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1) The euro is
going to crash against the dollar because European bank losses dwarf those in
the US
This bit of logic proves that deflationists (those predicting deflation in
the US) don’t understand deflation. Whether or not European bank losses
dwarf those in the US is irrelevant. It is the euro which will rally against
the dollar. Why? Because the euro zone, unlike the US, is about to experience
real, honest-to-god deflation. Ironically, deflation is staring US
deflationists in the face, and they are too blind to see it.
Understanding the difference between deflation and hyperinflation
The root cause of deflation and hyperinflation is the same: a nation plagued
by mountain of debt. This mountain of debt can be in form of a massive
national debt, an insolvent financial system, or both. What determines
whether a debt-plagued nation experiences deflation or hyperinflation is the
response of that nation’s monetary authority:
A) If the monetary authority does nothing while the country defaults on its
debt, its banks go bankrupt, and its depositors see their savings wiped out,
then that country will experience deflation.
B) If the monetary authority chooses to monetize a country’s national
debt, its banks’ bad loans, or the savings of depositors at failed
banks, then that country will experience hyperinflation.
The US in the 1930s as an example of deflation
When a series of banking panics rocked the US financial system in 1930s, the
fed did nothing as thousands of banks failed. As a result, between
1929 and 1933, two out of every five banks in America collapsed, and
depositors at those banks lost most of their savings, shrinking the US money
supply. Why did the fed let so many banks go under? For one, the Fed could
not by law directly lend to banks that did not belong to the Federal Reserve
System, and most banks remained outside this system at the time. Furthermore,
the fed was restricted on how much it could lend to its member banks: it
could not, for instance, lend to banks on their real estate loan portfolios.
Because of these regulatory restrictions (which have long since been
removed), the fed was powerless to prevent the depression’s cascading
bank failures.
The following passage from the St. Louis Fed summarizes the US experience with deflation:
Starting in 1930, a series of banking panics rocked the U.S. financial
system. As depositors pulled funds out of banks, banks lost reserves and had
to contract their loans and deposits, which reduced the nation's money stock.
The monetary contraction, as well as the financial chaos associated with the
failure of large numbers of banks, caused the economy to collapse.
Less money and increased borrowing costs reduced spending on goods and
services, which caused firms to cut back on production, cut prices and lay
off workers. Falling prices and incomes, in turn, led to even more economic
distress. Deflation increased the real burden of debt and left many firms and
households with too little income to repay their loans. Bankruptcies and
defaults increased, which caused thousands of banks to fail. In each year
from 1930 to 1933, more than 1,000 U.S. banks closed.
Germany In 1920s as an example of hyperinflation
In 1920, German banks were insolvent and did not have the cash to honor
checks. Since the German government itself was burned by its war debt and
reparations payments, it could not borrow to bail out its banks. Furthermore,
the government did not want to upset people with heavy taxes, and it feared a
rise in the unemployment which would result from bank failures. As a result,
Weimar Germany turned to the printing press to bail out its financial system,
and its currency was brutally destroyed by hyperinflation.
The following passage from a 1970 report on Germany's currency collapse
summarizes the German experience with hyperinflation:
In World War I, Germany -- like other governments -- borrowed heavily to
pay its war costs. This led to inflation, but not much more than in the U.S.
during the same period. After the war there was a period of stability, but
then the inflation resumed. By 1923, the wildest inflation in history was
raging. Often prices doubled in a few hours. A wild stampede developed to buy
goods and get rid of money. By late 1923 it took 200 billion marks to buy a
loaf of bread.
Millions of the hard-working, thrifty German people found that their life's
savings would not buy a postage stamp. They were penniless. How could this
happen in a highly civilized nation run at the time by intelligent,
democratically chosen leaders?
The roles have now reversed
Today, the US is the nation facing hyperinflation as the fed monetizes debt,
and the EU looks set for deflation as the ECB allows Europe’s financial
system to collapse. The reasons why is simple. Following the great
depression, the US took steps to insure it would never experience deflation
again, and Germany’s experience with hyperinflation shaped the EU in a
way to prevent hyperinflation from ever happening again.
The fallout of the US’s experience with deflation include:
A) The rise and domination of Keynesian economics in the US. Keynesianism is
the economic school of thought which gives such wisdom as “deficits are
good” and “you can spend your way to prosperity”.
B) All US bank deposits are now fully insured by the FDIC. This alone makes
deflation impossible in the US, as it forces the fed to either monetize
banks’ bad debt or monetize the deposits which were used to loan out
the bad debt.
C) The fed’s sweeping authority to bailout whoever they want, whenever
they want, however they want.
D) Social security and Medicare, which makes a default on the US’s
national debt unthinkable as this would reveal that the baby boomers
retirement savings are gone.
E) Free money for the unemployed! Unemployment benefits are being extended by
33 weeks to 59 weeks and the average $300 weekly benefits are being increased
by $25. You can now receive a 17,000 annual salary for getting laid off,
courtesy of the government’s printing press.
F) massive federal and trade deficits.
The fallout of the Germany’s experience with hyperinflation include:
A) The "no bail-out" clause of the Maastricht Treaty (the treaty
that led to the creation of the euro), which stipulates explicitly that
neither the Community nor any Member State is liable for or can assume the
commitments of any other Member.
B) The euro zone’s lack of FDIC-type deposit insurance
C) The ECB’s inflation fighting mandate.
D) Germany’s 3,413 tonnes of gold reserves, the largest in the world
(besides the US gold reserves, if they still exist), and the EU zone’s
10,413 tonnes of gold reserves.
E) Germany’s export oriented economy and trade surplus
F) Germany’s long standing low-inflation policy
G) Germany’s contempt for Keynesian economics. (a contempt I share)
The USD rally will end when Europe's financial system starts collapsing.
Investors will realize that the EU won't print money to bail out its banks,
and that will send the euro soaring against the dollar.
The dollar’s and the euro’s fate
Eighty years ago, at the most fevered moment of the German hyperinflation,
the exchange rate between the dollar and the Mark was one trillion Marks to
one dollar. This time around, it will be one trillion dollars to the euro (assuming the Maastricht Treaty holds).
As EU bank failures wipes out deposits and gold prices continue to rise (gold
price rose during the great depression’s deflation), eventually the
value of the EU’s outstanding currency will equal the value of its gold
reserves. At that point, the EU will have the option of converting the euro
into a hard currency, redeemable in gold.
2) Trade numbers show how China’s dependence on international trade
is smacking the daylights out of their economy.
Anyone who thinks things are going badly in China hasn’t been paying
attention
Optimism is growing in China. Economists
now project that China will be the likely leader of an
elusive worldwide economic recovery. China is the
only economy in the world to see significant growth in credit to corporate
and household sectors after September 2008: Chinese loan growth and money supply have
surged this January. Bank lending is multiplying the effect
of the government's spending in ways that wouldn't be possible in the United
States and Europe, where banks are burdened by toxic assets. The Shanghai
Composite Index of stocks has also climbed about 36% from November's lows
Falling imports don’t mean Chinese consumers are spending less
The reason why imports to China crashed 43.1% percent in
January is easy to figure out. Consider the following:
1) Consumers around the world are downshifting to discounters.
2) Over 95% of the merchandise in Chinese
Wal-Mart stores is sourced locally.
3) China’s undervalued currency makes all foreign imports artificially
expensive.
From these three facts, it should be clear that downshifting by Chinese consumers
is helping their economy while reducing imports. Furthermore, remember that
70% of the merchandise in US Wal-Mart stores is also from China, which means
that downshifting by US consumers helps China too.
It is true that falling exports are causing pain in China
China’s export sector is shrinking and
this means millions of migrant workers are losing their jobs. However, the
prospects for unemployed migrant workers are far better than they are for
America’s laid off workers. Unlike the US, China’s service sector
is experiencing double digit growth. This means that laid off workers are
finding new jobs or starting their own companies. Furthermore, migrant
workers and college graduates who are returning home will help boost
consumption in inner China. These young workers/graduates will push their
relatives to buy computers, cell phones, and other modern gadgets they have
gotten used to. The standard of living for rural China
will be going up.
China has begun major reforms of its social security net to boost
spending.
For the last three decades, China has experienced excessive industrial
expansion at the expense of consumption, with its consumption rate dropping
from around 55 percent of GDP in the 1980s to merely 35 percent last year.
The specter of high medical costs, coupled with the overall weak social
safety net, has been discouraging Chinese from spending their money. As an
example, Chinese government spending on health in 2006 amounted to less than
1% of the country's gross domestic product, ranking China 156th out of 196
countries surveyed. Medical reform has been deliberated by authorities since
2006, however China's battle with inflation has been taking priority over
moving forwards with these reforms.
Now with the inflation threat temporarily faded, China is finally moving
forwards with improvements to its social safety net. China has expanded social security and passed a new medical reform plan.
Broad insurance coverage and social security will, over time, start to shift
the balance in China away from savings and toward more consumption. China has
irreversibly begun to break its “dependence” on US consumers.
Chinese authorities plan to boost rural spending to spur economic growth
To encourage rural consumption, China has implemented a nationwide program to
provide 13% subsidies to rural residents on purchases of electronic goods
such as cell phones, washing machines, personal computers, motorcycles,
personal computers, water heaters and air conditioners.
The subsidy plan is working.
Rural sales overtook urban sales for the first time in the company's history
last year. Also, in the first 20 days of January, Chinese farmers bought more
than 160,000 items of home appliances on government subsidies, 90 percent of
the total in December.
China's focus on the consumption and standard of living of inner China is bad
news for the US. When inflation goes out of control,
Chinese officials will be faced with the choice of dropping its successful
effort to promote domestic consumption or dropping its dollar peg (which has
been unsuccessful at helping exporters).
The efforts to boost domestic consumption are working
Chinese consumers have been on a spending
binge, bucking the global trend. Chinese domestic
consumption is forecast to grow at about 20 percent in 2009.
The best place to see the diverging fortunes of the US and China is in a comparison between the US auto industry
and the Chinese auto industry, which offers a
stark contrast:
US auto industry:
- About 1,000
GM, Ford, and Chrysler auto dealers went out of business last year, and
about 2,500 more dealerships are expected to close in 2009.
- Manufacturers
are shelving plans to open new facilities.
- Hundreds of
suppliers are on the verge of going out of business in the next two
months because US auto production has virtually stopped.
Chinese auto industry:
- Dealerships
have stopped offering discounts on 80% of their sales because of strong
demand.
- Manufacturers
are investing in new plants and expanding workshop floors.
- All Chinese
auto makers are predicting growth for 2009, with some aiming to double
their vehicle sales.
In
January alone, Chinese battery and carmaker BYD sold 24,107 vehicles, up
80 percent from a year earlier.
It doesn’t look like the “hard landing” is going to be in
China…
3) China’s treasury holdings are a much bigger problem for China
than they are for the US.
I love this one. While it is true that China is having problems dealing with
their massive dollar reserves, to then say that those reserves are a bigger
problem for China then the US is hilarious.
Simply put, if you had to choose, which problem would you rather have?
A) China’s problem of having “too much cash”
B) The US’s problem of having “too much debt”
4) The US is facing a decade of falling prices
Droughts are plaguing the world’s
biggest agricultural regions, and the world
is heading for a drop in agricultural production of 20 to 40 percent,
depending on the severity and length of these droughts. Since the demand for
agricultural commodities is relatively immune to developments in the business
cycles (at least compared to that of energy or base metals), already rising food prices are
headed significantly higher.
In fact, agricultural commodities NEED to head higher and soon, to prevent
even greater food shortages and famine. The price of wheat, corn, soybeans,
etc must rise to a level which encourages the planting of every available
acre with the best possible fertilizers. Otherwise, if food prices stay at
their current levels, production will continue to fall, sentencing millions
more to starvation.
5) China is no more manipulating the yuan than the US is the dollar.
China’s 2 trillion dollars of reserves are proof of manipulation. The
process of building up foreign reserves puts downward pressure on a
nations’s domestic currency. So the yuan has been significantly
undervalued as a result of China’s reserve buildup.
The US, by contrast, has not been increasing or decreasing its foreign
reserve, and therefore has not been manipulating its currency.
6) If China floated the yuan, it could easily get smashed like other
export based economies.
A quick comparison of the fundamentals backing the yuan and the dollar should
reveal how they would fare if the yuan was floated.
China’s
fundamentals:
- At current
exchange rates, China could use its 2 trillion dollar reserves to
completely pay down its national debt and still have billions to spare.
This means China is one of the only countries on Earth which has a
positive net worth.
- China is
running record trade surpluses, averaging around 40 billion in the last
four months.
- China has
one of the world's healthiest and strongest financial
system.
- China’s
economy is growing, with its service sector experiencing double digit
growth.
- Most of the
world is dependent on China’s cheap consumer goods
- The Chinese
budget is balanced.
The US fundamentals:
- The US net
worth is negative $11 trillion dollars (with unfunded commitments
factored in = negative $53 trillion net worth)
- The US has
been running massive trade deficits for years.
- The US
financial system is completely insolvent
- The US
economy is collapsing, with both the service and manufacturing sectors
contracting rapidly.
- The US is
utterly dependent on the rest of the world for its basic consumer goods.
- The US
doesn’t even remember what a balanced budget is.
If China drops
its currency peg, the dollar is going to get killed.
For those who still think the yuan would crash if it was floated, I have a
few questions: is that how you invest your money? Do you go looking for the
company with the worst possible fundamentals? (Companies drowning in debt,
with declining sales, and no growth prospects) Or do you invest your money in
companies with strong fundamentals?
7) There is nothing else that's as good of an investment as the US dollar.
ANYTHING is better than the US dollar: Yuan, euro, yen, gold, silver, oil,
food, art, etc… Even the British pound will be worth more against the
dollar by the end of the year. (and the British pound isn’t going to be
worth much…)
Eric
de Carbonnel
Market Skeptics
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