Below is another great article from John Mauldin via his weekly newsletter.

John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to:http://www.frontlinethoughts.com/learnmore

From ghoulies and ghosties
And long-leggedy beasties
And things that go bump in the night,
Good Lord, deliver us!

–Old Scottish Prayer

Where the Wild Things Are is a beloved children’s book and now a beautiful movie. But in the investment world there are really scary wild things lurking about in the hidden recesses of the economic landscape. Today we look at one of the unintended consequences of the Federal Reserve’s low interest rate policy.

For quite some time, I have been arguing that we are faced with no good choices, not just in the US but in the entire "developed" world. I see a low-growth, Muddle Through world over the next years (with a double-dip recession just to liven things up). However, that does not mean that we will lack for volatility. Things could get volatile rather quickly. Let’s quickly set the background.

It Is Not Just Japan

Let’s look at today’s interest rate picture. Yesterday, we had the bizarre occurrence of banks actually paying the government to hold their cash. Three-month treasuries yield a miniscule 0.01% in interest. If you opt to buy a one-year bill you get all of 0.26%. You can see the entire spectrum below.

Look at the graph of the yield curve below. It is as steep as we have seen it in a long time. But that is almost the point. Banks are essentially getting free money. If you are a banker and can’t make money in this environment, you need to quit and find meaningful employment.

And that is part of the rationale that the Fed espouses with its low interest rate regime. Not only does it allow banks to repair their balance sheets, it also encourages investors to put money into riskier assets in order to get some return on their investments. Over $260 billion has gone into bond funds this year, and just $2.6 billion into stock funds. However, you have to balance that with the fact that some $400 billion has left money market funds paying less than 0.2%. So there is some movement to capture yield.

But is it just banks that are getting cheap money? And is encouraging investors to find riskier assets a sound policy? Maybe not.

The Euro-Yen Cross and the Dollar Carry Trade

I wrote a great deal in the past few years about the strong correlation of the euro-yen cross to stock markets all over the world in general. (The euro-yen cross is the exchange rate of the euro and the Japanese yen.) This was a proxy for the Japanese carry trade. The stock markets of the world rose and fell in synchronization with the yen versus the euro.

A currency carry trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.

The Japanese drove their rates down to essentially zero in the 1990s. By early 2007, it was estimated that the yen carry trade was over $1 trillion. But when the world credit crisis hit, the world wanted dollars. They paid back the yen and bought dollars, driving the yen higher and killing the yen carry trade. Who wants to borrow in a currency that continues to rise, even if the costs are low? And often, large leverage was used, so small movements in the currency could destroy outsized amounts of capital.

But now, there are some who are beginning to ask whether there is a dollar carry trade. In the last nine months, the correlation between the dollar and the stock market has gone to about 90%. If the dollar rises, the stock markets and other risk assets tend to fall, and vice-versa. It would appear that investors and funds are borrowing cheap dollars on a short-term basis and investing in all sorts of risk assets. Not only have stock markets risen, but so have high-yield bonds, commodities, and so on.

We have seen the steepest rise in US stock markets coming out of a recession since the end of the last world war. The market is "discounting" a 5% GDP next year and a profit rebound beyond anything in past experience. Depending on the quarter, operating earnings are expected to rise by anywhere from 30-40%. P/E ratios are back at 23, well above the 17 we saw in the summer of 2007 (I am using 4^th quarter 2009 estimates so as to not have to take into account the disastrous 4^th quarter of last year.)

Worrying about a dollar carry trade is not just a preoccupation of my friends Nouriel Roubini or David Rosenberg or Frank Veneroso. Look as this story from Bloomberg:

"China’s Liu Says U.S. Rates Cause Dollar Speculation

"Nov. 15 (Bloomberg) — The decline of the dollar and decisions in the U.S. not to raise interest rates have caused "huge" speculation in foreign exchange trading and seriously affected global asset prices, said Liu Mingkang, chairman of the China Banking Regulatory Commission."

"The continuous depreciation in the dollar, and the U.S. government’s indication, that in order to resume growth and maintain public confidence, it basically won’t raise interest rates for the coming 12 to 18 months, has led to massive dollar arbitrage speculation," he told reporters in Beijing today at the International Finance Forum.

"Liu said this has ’seriously affected global asset prices, fuelled speculation in stock and property markets, and created new, real and insurmountable risks to the recovery of the global economy, especially emerging-market economies.’

"His view echoes that of Donald Tsang, the chief executive of Hong Kong, who said the Federal Reserve’s policy of keeping interest rates near zero is fueling a wave of speculative capital that may cause the next global crisis."

"’I'm scared and leaders should look out,’ Tsang said in Singapore Nov. 13. ‘America is doing exactly what Japan did last time,’ he said, adding that Japan’s zero interest rate policy contributed to the 1997 Asian financial crisis and U.S. mortgage meltdown."

It is not just China. Brazil has moved to impose a tax (or tariff) on investment money coming into the country on a shorter-term basis, as they are worried about both a bubble in their markets and in their currency. Russia is openly considering similar policies.

I have been doing a lot of speaking in the last month. In almost every speech, I warn of the significant imbalance in the dollar. I walk to the very end of the stage to help illustrate that the world now has on a massive ABD trade. By that I mean Anything But Dollars. Everyone is now on the same side of the boat. They have borrowed dollars to buy other risk assets, assuming that the dollar, like the yen in the glory days of the yen carry trade, will continue to fall. Dollar bears are everywhere.

Explanations abound for why the dollar is a trash currency. It is Fed policy, or the Obama administration’s willingness to run massive deficits, or the trade deficit or our health-care policy or (pick any number of issues). But I wonder.

Global trade collapsed last year and well into this year. Global trade was essentially done in dollars. If global trade is down 20% or more, then there is less need for companies in various countries to hold dollars and more need for local currency because of the crisis. Thus, after a rush to safety in the credit crisis, there is a rational selling of dollars by business.

Look at the above chart. Notice that the dollar is roughly where it was 20 years ago. And notice the recent jump during the credit crisis. We are not even back to where we were before the crisis.

What happens if world trade picks back up, as it appears to be doing? Admittedly, it is not a robust recovery as yet, but it is rising. That means more need for dollars. And dollars which are being borrowed (and probably leveraged!) on the assumption the dollar will continue to fall.

And I agree that, over time, the case for the dollar is not as good as I would like. But in the meantime, we could have one very vicious dollar rally, which would take equity markets down worldwide, along with other risk assets. Why? Because it would be a major short squeeze.

Barron’s just did a survey. It revealed that the bullish sentiment on stocks is quite high and almost everyone hates US treasuries (graph courtesy of David Rosenberg of Gluskin, Sheff)

Whenever sentiment gets too strong in one way or the other, it is usually setting up the markets for a rally in the despised asset. Mr. Market like to do whatever he can to cause the most pain to the largest number of people.

I am not predicting a near-term crash or imminent precipitous bear, although in this environment anything can happen. I am merely noting that there is an imbalance in the system. The longer this imbalance goes on, the more likely it is that it will end in tears. And the irony is that a recovering world economy could be the catalyst.

The Wild Things? They may be hiding in a portfolio near you. Just food for thought. Stay nimble.

Source

Where the Wild Things Are – John Mauldin

Related posts:

• Chart of the day: Aussie – Yen cross
• Is the U.S. dollar carry trade replacing the one in Japanese yen?
• Japan’s easy money policy was the trigger for the tech wreck
• Mea culpa on the need for a new currency
• The dollar is rising against floating currencies

Max Keiser certainly has a way with words. In one of his latest TV appearances, using the colorful analogy of “Warren Buffett’s toilet paper,” he calls the U.S. dollar worthless.

He goes on to say that China is addicted to this worthless paper because they are using it to stimulate their domestic economy. In another memorable analogy, he labels this an “opium” addiction which will cost the Chinese dearly.

While the Chinese (and the Indians) are increasingly turning to gold as a currency alternative, it is fairly clear that China will have to eventually take an enormous haircut on its holdings of U.S. paper assets. One reason the Chinese are refusing to revalue the renminbi is their desire to forestall this eventuality – and with good reason. Last year, the Chinese central bank needed to go cap in hand to the Finance Ministry because the central banks U.S. dollar paper assets had so depleted the central bank of capital.

Keiser has a lot more to say. Very entertaining. Below is the video. It runs just under 5 minutes.

Related posts:

• China “serious about the plan to internationalise” Yuan
• China launches retaliatory investigation into U.S auto subsidies
• Japanese defend dollar’s status while China tears it down
• Quote of the day: China hopping mad about GSEs
• China wants to get rid of the dollar

On the eve of U.S. President Barack Obama’s visit to China, a major Chinese official has criticized U.S. monetary policy in unusually harsh language. Liu Mingkang, China Banking Regulatory Commission chairman said the zero interest rate policy of the U.S. Federal Reserve posed a “new systemic risk.”

Liu, using language reminiscent of warnings by NYU economist Nouriel Roubini and speaking at a financial forum in China’s capital Beijing, said:

This situation has already encouraged a huge dollar carry trade and had a massive impact on global asset prices… It is boosting speculative investment in stock and property markets and will pose new, insurmountable risks to the global recovery and, particularly, to the recovery in emerging markets.

In my view, this is pure political posturing by the Chinese in order to defuse any U.S. criticisms of Beijing’s currency peg. Call it a pre-emptive strike. The U.S. has seen the unemployment rate rise to 10.2% and the trade deficit rise quite dramatically as well. Many are blaming the Chinese and their currency peg to the U.S. dollar.

When Barack Obama visits China this week, the Chinese expect him to focus on the yuan dollar peg. His administration will find it increasingly difficult to hold protectionist pressures at bay given the yuan’s firm peg to the U.S. dollar even while the dollar has plummeted.  To prevent the U.S. from successfully painting the Chinese peg as the sole major risk to the global economic recovery, the Chinese must therefore point to the destabilizing effects from measures taken by the U.S. to reflate its domestic economy.

The Chinese have shown success thus far. Last week, Tim Geithner penned an Op-Ed in the Wall Street Journal along with the Finance Ministers of Indonesia and Singapore which pointed a critical finger at China by asking for “market-oriented exchange rates.” Yet when the APEC (Asian Pacific Economic Cooperation) summit in Singapore ended that same language was cut from the final commiunique.

On the other hand, there has been little change in the prospects of a revaluation of the yuan peg.

Reuters reports:

Chinese Vice Commerce Minister Chen Jian on Sunday played down talk of a shift in the central bank’s currency policy as well as mounting expectations of a rise in the yuan’s exchange rate.

Speculation that China might let the yuan resume its climb after a 16-month pause swirled after a change last Wednesday in the long-standing wording used by the People’s Bank of China to describe its currency stance.

In its third quarter monetary policy report, the central bank failed to refer to keeping the yuan "basically stable at a reasonable and balanced level" when discussing the outlook for the exchange rate.

Asked whether the PBOC was heralding a return to the gradual appreciation of the yuan against the dollar seen from July 2005-July 2008, Chen told Reuters: "I don’t think the central bank meant to say that."

And all indications suggest that we are now returning to the same unbalanced pre-crisis growth model – but with the global economy in a considerably more fragile state. In this climate, the issues of the yuan currency peg and low interest rates in the U.S. will continue to be front and center for some time to come.

Related posts:

• Chinese to start settling trade in Yuan
• China issues bonds to “promote the RMB in neighbouring countries”
• US angling to get Chinese to revalue renminbi
• China slams U.S. profligacy
• Is China avoiding using US dollars?

Is it just me or did Secretary Geithner just talk out of other side of his mouth? Today he wrote an Op-Ed in the Wall Street Journal with two Asian leaders to mark a big meeting of APEC (Asian Pacific Economic Cooperation) in Singapore.

The WSJ article started out with a bunch of diplomatic niceties about how everyone was working together and must continue to do so, so that all may prosper.

We have just lived through the greatest challenge to the world economy in generations. In acting together, policy makers have shown that they understand the most important lesson of this crisis: Our economies are inexorably linked. We must now work together to ensure strong, stable and balanced growth in the future…

We also must keep our sights on maximizing the potential of global markets. Both exports and imports remain critical stimulate the flow of knowledge and innovation that is enabling emerging economies to catch up with developed-world living standards.

Then it went on to re-affirm the utility of APEC, which people like Andy Xie are calling useless.

APEC will play an indispensable role in establishing strong, sustainable and balanced growth. Our 21 members—which include nine members of the G-20—account for 40% of the world’s population, over half of global GDP and nearly half of world trade. Our ranks include the world’s largest and fastest-growing economies.

But, you kind of got the feeling, this was leading to something else. Wait…wait… hold it… there it is – halfway through paragraph six:

Depending on individual economies’ circumstances, a combination of macroeconomic policy adjustments and structural reforms will be needed. Market-oriented exchange rates in line with economic fundamentals will be essential in assuring the resource and sectoral shifts to match and foster the new patterns of demand.

Everyone knows they are talking about the Renminbi. Remember, Secretary Geithner is the same fellow who accused the Chinese of manipulating their currency during his confirmation hearings. And most people think a freer floating Renminbi would be revalued not devalued.

Yesterday, I posted “Geithner impersonates Nicholson – America, you can’t handle the truth” in which Secretary Geithner was saying he supports a strong U.S. currency, but today he is talking about “market-oriented exchange rates.”

C’mon. We’re not that stupid.

Related posts:

• US angling to get Chinese to revalue renminbi
• China “serious about the plan to internationalise” Yuan
• The dollar is rising against floating currencies
• Japanese defend dollar’s status while China tears it down
• Geithner and Summers consolidate power

Tim Geithner has issued a Code Red on the U.S. dollar, but he doesn’t think Americans can handle it.

I believe deeply that it’s very important to the United States, to the economic health of the United States, that we maintain a strong dollar.

Secretary, I have just one more question. If you gave an order that the dollar wasn’t to be touched and your orders are always followed, then why would the dollar be in danger?

I want the truth!

You can’t handle the truth!

I have a greater responsibility than you can possibly fathom. You weep for the dollar, you curse the U.S. Government. You have that luxury. You have the luxury of not knowing what I know – that the dollar’s death, while tragic, probably saved lives. And, my existence, while grotesque and incomprehensible to you, saves lives.

I have neither the time nor the inclination to explain myself to a man who rises and sleeps under the blanket of the very freedom that I provide and then questions the manner in which I provide it.

Did you order the Code Red?

You’re goddamn right I did.

Source

Geithner Says Strong Dollar ‘Very Important’ to U.S. – Bloomberg

Happy Veterans’ Day (especially to my dad, uncles and aunt and all of those no longer with us)

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Andy Xie thinks the Fed is on an inflationary path.  Last month, he wrote an article in Caijing which says that ‘stagflation lite’ is the Federal Reserve’s preferred outcome. What’s interesting is his recent article about the need for China and Japan to join forces under an ASEAN umbrella, rejecting the APEC umbrella shared with the U.S.

In last month’s article, Xie said:

The bottom line is that, regardless what central banks say and do, the world will be awash in a lot more money after the crisis than before — money that will lead to inflation. Even though all central banks talk about being tough on inflation now, they are unlikely to act tough. After a debt bubble bursts, there are two effective options for deleveraging: bankruptcy or inflation. Government actions over the past year show they cannot accept the first option. The second is likely.

Hyperinflation was used in Germany in the 1920s and Russia in late 1990s to wipe slates clean. The technique was essentially mass default by debtors. But robbing savers en masse has serious political consequences. Existing governments, at least, will fall. Most governments would rather find another way out. Mild stagflation is probably the best one can hope for after a debt bubble. A benefit is that stagflation can spread the pain over many years. A downside is that the pain lingers.

If a central bank can keep real interest rates at zero, and real growth rates at 2.5 percent, leverage could be decreased 22 percent in a decade. If real interest rates can be kept at minus 1 percent, leverage could drop 30 percent in a decade. The cost is probably a 5 percent inflation rate. It works, but slowly.

If stagflation is the goal, why might central banks such as the Fed talk tough about inflation now? The purpose is to persuade bondholders to accept low bond yields. The Fed is effectively influencing mortgage interest rates by buying Fannie Mae bonds. This is the most important aspect of the Fed’s stimulus policy. It effectively limits Treasury yields, too. The Fed would be in no position to buy if all Treasury holders decide to sell, and high Treasury yields would push down the property market once again.

I certainly agree with him. You don’t have to be in the hyperinflation camp like Marc Faber to think the Fed takes Ken Rogoff’s suggestions about 6% inflation seriously. In a May post, I said:

Basically, the Fed wants to inflate our way out of this depression – that’s the dirty little secret.  There is really no other policy choice because the mountain of debt in the United States is immense.  And I think Bernanke, Geithner and Summers have proven they are willing to do anything to reflate this economy and avoid debt deflation dynamics.

And when I say anything, I mean create asset bubbles that are being given intellectual cover by the likes of Frederic Mishkin. This is a policy of economic weakness.

So what should the Asians do?  China is desperate to employ its tens of millions of countryside transplants cruising its cities in search of urban employment. That’s a major reason it keeps its exchange rate fixed to a plummeting dollar, making not just Americans but Europeans irate?  Japan has been in a modern day depression for twenty years. Its sovereign debt-to GDP is now over 200%, risking a downgrade.

Xie says the two should join forces – in part as a rejection of the U.S., which he basically calls a fading power (although the paragraph above points to serious weaknesses in China and Japan as well).

Here is an excerpt of Xie’s article:

Yet the fundamental case for Japan to increase integration with the rest of Asia and away from the United States grows stronger every day. Despite high per capita income, Japan remains an export-oriented economy, having missed an opportunity to develop a consumption-led economy in the 1980s and ’90s. In the foolish belief that rising property prices would spread wealth beyond the industrial heartland in the Tokyo-Osaka corridor, the government of former Prime Minister Kakuei Tanaka pursued a high-price land policy, discouraging the middle class from pursuing a consumer lifestyle as they saved for property purchases…

The point is that Japan has a strong and genuine case that favors more integration with East Asia. The United States is unlikely to recover soon and with enough strength to feed Japan’s export machine again. There is no more room for fiscal stimulus. Devaluing the yen to gain market share is not an option as long as Washington pursues a weak dollar policy. Without a new source of trade, Japan’s economy is doomed. Closer integration with East Asia is the only way out…

Five years ago, I wrote an op-ed piece for the Financial Times entitled China and Japan: Natural Partners. At the time, a prevailing sentiment was that China and Japan were antithetical: Both were still manufacturing export-led economies and could only gain at the other’s expense. I saw complementary demographics and capital: Japan had a declining labor force and China needed to employ tens of millions of youths migrating to cities from the countryside. China needed capital and Japan had surplus capital. And their trade relations indeed tightened, as Japan had increased the Chinese share of its overall trade to 17.4 percent in 2008 from 10.4 percent in ‘04.

Today, the situation has changed. China has a capital surplus rather than a shortage. Demographic complementarity is still good and could last another decade. As China shifts its development model from resource intensive to environmentally friendly, a new complementarity is emerging. Japan has already made the transition, and its technologies that supported the transition need a new market such as China’s. So even without a new trade agreement, bilateral trade will continue growing.

An FTA between China and Japan would significantly accelerate their trade, resulting in an efficiency gain of more than US$ 1 trillion. Japan’s aging population lends urgency to increasing the investment returns. On the other hand, as China prepares to make a numerical commitment to limiting greenhouse gas emissions at the upcoming Copenhagen summit on global warming, heavy investment and rapid restructuring are needed for its economy. Japanese technology could come in quite handy.

An FTA involving Japan and China would be a serious threat to American economic power. You can imagine that policy makers in Washington are opposed to this idea.  Let’s watch to see what kind of rhetoric comes out of Barack Obama’s China trip to see if this issue is discussed.

Xie’s article in its entirety is at the link below.

Source

Andy Xie: Why China and Japan Need an East Asia Bloc – Caijing

Related posts:

• Stephen Roach: Downturn in Asia less severe, but recovery later
• China: reflation play spells trouble for rest of the world
• Chart of the day: Aussie – Yen cross
• The Dollar
• China warns that the west’s quantitative easing is inflationary

I have said on a number of occasions that a sovereign nation that issues debt in its own fiat currency cannot default involuntarily.  The case most people point to as a counterfactual is Russia in 1998.  I mentioned Russia in a recent post:

Countries that have gone bust, Russia, Mexico, and Argentina were borrowing in foreign currency because of interest rate differentials. No sovereign nation which prints and issues debt in its own fiat currency can ever involuntarily be made insolvent.

I was on a trading desk that was dealing in synthetic GKOs before Russia defaulted in 1998, so I remember the incident quite clearly. Russia’s was not an involuntary default by a country which issues debt in its own fiat currency. Russia was a perfect example of a voluntary default due to huge foreign currency debt and foreign exchange reserve losses (see Wikipedia for a pretty accurate and thorough account on the events of the 1998 Russian financial crisis).

Marshall Auerback summed it up well in an email to me as we discussed this case in view of his post refuting chatter about Japan defaulting. Not the underlined words.

Russia didn’t have to default.  As a point of logic, the concept of ability to pay being inherently revenue constrained is not applicable to the issuer of a currency. Any such constraints are necessarily self-imposed (including various ‘no overdraft’ legislation in some countries for the Treasury at the Central Bank). The issuer can always make payment of its currency by crediting the appropriate account or by issuing actual paper currency if demanded by the counter party.

An extreme example is Russia in August 1998. The rouble was convertible into $US at the Russian Central Bank at the rate of 6.45 roubles per $US. The Russian government, desirous of maintaining this fixed exchange rate policy, was limited in its willingness to pay by its holdings of $US reserves, since even at very high interest rates holders of roubles desired to exchange them for $US at the Russian Central Bank. Facing declining $US reserves, and unable to obtain additional reserves in international markets, convertibility was suspended around mid August, and the Russian Central Bank has no choice but to allow the rouble to float.

All throughout this process, the Russian Government had the ability to pay in roubles. However, due to its choice of fixing the exchange rate at level above ‘market levels’ it was not, in mid August, willing to make payments in roubles. In fact, even after floating the rouble, when payment could have been made without losing reserves, the Russian Government, which included the Treasury and Central Bank, continued to be unwilling to make payments in roubles when due, both domestically and internationally. It defaulted on rouble payment by choice, as it always possessed the ability to pay simply by crediting the appropriate accounts with roubles at the Central Bank.

Why Russia made this choice is the subject of much debate. However, there is no debate over the fact that Russia had the ability to meet its notional rouble obligations but was unwilling to pay and instead chose to default.

Russia defaulted voluntarily, an event which the geniuses at Long-Term Capital Management failed to model correctly. Moreover, the immediate stress on Russia was not the rouble-denominated debt but the mountain of foreign currency obligations via an unrealistic currency peg which were draining reserves. Similar events unfolded in Argentina a few years later as their currency board crumbled and the Peso was devalued by three-quarters.

Again, the point is that a government can always make good on its own fiat currency obligations if it chooses to do so. The real question is why a country might voluntarily default on its own currency debt or involuntarily on foreign currency debt.  The answer usually has to do with taxes.  In Argentina and Russia, the government was unable to prove that its taxation policies were benefitting its citizens, creating rampant tax evasion, especially in the monied classes. Capital flight took form as many dodged taxes. Capital flight eventually turns into currency revulsion which creates the pre-conditions for depression, as Latvia, Estonia and Lithuania learned most recently.

The relationship these examples from the Baltics, Argentina and Russia have with Japan and the United States is taxes. When taxes seem unfair or excessive, the citizens evade taxes and eventually revolt; you end up with a situation like Russia circa 1998, Argentina circa 2002 or Zimbabwe circa 2007.

Related posts:

• Russia devalues currency again as foreign reserves plummet
• Latvia – the insanity continues
• The Age of the Fiat Currency: A 38-year experiment in inflation
• Argentina faces potential collapse
• Russia cuts Europe off completely from its gas

Marshall Auerback here. You saw Ed’s last post on China, quoting from Peter Tasker, one of the top analysts in Japan when I lived there. I take Peter’s insights very seriously. His analysis implies something a lot more in regards to currencies, trade and credit.

China’s bank credit expansion is so great that even if nominal GDP is up five to ten percent, the credit to GDP ratio will rise by about thirty percentage points.  It took Japan ten years to  take it up by fifty or sixty percentage points, and it has already been high in China before this credit boom. How high, no one knows because there is no good data on debt outside the banking system.  But there is such debt.  The debts of households and firms outside the banking system could be thirty percent of GDP.  The total ratio now could be 185%.  This is the same as Japan at the peak and close to the US now. 

This could keep China going for quite some time, but the consequences for Japan could be disastrous.  Indeed, for most of Asia, which could precipitate another crisis for them down the road.

One relatively unexplored aspect of the emerging Asia crisis of 1997 was what pushed these countries heavily into current account deficits.  But between 1992-94, China devalued the RMB by close to 60% (she was already running a current account surplus when she did it the second time), which created huge competitive pressures for the other countries and pushed them rapidly into deficit.  This time, China is devaluing along with the US dollar and reflating a credit bubble — not to encourage domestic demand, but to create a renewed export juggernaut, at a time of weak external demand.  This could really be problematic for the rest of the world.

I wonder how long before the protectionist pressures emerge?

Related posts:

• China is now on the same bubble path as Japan post-1987 crash
• The bullish argument for China
• G-20: China is clearly looking for a new world order
• Japanese defend dollar’s status while China tears it down
• China is now America’s largest creditor

This is the second straight month that the RBA has raised interest rates. From the Sydney Morning Herald:

The Reserve Bank has lifted its key interest rate for a second month in a row as it attempts to keep Australia’s economy on track for sustained growth.

Today’s widely tipped 25-basis-point increase raises the central bank’s cash rate to 3.5 per cent, marking the first back-to-back monthly increase by the RBA board since March last year when rates peaked at 7.25 per cent.

I remember seeing data showing that once central banks start raising rates, they continue to do so for months. They do not raise rates one month, then lower them the next and then reverse course. Does anyone have the data? This makes me suspect that rates are due to go higher globally rather than lower.

If you think this rate increase will lead to a global double dip because of underlying economic weakness, you should expect the yield curve to flatten. Operation Twist anyone?

Related posts:

• Norway makes three
• Interest rates, the pound and good news for Brits
• Credit markets are easing again
• RBA hikes rates 25 basis points in Australia
• Australia is set for a slowdown

Ireland has made heroic strides in trying to deal with its economic problem after a spectacular property bust. But it is looking increasingly like it will not be enough. According to a senior Irish minister, the next stop for Ireland could be the International Monetary Fund (IMF) for a bailout.

The crisis has been building for some time and I have documented some of the milestones here over the last 16-odd months.

• Jun 2008: Ireland: government blew the boom
• Sep 2008: Ireland guarantees bank deposits at six banks
• Nov 2008: Is Ireland the next Iceland?
• Dec 2008: Irish equities suffer largest losses in 215 years
• Feb 2009: Do BRICs (and Germans) Eat PIGS?
• Jul 2009: Depressionary bust in Ireland is echoed in California
• Aug 2009: Government banking Irish edition

Its bad bank – called the National Asset Management Agency (NAMA) – is the most ambitious of its kind and harkens back to the Swedish crisis solution of the early 1990s.  They are truly trying everything they can to revive their economy.  But, a fiscal crisis is looming.

A Fistful of Euros reports:

In April, a supplemental budget that was supposed to settle things for the rest of 2009 forecast a general government balance of -10.75 percent (of GDP) for 2009 and 2010.  Assuming the same package of cuts as the April budget did, the respected Economic and Social Research Institute has just forecast deficits of close to 13 percent for 2009 and 2010.  2 percent of GDP went missing from revenue projections over a few months.  To give credit where it’s due, the IMF never believed the government’s deficit forecasts even at the time they were formulated and forecast deficits of 12 percent in 2009 and 13 percent in 2010.

How big a deal is 2 percent of GDP?  Well, the Irish government has told the European Commission that it will have the deficit down to the Maastricht level of 3 percent of GDP by 2013.   Since the macroeconomic framework for Budget 2010 has already been set, that’s 3 budgets to achieve a fiscal adjustment of 10 percent of GDP, and formulated in the context of inability to reliably forecast tax revenue even 6 months ahead of time.   And the new forecasts allow for a relatively benign global environment relative to the dire projections of earlier in the year, so this is specifically a crisis within the Irish Exchequer.

There is zero chance the Irish are going to be able you make a fiscal adjustment of 10% of GDP in 3 years in a weak economic environment. And we know where this type of policy leads by looking at Latvia.  So, now it seems government officials are finally coming clean and admitting, much as Latvia has done, that the only way out of this fiscal crisis is a bailout plain and simple.

The FT reports:

A senior Irish minister has for the first time warned Ireland could be forced to go to the International Monetary Fund for help if the country cannot implement the necessary cuts in the December budget.

The bleak assessment by Mary Harney, health minister, and former deputy prime minister, was one of several ministerial warnings on Friday choreographed to bolster public opinion for what is set to be harshest budget in the country’s 88-year history.

Mrs Harney, a leading economic reformer, said: “We’re spending €500m a week more than we’re raising. That’s an unsustainable situation.

“If the government hasn’t the capacity to do what’s needed, then others will come in like the IMF and overnight they will make decisions.”

Given the fixed exchange rate into which Ireland is locked via the Euro, there will be no competitive currency devaluation.  So the spectre of banking collapse is still a force with which to reckon. Monies from the IMF will certainly reduce the risk.

Related posts:

• Trouble in Ireland as Fitch cuts debt two notches to AA- and deficits soar
• Ireland guarantees bank deposits at six banks
• Ireland nationalizes Anglo Irish bank
• Irish unemployment gaps up by most in 40 years
• Ireland: government blew the boom

In what looks to be a central line of attack in the quest to re-balance the global economy, the Treasury Department has ratcheted up the rhetoric against China’s currency peg. The Treasury’s semiannual report to Congress slammed the Chinese for their lack of exchange rate ‘flexibility,’ but stopped well short of accusing the Chinese of currency ‘manipulation’ as Tim Geithner had claimed during his confirmation hearings before Congress.

Bloomberg reports:

“Both the rigidity of the renminbi and the reacceleration of reserve accumulation are serious concerns which should be corrected to help ensure a stronger, more balanced global economy consistent with the G-20 framework,” the report said. “The Treasury remains of the view that the renminbi is undervalued.”

China’s foreign-exchange reserves, the world’s biggest, surged in the third quarter as an economic recovery attracted speculative capital and a weak dollar boosted valuations of its yen and euro assets.

Record Reserves

The holdings climbed about $141 billion to a record $2.273 trillion, the People’s Bank of China said this week. That was less than the unprecedented $178 billion gain in the second quarter.

The Obama administration wants China to “pursue policies that permit greater flexibility of the exchange rate and lead to more sustainable and balanced economic growth,” the report said. The U.S. will continue to push China to allow the yuan to appreciate in two-way meetings and through meetings of officials from the Group of 20 nations.

People’s Bank of China officials have called this year for an alternative to the dollar as a global reserve currency. At the same time, the issue hasn’t been a central point of debate at recent international summits like a meeting of Group of 20 leaders in Pittsburgh last month.

If Treasury is looking to burnish its populist credentials, making these statements to Congress where protectionist and populist sentiment is running high is certainly the place to do it.  The question is: what’s your endgame?

Right now the US dollar is looking weak despite Mr. Geithner’s advocacy for a stronger dollar.  If you ask China for more exchange rate flexibility, you clearly are not serious about a strong dollar – and everybody knows it.

Here’s how I see things playing out:

• Congress looks at this report and concurs that the key to ending slower global growth is to correct global imbalances via a Chinese currency revaluation. Fair enough.
• However, individual Congressmen, looking to reassure jobless constituents ahead of the midterm elections, will escalate by presenting bills to ‘punish’ China if no actions are taken.
• China will be aghast at this and, in a further escalation, start making noises about ditching the dollar.

At this point, the question is how does this get resolved.  To date, bilateral U.S.-Chinese economic tensions have escalated and led to protectionism. Further escalation will yield unpredictable results and will be destabilizing. Chinese officials cannot be seen by their domestic constituency caving to American pressure.  This would undermine their authority and create problems domestically. Therefore, a public frontal assault on the renminbi peg is likely to backfire.

Like Stephen Roach, I see protectionism as the largest threat to global recovery. Let’s hope the Administration is aware of the dangers.

Related posts:

• China “serious about the plan to internationalise” Yuan
• Japanese defend dollar’s status while China tears it down
• Mea culpa on the need for a new currency
• China slams U.S. for inflating global asset prices via carry trade
• Is China avoiding using US dollars?

This is a cross-post from an article I wrote at the finance site New Deal 2.0, a one-stop-shop for current news, sharp analysis and potential solutions of the country’s fiscal crisis. Edward linked to this in this morning’s links, saying “I don’t agree 100% but this is a good overview” – tied to the Austrian business cycle theory as he is!

He asked me to post this here as well. I hope this will help identify some of the flaws in conventional economic orthodoxy.

Fears about the falling dollar are stoked by neo-liberal money myths that harken back to the gold standard system.

It seems there isn’t a day that goes by without more commentary on the demise of the dollar and the concomitant risk of a collapse of the world’s reserve currency. Again, the reasoning here appears largely to be based on the tyranny of orthodox neo-liberal economics. Orthodox economists view dollar depreciation as an imminent danger which raises the relative costs of imports, and imparts an inflationary bias to the economy. Moreover, they argue that depreciation leads to expectations of further depreciation and fuels the run out of the currency.

So, in the logic of this view, there may be no interest rate that is high enough to counter expectations of losses due to depreciation and possible default, which means that there will be no alternative but to urgently restore reserves of foreign currency either through renegotiation of foreign debt obligations, international donor assistance or default, especially given our supposedly “reckless” and “irresponsible” government spending, which is supposedly robbing future generations of growth and prosperity.

Large deficits are not the problem

Let’s all take a deep breath here: Whilst the dollar index has fallen some 15% from the high sustained earlier this year, it is still above the lows sustained at the height of the credit crisis reached about a year ago. Secondly, there seems to be a fear that the current fall in the dollar could well engender inflation, and create a panicked response from policy makers where the Fed actually does raise rates and the Treasury begins to reduce government spending. Given high prevailing debt levels and the weak state of the consumer’s personal balance sheet, this would be an unmitigated disaster.

It is true that excessive government deficit spending can be inflationary, and could therefore cause some impact on exchange value of dollar. But this can’t be viewed in some sort of vacuum. The size of the deficit is irrelevant in itself. There is no meaning in the terms ‘large deficit’ or ’small deficit.’ You have to relate them to the extent of labor and capital underutilization, which is a human measure of the aggregate demand deficiency. The fact that labor underutilization is now in excess of 16 per cent in the US (combined unemployment, underemployment and hidden unemployment) and capacity utilization is in the 60-65 per cent range rather than 90 per cent range sends one very clear message – the deficit is not large enough.

So the correct policy response is to spend until we get to full employment. That is the only consequence of excessive deficits — insolvency is not possible. Your social security check will never bounce in a country issuing debt in its own freely floating non-convertible currency.

The size of our government deficit is endogenously determined, which is to say that it has no external cause; it is a function of internal, domestic phenomena. Today, the deficit is largely a function of weaker spending power and concomitantly lower economic growth. (”Good government spending” more or less seeks to fill private output gaps; “bad government spending” is a consequence of government not taking responsibility for filling the spending gap and instead letting this occur via the automatic stabilisers). So the scenario of ever-increasing deficits is unlikely because as economy heats up, deficit shrinks and turns to surplus (as during the Clinton years and also the 1920s).

The orthodox interpretation of a nation with a declining currency and a large current account deficit appears to indicate that the nation concerned is “living beyond its means” — with excessive domestic demand that boosts imports; the excessive demand also fuels inflation that restricts exports. The presumption is that the resultantly large deficit must be “financed” by flows of foreign reserves, which, for the most part, must be attracted by high returns and a stable political, economic, and social environment.

From the US perspective, this means that if America cannot continue to attract these needed reserves, it must raise rates to attract new foreign capital, which in turn will slow its growth to reduce imports; lower prices and wages could also encourage exports. The obvious portent of the default on foreign debt obligations is then used to argue in favour of restricting government spending. Thus, both monetary and fiscal policy ought to be tightened to encourage such capital flows even as this reduces the need for them. In other words, an emerging markets’ crisis writ large.

Deflation or inflation?

But the reality is not so much that the US is inflating, so much as that the rest of the world is deflating relative to the dollar. Import prices are still generally falling, inflation remains quiescent and private credit growth is now contracting. These are hallmarks of deflation, not inflation. Additionally, the US is not borrowing in a foreign currency (in contrast to Iceland or Latvia or the Asian countries during the 1997/98 emerging markets’ crisis), so it does not face an external funding constraint.

What about China? True, there may be some indications that there is some shifts in terms of private portfolio preferences. Perhaps the Chinese don’t want to buy as many dollars as they did before. Perhaps hedge funds are now laying on a big “short dollar” trade in the markets. These are one-off portfolio preference shifts and it seems inadvisable for US policy makers to respond to every single vicissitude of changing market sentiment. That way leads to Latvia and economic implosion.

It’s hard to believe that a nation with 10% official unemployment and likely double that when one factors in underemployment is actually “living beyond its means.” It is even crazier to suggest that we should scale back government spending and private consumption, when there is substantial unused capacity and under-utilised resources (particularly labour). In those circumstances, the nation could not possibly be living beyond its means.

What about those terrible “global imbalances” that we are told must be rectified, what I call “the cult of zero imbalances”?

Well, let’s consider that as a possible policy response.

Policy fables

According to the G20 communiqué, those countries running current account deficits, most notably the U.S., would have to define ways to boost savings. Nations running surpluses – China, Germany and Japan, among others – would detail how they propose to reduce any reliance on exports. The U.S. would likely need to commit to a sharp deficit reduction by government. Europe would need to commit to improving competitiveness. That could mean introducing “labour market reforms” (an interesting choice of language here), which generally is code for being able to sack workers and destroy the power of trade unions.

The collective impact of these measures? We want more domestic led consumption in Asia and the EU (especially Germany), but then the two largest economic areas (the US and Europe) would have to deflate their economies. The former, by reducing the public net spending which would thwart the goal of “boosting” saving, and the latter, by widespread shedding of workers and the resulting collapse in consumption (and rising deficits via the automatic stabilizers as welfare payments and crime rose).

These, of course, are the traditional “remedies” proposed by the IMF — and we can see what a great job this organisation has done. Just ask any Argentinean. Neo-liberal-based policy recommendations almost invariably make things worse. We have ample examples of this in Asia, Russia and Brazil during the 1997/98 emerging markets and more recently in Iceland and the emerging market economies of Eastern Europe.

Goldbug mentality still dominates

It is important to understand that much of the economic orthodoxy is still dominated by the “gold standard paradigm”.

Under the Gold Standard, the leading economies of the world, through their monetary authorities, agreed to maintain the “mint price” of gold fixed by standing ready to buy or sell gold to meet any supply or demand imbalance. Further, the central bank (or equivalent in those days) had to maintain stores of gold sufficient to back the circulating currency (at the agreed convertibility rate). The currency was strictly convertible into gold at the fixed parity. So this was a convertible, fixed exchange rate system.

Gold was also considered to be the principle method of making international payments. Accordingly, as trade unfolded, imbalances in trade (imports and exports) arose and this necessitated that gold be transferred between nations (in boats) to fund these imbalances. Trade deficit countries had to ship gold to trade surplus countries. Money literally did “flow” between countries (which is why we still speak in terms of “capital inflows” and “capital outflows” even though the reality of current modern monetary operations is that we electronically credit and debit bank accounts).

This inflow of gold into surplus countries allowed them to expand their money supply (issue more notes) because they had more gold to back the currency. This expansion was in strict proportion to the gold-currency parity. The rising money supply would push against the inflation barrier (given no increase in the real capacity of the economy) which would ultimately render exports less attractive to foreigners and the external deficit would decline. The trade deficit country would lose gold reserves and this would force their government to withdraw paper currency which drove up unemployment and drove down the price level. The latter improved the competitiveness of that economy. The two adjustments – for the surplus and deficit countries — helped to resolve the trade imbalance. But it remains that the deficit nations were forced to bear rising unemployment and vice versa as the trade imbalances resolved.

So under the Gold Standard, the government could not expand base money if the economy was in trade deficit. It was considered that this constraint acted as a means to control the money supply and generate price levels in different trading countries which were consistent with trade balances. The domestic economy, however, was forced to make the adjustments to the trade imbalances.Monetary policy became captive to the amount of gold that a country possessed (principally derived from trade).

In practical terms, the adjustments to trade that were necessary to resolve imbalances were slow. In the meantime, deficit nations had to endure domestic recessions and entrenched unemployment. So a gold standard introduces a recessionary bias to economies with the burden always falling on countries with weaker currencies (typically as a consequence of trade deficits). This inflexibility prevented governments from introducing policies that generated the best outcomes for their domestic economies (high employment). Ultimately the monetary authority would not be able to resist the demands of the population for higher employment.

We no longer have this currency system, but traditional economic thinking and modelling is still based on it, which is why notions of “affordability” and “sustainability” still dominate our economic discourse. But given that we operate under a fiat currency system (where government declares money to be legal tender), we face no operational constraint per se, or issues of national solvency.

So, in regard to the dollar, what is our advice to Lawrence Summers, Tim Geithner, and Ben Bernanke? Do nothing. In the words of the English poet, John Milton, “They also serve, who only stand and wait”.

Related posts:

• The dollar is rising against floating currencies
• The Cult of Zero Imbalances
• Hyperinflation, national bankruptcy, dollar crash and other exaggerations
• Japan does not demonstrate the failure of stimulus
• Japanese defend dollar’s status while China tears it down

Earlier today I wrote a post featuring comments by Marc Faber as I like to do from time to time.  In this particular case Dr. Faber was waxing prosaically about an eventual bankruptcy of the U.S. government.  His money quote was:

“Next station is when the U.S. government goes bust.”

I love this guy. Quite frankly, the man is a quote machine.  He makes a lot of outrageous statements that get him noticed.  Here are a few that I have featured in the past:

• Oct 2009 – “Monetary policy in the United States will stay expansionary”
• Sep 2009 – “The future will be a total disaster, with a collapse of our capitalistic system as we know it today, wars, massive government debt defaults and the impoverishment of large segments of Western society.”
• May 2009 – “I am 100% sure that the U.S. will go into hyperinflation”
• Mar 2009 – “The feds poured the gasoline and lit the match. Now they’ve joined the fire department”
• Nov 2008 – “I advise every American to hold his gold outside of the United States”
• Mar 2009 – “Don’t underestimate the power of printing money.”

The last one is my all-time favorite.  And there are many more available on this site and elsewhere.  Dr. Doom is very entertaining indeed – which is why I quote him so often.  But, is he right?

That’s a good question – one I will take up indirectly by introducing the latest piece by Martin Wolf, another author I have featured here from time to time. You may have seen me tweet this earlier today. I had intended to add it to the links for tomorrow, but Niels Jensen, who I also feature here often, convinced me to write it up as an ‘antidote’ to Faber.

Here’s how Wolf begins his article:

It is the season of dollar panic. These panic-mongers are varied: gold bugs, fiscal hawks and many others agree that the dollar, the dominant currency since the first world war, is on its death bed. Hyperinflationary collapse is in store. Does this make sense? No. All the same, the dollar-based global monetary system is defective. It would be good to start building alternative arrangements.

This is exactly what the Chinese are doing. They are preparing themselves for a non-dollar future. This is why the Chinese are buying gold. This is why the Chinese are settling trade in Yuan. And this also why the Chinese are getting a bunch of other countries onside.  But they are not looking for a dollar crash as I indicated last week.

Then, there is the part about Dollar weakness being a sign of inflation. Here’s what Wolf has to say about this idea:

The dollar’s correction is not just natural; it is helpful. It will lower the risk of deflation in the US and facilitate the correction of the global “imbalances” that helped cause the crisis. I agree with a forthcoming article by Fred Bergsten of the Peterson Institute for International Economics that “huge inflows of foreign capital to the US facilitated the over-leveraging and underpricing of risk”.* Even those who are sceptical of this agree that the US needs export-led growth.

I hope this argument sounds familiar because it is one I made when I asked is the Fed just jawboning? The U.S. wants – it needs a lower dollar to avoid deflation. Quantitative easing is not solving the deflation question. The U.S. government wants a strong dollar? Well, policymakers say one thing and wish for another. The U.S. insistence on focusing on global imbalances at the G-20 should tell you what policy makers really want. This is why the dollar is falling. 

The problem of course is that the dollar’s recent rout is not necessarily helping the U.S. because the dollar is overvalued vis-a-vis a host of pegged currencies. And while those currencies are under pressure to drop the peg, they are resisting because they do not want to move toward a more re-balanced global growth paradigm unless forced to do so.  Unless these countries (read China) do something on the currency front, expect more of this, this and this – protectionism.

Then, the question arises, if everyone hates the dollar, what are they moving to? Wolf says:

Finally, what can replace the dollar? Unless and until China removes exchange controls and develops deep and liquid financial markets – probably a generation away – the euro is the dollar’s only serious competitor. At present, 65 per cent of the world’s reserves are in dollars and 25 per cent in euros. Yes, there could be some shift. But it is likely to be slow. The eurozone also has high fiscal deficits and debts. The dollar will exist 30 years from now; the euro’s fate is less certain.

This view may be too complacent. The danger of a collapse of the dollar is small and of its replacement by another currency still smaller. But a global monetary system that rests on the currency of a single country is problematic, for both issuer and users. The risks are also growing, particularly since the emergence of “Bretton Woods II” – the practice of managing exchange rates against the dollar.

I liken this argument to George Soros’ comments on dollar weakness: "The dollar is a very weak currency except all the others." Right now, there is no alternative to the dollar.  Some people are fleeing U.S. assets if they can. But the alternatives are limited and this limits how far the dollar will fall. And this is unfortunate because the monetary system now in place is in need of change.  Without it, we are likely to see nationalistic policy responses to economic weakness, which will induce conflict.

Wolf says:

I arrive, by a somewhat different route, at the same conclusion as Mr Bergsten: the global role of the dollar is not in the interests of the US. The case for moving to a different system is very strong. This is not because the dollar’s role is now endangered. It is rather because it impairs domestic and global stability. The time for alternatives is now.

Apropos alternative monetary systems, we might start with Paul Davidson’s ideas, which I first highlighted here in November.  So there is no hyperinflation, no U.S. national bankruptcy, and  no dollar crash coming. But, the financial crisis demonstrates we are living on borrowed time and need a new monetary system. The time is now.

Source

The rumours of the dollar’s death are much exaggerated – Martin Wolf

Related posts:

• Marc Faber: “U.S. dollar weakness is a symptom of inflation in the system”
• China to diversify out of U.S. dollars
• Japanese defend dollar’s status while China tears it down
• The latest dollar rout revealed
• Hayek: “I am not only against inflation but I am also against deflation.”

Below are two videos from Marc Faber’s recent interview on Asia Confidential.  In it, he takes questions from user emails in regards to the U.S. dollar, economic decline in the U.S. and gold as an investment.

He sees a need for the U.S. to borrow increasing amounts of money going forward – not less. As a result, what was a crisis in finance in 2008, resulting in the nationalization of Fannie Mae and Freddie Mac will become a national bankruptcy. The U.S. will borrow and print money. The dollar will fall precipitously. Then, “next station is when the U.S. government goes bust.”

Edward here. This might make for good headlines on Bloomberg, but it is patently false.  The United States is not now or ever going bust. A sovereign government which borrows in its own currency in a fiat currency system can never go bust. An entity which borrows and prints its own money does not have the same constraints that, say, California or Ireland have. How prices are affected is another issue altogether.

That’s where gold comes into the picture. Here, there are many questions.

• Is it overvalued?
• Is it a good inflation hedge?
• How does gold perform in deflationary environments?
• How does it perform against equities over the longer run?
• What about silver?

Faber takes on all of these.

On the whole, he is an inflationista and does not believe the U.S. will suffer deflation. When asked how gold might perform in a significant deflationary environment, he responds “first of all, I would like to make a very clear statement. I will believe in deflation once we have a significant period of U.S. dollar strength. U.S. dollar weakness is a symptom of inflation in the system.”

He goes on to say that gold outperforms other asset classes in a deflationary environment and is therefore a good hedge against fiat currency revulsion whether one expects deflation or inflation.

My own view is similar. However, I would differentiate between consumer price inflation, which will remain non-existent while industrial capacity and employment levels are at depressionary levels.  The inflation in the system will manifest itself first in asset prices – with industrial and food commodities or oil being the transmission mechanism into consumer prices.  Secular consumer price inflation will not return until the slack in the system is purged. 

I would add that this is one principal reason that the Great Moderation occurred despite enormous money printing in Japan and extraordinarily loose monetary policy in the U.S.  After China, India and Eastern Europe joined the capitalist system, the enormous increase in labor – both skilled and unskilled – acted as a check on inflation of the consumer price variety.

Alan Greenspan was fooled by this and kept monetary policy too loose. The result was asset bubbles again and again.  Going forward, it would comforting to see central banks target asset prices not just to gain policy traction through reflation but in order to cool the economy through deflation.

Related posts:

• China to diversify out of U.S. dollars
• Quote of the day: William White and inflation
• The inflation – deflation debate redux
• Morgan Stanley warns of a new inflationary period
• Bernanke is responsible for the market meltdown

There is an enormous dichotomy in foreign exchange markets that has wide-ranging implications for the global economy.  In Europe, most currencies float freely against the U.S. dollar. In Asia and the Mideast, most do not.

What this has meant in practice is two things. First, as the U.S. dollar has weakened, it has done so only against those currencies which are free floating. This has meant the lion’s share of any adjustments in global imbalances have fallen on the likes of Japan and Germany. Second, those countries which are pegged have had to resort to currency intervention and a massive build-up of foreign reserves to stop their currencies from appreciating.  This is inflationary for those countries, and is one reason there is a housing and equities boom in Asia right now.

But, as the dollar continues to weaken, those countries with pegs will be under pressure to drop their peg or to revalue their pegs higher.  The Bloomberg video linked below explains. The dichotomy whereby the adjustment process is done only through free-floating currencies is inherently unstable – and invites a nationalistic response.

A busted peg in any major U.S. trading partner’s currency is likely to have a very negative psychological impact on currency markets and severe knock-on effects.  These are what I call digital events.  It’s all or nothing, on or off. Either the peg is revalued enormously or there will be continuing pressure.

As an example, look back to 1998 when the Russians attempted to devalue the ruble.  The immediate effect was a sense that the ruble was not devalued enough, leading to an all-out assault on the currency and a much more massive devaluation which in turn triggered default.

I would anticipate a similar albeit less pronounced dynamic were the Chinese or the Saudis to revalue significantly.  There would be tremendous downward pressure on the greenback globally, more pressure on the busted pegs and increasing pressure on other pegged currencies to revalue. The result, of course, would be higher interest rates in the United States and a likely double dip.

Busted pegs are not something I necessarily expect. However, this is the type of exogenous shock that is a clear downside risk to my more benign muddle through baseline scenario – and one reason to prefer gold over bonds in reducing exposure to equities.

Currencies Pegged to Dollar May Abandon Greenback: Video – You Tube

Related posts:

• The dollar is rising against floating currencies
• The Big Mac Index
• The Dollar
• Is the Fed just jawboning?
• U.S. Dollar: Cliff Diving Again

Marshall Auerback here.  I want to add a few thoughts on the situation in Latvia which Ed has highlighted on several occasions. His allusion to Argentina to describe the situation in the Baltics last July was on the money. I have a solution here out of the Argentine playbook.

In Latvia, the neo-liberal insanity continues.  The EU and IMF have told the government to borrow foreign currency to stabilize the exchange rate to help real estate debtors pay the foreign-currency mortgages taken out from Swedish and other banks to fuel its property bubble, raise taxes, and sharply cut back public spending on education, health care and other basic needs to “absorb” income. Higher taxes are to lower import demand and also domestic prices, as if this automatically will make output more competitive in export markets.

But Latvia doesn’t produce much to export. The Baltic States have not put in place much production capacity since gaining independence in 1991. Latvia, like other post-Soviet economies, has scant domestic output to export. Industry throughout the former Soviet Union was torn up and scrapped in the 1990s. (Welcome to victorious finance capitalism, Western-style.) What they had was real estate and public infrastructure free of debt – and hence, available to be pledged as collateral for loans to finance their imports. Ever since its independence from Russia in 1991, Latvia has paid for its imported consumer goods and other purchases by borrowing mortgage credit in foreign currency from Scandinavian and other banks. The effect has been one of the world’s biggest property bubbles – in an economy with no means of breaking even except by loading down its real estate with more and more debt. In practice the loans took the form of mortgage borrowing from foreign banks to finance a real estate bubble – and their import dependency on foreign suppliers.

So instead of helping it and other post-Soviet nations develop self-reliant economies, the West has viewed them as economic oysters to be broken up to indebt them in order to extract interest charges and capital gains, leaving them empty shells.

The sad part about this whole episode is that Latvia’s problems could be fixed over a weekend. Here’s what I would do:

1. Drop the peg to the euro, which functionally acts like an gold standard external constraint.
2. Don’t answer the phone when the foreign creditors call the government.
3. Have the banks declared insolvent, convert their external debt to equity, and then have them reopen that way on Monday with full deposit insurance guaranteed in the now free floating local currency.
4. Enact a 0% rate policy (use fiscal policy to regulate demand going forward).
5. Offer a local currency minimum wage job that includes healthcare to anyone willing and able to work as was done in Argentina after the Kirchner regime repudiated the IMF’s toxic package of debt repayment.

Full employment and economic prosperity would come in no time at all.

The last line is the key.  Improve employment and aggregate incomes and demand follows – as does creditWORTHINESS.  At the final stage, credit will follow.

Even a banker can figure that one out.

Related posts:

• China is set up for a big fall
• China issues bonds to “promote the RMB in neighbouring countries”
• Bloomberg talks Eastern Europe as Latvia downgraded
• Latvia as the new Argentina redux
• China can handle collapse of speculative inflows

I tend to think so. Yesterday, Ben Bernanke made what some media outlets are calling hawkish statements.  This, combined with heavy currency intervention by Asian central banks, helped to strengthen the U.S. dollar. However one must ask if there is anything fundamental about these moves.

Just a few days ago, we got a sensational article via the British Daily the Independent in which a well-respected journalist suggested that a move was afoot to move away from the greenback as the globe’s main reserve currency.  This sent the dollar into freefall against a host of major free-floating currencies and gold to an all-time high. I wrote a skeptical post about the report at the time (see my post here). And I think the currency intervention demonstrates why.

Many of the Asian currencies are pegged to the U.S. dollar.  So when the greenback declines in value, they are forced to intervene in currency markets to maintain their pegs.  if they do not and allow their currencies to appreciate, this hurts export growth in Asia.  So clearly, the central banks in Asia do want to upset the apple cart by permitting a freefall in the value of the dollar.  Asia is too dependent on export to the U.S. for this to be a preferred policy at this juncture.

Meanwhile, the U.S. does not want a freefall either. Certainly, they want inflation (via a currency depreciation if necessary) but they do not want higher interest rates which is what a freefall would mean. So the Fed is jawboning the market.  First, we saw Kohn and Fisher out making hawkish statements. now it’s Bernanke’s turn. 

What Bernanke actually said is that the federal reserve was prepared to withdraw liquidity in a number of ways, the most interesting of which was the so-called reverse repo by which the Fed finances its own portfolio via the banks instead of the of the way around (see story here). Bernanke also mentioned paying interest on reserve deposits, a topic he has broached before.  But, the bottom line is this:

My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period.

This is what Bernanke said in his presentation.

Translation: We are keeping rates at zero percent for the indefinite future, something Bill Dudley at the New York Fed has said as well. The bottom line is that despite what hawks like Hoenig or Fisher might say, we are going to be on easy street for some time to come.

Related posts:

• Asian inflation in the pipeline
• The dollar is rising against floating currencies
• Big Mac Index: Europe overvalued, Asia undervalued
• Currencies pegged to the dollar under pressure to drop peg
• Federal Reserve’s Fisher says tightening will be aggressive

Gold hit a record high of $1,044.30 an ounce, beating the previous record of $1,032.35 set back in March and up a monster $26 on the day. The impetus is the crashing dollar, brought down by a report (later denied) that OPEC states and the Chinese were organizing a secret abandonment of the US dollar (see story here).

It is still rising.  In fact all commodities are rising sharply against the dollar. WTI Crude is up 2%, oat futures are up 3%, wheat futures are up 4 1/2%,  and corn futures are up almost 7%. And, we are seeing parabolic moves in silver (up almost 6%) and copper (up over 3%) as well.

But, of course, the Dow is up over 160 points despite this news of dollar revulsion. A little gallows humor over at Zero Hedge captures the mood amongst the shorts (hat tip Scott). This rally is absolutely turbo-charged. Can nothing take it down?

Sources

Spot gold – Kitco

Commodity futures – Bloomberg

Related posts:

• The dollar collapses
• The dollar rally spells trouble for some investors
• Has anyone noticed the Dollar has gone into freefall?
• US Dollar rising dramatically
• Chart of the day: US Dollar

The U.S. dollar is getting crushed again today.  I have been waiting to see if and when it hits parity with the Swiss Franc. Today’s action brings us that much closer. The dollar is losing ground against the dollar bloc (Kiwi, Aussie and Loonie) as well as against the Franc and Euro.

What gives? Allegedly, a plot by central banks to dump the dollar, according to British daily the Independent.

In the most profound financial change in recent Middle East history, Gulf Arabs are planning – along with China, Russia, Japan and France – to end dollar dealings for oil, moving instead to a basket of currencies including the Japanese yen and Chinese yuan, the euro, gold and a new, unified currency planned for nations in the Gulf Co-operation Council, including Saudi Arabia, Abu Dhabi, Kuwait and Qatar.

Secret meetings have already been held by finance ministers and central bank governors in Russia, China, Japan and Brazil to work on the scheme, which will mean that oil will no longer be priced in dollars.

The plans, confirmed to The Independent by both Gulf Arab and Chinese banking sources in Hong Kong, may help to explain the sudden rise in gold prices, but it also augurs an extraordinary transition from dollar markets within nine years.

Let’s call this dollar revulsion.  Now, I am sceptical about the authenticity of all of this revulsion.  But, it is having an affect on currency markets.  While I see the U.S. dollar as a weak currency, I am not convinced that anyone (except maybe Iran or Venezuela) thinks it is in their best interest to provoke a disorderly depreciation. The Chinese, with their $1 trillion in reserves, have a vested interest in preventing a disorderly move away from the U.S. currency.

Nevertheless, people are talking. FT Alphaville reports Jim Grant taking this very seriously:

This is not new news of course, for such a change from dollar pricing to some other methodology has been discussed, rumoured, tossed about for months, but this time we note that Japan and France are involved in the meetings and that changes the tenor of the rumours entirely. Too, the addition of the Saudis and the Emirates AND Kuwait to the meetings adds further importance and seriousness to the threats…

The article in The Independent becomes quite serious in that The Independent has not been given to such rumours in the past. This is not The Sun, nor the NY Post.

Is it curtains for the U.S. currency?  Maintain a healthy dose of scepticism.  But, I will say this: if the dollar does decline, Bernanke and the gang will be high-fiving it up and down the corridors of Washington because the dirty little secret is the U.S. wants currency depreciation. Policy makers in America want inflation.  This gets them out of a policy cul-de-sac and certainly helps the U.S. to increase savings without government deficits via an invigorated export sector.

Who hates this: the Swiss especially (see here and here).

Stay tuned.

See also: Plans to Move Away From Dollar Pricing of Oil – Naked Capitalism

Related posts:

• Japanese defend dollar’s status while China tears it down
• Mea culpa on the need for a new currency
• The weak dollar trade regains momentum
• China to diversify out of U.S. dollars
• Is China avoiding using US dollars?

One other reason to sell the dollar is interest rates.  Why not borrow in dollars where interest rates are low and invest elsewhere where yields are high?  This is what is known as the carry trade.

In the past decade, the Japanese yen and the Swiss franc were favorites for the carry trade because of their low yields.  But now, the U.S. dollar presents the same opportunity due to the likelihood that rates will stay low for a long time to come.

The video below explains.

See also Is the Dollar Set to Become the New Yen? from Market Beat.

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• Is the U.S. dollar carry trade replacing the one in Japanese yen?
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I just finished reading a Financial Times article about the likely coordinated global policy solutions to emerge from the upcoming G-20 meeting in Pittsburgh.  It does not sound like there is a huge amount of consensus. Indeed, it sounds like there is a lot of finger pointing regarding what the true causes of the financial crisis were.

China expressed scepticism on Thursday about a US and European push to launch an effort to tackle global economic imbalances at next week’s G20 summit in Pittsburgh.

Zhou Wenzhong, China’s ambassador in Washington, said: “People should not focus on only one thing, that is balancing the economy.” The International Monetary Fund should concentrate on doing a better job of monitoring the build-up of financial risks.

Translation: You lot in the West created a house of cards in the financial sector to fund a drunken binge of excess consumption. Your guy Stephen Roach even says so. Clearly, this is where we need to focus future reforms.

Edward here.  Don’t take my word for it that this is what the Chinese are saying.  Later in the same article, we get the following from Ambassador Zhou:

Imbalances were “certainly not the root cause of the problem”, Mr Zhou said. “The root cause of the crisis is the lack of supervision and abuse of the openness of the market, very risky levels of leverage and too much speculation.”

Unfortunately for Zhou, this is not the interpretation of events being drawn in the West.  Western officials are more interested in correcting ‘global imbalances.’

“Global imbalances have to add up to zero, so if the US is going to be less the consumer and importer of last resort then other countries are going to need to be in different positions as well,” a senior administration official told the Financial Times recently.

Britain, France and other European nations are backing a push on global imbalances at the G20 summit. Gordon Brown, the UK prime minister, said this week: “When I attend the G20, I will be putting the case for a global compact for growth and stability for now and for the future.”

Brown and the other Western leaders are not denying responsibility for the global meltdown as directly as Zhou seems to.  Nevertheless, you must realise that this is a coordinated effort to re-focus the policy debate on China, its pegged currency, trade surplus and huge accumulation of foreign currency reserves.  I call this the Blame Asia meme. I would be curious to hear what the Brazilians, Indians and Russians are saying about all of this.

The question is whether this tiff over who caused the crisis in the first place will impede consensus about coordinated global policy going forward.  No one country or set of policy makers covered themselves in glory in the lead up to this panic.  Yet, because the same set of individuals is still at the table, we now see greater interest in putting a positive spin on past events than on moving forward in a constructive way.

Correct me if I am wrong.  It sure looks like we shouldn’t expect anything substantive to result from the G-20 meeting in Pittsburgh.

Source

China scorns focus on imbalances – FT

Related posts:

• Tear gas and rubber bullets at G-20 Protests
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The U.S. Dollar fell to its lowest against the Swiss Franc and Euro, while the Canadian dollar and the Scandinavian currencies are also near year highs as well.  If you read Bloomberg, you might think this has to do with a bullish equity market call as the dollar’s status as a safe haven is less needed.

(video embedded below)

But, the facts don’t add up.

• Equity markets sold off globally last week.
• Gold is now above $1000 an ounce.
• Commodities are rallying against the dollar as are commodity currencies.
• The Chinese are trying to internationalise their own currency and talking of moving out of dollars
• Ken Rogoff and Joseph Stiglitz are among prominent economists talking the dollar down.

The downward move in the U.S. dollar has everything to do with a fundamental weakening of appetite for U.S. dollars and much less to do with safe haven status.

Related posts:

• U.S. Dollar: Cliff Diving Again
• U.S. Dollar: Cliff Diving
• Conservatorship of GSEs is bad for the dollar and inflation
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• Rosenberg: The U.S. dollar could be next

In the latest move toward China’s long-term strategy of internationalising its currency, the Chinese Ministry of Finance announced today it will issue government bonds valued at 6 billion yuan in Hong Kong.

The last article I wrote on this subject was a little over a week ago when the Chinese Vice-Premier Wang opined that the government was looking for ways to make the Yuan a more international currency.  I see this statement by the Finance Ministry as putting paid to those words.

The yuan bond issue, worth about $879 million, will ‘‘promote the RMB in neighboring countries,’’ referring to the renminbi currency, ‘‘and improve the yuan’s international status,’’ the Finance Ministry
said in the statement on its Web site.

‘‘The first step toward internationalization is regionalization,’’ Shi Lei, a foreign currency analyst at Bank of China in Beijing, said in an interview. ‘‘China wants to develop the offshore market in Hong Kong.’’

While domestic banks like Bank of China and the Export-Import Bank of China have already been issuing yuan-denominated bonds in Hong Kong for a couple of years, at the encouragement of Beijing, this is the first time that government bonds, the equivalent of treasuries, are to be issued. The bond sale is set for Sept. 28.

Source

China to Sell Government Yuan Bonds in Hong Kong – Deal Book – NY Times

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• Industrial & Commercial Bank of China

According to an account published in the Daily Telegraph by Ambrose Evans-Pritchard, the Chinese government is quite anxious about money printing in the United States and the effect this printing could have on China’s dollar denominated reserve assets.

For months now, the Chinese have signalled growing unease with U.S. monetary policy. And now comes the clearest signal yet that they are moving away from the dollar.  Cheng Siwei, a former vice-chairman of the Standing Committee, said point blank that the Chinese central bank was about to actively diversify new reserve assets away from the U.S. dollar and into currencies like the Yen and the Euro.  He also mentioned Gold as an alternative the Chinese are exploring.

The $2 trillion in U.S. dollar reserves the Chinese already have are a sunk cost.  Going forward, the Chinese are free to do as they wish with incremental additions to reserves. To the degree that they sell dollars and buy gold, Yen or Euros, there can only be downward pressure on the U.S. dollar.

Cheng Siwei, former vice-chairman of the Standing Committee and now head of China’s green energy drive, said Beijing was dismayed by the Fed’s recourse to “credit easing”.

“We hope there will be a change in monetary policy as soon as they have positive growth again,” he said at the Ambrosetti Workshop, a policy gathering on Lake Como.

“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,” he said.

China’s reserves are more than – $2 trillion, the world’s largest.

“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,” he added.

The comments suggest that China has become the driving force in the gold market and can be counted on to buy whenever there is a price dip, putting a floor under any correction.

Mr Cheng said the Fed’s loose monetary policy was stoking an unstable asset boom in China. “If we raise interest rates, we will be flooded with hot money. We have to wait for them. If they raise, we raise.

“Credit in China is too loose. We have a bubble in the housing market and in stocks so we have to be very careful, because this could fall down.”

Mr Cheng said China had learned from the West that it is a mistake for central banks to target retail price inflation and take their eye off assets.

“This is where Greenspan went wrong from 2000 to 2004,” he said. “He thought everything was alright because inflation was low, but assets absorbed the liquidity.”

Notice the statements about an asset bubble in China and the admission that loose U.S. monetary policy is a transmission mechanism.  Cheng is right to worry about asset prices in addition to consumer prices as the Chinese economy has a huge amount of overcapacity right now and any inflation is bound to become apparent in asset prices first.

To be sure, there are other voices in Chinese officialdom that are striking a less alarmist tone. One cannot rely on the words of one Chinese official to represent policy makers in China.  And Cheng never said the Chinese are now actively diversifying away from the U.S. dollar. Nevertheless, Chinese officials have been talking along this dollar bearish line for months now and I tend to believe their words will lead to action.

That is, at a minimum, bullish for Gold and bearish for the U.S. Dollar.

Source

China alarmed by US money printing – Telegraph

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• The China gold announcement is not that significant
• Is China avoiding using US dollars?
• Bernanke is responsible for the market meltdown
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Chinese vice-premier Wang Qishan has been appointed to lead a taskforce to make the renminbi the currency of choice for trade settlements, especially with regional trading partners. HSBC economist Qu Hongbin believes this latest salvo in China’s intensifying efforts to ditch the dollar demonstrates the Chinese are moving sooner than most expect to internationalise their domestic currency.

Hu Xiaolian, vice-governor of the People’s Bank of China, is being enlisted to head the research division of the taskforce. Officials from six other central departments have also been drafted to the taskforce.

"China really wants to give a big push in internationalising the renminbi," notes Qu. "Of course it would be a multi-year, long-term process". Still, he adds, the initial stage of expanding the renminbi’s role in trade settlement could be "faster than many expect".

Since China recently became the world’s largest exporter and is the second-largest trading country, expanding the role of renminbi in cross-border trade settlement is "simply a catch-up game," says Qu. "I won’t be surprised if, in the next three to five years, around half of China’s annual cross-border trade is settled in renminbi rather than US dollars."

Given the high volume of China’s trade, even if half of its trade flows are settled in renminbi, that would make it "one of top three international currencies in the world." This, he adds, "will have a substantial impact, not only on China but also the global economy."

I still believe there is no currency that can replace the dollar as the world’s reserve currency in the next few years.  But, the Chinese certainly are hedging their bets.  Eventually, these efforts will bear fruit.

More here.

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• Chinese to start settling trade in Yuan
• Mea culpa on the need for a new currency
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