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The Falling US Dollar

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It does appear that the Chinese central bank has been propping up dollars, building up a huge foreign currency balance in the bargain. I've read some commentary about how the Chinese accumulating a holding of about $1.5 T has soaked up enough dollars (pumping Yuan into China instead) to keep $-inflation lower than it could be. Given that the Chinese balance is so huge -- almost equivalent to total U.S. M1 -- the explanation sounds convincing.

Keeping the dollar propped up is probably one important spur to Chinese export-driven local investment. If the theory is true, then part of this is malinvestment that will unwind when the Chinese central bank starts to unwind -- or slow the accumulation of -- US$ balances.

Any thoughts on this line of argument, GB and A.West?

Edited by softwareNerd

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Quite true, GB. One of the big current puzzles related to global investing and economics is whether the Chinese investment boom of recent years is driven by distortions in the US and Chinese financial systems that provide incentives for malinvestment. The big challenge is that malinvestment rarely looks like malinvestment to most people at the time it's initiated. I can find anecdotal and causal evidence to support the hypothesis that at least some of China's massive fixed asset investment is negative IRR over the long run. The hard part to determine is how much of it. Unfortunately, one really only knows until the tide of credit expansion goes out and economies begin to slow.

China has had bank loans growing at 30% or so for years, with fixed asset investment representing around 40% of economic activity. Since the start of the decade, it's annual steel consumption has more than tripled, with most of this going into construction uses, much of it directed by bureacrats who have much to gain and little to lose if a project (office or residential real estate) is completed, and with government controlled banks providing the lending, banks with a very poor track record in differentiating good from bad loans. That smells like malinvestment. It may well be that monetary policy in the US is tied to investment trends in China in this case, and perhaps vice-versa.

Interesting. China's investment does seem to float on air. Maybe it is floating on a sea of dollars. I guess that is what softwareNerd is saying:

It does appear that the Chinese central bank has been propping up dollars, building up a huge foreign currency balance in the bargain. I've read some commentary about how the Chinese accumulating a holding of about $1.5 T has soaked up enough dollars (pumping Yuan into China instead) to keep $-inflation lower than it could be. Given that the Chinese balance is so huge -- almost equivalent to total U.S. M1 -- the explanation sounds convincing.

Keeping the dollar propped up is probably one important spur to Chinese export-driven local investment. If the theory is true, then part of this is malinvestment that will unwind when the Chinese central bank starts to unwind -- or slow the accumulation of -- US$ balances.

Any thoughts on this line of argument, GB and A.West?

Among the two of us, A.West is the China and international trade expert, so I will defer to him. Any thoughts, A.West?

The basic question of whether China's boom is at least partially a malinvestment boom is important. Of equal interest if it is malinvestment, how have the Chinese gotten away with it for so long?

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If we believe the figures from China's central bank, then they have been taking in more dollars than they give out. In other words, it appears that they have been converting those extra dollars to Yuan and thus increasing their local money supply.

... how have the Chinese gotten away with it for so long?
China has been going through a major legal-structural changes that are causing once-in-a-lifetime increases in productivity. Can we assume that such increases might have been accompanied with falling prices and a strengthening local currency, if they had kept their money supply steady? Instead, China has some inflation and a currency that is pegged to the dollar (only being allowed a slide recently). Could this be part of the explanation? In other words, they can get away with 7% price-rises instead of the 17% price-rise one might expect from looking at Yuan money-supply, because productivity knocked off the other 10%? (Just throwing in some figures for illustration here.)

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In other words, they can get away with 7% price-rises instead of the 17% price-rise one might expect from looking at Yuan money-supply, because productivity knocked off the other 10%? (Just throwing in some figures for illustration here.)

Conceptually, that makes sense, but I do not have special expertise or data on China to validate your hypothesis. It does remind me of the U.S. in the 1920s, though. Prices were flat, but that hid a good deal of monetary inflation that was offset by tremendous productivity growth. Absent the inflation, prices would have declined as they had during most of the 1800s when money was gold-based and inflationary episodes were rare. (Inflation occurred when the gold standard was temporarily suspended during wars, such as the Civil War.)

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That's the general idea Softwarenerd and GB. The difficulty is trying to determine how much of the Chinese economic growth is built on value-added investment, and how much on value-destructive investment. The heavy RMB expansion and multiple government financial system refinancings (recapitalization of past bad loans) means that malinvestments are almost never liquidated in the Chinese economy.

Property investors barely care about return on investment - if they can get a loan, and permission, they will build. Some people are beginning to say that Chinese are "developing for the sake of development" rather than economic return.

But there's also a lot of hard work at low cost being done in China. I try to never forget the images I've seen of people running machine tools out of their 2-room home/workshops at 11pm Sunday nights. They are competing against Joe sixpack who thinks he has a right to earn $70,000 a year doing the same thing and putting in half their hours.

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The IHT carried an article about Chinese local inflation finally pushing up prices of their exports.

After falling for years, prices of Chinese goods sold in the United States have risen for the last eight consecutive months. ... ... Chinese imports constitute 7.5 percent of spending by Americans on consumer goods, but they make up much bigger shares of several popular categories, including about 80 percent of toys, 85 percent of footwear, and 40 percent of clothing. ... ... "This is what I call the perfect storm," said Alan Hassenfeld, the chairman of Hasbro, the world's second largest toy maker, during a recent visit to China. "We've got higher labor costs and labor shortages, plastic prices have gone way up and we're doing more safety testing." ... ...

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Great article sNerd.

Here is another one titled Dollar defies Fed's Rate Cut.

Despite the Fed cutting US rates by 1.25 percentage points over the past two weeks, the dollar has weakened only slightly. Typically, a dramatic fall in interest rates would make returns from Treasury bonds less attractive.

Experts say that there are several reasons for the dollar staying relatively strong. Mr Loynes said: “The relationship between interest rates and currencies is not mechanical. This is a rare case of the currency markets being forward-looking. In the near term, bonds will be worth less, but the quick reaction of the Fed could point to a more positive outlook in the medium term for the US economy.”

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So much for the dollar strengthening as I posted above. It has hit a new low today against the Euro, the Brazilian real, and the New Zealand dollar. It will take nearly $1.51 to buy a Euro today after Fed Vice Chairman Donald Kohn yesterday essentially dismissed the notion that he was worried about inflation and more worried about "near-term growth." Gold is at a record high, $967.70 an ounce, up 12% for the year. Crude oil is at a record high; some oil analysts on CNBC are saying gas will cost $3.50 a gallon within a few weeks and $4 a gallon by spring. Grocery and commodity costs are through the roof as well, causing many businesses to raise prices. The 5-5-5 (3 pizzas for 5 dollars each) deal at Domino's Pizza is now the "three for 5.50 deal." Essentially the dollar is at an all-time record low versus any marketable good...

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I apologize if this question has already been addressed in the essence earlier in this thread. I did not see anything.

Will the U.S. economy collapse under the weight of the prodigious amount of debt that has been racked up over the past few decades?

My speculation is that so long as individuals in the U.S. are producing real values, i.e., advances in medicine, new software, better consulting services, faster computers, better military equipment, advances in bio-engineering and other idea-based goods, then the U.S. economy will not collapse. However, the enormous credit and monetary expansions of the Bush Administration (and preceding administrations) will still continue to greatly devalue the dollar. Thus, in effect, they are just engaging in large-scale metaphorical larceny with respect to the dollar's purchasing power.

The main motivation for asking this question is that my friend, who is unfortunately an ardent Ron Paul supporter, keeps on writing Facebook notes suggesting that "[u.S. taxpayers] will no longer even be able to pay the interest on the [national] debt", "taxes would have to be raised to confiscatory levels" and "we are approaching a de facto default on our debt."

Despite the reckless deficit spending of the U.S. government, I am still confident that my friend is wrong about an imminent economic disaster but I am sure that I do not fully understand the financial economics of the issue. What do you guys think?

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Will the U.S. economy collapse under the weight of the prodigious amount of debt that has been racked up over the past few decades?
The long-term answer lies outside economics, because the crux is the political direction of the U.S. and the world.

Is a collapse imminent due to the national debt? "Collapse" can mean a lot of things, as can "imminent". Suppose we define "imminent" to mean: within a decade or two. And suppose we assume that the U.S. debt and GDP in the next two decades will grow at the same pace as it did in the last two decades. Then, we end up with the startling realization that the U.S. debt will be less, as a percentage of GDP, not more. In other words, from 1988 to 2008, while the U.S. debt grew from $2.6 trillion to almost $10 trillion, the GDP grew as well. As a percentage of GDP, the debt grew from 52% to 66%. However, 20 percentage points of that growth has been the following: the government writing IOUs to the Social Security administration, while spending that money for non-SS purposes! So, if one looks at the payroll tax as simply being another tax, and if one looks at SS outflows as being like any other government outflow (i.e. subject to change, rather than a real obligation), then one finds that the net debt owed to entities outside the government, fell from 36% of GDP in 1988 to about 32% of GDP in 2008.

Even if one assumes that SS obligations have the same status as other debt, one cannot project a Debt/GDP ratio over 90%, if the status quo continues. (That's a big if!)

OTOH, what if the U.S. politics is such that nothing is done to tackle SS over the next two decades, and what if new "obligations" (e.g. expanded health-care) are added on, and what if expanding controls knock a few percentage points off GDP growth. One can build up ever more scary scenarios: but, it's really a political prediction, rather than an economic one.

[Added 3/19: Other than SS promises, another huge looming problem that must be tackled sooner rather than later is: the underfunding of public pension funds. In some ways this is more serious that SS: in the sense that these are legally binding obligations.]

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Edited by softwareNerd

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Great post sNerd!

I suppose I have been reading too many predicted economic catastrophes with regards to the U.S. stock market from the gold-bug libertarians as of late. I think Ron Paul supporter Peter Schiff might be a major source of these dire predictions. I also noticed that Richard Salsman commented a few years ago that

I have found that "gold bugs" - or gold-bug-type "financial advisors" - are the ones who most often mislead neophyte investors; these crazies take advantage of most people's perfectly-legitimate distrust of government and push such ideas as that hyperinflations or widespread debt collapses are "just around the corner" and therefore that gold or other tangibles (canned food, bottled water, munitions and survival shelters) - are the only viable investments.

Thus, I am not really too worried when I hear dire predictions from the Ron Paul types. However, the thing that really caught my attention is that in Yaron Brook's 3/19 appearance on Fox Business News at around 16 minutes into the linked clip, Dr. Brook says in response to the question "what should an investor do now to make money?"

"I think you stay out of this market. I would not be in the stock market right now. I think there is too much uncertainty."

I am not sure what he means by this. Does Dr. Brook mean that we should not make any risky short-term investments until it is clear how the market will react to the massive U.S. taxpayer-subsidized bailout of Bear Stearns? Does he mean that the dollar is so devalued that investing in anything involving stocks traded in the NYSE is a bad idea? What about mutual funds involving such stocks? I have no idea. What do you think he meant?

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What do you think he meant?

I have no idea...I can't believe he didn't elaborate, or wasn't asked to. :thumbsup: Maybe you can email it to him/ARI and get a response?

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What do you think he meant?
He mentions uncertainity. I assume that he means that the short-term is going to depend on Fed decisions and political decisions, and is going to be a really bumpy ride, with the unpredictability that comes from the political nature of these decisions. Edited by softwareNerd

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He mentions uncertainity. I assume that he means that the short-term is going to depend on Fed decisions and political decisions, and is going to be a really bumpy ride, with the unpredictability that comes from the political nature of these decisions.

When I listened to that video first time, I got his words as not to invest into a specific part of the market, specifically, the one around mortgages.

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Oil, rice, Potash @ all time highs today. Anyone been to the grocery store lately? Prices have skyrocketed within the last 6 or so months on nearly every item. Also, Check out this article about Europe:

ECB Watch: Red Hot Inflation

Summary:

French CPI increased 0.8% on the month last month. German prices rising quickly as well. Eurozone prices have risen 3.5% on the year as of March. Luckily, the ECB maintains its stance on fighting inflation and refuses to lower interest rates while other economies such as US do.

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Luckily, the ECB maintains its stance on fighting inflation and refuses to lower interest rates while other economies such as US do.

I'm betting we'll see double digit interest rates by the time the FED figures out that it's screwing the economy with it's current "stimulus" tactics.

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I'm betting we'll see double digit interest rates by the time the FED figures out that it's screwing the economy with it's current "stimulus" tactics.

I would be willing to wager on that as well. The US may be in store for another Paul Volcker-style recession sometime in the near-future.

Just a note here: Current differences between the ECB and Fed are being clearly shown by this recent financial crisis. It has been interesting to watch the difference in monetary policy take shape. From my understanding, the Fed has a dual mandate of fighting inflation, and keeping unemployment low. The ECB seems to take more of a Milton Friedman monetarist type approach, in that its only mandate is to keep inflation low. We know, of course, that neither policy works over the long term. I'm just saying it's interesting to note the differences in policy at this point in history.

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I think you all might be interested in these video regarding a ficticious (but not at all impossible) "day the dollar collapses".

You will also see Peter Schiff arguing in the video. And while there seems to be a little bit schadenfreude on part of the Euro fans (I don't think the Euro will fare much better, it seems Peter Schiff thinks so) it is not so far from reality if Bernanke continues to print money and China loses its confidence in the Dollar.

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