Posts Tagged ‘US dollar’

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.

What can you do to protect yourself from increasing currency volatility?

Sunday, September 19th, 2010

Six months ago, we wrote about America’s consideration to label China as a “currency manipulator” in Watch April 15 2010: simmering tensions between US and China. Just before the deadline, China appeared to make a little concession about their RMB, thus avoiding the “currency manipulation” label.

Today, currency tension between the US and China is rising again. The little concession that the Chinese government made was simply not enough. American lawmakers are getting impatient and are itching to enact laws to slap China with trade sanctions. Should that happen, it will be the beginning of a damaging trade war between the world’s largest economies. Their charge is that China’s artificially low currency is responsible for (or at least contributed to) America’s economic woes. But as we wrote in Watch April 15 2010: simmering tensions between US and China,

But the mob wants to find a scapegoat to blame for their woes. It so happens that the most convenient scapegoat is China (specifically, China?s policy of artificially holding its currency down) because at this point of the cycle, China is looking very good. It is perceived that this policy worsen America?s unemployment rate. By implication, it is perceived that with China?s official unemployment rate much lower, China is ?prospering? at America?s expense.

Currency tensions between China and the US are nothing new. As we wrote in that article, it’s been around for the past 3 to 4 years. Many times, the rhetoric about America labelling China a “currency manipulator” came and went away without eventuating into reality. However, that does not mean that it will never happen. As America’s economic woes worsen, the pressure to find a scapegoat will increase. As a result, the probability of a trade war will increase.

The Chinese, on the other hand, are not standing idle, waiting for a trade war to happen. For starters, they are establishing trade and investment links with Asia, Middle-East and Africa. Secondly, it is no secret that they have been diversifying their colossal hoard of reserves away from the US dollar. Given the well-known intention of the Federal Reserve to print more money, diversification has become increasingly urgent. But that in itself is not easy because given the colossal size of the money involved, any whispers and hints about any particular Chinese diversification strategy will move the markets quickly in a big way. For example, the recent rumours that China was buying up Japanese government bonds probably helped to contribute to the surging yen. As a result, the Japanese government became very unhappy because a very strong yen will negatively impact on their export-oriented economy. In response, the Japanese government may take concrete actions (beyond just talking about it and taking token measures) to weaken the yen, in which the end result is more Japanese purchase of US government debt.

In such an environment of competitive currency devaluation and price volatility, what should investors and savers do?

To us, it is clear that having all your savings and investments confined to a single country or currency is an increasingly risky proposition. Currency exchange rates will become more volatile, with implications on asset values, price inflation and economic growth (see Real economy suffers while financial markets stuff around with prices). For example, in Japan, real businesses are suffering as a result of the rising yen. The Germans, on the other hand, are secretly gloating whenever the euro weakens. In Australia, should the banking system fall into a crisis as a result of the bursting of the property bubble, the consequence of a resulting collapsing Australian dollar will be price inflation (see Can price inflation occur in the midst of debt deflation?).

If currency volatility goes to the extreme, investors will even have to question the idea of national currency as a store of value. So, what can investors and savers practically do to mitigate against this?

Quite some time ago, we talked to the guys at and learnt of how a lot of their clients (presumably the “rich”) use them. In case you do not know, (a regulated company operating in the financial services industry) enables

… you to hold gold, silver & platinum that is fully insured and stored securely in specialised bullion vaults in London, Zurich and Hong Kong. All metal is owned directly by you with no counterparty risk.

You can “easily buy gold, silver & platinum and take delivery of physical bars of gold.”

What their clients did was to use their account as a conduit to link their bank accounts all over the world. This strategy makes sense as it gives investors and savers the flexibility to shift their savings all over the world, using gold, silver and platinum as an anchor for the store of value. In an environment of currency volatility, this flexibility is a valuable aid in helping to protect your hard-earned savings from hare-brained government interventions.

However, for those who are ultra-pessimistic and distrust any assets that have any hints of paper, the only way to go is to take possession of physical gold and silver (see How to buy and invest in physical gold and silver bullion).

Currency crisis ahead? Part 1- Potential short squeeze on the US dollar

Tuesday, October 27th, 2009

Jimmy Rogers had been saying that he expects a currency crisis soon, maybe this year or next year. While we agree with Jimmy Rogers, that in itself is not particularly insightful. The difficulty is in predicting the timing of the currency crisis.

As we explained the dilemma of the world’s major creditor nations in What if the US fall into hyperinflation?, it is clear that the current status quo is an accident waiting to happen. The question is, in what form this accident will look like. Already, the rise of the Australian dollar and Brazilian real is described as “bubbles” by some pundits.

Unlike short selling of stocks, there is an unlimited supply of US dollars (which is the world’s reserve currency) that can be borrowed at effectively zero interest rates to be ‘shorted.’ Since the exchange rate of currencies are relative, shorting the US dollar is the same as going long on other currencies. As we said before in Return (and potential crash) of the great Aussie carry trade, this state of affairs is indeed a paradise for speculators.

Indeed, shorting the US dollar is so popular that central bankers of the creditor nations must be getting nervous. What if, the selling momentum gathers steam and snowball into a US dollar crash? There will be hell to pay should that happen. Possible outcomes of such a scenario include more bank collapses, trade war, hyperinflation and so on (see What Happens If the Dollar Crashes). Therefore, we expect coordinated central bank intervention in the currency markets soon to thwart such an eventuality. The longer they wait, the closer the point of no return will arrive. If coordinated actions are not forthcoming, individual unilateral actions will be taken (e.g. Brazil recently announced a tax on speculative capital), which is less desirable because the outcome tend to be more messy, unpredictable and contradictory to the objectives of other nations.

What will happen to the financial markets when central bankers really do that?

For speculators who are taking advantage of the higher and higher interest rates in Australia (i.e. borrow are zero in the US, buy AUD and then collect the higher interest yield), a rising US dollar will result in an instantaneous loss. Rising interest yields in Australia will not cover that loss since it has to be parked for an extended period of time to bear the returns. Therefore, speculators will pull their cash out of Australia immediately to buy USD. That in itself will result in the USD appreciating further, resulting in further losses for the existing speculators who have yet to pull their cash out, prompting them to panic and rush for the exit. For the speculators who are punting on the stock market, they will liquidate their stocks and rush for the exit too. The same can be said for the commodity markets, including gold and silver. This is a classic short squeeze, which will occur when the momentum and sentiments are at the extreme.

But this is just a better outcome. In the next article, we will talk about a possible Black Swan in November that may trigger a real currency crisis.

What can spark a USD rebound in the short term?

Tuesday, October 13th, 2009

Back in April last year, we wrote in What if the US fall into hyperinflation?, countries like China, Middle East and Russia will be taking two-pronged action:

1. Slowly and quietly diversify away their US dollar reserves. Obviously, none of these countries will be doing so while talking about it with their megaphones- the US dollar will crash straight away if they act so foolishly.

2. Since there is so much to lose from a collapsing US dollar, we can be sure that central bankers around the world are collaborating together to avert a sudden loss of confidence in the US dollar. If possible, they may even want to engineer a rise.

The first point is old news. Blogs and the mainstream media have reported on that extensively (e.g. US dollar rout gains momentum). Everyone knows that. The strong down-trend in the US dollar is testament to the fact that the majority are shorting the US dollar. The carry trade that we wrote in Return (and potential crash) of the great Aussie carry trade is an example of such.

The problem with the first point is that given the strong down-trend of the US dollar, foreign central bankers must be getting worried that selling of the US dollar can eventually become a ‘bubble,’ which implies a crash in the US dollar. Therefore, we can expect that something will be done sooner or later in the name of ‘preserving’ their export trade. It is time to be on alert for a short-term US dollar rebound, which is likely to be coupled with falling stock prices (see Indicator turned bearish despite high in index) and falling gold prices. Indeed, this little news article has been reported in the Financial Times:

Asian central banks intervened heavily in the currency markets on Thursday to stem the appreciation of their currencies against the US dollar amid fears that their exports could be losing ground against China.

The mainly south-east Asian countries have been spurred to defend the competitiveness of their currencies by China?s decision to in effect re-peg the renminbi to the dollar since July last year.

The question is whether these currency interventions will be coordinated or haphazard among the central bankers. But we can be sure that interventions will increase as the rout of the US dollar continues.

But make no mistake about this: in the long run, the US dollar will weaken.

Has gold moved on to a secular shift?

Thursday, September 17th, 2009

Since we wrote Explosive gold price movement ahead. But up or down? more than 2 weeks ago, gold prices had moved up from US$953 to US$1020 at the time of writing. In terms of Australian dollars, gold prices had not moved much. This break-out of gold prices from a narrow trading range had sparked excitement and derision among the proponents and opponents of gold. But beneath all these chatter and excitement, there are a few interesting trends that we would like to highlight to you:

Declining central bank gold sales
For decades, central banks were net sellers of gold, culminating in the Bank of England’s sale of half its gold holdings in 1998 at the bottom (‘perfect’ timing for the British right?). But over the past couple of years, European central banks are getting less keen to sell their gold. Between 2004 and 2009, under the Washington Agreement, central banks can sell at most 2500 tonnes of gold on a net basis. But only 1867 tonnes were sold. In September this year, another 5-year agreement was signed, permitting at most 2000 tonnes of gold to be sold. In 2009, only 140 tonnes of gold were sold. So, among the signatories of the Washington Agreement, there is a falling trend in the quantity of gold being sold by central banks. At the same time, the central banks of emerging countries (e.g. Russia) are making clear their intention of increasing their gold reserves. For example, Russia announced their aim of increasing their gold reserves from 2% of total reserves to 10%. According to specialist gold analyst Jeff Nichols, the world may be at a turning point whereby central banks is moving from being net sellers of gold to net buyers of gold.

China increase its gold reserves through domestic production
Last year, China suddenly announced that they had increased their gold reserves by 76% since 2003 (454 tonnes) through domestic purchase of their gold production. Over that time, China became the world’s largest gold producer. It is reported that China exports none of their domestic gold production and even banned the export of silver.

Hong Kong recall its gold from London
Recently, Hong Kong recalled its physical gold from London (see Hong Kong recalls gold reserves from London) to be stored in its own storage depository facilities. It is widely believed that this will help Hong Kong be a regional trading hub. There are marketing plans to convince Asian central banks to transfer their gold reserves to Hong Kong. At least one company is planning to launch a gold ETFs? that stores its gold in Hong Kong’s new depository.

Chinese government pushing gold and silver to the masses
Before 2002, it is illegal to own gold in China. Today, the situation is completely reversed. As?China pushes silver and gold investment to the masses reports,

Apparently China is pushing the idea of buying gold and silver for investment purposes to the general population in the way that Western television sells soap powder.

The report notes that China’s Central Television, the main state-owned television company, has run a news programme letting the public know how easy it is to buy precious metals as an investment.? On silver investment the announcer is quoted as saying ” China has introduced its first ever investment opportunity for silver bullion. The bars are available in 500g, 1kg, 2kg and 5kg with a purity of 99.9%. Figures show that gold was fifty times more expensive than silver in 2007, but now that figure has reached over seventy times. Analysts say that silver has been undervalued in recent years. They add that the metal is the right investment for individual investors and could be a good way to cash in.”

This has fuelled a belief that since the Chinese government are convincing the masses to buy gold, then they will not allow gold prices to slump in order not to alienate the masses.

China openly expressed its lack in confidence in the US dollar
China, with US$2 trillion of US dollar assets are not happy with the Fed’s policy of currency debasement. Six months ago, Chinese Premier had already expressed his worry of the US dishonouring its debt through the path of monetary inflation (see Nations will rise against nations). In this article, Cheng Siwei, former vice-chairman of the Standing Committee and now head of China’s green energy drive openly expressed the Chinese government’s dismay at American monetary policy. He said,

We hope there will be a change in monetary policy as soon as they have positive growth again.

If they keep printing money to buy bonds it will lead to inflation, and after a year or two the dollar will fall hard. Most of our foreign reserves are in US bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen, and other currencies.

Gold is definitely an alternative, but when we buy, the price goes up. We have to do it carefully so as not to stimulate the markets.

This is leading many to believe that China will scoop up to buy gold at the dips, thus a ‘put option’ for gold.


This is getting interesting. Notice the two opposing forces (by two different groups of big boys) at work?

Rumours of China diversifying their US dollars

Tuesday, April 21st, 2009

Back in January 2008 (15 months ago), we wrote 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. Therefore, any threat to the long-term value of their savings will be a long-term threat to their economy.

The US is ‘printing’ their dollars into existence from thin air to fund their stimulus and bailouts at a time when the credit-worthiness of their financial system flounders in a deteriorating economy. Needless to say, the Chinese must have doubted that their hoard of US dollar reserves will function as a reliable store of value in the days to come. So what can they do? As we wrote twelve months ago, in What if the US fall into hyperinflation?, we wrote,

Since a collapsing US dollar means terrible unimaginable consequences, we expect countries like Europe, China, Middle East and Russia to be doing something quietly in the background. But it is not easy because if they do so in a hurry, there will be severe disruption in the financial markets, turning a US dollar rout into a self-fulfilling prophecy. What can these countries do? We see two major courses of actions:

  1. Slowly and quietly diversify away their US dollar reserves.  Obviously, none of these countries will be doing so while talking about it with their megaphones- the US dollar will crash straight away if they act so foolishly.

Today, we are hearing of rumours among mainstream economic commentators that the Chinese are buying up commodities (notably copper) as a means to diversify away from their US dollars. Not only that, there is a recent trend of the Chinese buying up stakes in resource companies (Rio Tinto, Oz Minerals) and spending money on resource investments all over the world (including Africa and South America).

Not only that, the Chinese are setting up currency swap agreements with their trading partners so that their yuan could be directly used for trade instead of using the US dollar as an intermediary. Some commentators are speculating that this is a Chinese scheme to set up their yuan as a world reserve currency.

In the months and years to come, the Chinese’s intention will become clearer. This will not be good for the US dollar. But if other countries are also inflating their currencies in order to fund their budget deficits, bailouts and stimulus, then the devaluation of the US dollar will not be apparent. Instead, it will show up as rising gold and commodity prices and the return of price inflation.

If gold has no intrinsic value, is it a bubble?

Tuesday, March 17th, 2009

Today, we just received a comment from one of our readers,

I got two emails in my inbox today from sources I subscribe to that made me think of you and your hoard of gold. Firstly, the view of a smart guy who knows a lot about investing:

Gold is very expensive

Secondly, the views of another smart guy who knows a lot about technical analysis:

Gold Divergence Poses A Question

I think the gold/oil ratio is particularly telling, in that a gold bubble began forming in late 2008. Like I said previously, I don?t want to try to timing getting out of gold and into real assets, but good luck to you.

We took a read at the first link and saw this:

I know the gold bugs will hate this idea – because it harks back to the argument against gold – which is that it has no intrinsic value.

This is one of the most common argument against gold. While this argument is true in itself, the person who wrote that sentence has clearly forgotten the mirror image of that argument. As we wrote in October 2006 at Is gold an investment?,

This is because with its extremely limited industrial use, gold will not be worth that much at all.

So, we will repeat this point again: Gold has no intrinsic value. So, if gold has no intrinsic value and if you see its price going up, it is easy to conclude that it is a bubble. Now, having established the fact that gold has no intrinsic value, we will ask a mirror image question. What intrinsic value does a crisp piece of paper called the US dollar has?

You see, like gold, a crisp piece of US dollar has no intrinsic value too! There are completely no industrial uses for that piece of paper called the US dollar. Now, ask yourself this question: if that piece of paper called the US dollar has practical industrial use or is consumable the way tissue paper and tooth-pastes are, do you think people will still want to treat it as money? Now, imagine if one day the US government decree that all tooth-pastes become legal tender for payment and settlement of debt (i.e. function as money), how would you feel if you have to physically consume your money daily for the sake of oral hygiene?

Therefore, as we said before in Properties of good money, one important property of money is that it must not be something that is consumable. The only way for this property to be fulfilled is for money not to have any intrinsic value.

Now, back to gold. As we wrote before in What should be your fundamental reason for accumulating gold?,

We accumulate gold not just simply because we believe its ?price? is going up (though we think it is most likely to be so as a side effect?in case you are confused by what we mean, read on). This is because if we do so, the implication is that we are calibrating the value of gold in terms of units of fiat paper money (see Entrenched perception on the value of paper money).

Therefore, the fundamental reason for accumulating gold is not to ‘make’ money. The reason why you do so, is because you lack confidence in legal tender money. The bull market for gold since 2001 is an indication of a declining confidence in legal tender money, which like gold, has no intrinsic value. So, if you are very suspicious of central bankers playing hanky panky with the crisp piece of paper money called the dollar/ poound/ yen/ franc/ yuan/ etc, then your only alternative is to exchange those funny paper for physical gold.

Now that you understand this very fundamental point, what if you are still concerned about timing the market? If you are getting more and more suspicious of legal tender money (or getting more and more worried of a doomsday scenario), then market timing will be the least of your concern. Sure, you may want to time the market to get the maximum bang (gold) for your buck (paper money). But if market timing is still your over-ridding concern, then you are really missing the big picture. If you see gold price going up and up, it means you will have much greater worries than just market timing.

But if after all these explanations, you are still concerned about marketing timing, Marc Faber has this to say in his latest commentary:

I really dislike being called a gold bug. I wish I could be positive about the global economy and social and geopolitical condition, but the more I think about current condition, the more depressed I become. Amidst a global slump I believe that we are moving toward high inflation (a further depreciation in paper money?s purchasing power), evil fascism, and vicious military confrontations. In theory, gold would be the best asset to own in this condition. Also, in theory, gold should be the perfect insurance against economic, social, and political Armageddon. However, I have some reservations.

For one, gold has already experienced a powerful bull market between 2001 and the present. As a result, gold has become relatively expensive compared to equities and the CRB Index. I am not suggesting that this outperformance of gold compared to other commodities and equities cannot continue. In fact, I believe that in time one Dow Jones will buy less than one ounce of gold. However, near term, gold would seem to be both over-bought against the Dow Jones and the CRB Index. I concede that the overbought condition of gold compared to the Dow Jones and compared to the CRB Index could be corrected by a strong rebound in the Dow and the CRB Index rather than a further downward correction in gold. My bet would be that the CRB Index has significant rebound potential and…

The other concern I have about owning physical gold (and as I just said, I am holding on to my physical gold) is that things will get one day so bad in the world that governments will expropriate gold, as the US did in 1933. This is unlikely to happen this year but it is a concern I have for the long term, especially if gold rallies to several thousand dollars per ounce as a result of money printing by all central banks or because of wars! As Voltaire remarked, ?it is dangerous to be right when the government is wrong.?

Whether you should be buying, holding or selling gold today will depend on your personal circumstances, which includes what percentage of your wealth are currently in gold, your level of suspicion against fiat money and your level fear for a doomsday scenario. But remember, having some gold is better than having zero gold.

Nations will rise against nations

Sunday, March 15th, 2009

A few days, as reported widely in the news media, Chinese Premier Wen Jiabao said at a press conference that

We have lent huge amounts of money to the United States. Of course we are concerned about the safety of our assets.

To be honest, I am a little bit worried and I would like to … call on the United States to honour its word and remain a credible nation and ensure the safety of Chinese assets.

Those words, when translated into English in writing, sound bland. But if you watch what he said in full video in the original language, then you will be able to appreciate the immense gravity of the situation from the tone of his voice.

But dear readers, you must understand that Premier Wen was just stating the obvious. There’s nothing new in what he said. All you have to do is to turn back to what we wrote in December 2006 and read Will the US dollar collapse? and Awash with cash?what to do with it? to see the big picture of what’s going on for years. As we wrote back then,

Lately, we are again hearing that central bankers are murmuring about diversifying their foreign reserves away from the US dollar. Does it mean that there is an imminent liquidation of their US dollar reserves? Well, this is not the first time they murmured about it and it is definitely not in their (including the Federal Reserve?s) interest to see a collapse of the US dollar. The Chinese, with their US$1 trillion of reserves, would not want to see their stockpile of US dollars to lose significant value.

That paragraph was written in the final days of 2006. Today, China’s US dollar reserve had doubled from they had more than 2 years ago. The major difference between today and back then is the emergence of the Global Financial Crisis (GFC).

Thanks to the GFC, the status quo, which had been running for decades, is stressed towards a breaking point (but who knows, perhaps that inevitable  breaking point could still be delayed for longer before an almighty snap happens). There are far too many contradictory and conflicting interests among nations.

For the US, as we said before in How is the US going to repay its national debt?, is facing a situation in the coming decades of having to pay a colossal amount of public debt. The public sector is facing a massive debt many times its GDP from the unfunded Medicare and social security liabilities. With the GFC, the US government is transferring more and more private debt to the public sector through bailouts, handouts and stimulus. It is either the US mobilise its monetary printing press to massively inflate away (i.e. print copious amount of money) all these debts or they face up to the reality that they are bankrupt and go through the cold turkey of an almighty deflationary collapse (read: almighty depression). If the US chooses the former, China will be furious because that will be doing the very opposite of what Premier Wen called on the US to do, namely to “honour its word and remain a credible nation and ensure the safety of Chinese assets.”

Unfortunately, the big problem is that the US (along with countries like Australia and UK) has been de-industrialising and hollowing out its economy for a very long time, while the China has been doing the opposite. To put it simply, the US is consuming more and more while China produces more and more. This gross imbalance has been playing out for too long. With the GFC, the US consumers are effectively bankrupt and cannot borrow any more to buy from China. China has lost its biggest customer and is in trouble too.

The coming G20 Summit will be filled with countries with conflicting agendas. The US (and UK) wants more stimulus (and of course, bailouts when required), which can only happen if they print money (i.e. devalue the US dollar), which is as good as spitting on China’s face. Europe (headed by Germany and France) wants the focus to be on regulations and prevention, which means they are less keen on stimulus and bailouts. This is because the latter will involve the tax-payers of countries like Germany rescuing the tax-payers of other EU nations. China, on the other hand, wants an overhaul of the current world order so that they can have more power and say to better reflect their status as America’s creditor. Obviously, the US will not like that because that will mean they have to voluntarily descend for an ascending China.

There are plenty of temptations to take the easy way out. For example, if the Chinese expect the US to inflate away their debts by printing money and thereby, devaluing the US dollar, they will be likely to devalue their RMB in order to continue the process of hollowing out the US economy. The US (and the Europeans), in response, could impose trade barriers on Chinese imports. The Chinese could retaliate by dumping their holdings of US Treasuries. Remember, these are just examples of what may happen and they are by no means predictions. But we trust that you get the idea here.

Therefore, outwardly, the world may be at peace. But inwardly, we believe there will be jostling for power, influence and resources between the major nation blocs. Bigger nations will use smaller nations as pawns, international armed non-state groups will intensify their activities and inter-ethnic conflicts will arise. We have no doubt that there will be plenty of Black Swans appearing in the days to come.

Changing the rules of the game

Monday, December 15th, 2008

Next year, the US government needs to borrow US$1.5 trillion to pay for its expenditure. Up till the end of November 2008, $4.16 trillions worth of spending programs were endorsed by the US government to bail out Wall Street and stimulate Main Street. There are rumours that the upcoming President Obama will sign in a trillion dollar economic stimulus package when he takes office next month.

Not too long ago, hundreds of millions of dollars were an unimaginable sum of money. After a while, the concept of million is replaced by the billion. Today, trillion supplanted the billion. How much money is a trillion dollars? Imagine you have a stack of US$1000. For that stack to reach $1 trillion, guess how high it has to go? The answer is: 109 kilometres! By comparison, the earth’s atmosphere is only 120 kilometres.

As we mentioned before in How is the US going to repay its national debt?, the US national debt stood at more than $4 trillion at the beginning of this year. With all these extra spending programs, bailouts, rescues and stimulus, it could easily more than double.

So, where is the US government going to get the money from? Will the Chinese, Japanese and Arabs be kind enough to lend them? Probably not, because the US government still owe these foreigners trillions of dollars of outstanding debt. Will they borrow from the American people? No, the American people are too deep in their own private debt to spare a dime. Will they tax the American people? No, because the US government want them to spend in order to ‘stimulate’ the economy. The only to do so is to shower them with even more money.

That leaves only one option- print money. The traditional way to do so is for the government to issue Treasury bonds to the Federal Reserve, which in turn conjures up the money from thin air to pay for them. But even then, at the rate at which the tide of financial destruction is going, the government cannot print fast enough. After all, there is a legal limit on the amount the Treasury Department can borrow. To break that limit, it has to seek the permission of Congress.

Is there a way to break tradition? In this recent Wall Street Journal article, it reported that the…

… Federal Reserve is considering issuing its own debt for the first time, a move that would give the central bank additional flexibility as it tries to stabilize rocky financial markets.

It isn’t known whether these preliminary discussions will result in a formal proposal or Fed action. One hurdle: The Federal Reserve Act doesn’t explicitly permit the Fed to issue notes beyond currency.

Just exploring the idea underscores many challenges the ongoing problems are creating for the Fed, as well as the lengths to which the central bank is going to come up with new ideas.

So, they are thinking of new ‘ideas’ to change the rules of the game in the middle of the session? Remember what we wrote in Recipe for hyperinflation:

One thing we have to be clear. Assuming that the ?rules? are strictly adhered to, there will only be one outcome for the current credit crisis: deflation.

Since the current structure of ?rules? will be too restrictive in such a war against deflation, there will be popular momentum towards the bending and rolling back of these ?rules.? If they press on relentlessly till the final end, there can only be one outcome: the US dollar will be joining the long list of failed fiat paper money in the annals of human civilization.

China devaluing their currency

Monday, December 8th, 2008

A couple of days ago, one of our readers, Zoo said that

Anyone read anything about China devaluing their currency? Just read a rumour that they are telling the USA they may embark on a currency devaluation within the next 14 days.

Four days ago, in this news report,

The [Chinese] central bank has shifted the central peg of its dollar band twice this week in a calculated move that suggests Beijing aims to offset the precipitous slide in Chinese manufacturing by trying to gain further export share abroad.

So far, devaluation is not a official government policy yet. But it has already sent shivers down the spine of many observers. To understand why, read on…

Firstly, many regard such a move by the Chinese as deflationary. If it is deflationary in the sense that Chinese-produced goods merely become cheaper, then it is not so much of a problem. After all, it is such kind of deflation (or rather, disinflation) that allows much of the Western world to enjoy low interest rates, low inflation and high asset prices over the past several years. But if it is deflationary because of trade, employment and currency flow reasons, then it will be a more serious problem.

One thing is clear- President-elect Obama will not be happy with such a Chinese move. Obama called China a “currency manipulator” during his election campaign, which if becomes an official view of his administration, will carry penalties under US trade laws. The US retaliation will most likely come in the form of tariffs on Chinese goods. This will have an eerie echo of the 1930 Smoot-Hawley Tariff Act in which the US

… raised U.S. tariffs on over 20,000 imported goods to record levels. In the United States 1,028 economists signed a petition against this legislation, and after it was passed, many countries retaliated with their own increased tariffs on U.S. goods, and American exports and imports plunged by more than half. In the opinion of some economists, the Smoot-Hawley Act was a catalyst for the severe reduction in U.S.-European trade from its high in 1929 to its depressed levels of 1932 that accompanied the start of the Great Depression.

It is said that the Smoot-Hawley Tariff Act helped to worsen the Great Depression. This time, it will be a severe reduction in trade between China and the US (plus the Europeans as well). A sudden freeze in global trade in the midst of a global financial crisis is hardly conducive for global cooperation that is necessary to fight this crisis.

This is just round one.

As the situation deteriorates, the Chinese government may respond with a ‘bugger it’ attitude and liquidate its hoard of US Treasuries. The outcome will be as we wrote before in China unwilling to hoard US dollars?what?s the implication?. The Chinese had threatened that in August 2007 (see China threatens economic nuclear bomb) and the US had almost gone along that path in April 2007 (see US shooting own foot with tariff on Chinese goods).

Such developments will be the economic equivalent of a nuclear war between two superpowers. The world will not benefit and it will be an economic disaster in the global scale. As in the 1930s, there will be trade blocs led by China, Europe and America, which can even develop into overlapping political and currency blocs. The US dollar is likely to crash (see What if the US fall into hyperinflation?) in the sense that it will no longer become the world’s reserve currency. Such an environment can lead to military conflicts as the chaos of 1930s arguably contributed to the Second World War of the 1940s.

The official Chinese government stand is currency stability. But beneath this serene official stand, it is likely that factions are vying for the Emperor’s favour. We can only hope that there are no miscalculations.