Fire Sale

[KendallJ]

By Kendall J from The Crucible & Column,cross-posted by MetaBlog

I learned something interesting in a meeting this week. I was sitting in an demand planning meeting for one of my products and discovered that we had a few orders that were delayed. It seems that booking export containers and ships is getting increasingly difficult. What with the devalued dollar and everything, U.S. exports look pretty cheap and stuff that normally would never leave the country is flying off the shelves. Sure enough I found a similar article that day in The Wall Street Journal, Container Shortage Puts US Export Boom in a Box. For those of you who didn't know, exporting US goods to places such as Asia used to be dirt cheap. So many inbound containers from places like China were piling up that freight rates were held very low just to find something to put in them so they wouldn't head back to China empty. Now, there's a shortage!

That's great right? Sales. Revenues. Profits. The economic stimulus the FED has been doing must be doing the trick. Wrong. This is simply a temporary spike and the brick wall we're going to slam into on the other side of this spike is made worse by the FED's recent attempts to keep the domestic economy going.

Here's how it works. The FED has devalued the dollar. US goods look cheap to other countries. They buy lots more than they normally wouldn't. US volumes spike up, and revenues and thus profits are higher. All looks great. Until US firms have to buy new raw materials to replenish those goods they sold. Guess what. It's a global economy. A lot of those raw materials come from overseas. A ton of finished consumer goods also come from overseas. We have to pay more to get them because our dollar is devalued. Oops. That means the prices we were charging before have to be increased. It takes a while for all those costs to trickle in, but if you watch key import commodities like oil you'll see what we're headed for. Now we're forced to increase prices and hoping to continue selling our goods. But wait, our prices will eventually get back to the levels they were before the dollar was devalued, and foreign countries won't want our exports any more.

Sure enough the signs are there. Today's Wall Street Journal, "Dollar Slips Below 7-Yuan Barrier". We used to blame the Chinese for messing with our currency, but releasing the Yuan from it's peg to the "boat anchor" of the dollar was smart, and now we see the devaluation clearly. And from yesterday's "U.S. Trade Deficit Widens" - import volumes ticking up along with exports. And the most telling, "Import Prices Show Broad Rise"

Import prices surged in March, lifted by not only oil but also the biggest jump in non-petroleum costs on record, a worrisome sign for inflation.

Petroleum import prices increased 9.1% last month and fell 1.9% in February; prices soared 60.0% in the 12 months since March 2007. Between March 2006 and March 2007, petroleum import prices climbed by 3.1%.

Excluding petroleum, all other import prices rose 1.1% in March, after increasing 0.7% in February. Prices excluding petroleum increased 5.4% in the 12 months since March 2007, nearly double the 2.8% climb between March 2006 and March 2007.

The FED has done the equivalent of announcing a "fire sale" on the US economy in the hopes that all while all that merchandise is going out the door no one will notice that we're actually destroying value by selling our goods too cheaply. On the other side of that is an even deeper slump. All the while the FED keeps pumping more money into the economy, and demanding greater regulatory authority. Argh.

We're headed for Jimmy Carter-era stagflation folks, and the FED is putting its foot on the accelerator to get us there. All the while they blame the financial markets for the woes that they directly caused. The solution is not going to be pretty. I wouldn't be surprised if we see double digit interest rates again before this is all over.

The real solution is not more government regulation over the economy, it's less, nay no government regulation of the economy. Lasseiz faire! The FED caused this mess. Had monetary policy been privatized, this wouldn't have happened. It's going to get much worse before it gets better, folks.

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[softwareNerd]

Today, I think it is the Chinese, more than the Fed, who are finally devaluing the US dollar

The Chinese government supports the US dollar by accumulating it as reserves at the People's Bank of China (PBC). In 1999, US total M1 and M2 were 1125 and 4650, and the PBC just had USD reserves of 155. That seemed pretty sizable (all number are billions US$). But... fast-forward to Dec 2007. This is the picture: US M1 and M2 are 1368 and 7333, while the non-gold reserves at the PBC are 1528.

Think about that, the PBC has more reserves than all the M1 in the U.S.! Or, looking at it another way, during 1999-2007, the growth in Chinese non-gold reserves has been 50% as much as the growth in U.S. M2!

[gags]

When the value of the dollar stabilizes, the Chinese and others are going to expand their buying spree in this country. During the 1980s the Japanese bought quite a few US assets, but I'm afraid this "fire sale" is going to make the last one look small in comparison.

[KendallJ]

Today, I think it is the Chinese, more than the Fed, who are finally devaluing the US dollar

The Chinese government supports the US dollar by accumulating it as reserves at the People's Bank of China (PBC). In 1999, US total M1 and M2 were 1125 and 4650, and the PBC just had USD reserves of 155. That seemed pretty sizable (all number are billions US$). But... fast-forward to Dec 2007. This is the picture: US M1 and M2 are 1368 and 7333, while the non-gold reserves at the PBC are 1528.

Think about that, the PBC has more reserves than all the M1 in the U.S.! Or, looking at it another way, during 1999-2007, the growth in Chinese non-gold reserves has been 50% as much as the growth in U.S. M2!

hmmm. That's an interesting thesis. The Chinese can accumulate dollars, but they dont' expand the money supply. How does their policy "force" the FED to do so?

[softwareNerd]

The Chinese don't force the U.S. to expand the money supply. What they have done is cushion the effects.

Here's a "crazy hypothetical": Imagine that you were an extremely rich guy who owned lots of businesses, and you were unhappy about the growing U.S. money supply. So, you decide that you would stop spending as much as you normally do (including "spending" in the sense of investing in factories etc.). Instead, you decide to build up US dollar balances. You do not even put much of this money back into circulation by buying U.S. government bonds. You're so rich, that at the end of 10 years, you have built up a US$ balance that is equivalent to all the M1 in the US.

The impact of such an absorption would be to dampen the effect of US money growth. By doing so, you might actually encourage the U.S. government to create more money than it otherwise would, in a sort of moral hazard, where you are cushioning them against some of the downside.

The Chinese were not motivated by a desire to help the U.S. out on its growing money supply; they had their own reasons. (Other countries have been doing the same, but most of them are much smaller than the Chinese.)

The U.S. Treasury department has been complaining to the Chinese about this for years, asking them not to support the US dollar in this way. Finally, the Chinese have relented. I doubt it is purely to be friendly with the U.S. government. They have their own motivations. Still, for about a year or so, they have decided to change course. They still have not changed radically, but just enough to make sure the dollar falls against their currency.

So, after spending the last few year falling against commodities, now the U.S.$ will also fall against the Yuan.

BTW: I don't take any credit for this thesis; it's a fairly common one among some people on Wall Street.

Some more general refs: Here, here and here.

Edited April 14, 2008 by softwareNerd

[KendallJ]

Well, I view this a little bit differently. My understanding was that China had essentially managed their money supply to keep the Yuan pegged to the dollar. That in an of itself not a bad thing. China has a confiscatory policy with regards to dollars, (which is a bad thing for its own people) which gives it more power than others to maintain the peg.

But that means the fate of Yuan is tied to the fate of the dollar. As the dollar inflates, China has to accumulate dollars to keep the peg. But that also means the Yuan will inflate, causing the same disaterous results there as here. Releasing the peg to the Dollar is smart fiscal policy when the idiots at the FED can't manage to get their policy right. CHina is essentially voting no confidence in the FED's ability to keep the dollar stable.

Blaming them for creating a moral hazard seems far less important than blaming hte FED for biting on it. It is like blaming a car rental company for the damage you're temped to do to it because 'it's a rental' on the act of renting you the car in the first place. It is essentially saying to China, "Please don't have so much confidence in the dollar to use it as your standard, because then we might be tempted to make it a less reliable currency..." The US doens't need to have the "moral hazard" problem extinguished to somehow keep it from debasing it's own currency, and any rational country who had originally pegged their currency to what they thought was a stable standard would release that peg if the standard became inflated.

There are lots of things that I'd be upset with China for, but this is not one of them.

Edited April 14, 2008 by KendallJ

[adrock3215]

I wouldn't be surprised if we see double digit interest rates again before this is all over.

I'd love to see double digit interest rates. When the time comes, I will be piling as much money as I can into Treasuries. A smart individual would have purchased as many 30-year T-bonds as he or she could during the early 80's and locked in phenomenally high rates (18-20% yearly) for very little risk, if I remember correctly.

[softwareNerd]

I think we probably agree about of the process/mechanics at work here.

I think the apparent difference is in the placement of blame and the evaluation of future trends.

In terms of blame, I don't want to absolve the U.S. government and our Fed. They are to blame for the drop in the value of the dollar. Even if the U.S. government was not wholly free-market, if they simply did not run up huge deficits, and if they did not inflate the currency, things would be fine on this score. I don't want to be the drunkard, blaming someone else for giving in and giving me a drink after I have badgered them for it. If I were a Chinese citizen, however, I would blame the Chinese government for allowing as much local inflation as they have done, in order to keep the US high vis-a-vis the Yuan.

On evaluation of future trends, the point I was making was that today it is the Chinese who have finally decided to do less intervention. The current drop in the $ vis-a-vis the Yuan is not the result of some new Fed devaluation. It has been a long time coming and is something that would have happened earlier if not for Chinese government intervention. Today, we get 7 Yuan (RMB) to the US$; by next year, the best guess is that it will be 6 to the dollar. This means that U.S. exports to China will continue to look increasingly more favorable to businesses in the U.S.

[DarkWaters]

If I were a Chinese citizen, however, I would blame the Chinese government for allowing as much local inflation as they have done, in order to keep the US high vis-a-vis the Yuan.

On evaluation of future trends, the point I was making was that today it is the Chinese who have finally decided to do less intervention. The current drop in the $ vis-a-vis the Yuan is not the result of some new Fed devaluation. It has been a long time coming and is something that would have happened earlier if not for Chinese government intervention. Today, we get 7 Yuan (RMB) to the US$; by next year, the best guess is that it will be 6 to the dollar. This means that U.S. exports to China will continue to look increasingly more favorable to businesses in the U.S.

Typical economic commentators, op-ed writers and television personalities seemed to accuse the Chinese government of "undervaluing the yuan" to increase Chinese exports. However, given sNerd's post I just thought, is this actually a conscious action of the Chinese government, or are they just not constantly undergoing monetary expansion to keep up with the credit expansion in U.S. dollars that is the result of the record deficit spending of the U.S. federal government? sNerd, am I interpreting your post correctly, or is this a separate issue? To me this, sounds exactly like what you meant when a lush who is staggering drunk (the U.S. government being drunk on inflating the USD) blaming his fairly sober buddy for giving him another drink (China for inflating the Yuan in response to US pressure.)

So I imagine that the Chinese government is not exactly a model for sound monetary policy. However, how bad have they been in this regard, with respect to over the past few decades, compared to the United States?

[KendallJ]

On evaluation of future trends, the point I was making was that today it is the Chinese who have finally decided to do less intervention. The current drop in the $ vis-a-vis the Yuan is not the result of some new Fed devaluation. It has been a long time coming and is something that would have happened earlier if not for Chinese government intervention. Today, we get 7 Yuan (RMB) to the US$; by next year, the best guess is that it will be 6 to the dollar. This means that U.S. exports to China will continue to look increasingly more favorable to businesses in the U.S.

Ah I see, so you're looking at the added impact of China's decision to drop its peg. You're right there. That is and will be substantial, and it will accelerate the looming domestic crisis, but you're right, it will prop up exports for a while to the extent that China imports US goods.

[softwareNerd]

... are they just not constantly undergoing monetary expansion to keep up with the credit expansion in U.S.

Not just to keep up, but to stay "ahead" (in the bad sense of inflating their money supply faster than the U.S. inflates its own). They've nobody to blame but themselves. The powers that be in China are probably congratulating themselves for having accumulated such a huge hoard of US$. Their citizens probably do not realize that it is money that should have flowed to them instead. In grossly simplified terms, they seem to have followed a US$ inflation-plus policy: for every 10% you increase your money supply, we'll increase ours by 15% (figures are illustrative only).

However, how bad have they been in this regard, with respect to over the past few decades, compared to the United States?

According to the People's Bank of China, both M1 and M2 in China grew at an average rate of 16% per year from end-1999 to end-2007. Edited April 14, 2008 by softwareNerd

[KendallJ]

James Fallows had a nice summary of how the Chinese central banking system works in the last Atlantic.

[softwareNerd]

Thanks, Kendall. That's an excellent article.

I had a thought...maybe we can sell them Louisiana for $1.4 trillion

Edited April 15, 2008 by softwareNerd