With the return of Shinzo Abe and his Liberal Democratic Party to power in Japan, the market for US Treasuries may be losing its last external pillar of support. Re-elected on September 26th, Abe has quickly set a course for limitless inflation, saying Japan must "free itself from deflation and the strong yen." This is significant to the global economy as Japan is the largest foreign power left with a strong appetite for US Treasuries. If this demand falters, the Fed may be the only remaining buyer of new Treasury issuance.
Abe's Plan
This election marks Abe's second turn in the premier's seat. He first held the position from 2006 to 2007, when he abruptly resigned as the first of a string of unpopular one-year premierships. Notably, in the intervening time, the LDP lost its lower house majority to an opposition party for the first time since its formation in 1955. The victors, the Democratic Party of Japan, had been formed in 1998 on a platform of reducing corruption and making Japan more progressive.
Unfortunately, as we know from our past century of experience in America, progressivism is not the cure for an ailing economy. The DPJ was predictably unsuccessful at reining in the bureaucracy, but did manage to push through a damaging doubling of the national sales tax and additional entitlement spending.
Similarly to President Obama's 2008 election, the Japanese people were sold a lot of rhetoric about hope and change and, lacking any sincere alternatives, decided to give the new guys a shot. The results were equally disappointing on both sides of the Pacific.
While American voters decided to throw good votes after bad in 2012, the Japanese preferred to return to the devil they know. The only problem is, he's still a devil.
Abe has essentially promised to return to the failed but feel-good policies of LDP government for the last 3 decades; namely, he will prop up failing industrial giants and attempt to print his way out of an economic slump.
Saving Grace or Pain in the $%&?
The yen hit a post-war high against the US dollar in 2011 and has remained strong. For sound-money enthusiasts, this has been cause for celebration. But for Keynesian demand-siders, it's a crisis.
Rather than attribute decades of sluggish growth to an interventionist industrial policy, Abe and his cadres are blaming the strong yen. In response, Abe has called for the Bank of Japan to target at least 3% inflation.
For some time, the only saving grace for Japanese citizens who are unable to find jobs or secure financing has been that prices have been stable or falling. Abe intends to rob them of that salve while doing nothing to address the underlying infection.
While some Americans may feel a self-interested sense of relief that one of the major dollar-alternatives is being undermined from within, they are misunderstanding the knock-on consequences of this move.
The Last Major Pillar
For the Treasury to continuing having successful auctions at current rock-bottom interest rates, someone has to be purchasing. A lot.
Before 2008, most of the demand came from foreign central banks - especially China. Since the financial crisis began, China and many emerging market banks have dramatically reduced their purchases and even become net sellers.
The deficit has been made up by the Federal Reserve, domestic personal and institutional investors, and a few foreign holdouts led by Japan. In fact, Japan is about to overtake China as the largest foreign holder of US government debt.
This is significant in that the other two sources of funding - Fed and US domestic - are essentially intertwined. The more Treasuries the Fed purchases, the higher inflation becomes, which harms the US economy even further, which leaves domestic funds less wealth to invest in Treasuries. In my view, the foreign influx of capital has been the key third pillar that has kept this vicious domestic cycle from playing out in full.
How It Crumbles
Prime Minister Abe's plan to devalue the yen could thus be disastrous for both US and Japanese government finances. As the yen devalues, Japanese domestic investors - who make up the bulk of owners of Japanese Government Bonds (JGBs) - will be under intense pressure to sell out and find higher yields elsewhere.
This flight of capital will threaten Tokyo with default, so the likelihood is that the Bank of Japan will begin directly buying JGBs on an even larger scale (as our Fed has done since the financial crisis) instead of buying US Treasuries. They may even become net sellers of Treasuries in order to finance their bailout of Tokyo while controlling inflation.
This will, in turn, put tremendous pressure on US Treasury investors. As the outflows mount, the Fed will no doubt announce another program to buy Treasuries under the guise of promoting economic stability. If the Fed becomes the permanent crutch of the Treasury, we can expect inflation to get higher and higher - driving more and more investors out of Treasuries.
Decoupling Continues
It is clear that Washington and Tokyo are but two sides of the same coin. Japan's debt-to-GDP is about 212%, while the US has just crossed 100%. Both are highly dependent on domestic investor interest in government debt to keep the charade going, and neither have prospects of paying their debts without real write-downs for investors.
Unfortunately, neither government is using the time before this real crash strikes to even attempt to shore up their positions. The platform of Shinzo Abe seems poised to undermine Japan's ability to continue subsidizing US government debt. Left without any significant external supports, Treasuries will be in an extremely weak position when attention shifts from the EU sovereign debt crisis to the our own tattered finances.
Fortunately, there are ways for investors to escape Abe and Obama's tandem cliff-dive. Recent data shows that China continues to build a viable alternative. The South Korean won and Taiwan dollar are now significantly more correlated to the movements of the yuan than the yen or the US dollar. These booming economies will sustain demand for commodities as they build real wealth. With the old statesmen of sovereign debt compromised, I expect the up-and-comers to continue to turn to gold and silver in droves.
Peter Schiff is CEO ofEuro Pacific Precious Metals, a gold and silver dealer selling reputable, well-known bullion coins and bars at competitive prices.
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The communist revolutions in the 20th century sought to nationalize the wealth generated by privately held industries back to the "exploited" workers on whose backs the profits were supposedly derived.America has made the rejection of this idea and its support of free market principles the centerpiece of its economic narrative. However, as a result of our current and proposed tax policies towards corporate shareholders, our government collects a portion of industrial output that would inspire envy in even the most rabid Bolshevik.
The purpose of a corporation is to generate profits for owners (all other functions are secondary to this goal). Public corporations distribute these profits through dividends. But as a result of America's system of double taxation, where income is taxed on the corporate level and then again on the personal level, government receives a much bigger share of corporate income than the owners themselves. I also address this topic inmy latest video blog .
Suppose a publicly held U.S. corporation made one million dollars in income over the course of a year. Currently its profits would be taxed at a 35% level (for the purpose of this example I will not factor in the lower rate that is applied to its first $100K of profits), meaning that the company would have to pay $350,000 directly to the government (assuming it earned its income without special tax breaks). Of the $650,000 that remained, the typical dividend-paying corporation might distribute 40 percent to shareholders (this is known as the "payout ratio" and the actual average is slightly below 40%). So in this instance the company would pay $260,000 (40% of $650,000) to shareholders. The remaining $390,000 would typically be held as "retained earnings," and would be used to maintain and replace depreciating equipment, make capital investments, fund research and development, and expand operations. If the company did not make such investments it would be impossible for it to survive and its ability to perpetuate profit distributions would be limited.
These retained earnings still represent assets to shareholders, but their primary purpose is to generate future profits and higher dividends. However, shareholders do not directly benefit from those retained earnings until future distributions are paid. Sure they can sell their shares at a gain, paying a capital gains tax in the process, but this merely transfers those deferred benefits to the new buyer.
When received by shareholders, the $260,000 in dividends are taxed again at a rate of 15 percent (according to current law). As a result, shareholders receive just $221,000 of the million dollar profit. The $39,000 in dividend taxes are added to the $350,000 "off the top" corporate tax to bring the government's total take of the company's profits to just a shade under $390,000. In other words the government gets about 75% more cash flow from the company than the actual owners. Looked at in a slightly different way, the government gets about 65% of the non-retained earnings while shareholders, who put up the money and take all the risk, get 35%. Does this seem fair?
This level of taxation puts American corporations at a noticeable disadvantage vis-a-vis companies in the countries against which we are most keenly competing. In China, the slicing of the pie is much more favorable to owners. There, corporations are taxed at a rate of 25% and dividends at 10%. Using these numbers (and the same payout ratio used for the U.S. corporation), the Chinese government gets 51% of distributed corporate profits and shareholders get 49%. In Hong Kong (which is part of Communist China), the situation is even better. There, the corporate tax rate is 16% and the personal dividend rate is zero. If you do the math there, the government gets 33% and the shareholders get 67%.
This comparison raises an interesting point. If shareholders in communist China are allowed to keep more of their earnings than shareholders in capitalist America, which nation is more communist and which more capitalist?
Late last month the Obama Administration and Mitt Romney offered competing proposals on corporate tax reform that both politicians say would make U.S. corporations more competitive. Romney's plan lowers the corporate tax rate to 25% while maintaining the dividend tax at 15%. This makes things slightly better, sending 54% of distributed earnings to the government and 46% to shareholders (not quite as generous as Communist China). Not surprisingly however the Obama plan will make things much more difficult.
Although the President proposes lowering the corporate tax rate to 28% he also wants to scrap the dividend tax and instead tax the distributions as ordinary income. In practice, the vast majority of individual recipients of dividends fall into the higher end of the income spectrum. Which means a very large chunk of these dividends will be taxed at the highest personal rate of 39%. But Obama also wants to subject these high earners to a surtax to pay for his health care initiative, which means that many of the recipients will be taxed at a rate of 44% (this also accounts for the phase out of personal deductions for higher earners!) So for these high-income earners, using our current example, the new distribution split with the government under Obama's proposals will be about 70/30 in favor of the government. This is actually worse than the status quo.
But it's actually much worse than that. The corporate income tax is just one of the veins that corporations open for government. Think about all the other taxes that corporations pay, such as the payroll taxes and sales taxes. Sure they pass those taxes on to their employees and customers, but the revenue flows 100% to the government with shareholders getting nothing but a bill for the cost of collection.
Then there are all of the taxes paid directly by the employees themselves on their wages and salaries. Sure, this money belongs to employees and not shareholders, but if not for the profit-making activities of corporations, those wages and salaries, and resulting taxes, could not have been paid. And while employees derive benefits from those after tax distributions too, shareholders get nothing.When all of these channels are factored in, think about how much more the government derives in taxes from corporate activity than its owners receive in dividends. Who knows how high this figure is, but I'm sure the government's take is many multiples of what shareholders receive.
Back in the 19th Century, America really was a capitalist country. We had no corporate tax and no personal income tax. Shareholders got 100% of distributed corporate income. As a result of this structure, U.S. corporations grew rapidly and helped spark the fastest economic expansion the world had ever seen. But that was then, this is now.
Given the current numbers, even if our leaders were dyed-in-the-wool Marxists, what would be their motivation to nationalize Fortune 500 companies? If they already receive the lion's share of profit distributions, what would be the point? Such a move risks upsetting the management structures and destroying the remaining profit motive. It would risk killing the goose that lays the golden egg. If government nationalized a company, it would also have to manage it. Does anyone think bureaucrats would make better decisions than private owners? What's worse, if those decisions produced losses rather than profits, the government would have to absorb them. Under the current systems, the government gets the lion's share of the profits, but private shareholders are stuck with 100% of the losses.
There is actually a name for our present system: fascism. While fascism and communism are both forms of socialism, at least the fascists are smart enough to know that if the means of production are nationalized, employees and owners won't work as hard, and the government will lose revenue.
It's a shame that the country that was once the beacon of freedom and economic liberty no longer has the ability to recognize what capitalism actually looks like. Unless corporate owners are appropriately rewarded for their risks, U.S. corporations will not regain their lost dominance, Americans will not regain their lost liberty, and our standard of living will continue to fall. As it stands now, the United States has become a people of the government, by the government and, most importantly, for the government.
The economy continues to prove that it didn’t need a stalemate between democrats and republicans over whether or not we should expand our credit limit in order to poop the bed. Gross Domestic Product climbed a paltry 1.3% in the second quarter of this year following a severely downgraded Q1 print of just 0.4%. Growth in the first quarter was revised down from a 1.9% prior estimate. Also today, the Institute for Supply Management-Chicago Inc. said its business barometer fell to 58.8 in July, from 61.1 in the prior month. And the Thomson Reuters/University of Michigan final index of consumer sentiment fell to 63.7 this month, which was the weakest since March 2009, from 71.5 in June.
Where are all those shills who assured us last year that 2011 would display a “V” shaped recovery in jobs and the economy? I know, I heard some of them today saying that the second half of this year is going to be great! Their reasoning was the same as it always is. Earnings are going to be wonderful because half of S&P 500 companies' earnings are in foreign currencies. Then, thanks to our crumbling currency, those foreign earnings translate into a ton of U.S. dollars—those dollars don’t buy you very much, but who cares as long as we are able to say we beat Wall St. expectations.
The poor, lonely Tea Party is vilified as being inhuman and behaving as insane children for not allowing the country to bankrupt itself as quickly as possible—even by members of their own party (read here what John McCain had to say for yourself). I guess the philosophy of McCain and his friends is that we should raise the debt ceiling to infinity and beyond and just pay our creditors back with more printed money. After all, the National Debt has grown from $400 billion in 1971 to $14.4 trillion today, so what’s a few more trillion between now and 2013? The dollar has lost 98% of its purchasing power in the last 40 years, so why not keep on defaulting on our debt through inflation and destroy the last few vestiges of the middle class. Sounds like a plan to me. It’s just business as usual. They urge us to keep up the spirit of cooperation and goodwill that has served to render this country insolvent.
The only problem is that the Chinese have stopped laughing at Geithner’s so called “strong dollar policy” and are now allowing the Renminbi to rise against the greenback (up nearly 6% in the last year). If we continue down this road much longer the only buyer of U.S. debt will be the Fed. That’s the real down grade to come. Not from the credit rating agencies, but from our foreign creditors. Once we have a failed Treasury auction, it will engender a vicious cycle. Debt service expense will soar, which causes out of control deficits. The Fed will be forced to purchase more of the debt and inflation rates become intractable, thus destroying GDP growth. Runaway debt, interest rates and inflation is what the Tea Party is trying so hard to avoid and it is a cause worth fighting for!
And, of course, Greece isn't the only problem. Ireland and Portugal are vying for second-worst debt crisis in Europe. Spain, representing over 12% of eurozone GDP, saw sovereign yields jump from 4.1% at the beginning of 2010 to 6.6% by the end of the year. Yields on most other eurozone countries have been rising as well - a clear indication that the eurozone is an increasingly risky bet.
While a euro secession by the PIGS could actually leave a stronger currency region at the end, it would be a traumatic event. That prospect is undermining confidence in the euro at just the time when the world is considering where to go next.
Perhaps a mature currency that didn't falter so easily amidst the recent global financial crisis would be a good contender for the world's reserve. The euro, by contrast, is both young and in serious trouble. If less than two-dozen nations are too immense a burden for the euro to shoulder, should we expect better results when it's stretched across two hundred?
YUAN: CAPITALIST COUNTRY, COMMUNIST CURRENCY
The investment community is slowly coming around to my long-held excitement about the miraculous growth of China. This is no frenzy. In fact, if anything, I think many are still too skittish when it comes to this market. Yet, those that are jumping on the bandwagon are now proclaiming the Chinese yuan as the logical successor to the dying dollar. But while China is becoming an immense economic force, the yuan itself is hobbled by the country's communist past.
Foremost, China enforces stern capital controls on the yuan. A reserve currency must be freely and easily exchangeable with other currencies. Even within China's borders, one cannot exchange large amounts of yuan for dollars or any other currency.
China is slowly undertaking reforms to relieve these controls, but remember they were not put there arbitrarily. The controls allow China to suppress the value of the yuan, thereby maintaining artificially high exports, among other consequences. If China allowed the yuan to trade freely, it would lose the power it maintains over its money - and by extension, its people.
Let's remember that all fiat currencies are routinely manipulated and inflated. The People's Bank of China has reported M2 growth of over 140% in the past five years - almost entirely to maintain a stable exchange rate with a depreciating dollar. Given rampant inflation, combined with exchange restrictions and a serious lack of transparency, the yuan is simply not ready for primetime.
YEN: BLACK HOLE OF DEBT
The Japanese yen is the third amigo at the international fiat fiesta. While it doesn't suffer the structural risks of the euro, the yen is subsisting in an environment of massive sovereign debt. Japan's debt-to-GDP ratio is the highest of any developed country at 225%, meaning there is a perpetual impetus to print more yen to pay it back. The yen must endure this debt-noose, making it a poor alternative to the USD, which suffers the very same problem.
While I believe Japan is in a much better position because it generally maintains a net trade surplus and because most of their debt is held domestically, it's still not a stable unit with which to conduct world trade.
Perhaps more importantly, with a world seeking yen reserves, the price of yen would increase drastically. This is politically unpalatable in Japan, where the export lobby is constantly trying to push the yen down to boost their sales overseas.
These two factors combine in such a way as to make the yen a plainly infeasible reserve currency. The appreciation in yen value would simultaneously make Japan's debt problems worse and cause its export industry to suffer greatly, meaning that Japan probably doesn't want this role any more than we want her to have it.
As an aside, if you type "yen as reserve currency" into Google, it will ask, "Did you mean:yuan as reserve currency?" I guess even the world's smartest search engine doubts the yen could fill that role.
THE SIMPLEST ANSWER IS OFTEN THE BEST
As J.P. Morgan famously said to Congress in 1913, "gold is money and nothing else." Morgan meant that gold was unmatched in its effectiveness as a store of value and medium of exchange.
Given that his namesake bank started accepting physical gold bullion this past February as counterparty collateral, why should the trend of a widespread return to gold be considered only a remote possibility? On the contrary, it should be expected - if for no other reason than every other currency is fundamentally dismal.
Markets are powerful things, and require a reliable medium of exchange. The call for sound money is not just philosophical; it is derived from the market itself. Throughout human history, merchants have always turned to pure gold and silver over every pretender. This is not the first experiment in a paper money system, nor is it the first widespread debasement of money. In fact, the lessons of history were impressed upon our well-read Founding Fathers to the point that they included the following clear language in the Constitution: "No state shall... make any Thing but gold and silver Coin a Tender in Payment of Debts."
While it has always been possible that another fiat currency would rise up to take the dollar's place, and thereby keep this irrational experiment in valueless money going awhile longer, the particular circumstances that abound today make it seem less and less likely to me. Instead, I'm seeing signs that the world is moving back to gold at a breakneck speed.
This is a return to normal and has many positive implications for the global economy. It's certainly a trend we can all welcome, and profit from.
As I said yesterday, if you borrow trillions of dollars over the course of a couple of years—most of which are printed—and you make money free for more than two years; you will get a little bit of growth but whole ton of inflation. Gold and oil are rising yet again this morning and the consumer is getting pinched by a surging cost of living that isn’t susceptible to core rate mollifications.
The Non-Farm payroll report for February showed that the U.S. gained 192k net new employees. Average hourly earnings rose to $22.87 from $22.86 in the prior month, today’s report showed. The average work week for all workers held at 34.2 hours. And the unemployment rate ticked down to 8.9%.
That is the good news and it is mostly in the rear view mirror. Now we have the following facts to deal with: companies are operating at peak margin levels, the S&P dividend yield is very close to the lowest in its history (1.71% vs. the average 4.35%), inflation rates that are rising and interest rates that are sharply rising off their all-time lows.
Most investors and main stream pundits are cheering the success and validation of Keynesian borrowing and spending economics. But I see things quite differently. What lies ahead now is the need for a massive contraction in private and public spending and at the same time a surge in borrowing costs as the Fed unwinds its balance sheet. Of course the above has to happen very soon before oil gets back to $147 per barrel, the dollar collapses, the bond vigilantes wake up and inflation destroys the economy.
The proof of Ben's success can be seen in comparing how the foreign exchange markets reacted to the recent crisis in the Middle East with how they reacted to the financial crisis of 2008. Back then, investors looking for safety abandoned their foreign currency positions and piled into the U.S. dollar (the market for U.S. Treasury Bonds in particular). As a result of these fund flows, the U.S. dollar surged 20% from August to November 2008.
However, during this latest round of global destabilization the dollar experienced no such rally. In fact, the greenback shed about 5% of its value since the Tunisia revolution began in December of 2010. The reason should be clear; the Fed has placed international investors on notice that it will unleash even greater doses of dollar debasement at the first whiff of additional economic weakness, deflation threat, or dollar appreciation. Just this week, Bernanke once again made clear that despite what he considers to be a better growth outlook at home and abroad, and spreading global inflation, the United States will not pull back from monetary accommodation, even as other nations conspicuously do so. The architect of U.S. monetary policy has stated explicitly that dollar debasement will continue for the indefinite future.
Knowing this, why would any international investor seeking a "safe haven" choose to park assets in U.S. sovereign debt? If Bernanke is to be believed, continued economic weakness in the U.S. will cause low-yielding Treasuries to lose value due to inflation while the weakening dollar erodes the underlying value of the bond in real terms. This is a one-two punch that sane investors will seek to avoid. It is no coincidence that a record percentage of U.S. Treasury auctions are now being bought by central banks, for whom sanity is a lowly consideration.
But in reality, the Fed has much less influence over the dollar's value than do central bankers in Beijing. There is little disagreement among economists that without Chinese support, the dollar would be a dead duck. But for the last twenty years or so the monetary arrangement that pegged the yuan against the dollar served the interests of both countries. The U.S. enjoyed a flood of cheap imports, the benefits of ultra-low interest rates, and a strong currency. The Chinese received a booming export economy, which accounted for about a third of the country's GDP, and the ownership of a significant portion of the future of the United States. To maintain this peg, the People's Bank of China had to print trillions of yuan and perpetually hold more than $1 trillion U.S. dollars in reserve.
But recently, having led to rampant money supply growth and inflation in China, the peg has become more trouble than it's worth, particularly from the Chinese perspective. The latest reading on YOY money supply growth has China's M2 increasing by 17.2%; which has helped send their reported CPI up 4.9% YOY.
Inflation in China is pushing up the prices of its exports. According to the latest survey released February 14th from Global Sources (a primary facilitator of trade with Greater China), export prices of various China products are likely to increase in the months ahead, especially if the cost of major materials and components continues to soar. The survey of 232 Chinese exporters revealed that 74% of respondents said they boosted export prices in 2010. The U.S. Bureau of Labor Statistics reported in early January that its China import price index rose 0.9% in the fourth quarter after holding steady for the previous 18 months. And Guangdong, the biggest exporting province, said recently that it would increase minimum wages by around 19% this March.
But here is the rub; China maintains its peg in order to keep export prices from rising in dollar terms. But the peg is now causing export prices to rise anyway. As a result, the policy is a dead letter. The simple fact is that the threat to China's exports will exist whether they let their currency appreciate or not. But a strong currency offers the benefit of greater domestic consumption, while a weaker currency offers nothing.
The Chinese government will take the path that preserves and balances their economy while enriching their entire population, rather than go down the road to never ending inflation. For China the realistic hope is that the greater purchasing power of a strong currency will enable their growing middle class to supplant U.S. consumers as the end market for China's own manufacturing efforts. However, for the U.S. the challenge will be to develop a diversified manufacturing base in an expeditious manner before surging interest rates, a plummeting dollar and soaring inflation overwhelm the economy.
The dollar's recent reaction to the turmoil in the Middle East and China's inflation problem illustrate that we have come to a watershed moment in American history. The decade beginning in 2010 should prove to be the decade in which the U.S. dollar loses its status as the world's reserve currency. As bad as that blow may be, the loss may provide the shock needed to get our economy back on a sustainable path. The real danger lies in refusing to adapt to the changing environment. Our current economic stewards are acting as if the dollar's status is written in stone, when in fact it's hanging by a thread.
It now appears that the United States has finally succeeded in its efforts to destroy confidence in the U.S. dollar. Given the currency's reserve status, its ubiquity in financial markets, and the economic power and political position of the United States, this was no easy task. However, to get the job done Washington chose the right man: Fed Chairman Ben Bernanke. Thanks to Bernanke's herculean efforts, investors across the globe have now been fully weaned from their infantile belief that the U.S. dollar will remain the ultimate safe haven currency.
The proof of Ben's success can be seen in comparing how the foreign exchange markets reacted to the recent crisis in the Middle East with how they reacted to the financial crisis of 2008. Back then, investors looking for safety abandoned their foreign currency positions and piled into the U.S. dollar (the market for U.S. Treasury Bonds in particular). As a result of these fund flows, the U.S. dollar surged 20% from August to November 2008.
However, during this latest round of global destabilization the dollar experienced no such rally. In fact, the greenback shed about 5% of its value since the Tunisia revolution began in December of 2010. The reason should be clear; the Fed has placed international investors on notice that it will unleash even greater doses of dollar debasement at the first whiff of additional economic weakness, deflation threat, or dollar appreciation. Just this week, Bernanke once again made clear that despite what he considers to be a better growth outlook at home and abroad, and spreading global inflation, the United States will not pull back from monetary accommodation, even as other nations conspicuously do so. The architect of U.S. monetary policy has stated explicitly that dollar debasement will continue for the indefinite future.
Knowing this, why would any international investor seeking a "safe haven" choose to park assets in U.S. sovereign debt? If Bernanke is to be believed, continued economic weakness in the U.S. will cause low-yielding Treasuries to lose value due to inflation while the weakening dollar erodes the underlying value of the bond in real terms. This is a one-two punch that sane investors will seek to avoid. It is no coincidence that a record percentage of U.S. Treasury auctions are now being bought by central banks, for whom sanity is a lowly consideration.
But in reality, the Fed has much less influence over the dollar's value than do central bankers in Beijing. There is little disagreement among economists that without Chinese support, the dollar would be a dead duck. But for the last twenty years or so the monetary arrangement that pegged the yuan against the dollar served the interests of both countries. The U.S. enjoyed a flood of cheap imports, the benefits of ultra-low interest rates, and a strong currency. The Chinese received a booming export economy, which accounted for about a third of the country's GDP, and the ownership of a significant portion of the future of the United States. To maintain this peg, the People's Bank of China had to print trillions of yuan and perpetually hold more than $1 trillion U.S. dollars in reserve.
But recently, having led to rampant money supply growth and inflation in China, the peg has become more trouble than it's worth, particularly from the Chinese perspective. The latest reading on YOY money supply growth has China's M2 increasing by 17.2%; which has helped send their reported CPI up 4.9% YOY.
Inflation in China is pushing up the prices of its exports. According to the latest survey released February 14th from Global Sources (a primary facilitator of trade with Greater China), export prices of various China products are likely to increase in the months ahead, especially if the cost of major materials and components continues to soar. The survey of 232 Chinese exporters revealed that 74% of respondents said they boosted export prices in 2010. The U.S. Bureau of Labor Statistics reported in early January that its China import price index rose 0.9% in the fourth quarter after holding steady for the previous 18 months. And Guangdong, the biggest exporting province, said recently that it would increase minimum wages by around 19% this March.
But here is the rub; China maintains its peg in order to keep export prices from rising in dollar terms. But the peg is now causing export prices to rise anyway. As a result, the policy is a dead letter. The simple fact is that the threat to China's exports will exist whether they let their currency appreciate or not. But a strong currency offers the benefit of greater domestic consumption, while a weaker currency offers nothing.
The Chinese government will take the path that preserves and balances their economy while enriching their entire population, rather than go down the road to never ending inflation. For China the realistic hope is that the greater purchasing power of a strong currency will enable their growing middle class to supplant U.S. consumers as the end market for China's own manufacturing efforts. However, for the U.S. the challenge will be to develop a diversified manufacturing base in an expeditious manner before surging interest rates, a plummeting dollar and soaring inflation overwhelm the economy.
The dollar's recent reaction to the turmoil in the Middle East and China's inflation problem illustrate that we have come to a watershed moment in American history. The decade beginning in 2010 should prove to be the decade in which the U.S. dollar loses its status as the world's reserve currency. As bad as that blow may be, the loss may provide the shock needed to get our economy back on a sustainable path. The real danger lies in refusing to adapt to the changing environment. Our current economic stewards are acting as if the dollar's status is written in stone, when in fact it's hanging by a thread.
The only thing melting up faster than the U.S. equity market these days is U.S. Treasury yields. The Ten year note is trading at 3.66% this morning—I wonder if Bernanke views that as a successful outcome of QEII? Meanwhile, Freddie Mac says the average rate on a 30 year fixed rate mortgage hit 4.81% this week, up from 4.17% in November of 2010. I guess rising rates are just one of those unintended consequences that Bernanke just didn’t count on. But those rising rates are helping the housing market to rollover. CoreLogic says that YOY home prices declined by 5.4%.
So the Fed will take falling home prices as a reason to continue counterfeiting 2.0 indefinitely. But China is dealing with their inflation by raising rates yet again. They upped their benchmark 1 year deposit rate by ¼ point to 3%. That’s the third time in four months that they have raised interest rates. The Chinese stock market is down for 2011 while the U.S. exchanges are up. But we are living on borrowed time once again. While the rest of the world is cutting spending and strengthening their currencies, we have dramatically stepped up our borrowing and printing practices. Bernanke and Co. maybe blind to inflation but I can assure the bond market has taken off the rose colored glasses.
Consumer credit rose for the third consecutive month led by the first increase in credit card charges in over two years. Credit increased by $6.1 billion to $2.41 trillion! I guess the frugal U.S. consumer lasted as long as one of “The Situation’s” girlfriends on “Jersey Shore.” Congratulations Mr. Bernanke!
Michael Pento, Senior Economist at Euro Pacific Capital is a well-established specialist in the “Austrian School” of economics. He is a regular guest on CNBC, Bloomberg, Fox Business, and other national media outlets and his market analysis can be read in most major financial publications, including the Wall Street Journal. Prior to joining Euro Pacific, Michael worked for a boutique investment advisory firm to create ETFs and UITs that were sold throughout Wall Street. Earlier in his career, he worked on the floor of the NYSE.
The global economy has become so unbalanced that even government ministers who would normally have trouble explaining supply or demand clearly recognize that something has to give. To a very large extent the distortions are caused by China’s long-standing policy of pegging its currency, the yuan, to the U.S. dollar. But as China’s economy gains strength, and the American economy weakens, the cost and difficulty of maintaining the peg become ever greater, and eventually outweigh the benefits that the policy supposedly delivers to China. In the first few weeks of 2011 fresh evidence has arisen that shows just how difficult it has become for Beijing.
Twenty years ago, China’s leaders decided to ditch the disaster of economic communism in favor of privatized, export-focused, industry. The plan largely worked. Over that time, China has arguably moved more people out of poverty in the shortest amount of time in the history of the planet. But somewhere along the way, China’s leaders became addicted to a game plan that outlived its usefulness.
In order to maintain the peg, China must continually buy dollars on the open market. But the weaker the dollar gets, the more dollars China must buy. And with the U.S. Federal Reserve pulling out all the stops to create inflation and push down the dollar, Beijing’s task becomes nearly impossible. Last week, it was announced that China’s foreign exchange reserves, the amount of foreign currency held at its central bank (mostly in U.S. dollars), increased by a record $199 billion in 4th quarter 2010, to reach $2.85 trillion. These reserves currently account for a staggering 49% of China’s annual GDP (if the same proportional amount were held by the U.S., our measly $46 billion in reserves would have to increase 163 times to $7.5 trillion).
In order to buy these dollars, the Chinese central bank must print its own currency. In essence, China is adopting the Fed’s expansionary monetary policy. In the U.S. the inflationary impact of such a strategy is mitigated by our ability to export paper dollars in exchange for inexpensive Chinese imports. Although prices are rising here, they are not rising nearly as much as they would if we had to spend all this newly printed money on domestically produced goods. The big problem for China is that, unlike the U.S., the newly printed yuan are not exported, but remain in China bidding up consumer prices. As a result, inflation is becoming China’s dominant political issue.
It was recently announced that in November China’s consumer price index rose 5.1% from the same time a year earlier, with food prices rising more than 10%. As unrest builds, the Chinese government has unleashed a series of policies to address the symptoms.
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