government expenditure to a higher plateau. Once we have bigger government, it is very difficult to shrink it as the difficulty currently faced by Greek government shows.

This is the issue that the Europeans are facing right now. If governments attempt to ‘stimulate’ their stagnant economies by spending big, their fiscal deficits will continue to grow, even to the point of no return. Consequently, the financial markets will lose faith in the governments’ debt because it will mean either (1) raising taxes, (2) default, (3) printing money, or (4) some combinations of the three. That’s their motivation for pledging to cut fiscal deficits in the recent G20 Summit.

But the problem is, if they cut their fiscal deficits (i.e. cut spending), their economies as measured by the GDP will shrink. Not only that, a shrinking economy implies a shrinking tax receipts for the governments, which in turn implies that they will have greater difficulty trying to repay existing debts. When that becomes obvious, you will see the bond and stock market reacting very negatively.

But for the Americans, since their government bonds are not yet under attack (given that among other reasons, the USD is still the world reserve currency), their more immediate problem is domestic growth. In fact, demand for American government bonds increased as a result of the flight to ‘safety.’ Hence, Obama was on record to urge the Europeans not to kill growth by shrinking government spending. But as Niall Ferguson said, at this current trajectory, the US will be like Greece in several years time.

So, who is right? The Americans or the Europeans?

Obama could urge for a policy of continued government spending because time is more on America’s side. The financial wolf packs are currently busy with Europe. So, Obama must be thinking that if America can try another shot at ‘stimulating’ their economy, maybe in due time, the government can then let the private sector take over. That will be the time to reduce the US government’s fiscal deficits. Hopefully, that can be done before the financial wolf packs set their sights on America.

Using an analogy, the current situation is like Europe being pressured on two fronts simultaneously with no room to move. America, on the other hand, is facing pressure only on one front. Obama’s plan is to send troops to that front, deliver the knock-out blow before sending troops to face off the looming second front. The plan will fail spectacularly if the enemy arrives on the second front before the knock-out blow on the first front can be concluded.

So, place your bet on whether you think America’s plan will succeed. If you think they can pull it off (i.e. honour their debts), then buy US Treasuries (American government debt). If not, get physical gold.

How to buy and invest in physical gold and silver bullion

Will governments be forced to exit from ‘stimulus?’

Tuesday, August 25th, 2009

Currently, there’s a belief in the financial markets that the worst of the Global Financial Crisis (GFC) is over and that it’ll be blue sky from now on. Indeed, it is possible that the the US economy may see a positive GDP growth in the next few quarters to come.

But here, as contrarians, we see a different picture. As we quoted the Bank for International Settlements (BIS) in Bank for International Settlements (BIS) warning on stimulus spendings, the ‘green shoots’ of growth is largely contributed to government bailouts, ‘stimulus’ spendings, money printing and cheaper money (e.g. zero interest rates in US).

Make no mistake about this: Government interventions cannot be sustained forever without increasing negative consequences in the longer term. Governments cannot ‘stimulate’ the economy. In fact, the word ‘stimulus’ is the most misleading word in economics lexicon because it conveys the idea of a surgeon ‘stimulating’ a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch. The longer the economy leans on the government crutch, the more dependent it will be on the government. Eventually, the government will become the economy. For those who haven’t already, we encourage you to read Preserving jobs at all costs leads to economic stagnation and Are governments mad with ?stimulating??.

Letting the economy lean on crutches indefinitely will result in decreasing economic health as time goes by. Furthermore, there’s always the risk that the side-effects will pressure governments to remove the crutches. As we quoted the BIS in Bank for International Settlements (BIS) warning on stimulus spendings,

Perhaps the largest short-term risk associated with the expansionary policies is the possibility of a forced exit. Monetary and fiscal authorities of the major economies have so far been relatively unconstrained in their ability to follow expansionary policies. This need not last. An extended period of stagnating economic activity could undermine the credibility of the policies in place. Governments may find it hard to place debt if market participants expect the underlying balance to remain negative for years to come. Under such circumstances, funding costs could rise suddenly, forcing them to cut spending or raise taxes significantly.

How will a pressure for a “forced exit” from crutches (bailouts, stimulus, money printing and cheaper money) happen? We can look no further than China as an example where ‘stimulus’ is most effective. As we wrote in Will August 2009 be the top for the year in China?,

Forcing credit growth in this case does not result in economic ?stimulation.? Instead, the result was a dangerous asset price bubble. Apparently, the Chinese government flipped its position and decided to rein in the bubble before it’s too late.

China is right now in a dilemma. Turning the credit tap off will result in many projects failing, which in turn will result in bad debts. Not turning the credit tap off will result in price inflation and asset price bubbles.

The problem with economic crutches is that there will be negative side-effects. It is only a matter of time before excess liquidity leaked into asset and commodity prices. Initially, this may not be a problem. But as we saw last year (see Who is to blame for surging food and oil prices?), this will eventually result in acute problems of price inflation (unless the next deflation pressure comes, for which it will be déjà vu again). If governments decide to withdraw the economic crutches, they risk letting the already weakening economy fall into deflation. If they decide not to withdraw them, they risk letting acute price inflation run amok.

What is likely to happen is that governments will attempt to walk on the middle ground by pretending to ‘fight’ inflation (e.g. raising interest rates too slowly and talk tough on inflation) and support the economy at the same time, hoping that the economy will turn out fine. It may work initially, but it’s a matter of time before the public will see through it.

Tougher times is ahead for everyone.

Government taking tougher line on debt and bubbles

Tuesday, July 28th, 2009

To be a successful investor, one must be be aware of the sea-changes that are happening in the economy and financial markets. One of the sea-changes is in the line of central bank thinking. As we wrote in How are central bankers going to deal with asset bubbles?, central bankers are now more ready to deal with asset price bubbles than before. Previously, central bankers were targeting price inflation rate with their monetary policy while they stood idly by to let house prices form a bubble. As Glenn Stevens, governor of the RBA said today as reported in this mainstream news article,

Not only would it confirm that there are serious supply-side impediments to producing one of the things that previous generations of Australians have taken for granted, namely affordable shelter, it would also pose elevated risks of problems of over-leverage and asset price deflation down the track.

Please note that we are not endorsing the economic literacy level of that news article. Rather, we are quoting Glenn Stevens to show you what is going on inside his mind. The RBA is also hinting repeatedly that the next move in interest rates is up. Basically, the RBA is telling Australians this: you better wake up from your old ways and get serious about repaying your debts because the party is over.

This line of thinking is in sharp contrast to China’s central bankers, who are allowing a debt bubble to grow (see Is China setting itself up for a credit bust?) and spill over into asset prices (e.g. property and stocks).

The next sea-change is the change in the line of thinking from our dear Prime Minister, Kevin Rudd. He wrote in his essay published a few days ago,

The roots of the crisis lie in the preceding decade of excess. In it the world enjoyed an extraordinary boom… However, as we later learnt, the global boom was built in large part on a three-layered house of cards.

First, in many Western countries the boom was created on a pile of debt held by consumers, corporations and some governments. As the global financier George Soros put it: ?For 25 years [the West] has been consuming more than we have been producing … living beyond our means.”

Second, these debts were racked up on the back of sky-rocketing asset prices. In several countries, stock prices and house values soared far above their true long-term worth, creating paper wealth that millions of households used as collateral for their growing debts.

This crisis has shown we have reached the limits of a purely debt-fuelled global growth strategy. Not only will the neo-liberal model of the past not provide growth for the future, its after-effects will make recovery more difficult. Mountains of global public and private debt, global imbalances, and a weakened global financial system will drag on global growth for a long time. As the renowned financial columnist Martin Wolf has written: “Those who expect a swift return to the business-as-usual of 2006 are fantasists. A slow and difficult recovery, dominated by de-leveraging and deflationary risks, is the most likely prospect.

This had been what we were arguing for a few years already (see Aussie household debt not as bad as it seems? on January 2008 and The Bubble Economy in October 2006). Kevin Rudd has finally understood the root cause of the GFC- spendthrift ways financed by rising debt using bubbly asset prices as collaterals. Now, he acknowledges that de-leveraging (repayment of debts) will be the fashion for a long time, in contrast to the past few decades of increasing debts. For many Generation Xs and Ys, the change from profligate to more frugal ways will be alien to them.

Unfortunately, as the mainstream always do, both the RBA and government is one-step behind.

The global economy is like a heart-attack patient on a life-support system. He faced a near-death experience in the second half of last year. Today, his condition has stabilised. But it will be a long time before he will fully recover and be fit enough to run again as in 2007. What the government is doing today is to inject more steroids (targeted stimulus spending financed by public debt) in the hope to see the patient running as soon as possible. The result is a walking zombie on life-support system (massive liquidity injections via ‘printing’ money).

As we wrote in Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view, the government is in danger of painting itself into a corner with no exit strategy (even though they’re talking a lot about it). If the exit strategy fails, we know the result is very high inflation (maybe even hyper-inflation).

Bank for International Settlements (BIS) warning on stimulus spendings

Sunday, July 5th, 2009

This week, the Bank for International Settlements (BIS), which is known as the central bankers’ central bank, warned governments all over the world from getting carried away with economic ‘stimulus’ spending. The BIS is the only international body that had correctly anticipated the global financial crisis (GFC) and warned of another great depression back in June 2007, when they released their 77th annual report (see Bank for International Settlements warns of another Great Depression).

In the 79th annual report, they warned,

Perhaps the largest short-term risk associated with the expansionary policies is the possibility of a forced exit. Monetary and fiscal authorities of the major economies have so far been relatively unconstrained in their ability to follow expansionary policies. This need not last. An extended period of stagnating economic activity could undermine the credibility of the policies in place. Governments may find it hard to place debt if market participants expect the underlying balance to remain negative for years to come. Under such circumstances, funding costs could rise suddenly, forcing them to cut spending or raise taxes significantly. External constraints could also bind for some countries. Particularly in smaller and more open economies [e.g. Australia], pressure on the currency could force central banks to follow a tighter policy than would be warranted by domestic economic conditions.

In other words, if economic stimulus spending failed to re-ignite economic growth, the bond vigilantes will lose their patience and make governments accountable. This means they will sell down government bonds, resulting in rising long-term interest rates. As a result, governments will find it harder and harder to raise money to spend in order to ‘stimuluate’ the economy further.

From this point, there can be two choices for governments:

  1. Cut spendings and raise taxes
  2. Print money

In a stagnating economy (with high household debts), we doubt the government will have the guts to undertake option (1). In Australia, judging from the howls of protests over the latest budgets, it is clear that the masses will not tolerate government austerity. The only alternative will be to undertake option (2)- printing money.

For countries like Australia, as we highlighted in bold in the above quotation of the BIS report, there is an added risk. Should there be any run on the Australian dollar, the RBA will be forced to raise interest rates regardless of how bad the domestic conditions are. With the Rudd government promising the moon (see Australian government?s contingent liability to exceed AU$1 trillion),the risk is that should they be required to deliver the moon, the Australian dollar will come under immense pressure and the Australian government bonds can be relegated to junk bonds.

At this point in time, the BIS is not sure whether stimulus spendings will work,

An open question as of this writing is whether the expansionary set of policies enacted in response to the sharp contraction in economic activity in late 2008 and early 2009 will succeed in stabilising the economy. A major cause for concern is the limited progress in addressing the underlying problems in the financial sector. The experience of the Nordic countries in the 1990s and other historical episodes suggest that a precondition for a sustainable recovery is to force the banking system to take losses, dispose of non-performing assets, eliminate excess capacity and rebuild its capital base. These conditions are not being met. A significant risk is therefore that the current stimulus will lead only to a temporary pickup in growth, followed by protracted stagnation. Moreover, a temporary respite may make it more difficult for authorities to take the actions that are necessary, if unpopular, to restore the health of the financial system, and may thus ultimately prolong the period of slow growth.

Without the financial system restored to health, it will result in economic stagnation, which will result in even more government economic stimulus, which eventually can only be financed by printing money. Evemtually, if this goes on, it will be, as we wrote in Supplying never-ending drugs till stagflation

Like drugs, the more you ?print? money, the less effective it will be in stimulating economic growth (see What causes economic booms and busts?). Eventually, it will come to a point that the economy will not respond positively anymore no matter how much money is being ?printed.? That is the nightmare of stagflation (low or negative real growth with sky-rocketing price inflation- look at Zimbabwe).

Currently, we are in this “temporary pickup in growth” stage.

Can government create jobs?

Thursday, April 2nd, 2009

Recently, one of our readers wrote,

I recently voted against Anna Bligh who?s govt has sent QLD into some $74B debt. Her plans are to keep spending. I found it horrific. The other party reckoned they wouldn?t spend as much and would cut govt spending by 3%. Well, I?m not sure I believed it but voted against the emcumbant anyhow – along with some 40+% of other QLDers. Anna was returned though and now feels that she has a ?mandate? to spend spend spend. It?s an horrific state of affairs. Most QLDers like me wouldn?t have been aware of the extent of govt debt built in in the ?good times?.

If you notice, this “spend, spend, spend” slogan is very strong in United States, Britain, Japan, Australia and maybe China (Premier Wen recently killed off the idea of a second stimulus spending). But Europe are cool about such an idea. Particularly, France wants more regulations in the financial system and threatened to walk out of the G20 Summit if their demand is overshadowed by the “spend, spend, spend” brigade (see France is threatening G20 walkout).

Back in our Queensland, State Premier Anna Bligh promised to create 100,000 jobs over the next 3 years. The State Opposition was so motivated to keep her accountable that they set up a Jobometer web site to monitor her ‘progress’ in her promise. Politicians, in order to win elections, will promise anything and everything even if the promise is dubious in merit. Can the Bligh government really create jobs as they promised? We suppose they are going to achieve that by the slogan of “spend, spend, spend.”

We believe it is not the job of governments to create jobs. Yes, they may employ civil servants to work on the administrative bureaucracy, legal enforcement, national defence and so on. Beyond that, governments cannot produce goods and services. For example, the Federal government’s NBN project has to be contracted to the private sector. Also, governments often end up outsourcing some of their services to the private sector. Given that governments’ general track records on running business enterprises are either non-existent or abysmal, the private sector is still the one that keeps the economy alive and  dynamic, create jobs, innovate and produce goods and services far more efficiently than any governments can do.

How is the Bligh government going to create jobs?

Are they going to employ surplus civil servants for the sake of ‘creating’ jobs? No, that is not a way to keep the economy healthy. If they do that, Queensland will end up with a huge and cumbersome government sector that crowds out and stunt the private sector. A stunted private sector will retard the economy’s potential to innovate, produce goods and services and keep the economy alive and dynamic.

Or are they going to spend it on goods and services produced by the private sector? Well, if there is a structural flaw in the economy (as we said before in Are governments mad with ?stimulating??), then the initial impact of such spending will only serve to primarily bid up the wages of the sectors that receive the government spending and will not solve the root of the unemployment (plus over-employment and under-employment) problem. For example, a redundant financial engineer is not going to be civil engineer overnight to work in the government’s outsourced infrastructure project (structural unemployment). He/she may end up working as a checkout chick/bloke to serve the cashed-up civil engineer at say, Woolsworth (under-employment). The civil engineer, on the other hand, may end up being overworked from the flood of engineering service demand from the government (over-employment).

One day, government expenditure on that sector (e.g. infrastructure) will subside. What happens next? Will the government have to come up with another stimulus spending program to keep the economic jig running? In the previous recession, the Japanese government had to keep the economic ‘stimulus’ pumping to the extent that they were said to have ended up building roads to nowhere.

Thus, even if the government end up boosting employment in the short-term through their “spend, spend, spend” program, it may end up counter-productive in the long run. If “spend, spend, spend” is their only strategy, then many years from now, the government will end up with very little to show for and citizens will be wondering where have all these money been wasted on.

Are governments mad with ‘stimulating?’

Thursday, March 26th, 2009

In the 1990s, when the Japanese bubble economy burst and fell into debt deflation, its banks were crippled with bad debts. In the ensuing decade, the Japanese government embarked on massive government stimulus programs. Roads to nowhere were built and there were even comments about resorting to military spending (which of course was dismissed later as mere rhetoric because of neighbouring countries’ sensitivities to Japan’s wartime past). When the first stimulus programs proved to have failed in its objective, a second and bigger one was announced. When that failed too, a third and bigger one was announced. Altogether, the Japanese government had embarked on 10 stimulus programs totalling 30 trillion yen. Today, the Japanese government’s debt is greater in size than the entire GDP!

Fast forward to today. The Global Financial Crisis (GFC) had prompted many countries to embark on major stimulus programs. This time round, most of the largest economies are doing the ‘stimulating’- US, UK, Japan (again) and China. The Europeans, on the other hand, are shying away from that. Here, in Australia, our government is also doing the ‘stimulating.’

One of the Einstein’s definition of madness is: continuing to do the same thing, hoping for a different outcome. So, it is pretty clear to us that madness is prevailing.

The root reason why all these stimulation will not work is that we have a structural problem in the global economy. Stimulus spending will not solve the structural problem. As long as the structural problems are not dealt with, the economic slump will not end. As we quoted Wilhelm R?pk’s 1936 economic classic at Overproduction or mis-configuration of production? in January 2008,

It is an indisputable fact that a general slump, which does not permit of the scale of production reached in the boom being maintained, sets in during the crisis, and it is equally indisputable that this general slump is the result of the total demand suddenly falling behind the total supply. But let us make sure what this means and what it does not mean. Under no circumstances can it mean that the cause of the general slump is to be sought in the fact that production has outstripped consumption and that too many of all goods at once are being produced.

Today, governments see the same thing and simplistically believe that aggregate demand is less than aggregate supply. Therefore, the solution, as they understand the crisis to be, is to ‘stimulate’ the economy in order to boost aggregate demand. But as we explained before in Overproduction or mis-configuration of production?, this idea is fallacious.

The whole point of an economic crisis is to correct the structural flaws in the global economy and clean out the wasteful mal-investments. But government bailouts and stimulus are interfering with the correction process. Therefore, this global economic malaise will be prolonged much longer than necessary. If governments go over the top with ‘stimulation’ that don’t work, the outcome will be hyper-inflation (see Supplying never-ending drugs till stagflation).

For our newer readers, we recommend that you read our guide, What causes economic booms and busts?.

Is China’s pump priming bad for the US?

Tuesday, November 11th, 2008

Yesterday, China announced a US$586 billion stimulus plan. That stimulus will be used mainly for infrastructure and social welfare. Some of this big money (US$29 billion) will come from government borrowing (see China’s Bond Sales to Increase on Stimulus Package (Update1)). It is not clear how much of that US$586 billion are new and additional spending on top of the existing pump priming already earmarked. Since this is just an announcement, the devil is still in the details.

The stock markets in Asia and Europe were ignited after the announcement. But the US stock markets did not share that enthusiasm. America does not have much to rejoice for. Why?

The reason is because China’s stimulus is hardly good news for America. To know why, you have to understand a couple of important differences between American and Chinese government spending:

  1. So far, most of the billions of dollars of American government spending go to bailouts. Every dollar that is spent on bailouts and rescues will be a dollar not be spent on rebuilding and maintaining the existing decaying and aging infrastructures in the nation. For China, apart from social welfare and tax benefits, the money will be spent on building new infrastructure.
  2. The US is already a colossally indebted nation (see How is the US going to repay its national debt?). They have to borrow or print even more big money for non-productive purposes. China, on the other hand, is the world’s largest creditor nation. They can easily finance all the big money with cash (figuratively). All these big monies are spent on more productive purposes (definitely more productive than bailouts and rescues).

So, since the Chinese government is flushed with ‘cash,’ where is the ‘cash’ going to come from? As we said before in Why did the foreigners bail out cash-starved financial institutions?,

China?s trillions of US dollars reserve is a form of savings that will be used to acquire their future needs for resources to power their economy in the long term.

Most of China’s US dollar reserve exists in the form of US Treasuries. Currently, the US Treasury bond market is the last bubble that is yet to burst. Along with that, with the collapsing commodity prices over the past few months, every Chinese US dollar reserve is worth even more (i.e. every US dollar that China has can buy more commodities then before).

The implications for the US are grim:

  1. The US government can forget about borrowing from China for their bailout and stimulus spending. They have to either borrow from their private sector (which is in no mood to lend because it is drowning in US$41 trillion of debt itself) or print money.
  2. China has to either sell down its hoard of US Treasuries or at least slow down its pace of accumulation considerably. With the US consumers choking on too much debt, the leakage of US dollars to China (through the Current Account Deficit) will dry up. This means the back flow of US dollars back to the US via Treasury bonds purchases will dry up too (see Awash with cash?what to do with it? on how this works). This means long-term interest rates in the US will have to rise. Since US mortgage rates are largely derived from long-term interest rates, this will mean trouble for US mortgage borrowers.
  3. Chinese liquidation of US Treasuries is bad news for the US dollar. In fact, without foreign central banks’ accumulation of US Treasuries, the US dollar would have collapsed long ago.

The question is, will China be able or willing to engineer an orderly liquidation of US Treasuries?

Government’s contradictory messages

Wednesday, October 22nd, 2008

Back in Can China save Australia?, we mentioned about SBS’s Insight program, Greed. As we read the transcript of that program, we cannot help but realise that while the government officials are busy trying to deal with this crisis, they are sending out contradictory messages as a side effect.

For example, take a read at this:

JENNY BROCKIE:  But what sort of possibilities are we talking about here? I mean unemployment going up to 10%, 20% in the event of this taking hold in Australia? What could happen?

LINDSAY TANNER:  Definitely not. None of us can see into the future and the international crisis is obviously so unprecedented that it’s very hard to make predictions, but the fundamentals in Australia are very strong. We’re better off than virtually anybody else in the world to deal with these problems and we remain optimistic that we will be able to ride through this buffeting in reasonable shape.

On one hand, Lindsay Tanner ruled out the possibility of Australia’s unemployment going north of 10%. Yet, on the other hand, he said that no one knows the future and make predictions. If you notice, by saying “Definitely not,” he is already making a prediction!

Incidentally, in Jobless rate may double as China slows, JPMorgan Australia’s chief economist Stephen Walters said that

“We now expect the jobless rate to more than double to 9% in late 2010, from the current 4.3%,” Mr Walters said. “Softer growth in one of Australia’s leading export destinations means Australia’s export volumes will be lower, as will be the terms of trade.

“That said, on our forecasts, there will be 1 million unemployed Australians by the second half of 2010.”

The current way of measuring the employment rate includes those who are under-employed (see Nearly 600,000 Australians under-employed). When the economy slows down, it is those kinds of jobs that will be shed first, especially jobs in businesses that depend on discretionary spending (e.g. retailing). Therefore, a figure of 1 million unemployed people is not so unthinkable after all.

The next contradictory message from the government is on spending:

JENNY BROCKIE:   OK, there are quite a few things in what you’ve said that I’d like to pick you up on because we live in very contradictory times at the moment. You’re saying we should be thinking about thrift. You’ve just released a $10.4 billion package and you’re telling people to go out and spend. I mean, should Siobhan keep spending, keep getting into debt? What’s the message the Government is sending at the moment?

We believe that the government’s $10 billion stimulus package is a misguided Keynesian policy that will not solve the problem.

Firstly, as we said before in Will Australia?s own pump-priming work?, it is far too little to combat the deflationary force.

Secondly, even if it is big enough to induce the masses to spend, it is the wrong medicine. If such policies are carried out to the extreme, the outcome will be hyperinflation (see Bernankeism and hyper-inflation). As we explained in Supplying never-ending drugs till stagflation,

Students of the Austrian School of economic thought will understand that indiscriminate ?printing? of money will worsen the plague of mal-investments and structural damage in the economy. Like drugs, the more you ?print? money, the less effective it will be in stimulating economic growth (see What causes economic booms and busts?). Eventually, it will come to a point that the economy will not respond positively anymore no matter how much money is being ?printed.?

Without the liquidation of mal-investments and restoration of the structural imbalances that is brought about by deflation, applying bigger and bigger stimulus packages will only function in similar ways to drugs- more and more for less and less effect. The reason why Keynesian reflationary pump-priming worked during the Great Depression was that it was applied after the cleansing effects of the deflation had done its work. But today, in reaction to the financial crisis, governments all over the world are doing so before the purge of fire. As a result, the much-needed economic correction that the economy had to have will not happen.