I believe that we are about to witness a market shift. For three weeks now the S&P 500 has been pushing above 1100 only to close below that level. Given the fact that there has been very little in the way of selling over the past 8 months, and given the extremely low volume, I think the preponderance of evidence suggests that we are at a market top. I would give equal chances to the S&P first touching either 900 or 1150. Therefore I believe the risk profile of the market justifies being flat or short equities over the next 2 months or until there is a 10% correction.
I'm not sure how this will affect precious metals in the short run. The question becomes - if the equity markets do start to tank like last Sept/Oct. will the dollar keep its anti-correlation or will the dollar fall alongside? If the dollar falls with the stock market than gold and silver could very well rally (particularly gold.) At this point however, I am rather skeptical. Until silver breaks $21.5 and gold demonstrates it is uncorrelated with the stock market, I would be lightening exposure to precious metals as well.
Blog Archive
Thursday, December 3, 2009
Wednesday, December 2, 2009
Close to meeting the final condition for a gold breakout
Although it is totally obvious that gold has made strong price advances in the past few weeks, I thought it was worthwhile to mention the three conditions that I felt were needed for a sustainable gold advance. The first and most obvious, was for gold to break and hold above its previous nominal high of $1035. This happened in October. The second condition, which was met in November was for the dollar index (dx z9) to hit 75. The third is for silver and the gold equity index to break to new decade highs (~$21.5 in silver and 520 for the HUI.) Although this still has not occurred, we got very close to a new high in the HUI today (516.6).
It is also worth mentioning that in the past week gold has made and sustained a new all time high in euros.
The most important rule in money management is to establish and follow intelligent and appropriate levels of leverage and the use of debt/margin. A level of margin that is appropriate for one asset class, is most certainly inappropriate for another. Financial crisis is almost always born out of using too much leverage for a given asset class, or making false assumptions about future valuation/income. The market where this was most obvious in the past decade was the real estate market.
It is also worth mentioning that in the past week gold has made and sustained a new all time high in euros.
The most important rule in money management is to establish and follow intelligent and appropriate levels of leverage and the use of debt/margin. A level of margin that is appropriate for one asset class, is most certainly inappropriate for another. Financial crisis is almost always born out of using too much leverage for a given asset class, or making false assumptions about future valuation/income. The market where this was most obvious in the past decade was the real estate market.
Monday, November 9, 2009
2 conditions of gold breakout are met
This will be a short post simply to observe that 2 of the 3 conditions that I listed for a sustainable gold breakout have now been met. First, gold broke above nominal highs back at the beginning of last month. More recently the dollar broke important support at 76 and has now confirmed the break, touching 75 and "rejecting" a rally above 77. There is heavy selling in the dollar this morning.
The final condition - silver and the HUI index breaking to new decade highs- has not yet been met, but the HUI is looking particularly strong this morning, and is at a 20 month high. I expect silver to play catch up if and when doubt fades about the reality of our economic recovery.
There are plenty of reasons to think that economic recovery could continue for another few quarters. As I posted last month, the last 40 years of data show that moderate input prices lead to above trend growth. I define moderate input prices as quarterly prices that are below the local three year high. For example, crude prices reached an average of ~$120 in 2008Q2. As long as prices stay below that level, I would guess that the effect on the economy would be positive. Translating this to physical reality, prices below their old highs indicate the presence of slack in the system - in this case the ability of Saudi Arabia and the UAE to increase oil production by 1 to 1.5 million barrels a day.
The contraction of consumer credit is worrying but the increase in government debt can substitute for this. The economy can grow in spite of being run poorly and/or in an unsustainable way.
Until there is some sort of crisis in the interest rate market, or a major shift in the faith placed in the US dollar, the economy can continue to grow in an unsustainable way. And so long as this is true, it is very likely that the gold:silver ratio will continue to fall.
Since gold has already advanced so strongly, I am thinking of buying silver on a break out. Thus if silver breaks above $21.5 I would expect it to advance strongly and play "catch up" to the gold break out.
The final condition - silver and the HUI index breaking to new decade highs- has not yet been met, but the HUI is looking particularly strong this morning, and is at a 20 month high. I expect silver to play catch up if and when doubt fades about the reality of our economic recovery.
There are plenty of reasons to think that economic recovery could continue for another few quarters. As I posted last month, the last 40 years of data show that moderate input prices lead to above trend growth. I define moderate input prices as quarterly prices that are below the local three year high. For example, crude prices reached an average of ~$120 in 2008Q2. As long as prices stay below that level, I would guess that the effect on the economy would be positive. Translating this to physical reality, prices below their old highs indicate the presence of slack in the system - in this case the ability of Saudi Arabia and the UAE to increase oil production by 1 to 1.5 million barrels a day.
The contraction of consumer credit is worrying but the increase in government debt can substitute for this. The economy can grow in spite of being run poorly and/or in an unsustainable way.
Until there is some sort of crisis in the interest rate market, or a major shift in the faith placed in the US dollar, the economy can continue to grow in an unsustainable way. And so long as this is true, it is very likely that the gold:silver ratio will continue to fall.
Since gold has already advanced so strongly, I am thinking of buying silver on a break out. Thus if silver breaks above $21.5 I would expect it to advance strongly and play "catch up" to the gold break out.
Saturday, October 31, 2009
Inflation in China--->default in the US
An interesting truth emerges from the discussion in the previous post http://outsidetheboxecon.blogspot.com/2009/10/some-graphics-on-us-fiscal-position.html: for a given theoretical maximum rate of repayment of debt (government budget surplus), the interest on the debt must be less than (rate of repayment)*GDP/(total debt). Let me give an example. If the theoretical maximum budget surplus is 5% of GDP, and debt is 80% of GDP, then any interest rate over 6.25% would mean the country was insolvent. In this case, inflation and economic growth are an enemy of the state, for if nominal GDP growth>6.25% the country is insolvent, but so long as inflation+GDP growth<6.25% the country can remain solvent. For a country like Japan with a debt 170% of GDP, a maximum budget surplus of 5% of GDP would imply that nominal GDP growth>3% implies insolvency for the country. This is a worry that has been getting no small amount of play in the media recently, as the demographics of Japan are decreasing the savings rate and major Japanese investment entities are starting to divest themselves of Japanese (Samurai) bonds. Looking back at this reality though, it is no wonder they have had a lost decade!
The issue of a necessary current account surplus presents another dilemma for US policy makers. How do we get a budget surplus without an accompanying current account surplus? This is, by definition, limited by the amount that savings exceeds investment:
(1) Budget surplus/deficit (taxes-gov spending) + domestic (saving-investment) = CA (exports-imports)
And how do we get a Current Account surplus without decreasing the relative value of our currency (which in turn stokes inflation)? The only way that I can see this is possible is if there is significant deflation in other countries. This would allow us to devalue our currency while not stoking domestic inflation. However, is this likely in an era of tightening supplies of oil and other natural materials? Not unless we have a concurrent worldwide depression. Healthy economic activity will lead to higher natural resource prices and worldwide inflation pressures.
Of course, this dilemma is inoperative until there is some demand for repayment of money loaned to the US government. But when that day comes, healthy economic activity and inflation abroad would lead to a default on US borrowing.
The issue of a necessary current account surplus presents another dilemma for US policy makers. How do we get a budget surplus without an accompanying current account surplus? This is, by definition, limited by the amount that savings exceeds investment:
(1) Budget surplus/deficit (taxes-gov spending) + domestic (saving-investment) = CA (exports-imports)
And how do we get a Current Account surplus without decreasing the relative value of our currency (which in turn stokes inflation)? The only way that I can see this is possible is if there is significant deflation in other countries. This would allow us to devalue our currency while not stoking domestic inflation. However, is this likely in an era of tightening supplies of oil and other natural materials? Not unless we have a concurrent worldwide depression. Healthy economic activity will lead to higher natural resource prices and worldwide inflation pressures.
Of course, this dilemma is inoperative until there is some demand for repayment of money loaned to the US government. But when that day comes, healthy economic activity and inflation abroad would lead to a default on US borrowing.
Some graphics on the US fiscal position
At the end of my last post, (http://outsidetheboxecon.blogspot.com/2009/10/revisiting-effects-of-oil-on-gdp.html) I mentioned that we were between a rock and a hard place as far as the fiscal situation of the US goes. Below are some graphics to show the history of our government expenditures, receipts, and deficit. All of the underlying data in this post are taken from two pages (GDP, FISCAL sections) of the St. Louis Fed website. http://research.stlouisfed.org/fred2/
Perhaps the most salient point is that since 1947, expenditures have never represented a higher percentage of GDP while government receipts are the lowest percentage of GDP since 1967! (PLEASE CLICK ON THE PICTURES TO ENLARGE)
Peter Bernholz's work studying hyperinflation has been cited widely in the financial press recently. In his most recent book, Monetary Regimes and Inflation: History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations - all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government’s deficit exceed 40% of its expenditures. This is mathematically equivalent to when expenditures>1.67*receipts. The graph below illustrates this ratio through 2009q2; it will continue to deteriorate for at least 2 more quarters and probably several more after that.
Just as alarming from a creditor perspective is that government receipts are lower now, in real terms, than they were in 2000! The fundamental ability of any entity to service its debt has an upper bound determined by two variables: available revenue, and creditor faith. Of course practically speaking, costs cannot drop to zero, but from a strictly theoretical perspective, revenue provides an upper bound to how fast the debt can be repaid.
The faith of creditors is integral because it determines the interest on the debt. If the interest on the debt was >30% we would already be incapable of servicing our debt even if the government had zero expenditures. It is amazing how quickly a country can go from totally credit worthy to bankrupt just based on the perception of risk from investors. As David Einhorn put it in a recent newsletter: "events can move from the impossible to the inevitable without ever stopping at the probable."http://www.google.com/url?sa=t&source=web&ct=res&cd=1&ved=0CAwQFjAA&url=http%3A%2F%2Fblogs.reuters.com%2Frolfe-winkler%2Ffiles%2F2009%2F10%2Feinhorn-vic-2009-speech.pdf&ei=IpjsSqPFLIPitQO9wqkI&usg=AFQjCNFgutUHC6D5SrkLIdnsRYQUnfSJMQ&sig2=PuTUGdIgrXiJf3ej-OVFtA a pithy interpretation
A FIRST PASS AT FUTURE DEBT REPAYMENT
To get an idea of what would be necessary to repay the government debt, we look at revenue stream, future expenditures, perception of risk, and nominal GDP growth.
First let's suggest a maximum theoretical revenue stream available to the US. The historical maximum (in % of GDP) for receipts is 31.9%, achieved in the first quarter of 2000. [WWII and the early 1980s both had percentages approaching 30% of GDP]. There is good reason to think that we cannot achieve a rate much greater than 30% of GDP. This is because the incentive to dodge taxes goes up exponentially with the tax rate. There is also an argument that high tax rates disincentivize the activity that is being taxed (particularly true for capital gains taxes.) For the purpose of argument, let's be generous and assume that we can achieve a sustainable rate of taxation of 32% of GDP. With this assumption, we can say that the US must default if the interest payments on our debt exceed 32% of our GDP. We are far off from that point now, as the interest on our debt represents only 5% of our receipts, and a little over 1% of GDP.
At first glance, 1% appears to be a pretty safe number. However, there are several things that must be true to keep it at that level. Most obviously, we must stop increasing the debt:GDP ratio. Most importantly however, market interest rates cannot rise. The current low cost of servicing out debt is merely a function of record low interest rates. These record low interest rates are dependent on two things: the nominal market interest rate must continue to hover around zero, and creditors must not perceive a risk of default. Market interest rates are (essentially) zero now only because those are the current expectations for returns. If the market shifts to the perception that GDP growth is sustainable, then interest rates will increase by an amount corresponding to the shift in perception. It is likely that fiscal and monetary policy will remain accommodative
until this perception changes! Therefore, we will continue to increase debt levels and increase monetary stimulus until perceptions of future growth, and the real interest rate, shift. So it is only a matter of time until the interest on the US debt will rise. If the average interest on US debt rose to a very modest 5%, interest payments would suddenly jump to 10% of our maximum receipts. Keep in mind that these calculations are made on our maximum receipts, not maximum budget surplus. Expenditures in the future will certainly not be zero.
Incorporating a realistic but austere forecast of expenditures, let's say that the country can cut government expenditures to 15% of GDP (which is less than half of our current expenditures of 35.5% of GDP). To be clear, cutting government spending to this level would seem draconian: social safety nets would be cut, defense spending would be decimated, medicare and social security would only be token programs, etc. We would be down essentially to education, a reduced military, bare-bones infrastructure spending, and emergency local and state services. With this austere assumption, the budget surplus could theoretically be 15% of GDP; even in this best-case scenario however, a 5% market interest rate would imply 20% of our budget surplus would go simply to service debt, and only 80% to pay down the principal.
Finally, and most importantly, we come to the risk premium demanded by investors. If investors think (for whatever reason) that there is an "x" percent chance of default, than the interest on government bonds will be approximately x%+real market rate. Let's illustrate this with an example: if the market perceives a 10% risk that the US will default on half its debt, then the risk premium charged on debt would be 5%. So if the nominal market rate of interest was 5%, and investors felt they were risking 5%(10% chance of losing half their principal) of their capital to default, the real rate would be 10%. A budget surplus of 5% of GDP with an interest rate of 10% on our current debt would imply that we were spending 120% of our surplus on servicing the debt. If we could not increase this rate of repayment, then we would be in default. You can see how quickly a loss of faith results in insolvency.
Adding in the element of inflation and GDP growth completes the picture. I talk about this more in the next post http://outsidetheboxecon.blogspot.com/2009/10/inflation-in-china-default-in-us.html, but briefly, the rate of inflation needs to be added to the real interest rate to give a nominal interest rate. If there is a 5% rate of inflation and 3% rate of GDP growth, even with a zero percent risk of default, the nominal interest rate would be about 8%. This would mean even a 5% current account surplus would not be sufficient even to service the debt on the US balance sheet.
Perhaps the most salient point is that since 1947, expenditures have never represented a higher percentage of GDP while government receipts are the lowest percentage of GDP since 1967! (PLEASE CLICK ON THE PICTURES TO ENLARGE)
Peter Bernholz's work studying hyperinflation has been cited widely in the financial press recently. In his most recent book, Monetary Regimes and Inflation: History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations - all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government’s deficit exceed 40% of its expenditures. This is mathematically equivalent to when expenditures>1.67*receipts. The graph below illustrates this ratio through 2009q2; it will continue to deteriorate for at least 2 more quarters and probably several more after that.
Just as alarming from a creditor perspective is that government receipts are lower now, in real terms, than they were in 2000! The fundamental ability of any entity to service its debt has an upper bound determined by two variables: available revenue, and creditor faith. Of course practically speaking, costs cannot drop to zero, but from a strictly theoretical perspective, revenue provides an upper bound to how fast the debt can be repaid.
The faith of creditors is integral because it determines the interest on the debt. If the interest on the debt was >30% we would already be incapable of servicing our debt even if the government had zero expenditures. It is amazing how quickly a country can go from totally credit worthy to bankrupt just based on the perception of risk from investors. As David Einhorn put it in a recent newsletter: "events can move from the impossible to the inevitable without ever stopping at the probable."http://www.google.com/url?sa=t&source=web&ct=res&cd=1&ved=0CAwQFjAA&url=http%3A%2F%2Fblogs.reuters.com%2Frolfe-winkler%2Ffiles%2F2009%2F10%2Feinhorn-vic-2009-speech.pdf&ei=IpjsSqPFLIPitQO9wqkI&usg=AFQjCNFgutUHC6D5SrkLIdnsRYQUnfSJMQ&sig2=PuTUGdIgrXiJf3ej-OVFtA a pithy interpretation
A FIRST PASS AT FUTURE DEBT REPAYMENT
To get an idea of what would be necessary to repay the government debt, we look at revenue stream, future expenditures, perception of risk, and nominal GDP growth.
First let's suggest a maximum theoretical revenue stream available to the US. The historical maximum (in % of GDP) for receipts is 31.9%, achieved in the first quarter of 2000. [WWII and the early 1980s both had percentages approaching 30% of GDP]. There is good reason to think that we cannot achieve a rate much greater than 30% of GDP. This is because the incentive to dodge taxes goes up exponentially with the tax rate. There is also an argument that high tax rates disincentivize the activity that is being taxed (particularly true for capital gains taxes.) For the purpose of argument, let's be generous and assume that we can achieve a sustainable rate of taxation of 32% of GDP. With this assumption, we can say that the US must default if the interest payments on our debt exceed 32% of our GDP. We are far off from that point now, as the interest on our debt represents only 5% of our receipts, and a little over 1% of GDP.
At first glance, 1% appears to be a pretty safe number. However, there are several things that must be true to keep it at that level. Most obviously, we must stop increasing the debt:GDP ratio. Most importantly however, market interest rates cannot rise. The current low cost of servicing out debt is merely a function of record low interest rates. These record low interest rates are dependent on two things: the nominal market interest rate must continue to hover around zero, and creditors must not perceive a risk of default. Market interest rates are (essentially) zero now only because those are the current expectations for returns. If the market shifts to the perception that GDP growth is sustainable, then interest rates will increase by an amount corresponding to the shift in perception. It is likely that fiscal and monetary policy will remain accommodative
until this perception changes! Therefore, we will continue to increase debt levels and increase monetary stimulus until perceptions of future growth, and the real interest rate, shift. So it is only a matter of time until the interest on the US debt will rise. If the average interest on US debt rose to a very modest 5%, interest payments would suddenly jump to 10% of our maximum receipts. Keep in mind that these calculations are made on our maximum receipts, not maximum budget surplus. Expenditures in the future will certainly not be zero.
Incorporating a realistic but austere forecast of expenditures, let's say that the country can cut government expenditures to 15% of GDP (which is less than half of our current expenditures of 35.5% of GDP). To be clear, cutting government spending to this level would seem draconian: social safety nets would be cut, defense spending would be decimated, medicare and social security would only be token programs, etc. We would be down essentially to education, a reduced military, bare-bones infrastructure spending, and emergency local and state services. With this austere assumption, the budget surplus could theoretically be 15% of GDP; even in this best-case scenario however, a 5% market interest rate would imply 20% of our budget surplus would go simply to service debt, and only 80% to pay down the principal.
Finally, and most importantly, we come to the risk premium demanded by investors. If investors think (for whatever reason) that there is an "x" percent chance of default, than the interest on government bonds will be approximately x%+real market rate. Let's illustrate this with an example: if the market perceives a 10% risk that the US will default on half its debt, then the risk premium charged on debt would be 5%. So if the nominal market rate of interest was 5%, and investors felt they were risking 5%(10% chance of losing half their principal) of their capital to default, the real rate would be 10%. A budget surplus of 5% of GDP with an interest rate of 10% on our current debt would imply that we were spending 120% of our surplus on servicing the debt. If we could not increase this rate of repayment, then we would be in default. You can see how quickly a loss of faith results in insolvency.
Adding in the element of inflation and GDP growth completes the picture. I talk about this more in the next post http://outsidetheboxecon.blogspot.com/2009/10/inflation-in-china-default-in-us.html, but briefly, the rate of inflation needs to be added to the real interest rate to give a nominal interest rate. If there is a 5% rate of inflation and 3% rate of GDP growth, even with a zero percent risk of default, the nominal interest rate would be about 8%. This would mean even a 5% current account surplus would not be sufficient even to service the debt on the US balance sheet.
Saturday, October 24, 2009
Revisiting effects of oil on GDP
Over the next week, I will revisit a paper that I wrote last year predicting the effect of high oil prices on GDP. In short, however, I would say that the lion's share of the effects of high oil prices on the economy have passed for now. Of course it is impossible to know what prices lie in the future, but so long as oil prices stay below $115, the effects on the economy will be minimal. In fact, since there appears to still be at least some resource slack in the system, there is room for above-trend growth starting in 2010q3 and lasting until 2011q2 or until oil prices move above their previous highs.
My prediction for quarterly growth (using oil price and consumption as the only determinant!) is as follows:
2009q3:+0.7%
2009q4:+1.4%
2010q1:+2.3%
2010q2:+2.8%
2010q3:+3.6%
2010q4:+3.8%
2011q1:+4.4%
2011q2:+4.4%
Of course there are wide error bars on these predictions and there are other determinants of GDP, but the wide brush prediction here is that resource prices are supportive of improving economic growth in the US.
The other determinant I would keeping a close eye on is of course the degree to which fiscal and monetary authorities continue their stimulative efforts. If the stimulative efforts are withdrawn, then this is going to create a negative effect on GDP for several quarters. Note also that we may be between a rock and a hard place when it comes to this subject. If we try to continue stimulative efforts (either fiscal or monetary) and foreigners balk at further bond purchases, or lower the value of the dollar, then this will undoubtedly cause oil prices to spike. So we will see.
Conclusion: although there is a menacing cloud still on the horizon, the weather should be good for the next several quarters!
My prediction for quarterly growth (using oil price and consumption as the only determinant!) is as follows:
2009q3:+0.7%
2009q4:+1.4%
2010q1:+2.3%
2010q2:+2.8%
2010q3:+3.6%
2010q4:+3.8%
2011q1:+4.4%
2011q2:+4.4%
Of course there are wide error bars on these predictions and there are other determinants of GDP, but the wide brush prediction here is that resource prices are supportive of improving economic growth in the US.
The other determinant I would keeping a close eye on is of course the degree to which fiscal and monetary authorities continue their stimulative efforts. If the stimulative efforts are withdrawn, then this is going to create a negative effect on GDP for several quarters. Note also that we may be between a rock and a hard place when it comes to this subject. If we try to continue stimulative efforts (either fiscal or monetary) and foreigners balk at further bond purchases, or lower the value of the dollar, then this will undoubtedly cause oil prices to spike. So we will see.
Conclusion: although there is a menacing cloud still on the horizon, the weather should be good for the next several quarters!
Wednesday, October 7, 2009
Revisiting Triffin's Dilemma, and gold as an escape hatch
This will probably be my last post on gold for awhile. I want to move back into energy issues over the next few weeks, but I felt there were a few more things that I wanted to say about gold. I will return to the paper I wrote in March on the dollar and comment on what appears to be a growing reality - that gold's use as a monetary asset is waxing.
The paper I wrote in March commented on the special dynamics that apply to the US dollar, that prevent the adjustments one would expect from a country with a large and persistent trade deficit. http://outsidetheboxecon.blogspot.com/2009/03/dollar-and-impending-currency-crisis_24.html While there seems to have been a marginal resumption of the bearish dollar trend, anecdotal evidence appears to support the idea that foreign asset preferences remain favorable to the dollar (the past 5 months of TIC reports are one piece of anecdotal evidence that this is the case.) Furthermore, although foreign creditors such as China have been vocal in their opposition to large US deficits, their actions do not match their words. Trade deficits and budget deficits have a strong correlation http://en.wikipedia.org/wiki/Twin_deficit_hypothesis. The Chinese might want the US to have more fiscal responsibility. However, the continued pegging of the Yuan (and pegging of other trade partners) to the dollar means that either the US government or the US citizenry must be in deficit. It has been widely observed that the US consumer is "tapped out" and is not going into more debt. So long as the Chinese, Saudis, etc, keep their exchange rates pegged at stimulative levels, either the US consumer or the US government will have to be in deficit. Actions speak louder than words, and the continued currency peg means that the Chinese prefer a US deficit (either public or private) to a fairly valued currency.
As much as the Chinese want a pegged currency for economic reasons however, they are now realizing that at some point their store of dollars will not be worth much in real terms. The possibility of replacing the dollar as the reserve currency is immaterial to this fact. Regardless of whether the US dollar is replaced as the reserve currency, its value will decline so long as economic activity is healthy. The fact that gold remains as a monetary asset that cannot be devalued is a fact that I think is slowly dawning on the large dollar holders of the world. It is for this reason, more than any other, that the continued increase in gold price is assured. Gold will be the safety valve, the escape hatch, and the attempted route out of the dollar holder dilemma.
I like to theorize about various options the Chinese face in dealing with their large dollar foreign exchange holdings. Assuming that they will at some point realize their dilemma of dollar exposure, how might they go about a change? If you feel I have missed any possibilities, please feel free to comment below.
Option 1: Increase the value of the Yuan
Costs: 1) decrease in exports, employment, and GDP
2) a decrease in the value of the dollar relative to the Yuan decreases the nominal Yuan value of foreign exchange holdings.
Benefits: 1) Increased purchasing power of the Yuan.
2) Long-term financial and economic health of the US is increased. Since the majority of foreign exchange is held in US dollars, this means the long term real value of these holdings might be stabilized.
Option 2: Continue the pegging of the Yuan.
This is the inverse of option 1
Costs: 1) Supporting a dynamic that results in continued budget deficits or private deficits (S-I<0) in the United States. Since the majority of foreign exchange is held in dollars, this destabilizes the long term real value of the large Chinese foreign exchange. This is a cost that may well be discontinuous, meaning that it will seem to be a small cost, and then dramatically shift to being a huge or total loss. Amazingly, this cost seems not to have dawned on the Chinese monetary authorities until after the 2008 financial crisis.
2) Decreased purchasing power of the Yuan; so long as economic activity is robust, this increases the price of real goods (particularly energy) and would stimulate inflation in China, (in spite of sterilization by the CB.)
Benefits: 1) Continued strength in exports support short-term employment and GDP goals.
2) Continued pegging allows the nominal value of Chinese foreign exchange to remain high in Yuan terms.
Option 3: Continue pegging but divest foreign exchange into gold and other real assets
Benefits: 1) Allows the continuation of advantageous trade terms. Exports>Imports keeps employment and GDP numbers high.
2) Nominal Yuan value of foreign exchange holdings are maintained.
3) Real value of foreign exchange holdings are maintained due to a diversification into real assets.
4) Dependence on the long-term solvency and productive capacity of the US is decreased.
Costs: 1) Potential for a bubble to form in real assets (particularly real monetary assets such as silver and gold).
2) The real value of foreign exchange will still go down since the possible scale of divestment into real assets is limited compared to the size of forex reserves.
In essence the costs of option 3 are more subtle but still present: either the amount of divestment is not significant, or it will create bubble values in the assets that are chosen for diversification. In spite of these costs, I think that option 3 probably represents the smoothest transition for Chinese and other dollar holders out of their dollar trap dilemma.
For the US the implications of this strategy will be increased financial stability, but an increase in the cost of real goods in the US market. The Federal Reserve will continue to be placed in an untenable position: any attempt to head off inflation will increase the value of the dollar but immediately crash the US economy. This appears to be the holding pattern that we are currently in, but I imagine that we will need to go through at least one more iteration of crashing the economy before the Fed catches on to this dynamic.
The paper I wrote in March commented on the special dynamics that apply to the US dollar, that prevent the adjustments one would expect from a country with a large and persistent trade deficit. http://outsidetheboxecon.blogspot.com/2009/03/dollar-and-impending-currency-crisis_24.html While there seems to have been a marginal resumption of the bearish dollar trend, anecdotal evidence appears to support the idea that foreign asset preferences remain favorable to the dollar (the past 5 months of TIC reports are one piece of anecdotal evidence that this is the case.) Furthermore, although foreign creditors such as China have been vocal in their opposition to large US deficits, their actions do not match their words. Trade deficits and budget deficits have a strong correlation http://en.wikipedia.org/wiki/Twin_deficit_hypothesis. The Chinese might want the US to have more fiscal responsibility. However, the continued pegging of the Yuan (and pegging of other trade partners) to the dollar means that either the US government or the US citizenry must be in deficit. It has been widely observed that the US consumer is "tapped out" and is not going into more debt. So long as the Chinese, Saudis, etc, keep their exchange rates pegged at stimulative levels, either the US consumer or the US government will have to be in deficit. Actions speak louder than words, and the continued currency peg means that the Chinese prefer a US deficit (either public or private) to a fairly valued currency.
As much as the Chinese want a pegged currency for economic reasons however, they are now realizing that at some point their store of dollars will not be worth much in real terms. The possibility of replacing the dollar as the reserve currency is immaterial to this fact. Regardless of whether the US dollar is replaced as the reserve currency, its value will decline so long as economic activity is healthy. The fact that gold remains as a monetary asset that cannot be devalued is a fact that I think is slowly dawning on the large dollar holders of the world. It is for this reason, more than any other, that the continued increase in gold price is assured. Gold will be the safety valve, the escape hatch, and the attempted route out of the dollar holder dilemma.
I like to theorize about various options the Chinese face in dealing with their large dollar foreign exchange holdings. Assuming that they will at some point realize their dilemma of dollar exposure, how might they go about a change? If you feel I have missed any possibilities, please feel free to comment below.
Option 1: Increase the value of the Yuan
Costs: 1) decrease in exports, employment, and GDP
2) a decrease in the value of the dollar relative to the Yuan decreases the nominal Yuan value of foreign exchange holdings.
Benefits: 1) Increased purchasing power of the Yuan.
2) Long-term financial and economic health of the US is increased. Since the majority of foreign exchange is held in US dollars, this means the long term real value of these holdings might be stabilized.
Option 2: Continue the pegging of the Yuan.
This is the inverse of option 1
Costs: 1) Supporting a dynamic that results in continued budget deficits or private deficits (S-I<0) in the United States. Since the majority of foreign exchange is held in dollars, this destabilizes the long term real value of the large Chinese foreign exchange. This is a cost that may well be discontinuous, meaning that it will seem to be a small cost, and then dramatically shift to being a huge or total loss. Amazingly, this cost seems not to have dawned on the Chinese monetary authorities until after the 2008 financial crisis.
2) Decreased purchasing power of the Yuan; so long as economic activity is robust, this increases the price of real goods (particularly energy) and would stimulate inflation in China, (in spite of sterilization by the CB.)
Benefits: 1) Continued strength in exports support short-term employment and GDP goals.
2) Continued pegging allows the nominal value of Chinese foreign exchange to remain high in Yuan terms.
Option 3: Continue pegging but divest foreign exchange into gold and other real assets
Benefits: 1) Allows the continuation of advantageous trade terms. Exports>Imports keeps employment and GDP numbers high.
2) Nominal Yuan value of foreign exchange holdings are maintained.
3) Real value of foreign exchange holdings are maintained due to a diversification into real assets.
4) Dependence on the long-term solvency and productive capacity of the US is decreased.
Costs: 1) Potential for a bubble to form in real assets (particularly real monetary assets such as silver and gold).
2) The real value of foreign exchange will still go down since the possible scale of divestment into real assets is limited compared to the size of forex reserves.
In essence the costs of option 3 are more subtle but still present: either the amount of divestment is not significant, or it will create bubble values in the assets that are chosen for diversification. In spite of these costs, I think that option 3 probably represents the smoothest transition for Chinese and other dollar holders out of their dollar trap dilemma.
For the US the implications of this strategy will be increased financial stability, but an increase in the cost of real goods in the US market. The Federal Reserve will continue to be placed in an untenable position: any attempt to head off inflation will increase the value of the dollar but immediately crash the US economy. This appears to be the holding pattern that we are currently in, but I imagine that we will need to go through at least one more iteration of crashing the economy before the Fed catches on to this dynamic.
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