Saturday, January 24, 2009

The Myth of the Eternal Status of the $US as 'the' Reserve Currency

There appears to be a mantra that is said in response to the idea of the collapse of the $US, which is to repeat the words '...but it is the world's reserve currency...'

Wherever I look, including occasional comments on the blog, I keep seeing this as a justification for why the $US will not fall. I feel it is time to address this point of view directly. I have, in part, answered some of the points in a recent post in the notes sections. However, I would guess that not everybody will get as far as the notes and, in any case, the points that I made could do with a little more elaboration and explanation. It is quite a lengthy post, but it must cover quite a bit of ground before it all pulls together at the end.

Before going further it might be useful to think about what a reserve currency actually is. First and foremost it is a way in which governments/central banks can store value, and it will be a currency that is the basis for comparison and execution in trade transactions. This is currently the function of the $US, which is the major reserve currency, with the Euro taking second place and the £GB third place (or perhaps it has slipped from this position of late?). However, in order for it to be the currency of transaction comparison, it must have a strong position in its own right in the world trading system.

At the moment there is no question at all that the $US is important as a reserve currency, and to deny this role would be fatuous. A large amount of trade is transacted in the currency as well as being the primary currency for government/central bank reserves.

However, that this is the current situation does not imply that this will be the situation into eternity. It is worth remembering that the £GB was once the reserve currency, but economic weakness saw it overtaken by the $US. In other words, reserve status is not a magical and unalterable fact. In many cases I sense that the argument against the collapse of the $US is actually a belief that a world in which the $US is not the reserve currency is an impossibility. This is not an argument, but an act of faith - a reserve currency does not exist by magic. The $US became the reserve currency due to the underlying economic strength and weight of the US in the world economy.

Before starting to look at the US role in the world economy, let's first of all be very clear about a particular point. Unlike the UK, the US is still a manufacturing heavyweight, and output of manufacturing has remained strong (the link takes you to an article that proposes that the service economy is supportable but it provides a useful chart), despite the decline of numbers of people employed in manufacturing.

In addition (again unlike the UK) added value from manufacturing in the US has been increasing. However, the same can be said of many competitors of the US, such as China. I found it very hard to find good data for this but did find this rather useful table (I suggest you pause and take a look at the link and the added value columns, taking particular note of the US and China).

As you will see in the table, the relative growth rates in added value between for example China and US are not very encouraging for the US on balance, and the data only goes to 2001. We should remember that China's growth rate has been accelerating. This is not to take away from the real gains in the US, but to emphasise that the position is relative slipping in comparison to China. I think we can safely assume that China's growth in added value will have seen very significant improvements since 2001, and we might speculate that the US may have gone into decline. At the very least, it is unlikely to have seen much growth (if anyone has better and more up to date figures, please feel free to post the link, as I do not like to make assumptions).

What we have here so far is not too bad a picture. The US appears to be doing well, but others are catching up fast.

However, this is not the whole story as, for example, the last point in time at which there was a US merchandise trade surplus was 1975. What this means is that the US consumes more than it produces in merchandise. Set against this, it might be argued, strength does not just lie in manufacturing but also as income from investments and export of services, intellectual property and so forth. The problem here is that the US has been running a continual current account deficit for a very long time. In other words, the US as a whole is running, in very crude terms, at an ongoing operational loss.

What we have here is a mixed bag of statistics and information, but no clear sense of what this actually means.

In order to understand what this actually means, there is a very curious and rather apt analogy that we can make with the US economy and the troubles of the US car industry. We might think of the US as General Motors (GM), and China as being like Toyota (we could add in Europe as Ford, and so forth, but for simplicity we will just look at the two). There are many parallels that we can make between the US auto market, and the world economy. An obvious parallel is the increase in market share of Toyota at the expense of GM, the ongoing losses at GM and the ongoing (until now) profits at Toyota. In both the US car market and global economy, there has been growth, but in both cases there has been a building of overcapacity (with resultant tough competition).

Added to this we have a contraction of demand in both the world economy, and a (more) dramatic contraction in the US automotive market. This contraction is cruelly exposing the weaknesses that were not so apparent in the 'good times'. This resemblance is most helpful to illustrate the bad state of the US economy, in particular if we think of the bailout of GM by the US government.

In the case of the GM bailout, the US government quite reasonably pointed out that GM had been having difficulties for a long time, and that the problems were evident during the good times. GM were already loaded up with mountains of debt, were saddled with huge structural legacy costs, their workers were paid far more than the workers in the Toyota factories, but with no advantage to explain this differential. They had been increasingly bleeding money. Whilst GM were still producing volume, they were simply not turning that volume into an overall profit. This might be a description of the US economy as a whole in comparison with China, although in an exaggerated form.

As a result of the fact that the problems were long standing, key conditions of the bailout were that GM management addressed the problems of both their legacy costs, as well as the wage differential between their workers and the Toyota workers. This was the minimum that was required. The government was willing to tide GM over for a short period, but only on the basis that they would have a breathing space to deal with these issues, and come back with a plan on how to move from making a loss to eventual profitability. This latter point will be the basis for any further assistance.

Few would argue that these demands are not reasonable, as the government wants to know that it is not going to be pouring money into a black hole (though, this is of course a political process, so whether the politicians will ever actually look at the eventual plan in a realistic and hard headed way is questionable). Few would also dispute that the declining market share of GM in relation to Toyota, the ongoing losses, are a big worry, and that the government is right to demand a plan from GM to show the way to profitability. Quite simply, the government does not want to throw money into a company that has no clear route to ever returning to profit.

It is at this point we need to ask the question about whether the US government is treating its own plans for the US economy in the way that it has treated the GM bailout. The US is still producing volume, but is operating at a loss. It is losing market share to a rival, which has been growing steadily and doing so profitably. Whilst both are suffering in the current market conditions, one has a large surplus with which to tide itself over, and the other is saddled with large debts. One is relatively loaded with legacy costs and the other is relatively free of such costs. In the past, GM and the US had a strong technological advantage, but even that advantage is eroding rapidly. In the case of the automotive industry, companies like Toyota appear to have surpassed GM in development, but this is not the case for the US economy and China. However, the differential is fast eroding, with China rapidly climbing the technological value chain.

If we look at the financial position of GM and the US at the moment, in very broad terms, they are aslo in a similar position. They share the problem that, even as debt is increasing, revenues are rapidly decreasing. This means that the debt is growing in both absolute terms, and in relation to revenue. This means that there is ever less income with which to service the existing debt, let alone any new debt.

I will not pretend that the US economy are the same, but the comparison/analogy does illustrate an important point when we consider the bailouts.

Whilst the bailout of GM is contingent (in principle) on a clearly defined route out of trouble, including a reduction in structural costs of the business, no such clearly defined route to reverse the deficits is being outlined for the US economy. It is just believed that, somehow, it will all come right in the end. For example, the GM autoworkers are being told that they will have to accept a cut in their pay and benefits package to narrow the gap with the Japanese transplant factories. As yet, no solid proposals for such plans have been forthcoming for the US economy. Various commentators are suggesting that there will be proposals to control the spending on welfare programmes for example, but nobody is saying that spending will be reduced.

In the case of Irwin Stelzer, his interpretation appears to be that the 'control' of expenditure will happen at some undisclosed notional better economic time in the future. In other words, everything will carry on as before, with any hardship delayed to some notional point in the future. Such a proposal from GM would rightly be regarded as a completely unrealistic denial of their underlying situation. Apparently, for the US economy, the same principles do not apply. If the stimulus/US bailout plan were subjected to the same basic consideration as the GM plan, it would be thrown out without any hesitation. It does not address the basic problems of the US economy at all.

As an aside, in one other respect, we have another curious comparison. One of the conditions of the bailout of GM appears to be that it must invest in electric cars. There is no proven market for these cars, no reason to believe that they will be a success, but a significant slice of their investment programme will be devoted to this cause. In much the same way, the US government is pouring 'stimulus' money into various green programmes. In both cases, there is a situation of significant financial problems, and in both cases precious capital will be sunk into activities with dubious prospects of positive returns. In both cases, economic pragmatism is bowing to the interests of politics. As I mentioned, an aside.

Overall, what we have is a situation in which the US government is seeking to rescue the economy in a way that would not pass their own criteria for the bailout of GM. The US government would not award a bailout to itself if it asked the same questions of itself as it did GM. It seems the basic questions that apply to GM do not, for no apparent reason, apply to the US economy. Overseas creditors will be taking note of the lack of a clear plan for return to surplus. They are not fools.

This should be a worry....but the $US is a reserve currency, so its ok. The US can just keep creating money, and all will be well. As I have mentioned, the US government is not an automotive manufacturer - we should remember that the US is a sovereign country, not a company able to turn to its own government as lender of last resort. In the case of the US government it has the central bank, and more of that later...

If the US wishes to borrow (aside from the central bank), it has two avenues for borrowing. On the one hand, it can use the deposits of US savers who, through the banking system, can buy government bonds. However, as we are all aware, the government is having to lend large amounts of money to the banks in order to prevent their bankruptcy, as they are insolvent and have lost much of their depositor's capital. The fact that the banks are also then lending this government money back to the government does not help in terms of clarity, but a money-go-round does not actually increase the finance available to the government through borrowing, and more of that later....

The bottom line is that the only way that the US government can really continue borrowing in normal ways is by raising money in international markets, and that means gaining finance from the surplus countries such as the oil producers and the big exporters like China and Japan. There is also potential for funding from countries like the UK where there is increasing nervousness about holding the £GB, and where the $US is still seen as a safe haven. The trouble is that, at this moment in time, all across the OECD governments are all on simultaneous borrowing binge, meaning that there is significant competition for available capital.

So far, the US has done very well out of this, as there has been a 'flight to safety', with the $US seen as a safe haven. This is the advantage of being the main reserve currency. It is the natural place to go when the markets are spooked. As a result, the $US has managed to defy gravity, and has remained relatively steady.

However, I will now quote a note from my previous post, regarding one of the major creditors to the US (again I am discussing China but the principle will apply to other holders of $US reserves):
However, a good way of looking at this is to think of yourself in the position of Hu Jintao. He is seeing that his exporters are collapsing, and that the growth necessary for stability is dropping away. Set against this, he has huge piles of foreign currency, a strong position to spend to support his economy. However, he has a difficult problem.

All the while his economy has been growing, it has accumulated massive reserves of foreign currency. In order to enact a stimulus, he really needs to utilise some of these reserves in order to prop up his economy. However, in order to utilise those reserves, they need to be sold into the market place to buy, for example, the commodities that will be required in support of infrastructure projects. If China starts trying to sell those reserves, he is in a position where there will be a flood of the currencies onto the markets. That flood of currency will depreciate the currency, as there are not enough goods to be purchased in the currency, and likely little demand at this time to use the currency as a reserve. During the downturn, others will equally want to use their reserves to finance their way through the trouble, rather than accumulating greater reserves.

If we look at the $US, if this is sold into the market, and sees the resultant depreciation, then there will be further troubles for exporters. Although the RMB is not a free floating currency, if the $US depreciates, and the RMB does not appreciate, the US will (quite reasonably) howl with rage, and will take protectionist measures. If that is the case, China can say goodbye to one of the major export markets.

In other words, what China has done is accumulate currency that it dare not use as, if it uses the currency, it will destroy the currency. The only solution available will be to try to discreetly sell as much of the currency as it can without 'spooking' the markets.

The trouble is that, with so many countries holding these $US reserves, most of whom have their own economic problems, it is likely that everyone is having the same thoughts, and confronting similar problems. What you have is a situation in which there is something like a Mexican stand-off. As soon as one starts selling, then everybody must start selling. They are all, at the same time, terrified of selling, because in doing so, they destroy the value of what they are selling. It is a time bomb just waiting to go off.
What I am pointing to here is a big contradiction. The $US is the reserve currency by tradition, but it is now clear that there is a fundamental problem with the currency. It is close to being completely unusable. This is not a reserve currency in that it is not a store of value.

The problem is more serious than I have suggested in the above quote. Mr. Hu is facing an even sharper dilemma. He has all of these $US reserves, a currency that he dare not use, but he will become increasingly in need of something to prop up his own economy. However, as we are all aware, the US is now on the path of quantitative easing, or printing money without constraint. At present, this has not yet fed into inflation but, as I explained in a previous post, the government is acting as a buffer soaking up the newly minted money before it actually reaches the market. A large part of the new money goes through the money-go-round creating a buffer, and the newly created money must go through the government before reaching the open market, and the government thereby also acts as a buffer on the money reaching the market. However, as the governments plans are enacted, this new money will eventually appear in the market place.

In a previous note on a post, I had the following to say regarding the UK, but it applies to the US:
If, for example, the banks use money to finance borrowing of overseas governments, this is a net outflow of currency, which will further weaken the £GB. If the money remains in the UK, it will eventually reach the economy in the form of loan guarantees, and various other government stimuli measures. In all cases, the money does eventually reach the market. The important point in all of this is that there is a significant buffer in all of this, which is the ability of the government to actually utilise the money such that it reaches both businesses and consumers in the UK.
I believe that in the case of the US, the freshly printed money is going straight to the banks, then is being lent to the US government, with very little going outside the US. As such there is going to be an increase in the money supply in the US in the near future, and that money will have nowhere to go except to chase a limited number of goods and services. The reason for this is quite difficult to explain, but I will try my best.

The first consideration is the supply of $US over time. There is a chart here which shows the massive amount of $US reserves that are now held by governments around the world. You will note the amazing rate of growth. One of the reasons that has been cited for the growth in reserves was the experience of the Asian crisis, but I will leave that to one side for the moment. The important point is that, as fast as the US could create money, it has been soaked up as increases in reserves around the world.

At the same time as this has happened, there have been several asset bubbles in the US, including the housing bubble. These have also soaked up the increase in money.

The problem here is that the US central bank has been pumping out huge amounts of money out with no apparent inflation. Like many central banker fixations, they have obsessed about inflation. Inflation happens when there is too much money chasing a limited number of goods or services. However, what has been happening is that the huge amount of printed money has been soaked up by central banks for reserves, and soaked up in asset price inflation, such that it has not been chasing goods and services. Furthermore the supply of goods has been increasing with the growing productive muscle of the emerging economies. As such, there has been a combination of very serious inflation in the money supply in the US without a corresponding increase in measured inflation.

Now the expression measured is very important, because asset price inflation did not count in official inflation. In particular, as fast as new money was produced, asset prices such as houses inflated. Greenspan, in his wisdom, allowed one bubble after another to soak up the expansion in money. However, we have now gone one bubble too far, and there is no new bubble on the horizon to soak up the money being dropped into the market (which would in any case just be a delay, not something that would be a 'good' thing). As such, one of the sources of money absorption has been bubbles in assets, which stopped the prices of other goods going up. Mainstream economists seem to think inflation was conquered, but it was just displaced into something that was not measured.

The other absorber of $US I mentioned was the steady accumulation of $US reserves by central banks. To understand this we have to once again imagine Mr. Hu in his Beijing office. Mr. Hu has a series of dilemmas with which he must wrestle.

On the one hand, he has more reserves than he can possibly do anything with. If he uses them, he destroys them. However, he needs to save his own economy. One way of doing that is to keep the exports flowing to the US. However, if he does that, he will simply accumulate even more reserves which he can do nothing with. Furthermore, if he is looking at the US plans with any kind of critical evaluation (which he has hinted at) then he will not see great prospects for the future value of the $US reserves.

In addition, without the exports to the US, Mr. Hu will see further contraction in his own economy, and possibly social unrest. In order for the exports to save him, he must accept the continuation of a system in which China exchanges pieces of paper with nice pictures on them in exchange for goods. In other words he must finance US consumption with massively subsidised Chinese production.

The problem is that Mr. Hu is not alone. There are many people sitting on $US as reserves but with very little that they can do with them. The trouble is that the money was issued without a corresponding growth in the output of value in the US economy. Instead of real growth in value, there was an apparent growth due to debt fuelled consumption. As such, there has been a significant growth in the supply of money without a significant growth in real output of value. As I have pointed out in many posts, GDP is a sham figure that is meaningless unless the source of the activity is included. Debt driven consumption produces significant activity now, but at the cost of future activity. It does not signify that an economy is creating more value or wealth, just more activity. In the case of debt fuelled growth, it is a mirage.

As such, what we have is a situation in which there has been a massive expansion in the money supply, but no commensurate sustainable expansion in the products or services that the money supply can purchase. As such supply of $US has outstripped the supply of US produced goods and services, and by a very large amount.

If we return to Mr. Hu, and those in a similar position, the only way out for them is to continue to soak up ever more $US. This is because there is now no assset bubble within the US to soak up the newly created money coming off the printing presses. There is no place for the newly created money to go into the US economy as it does not produce enough goods and services to soak up the money. This means that the only place it can go is overseas, meaning yet further $US accumulating in reserves overseas.

The trouble is that they already have more $US than they can do anything with. The fact that the $US is a 'reserve currency' is what has allowed for the destruction of the currency. As long as the $US was the reserve currency, it was possible for more and more to be issued for other central banks to accumulate, and this situation was not a problem - right up until now when all of the holders of the reserves need to actually utilise them. It is now that their real status as a reserve currency is being tested - that test is their worth as a store of value. It is failing that test.

In such a situation, the mantra that the $US will be saved because it is the 'reserve currency' starts to look increasingly weak. Here are the fundamental questions:

Why would anyone want more $US when the reserves that they have are already beyond any utility? For example, why would China wish to continue to pay for US consumption with their labour and savings? Why would any country wish to do this, as many other countries are in the same position of holding large $US reserves? As such, I would ask those who argue that the $US will not fall 'because it is a reserve currency' the following question:

'Under what circumstance do you think that a currency might lose its status as a reserve currency?'

In other words, how much money does the US need to pump into the market before every country, every individual, and every organisation calls 'enough'? How completely useless must the currency be before it collapses. Quite literally, there is $US trillion + out there, which no one can find any use for. If they use their reserves in any quantity, they risk destruction of their reserves.

Do the defenders of the $US as a reserve currency think that the creditors have not noticed that they are sitting on piles of paper they can not use? Do they think they are not analysing the US stimulus plan and not going through every detail looking for the time when they will be repaid for their loans? They are sitting on their reserves, and probably wondering if they will ever be of any use, of any value. With more money being pumped out, they will be getting very agitated. When they look at the stimulus plans, all they will see is ongoing deficits, and no plan for return to a surplus. Ever.

I must emphasise this point. At no point has anyone in the US government to my knowledge offered any plan that has not involved ongoing increase in debt, increase in the money supply, and there has been no plan whatsoever to return to surplus.

Under the current circumstances the $US is not a store of value, but a destroyer of value. I can almost visualise the meetings in governments around the world, as brows furrow over the central problem of the $US. What will be causing those brows to furrow is that, if the $US goes down, the world economy will follow it on down. On the other hand, if everyone holds on to the $US, the only way they can save it is through absorbing an ever increasing supply of $US, which means an ongoing financing of US profligacy in return for a currency of ever faster decreasing value.

Furthermore, the massive increase in supply of $US that comes with quantitative easing is just going to make the value of their existing $US more questionable, even without the prospect of adding more junk to the pile. The greater the supply of $US that are printed, the more that everyone is subsidising the US at the expense of their own economies and their own populations.

There is even worse than this for the $US reserve holders. Either they absorb those excess $US that are being created or that money will sit in the US chasing the limited stock of goods and services that are available from the US economy itself, thereby creating hyper-inflation within the US, and thereby also destroying the value of the $US. Either they subsidise exports and absorb the new money, or the value of their reserves is destroyed.

They must finance the US deficit and trade imbalances, or the $US is junk, and the world economy becomes junk with it. As I said, a Mexican standoff. Someone is going to blink, start selling the $US, and everyone will follow. The dollars will pour into the market.

I suspect that the US government and central banks around the world are in regular discussion on this issue, though less directly than I have put it here. It will be dressed up in nice language, and will all be terribly civilised and discussed in technical evasions of the reality. However - there will be a subtext - on the one side the US will be pointing to an apocalypse if the $US falls, and on the other side there will be the furrowed brows.

It is a very fragile situation, and it just needs a small push.....

Note 1: This has been a very challenging post to pull together, so I am worried that I may have missed points, or not been as clear as I should be. As such, any comments will be very welcome, in particular if there are any inconsistencies in the post.

Note 2: In a table earlier, you may also note that the UK has seen growth in manufacturing output, but this brings me to an interesting point. I will quote my first essay for the blog as follows:
'According to an EMEA report, gross added value from manufacturing in the UK saw a rise in the mid-nineties, followed by a decline in the early 2000 period, a decline that led to the added value falling back in 2005 to where it had been in 1999[20]. '
I have put this in as an aside, in case the figures in the table encourage a false sense of confidence in the UK economy. Also, you will see from another table I linked to a similar picture.

Note 3: This is a very long post, and I apologise for not responding to comments this time. However, many thanks for the comments and the many very useful and interesting links.

Note 4: I am aware I am focusing on China but, as I have mentioned in many posts, China is increasingly in the driving seat for what happens next. Of course, it is only one player amongst many, but it is an increasingly important player with potential to effect significant change. For example, if China were to bite the bullet and continue to finance US deficits....then the day of reckoning for the $US might be delayed for a while yet (though will still happen eventually).

27 comments:

  1. Hi CE,

    Nail on the head.

    A couple of American commentators I've read questioned the wisdom of piling up the deficit with absolutely no plan to pay it back beyond 'we'll be fine, we have the world's reserve currency'.

    But economists and policymakers are deliberately shying away from the difficult question(s) because their remit is all strictly short-term.

    This leads me to believe that the stimulus to the collapse will come from the external creditors (China/Japan/Saudi) deciding that they're sick of throwing money at the US economy.

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  2. Another three hours and you would have been right about a sovereign default in the UK before Christmas.

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  3. Really nice points made, the flight to safety going to the dollar is expected, but what happens if the US$ loses its security in the eyes of the world, what will the safe secure investment be?

    As you have pointed out, confidence in the dollar could break, and then what?

    There are strong indications that gold is breaking through the constraints that the fiat money system put on it in order to ensure its dominance. Gold however does not have the flexibility or liquidity of paper money, so fairly soon the demands will outstrip the physical ability to move it, so it will cease trading when demand becomes too high volume and the holders of gold cannot move it, something that would happen very quickly if confidence in paper money became a reality.

    As noted here

    http://www.commodityonline.com/ndtv/news/topstorydetails.php?id=14523

    Gold demand is outstripping supply in one of the biggest markets for physical gold. This is a good indication that confidence in currency has gone down and people are trying to save their wealth in the most traditional forms of wealth.

    Of course gold while a good store of wealth is not easy to shift if you need to buy things in the short term, which is why token money with a backing of gold became the default.

    So while the virtual money market and all the mess it has made collapses because there is more virtual money than real wealth, people will try to store wealth in gold or other real assets. The question in how much resources are available now the worlds population has grown to such heights is probably going to make such flights to assets a real problem

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  4. Everything is relative and at the moment, I see no real alternative reserve currency. The yen? The renminbi?

    Especially with China there is considerable political risk in my opinion.

    Also, the dollar has established itself as the currency equivalent of the "lingua franca" of the world and in my opinion will require a great momentum to shift this, much in the way that English will probably remain the business language of the world, even accounting for future changes in demographics.

    I don't think the dollar will always rule but any flight away from it and the establishment of a new no.1 reserve currency will probably take around 10 years.

    Let's not forget the "powers that be". Even if you don't believe in the "new world order", I strongly believe that vast political interests prevent the real natural course of markets.

    Chris
    My Twitter Page

    PS slight aside but wondered what you think of the huge public sector expenditure in the UK - maybe you can blog on it later: Soviet Britain swells amid the recession

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  5. In order to see what China will eventually do, you must answer the question you avoid. What happens if world economy completely collapses? What will happen next. Sure, economy as we know it no longer exists but it is not the end of the world. Something has to replace that system and the one that dictates what comes next, is the one who recovers faster and stronger.

    In a world collapse, countries are on their own, at least at start. International trade shuts down cause there are no set values to trade with. Nations will have to do with their own means for some period.

    Let us study China

    You need a strong and NUMERUS military to keep civil order. China has it. Having a population that is used on taking orders also helps a lot. Don't forget that China is still a communist country.

    You need to take control of your agricultural production, to feed your population (employed or not). If you grow enough food, you eliminate one of the basic reasons of turmoil. I think that China produces enough food to sustain itself.

    You minimize your use of energy to the absolute necessary. There is no need for all the export oriented industry to keep working. Reduce your energy consumption to survival levels, for example heating, cooking and light. Give it free to your citizens. People go unemployed but at least they don't starve or cold to death. You can divert some of the available workforce to the farms. Lots of free hands can replace that oil consuming machinery. Is China self-sufficient at that level?

    So, you have bought lots of time.

    From there you can slowly restart your international trade by exchanging products at first. China has the capacity to produce anything other countries need. For example, you open a few factories and exchange computers for resources with Russia. Clothing for food with New Zealand. New Zealand food for oil with Saudi Arabia.

    And you dictate your rules.

    What other country is better prepared for world economic collapse?

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  6. My bets as to what to invest into .

    Gold, then food, preferably long term sortable.

    Items easy to barter will then come in their own as well as guns and ammo and other munition related assets.

    Films like Mad Max will have short term interest, along with "How to grow Vegetables" and other survival guides.

    Predicted downturns on "An inconvenient Truth" and other Green tombs until the upturn on sustainability meets the bottom line of unsustainable debt and the shovel of "get a clue" meets the head of the general public so they realise debt isn't the holy grail.

    So endeth the lesson

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  7. Just a quick note. What I am describing here is a $US collapse which will cause some chaos in trade for a while. In addition to this, it will also create significant difficulties in many other respects.

    I generally avoid talking about social and other outcomes, but would stress that the problems of hyper-inflation and a collapsing currency do not necessarily mean complete chaos.

    Whilst the world trading system might go through chaos for a while, this does not mean that the world will end. Much of what will happen will depend on the reactions of governments to the upheaval. There is potential for them to ameliorate the effects, such that it is short, painful but relatively quick adjustment.

    In short I am not predicting the end of the world, though there is plenty of **potential** for unpleasant outcomes. My hope is that the reality of the situation will force a final acceptance that the only solution to the problems is real reform. It is quite possible that the currency crisis will just prick the bubble of our collective delusions...albeit in a very painful way..

    Kecske: Many thanks for the link which is interesting reading, and underlines the fragility of the £GB. I am not sure that such a story will reassure investors.

    It is also good to know that my analysis at the time was correct. The story also explains why it is that the measures being taken in the UK are progressively more extreme.

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  8. I still can't believe that the Chinese and US governments didn't understand this 10 years ago, yet they both carried on regardless. I know that politicians are prone to pursuing policies for short term popularity, but presidents and prime ministers also have an eye on how they will be portrayed in the history books. Could they really have not understood what they were doing? If the world's leaders had wanted to trash the economy, they could not have done it more effectively and thoroughly if they had planned it.

    The 'New World Order' conspiracy theorists have been banging on about this for years, and their predictions seem to be coming true with a seeming inevitability..!

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  9. Hello CE,

    Following on from your last comment, it would be very helpful to hear some suggestions for how the transition in the West from our present 'wealth' to an economy based on things of intrinsic value might be managed so the social pain isn't nightmarish.

    I've noticed a tendency in other well known blogs for some commentators to almost revel in the prospect of social chaos. I can only assume such people have no children...

    The politicians have passed through the headless chicken mentality and are now retrenching into defending their national interests - which was the harbinger of the Great Depression, I believe?

    Anyway, a review of the broad picture (freed from any understanding of economics as I am) would suggest that, in essence, the axis of industrial power is lurching decisively towards China & India.

    If there is very, very little we can do better and/or more cheaply than China's battallions of labour, then Europe and the US are left only with some compelling questions, not least ratios of population to productive land...

    I realise your blog is not intended for social commentary, but is it possible to map out a minimum pain version of our descent into reality?

    Many thanks.

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  10. I was just trying to point out that the "reserve trap" China finds itself in, might not be an actual trap. We still have nothing that China wants. It is opium wars again.

    Anonymous 9:37

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  11. Cynicus,

    No problems here – I felt your argument flowed beautifully. I have the following comments:

    1. With enough development there surely would be a market for electric cars – watch this video clip to see where we are: http://www.youtube.com/watch?v=OXqYbNEiW0Y
    Whether or not this will come about under green dictates from the US government remains to be seen.

    2. According to the animated Money as Debt series banks never directly loan depositors’ money.
    http://www.youtube.com/watch?v=cy-fD78zyvI
    Yes they must have certain reserves of deposits in order to make loans but once a loan is approved the bank simply clicks a button and creates the money out of thin air. It’s a subtle difference, but one which highlights the incredible power that banks possess. It states that 95% of money in the US economy is created in this way.

    Disturbingly it also remarks that only the money for the loan principal is created whilst the money for the interest is not. It analogises like a game of musical chairs people are chasing a fixed pool of money to pay for debts that exceed that pool and this is why we have bankruptcies.

    Perhaps Cynicus could comment on this – or maybe you already have in a previous post?

    3. To the Anonymous poster above who made an interesting point I had not considered, namely due to unprecedented supply constraints trading in gold would cease. Would this happen? Anybody?

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  12. his comment may interest you:-


    Obama Stumbles Badly Out Of The Gate

    Our new president committed a serious gaffe last week by allowing his nominee for Treasury Secretary, Timothy Geithner, to say the Obama Administration "believes that China is manipulating its currency."

    What makes it so unnerving for investors is that talk of unfair currency exchange rates is seen as a protectionist measure, the threat of which every sane economist believes would be enormously damaging to the global economy at this time. That protectionist measures during the Great Depression seriously worsened the crisis is economic dogma.

    Chinese officials reacted somewhat angrily to the charge, saying Friday that Beijing “has never used so-called currency manipulation to gain benefits in its international trade,” in a statement released by China’s commerce ministry. “Directing unsubstantiated criticism at China on the exchange-rate issue will only help US protectionism and will not help towards a real solution to the issue.”

    What makes the timing even worse is that China has become the biggest foreign holder of U.S. debt, second only to the U.S. government itself. The latest figures from the Treasury Department show that for the three months to November, China increased its purchases by 16.1% to $681.9 billion and by 48.6% for the year till then. Japan, the second largest foreign holder of U.S. debt, increased its holdings by just 1.28% in the three months to November but decreased its holdings by 2.1% for the year, the only foreign holder among the top ten to do so. Given that the Treasury will have to issue some $2 trillion to $3 trillion in new debt in the next couple of years and that for better or worse we will depend on China (and other nations) to keep stepping up its purchases, antagonizing a strategic rival (which China is) seems to be an especially dangerous policy.

    Traders in New York reacted nervously to the news, sending oil and gold up sharply as they sold Treasuries on the concern China might slow its purchases of U.S. debt.

    Actually, the threat of swift changes in U.S./China exchange rates either way would be enormously de-stabilizing at this time because it would cause tremendous distortions for currencies, equity markets and commodities.

    If China were to sharply reduce its financing of U.S. debt, a sudden appreciation of the yuan would occur. U.S. interest rates on all credit instruments would rise and the dollar would rapidly fall against the higher-yielding euro, pound, Australian and New Zealand dollars while the yen plummeted against everything. The Fed would likely have to step in and make up the difference, forcing it to print even more dollars than it already has been in order to monetize U.S. government debt, which is expected to be $1.2 trillion in fiscal 2009 before the stimulus plan is accounted for. Oil, gold and other commodities would skyrocket as the dollar plunged and equity markets would rise abnormally on the asset inflation. Upward pressure on China’s currency would further damage its already-weakened export sector and the country's (to say nothing of the world’s) economic growth. Imports would not increase much if the yuan appreciated; Chinese citizens tend to be savers because little exists in the way of health benefits or social programs, and China ranks just 131st globally in per capita GDP with an estimated $6100 of yearly income (2008 figures).

    If China were to suddenly increase its purchases of U.S. debt, the yuan would depreciate, sharply accelerating its out-sized trade surplus. Protectionist sentiments would increase which could possibly start a trade war in the middle of the worst economic crisis since the Great Depression, crashing fragile equity markets the world over in the process. The dollar would likely accelerate sharply against the higher-yielders, possibly to the point of bankrupting economies like Britain which has large amounts of external debt financed in dollars. The yen would gain against everything. Oil and gold would crash and production of oil would be sharply curtailed.

    It will be very important to closely observe any further comments from Washington and Beijing. Heightened tensions between the U.S. and China, should they ocurr, will have serious ramifications for global markets. Above all else investors hate uncertainty, so it would seem that it would be best at this time if the new administration did everything in its power to maintain a semblance of calm with regards to U.S. and Chinese trade relations. To paraphrase Mario Puzo from his book The Godfather, “keep your strategic friends close, but keep your strategic rivals closer.”

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  13. Surely for China the accumulation of the $US has been a by-product.

    A modern infrastructure, high employment and a lack of social unrest have been the goals.

    The Chinese feel better about themselves after a great humiliation, they do not want to rock this boat.

    It is of course madness that the world's reserve currency belongs to one nation. I suspect those dollars will one day be swapped for the "bancor" or something. (not gold, the need to expand the money supply is important).

    If there was a switch to the bancor, it could be possible to wipe out alot of global debt without destroying accumulated stored value.

    Time will tell.

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  14. Interesting to note for all the people here and elsewhere hawking gold is that during the great depression FDR confiscated private gold and threatened the "gold hoarders" with gaol.

    Good article here: http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/4339501/Bad-news-were-back-to-1931.-Good-news-its-not-1933-yet.html

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  15. @Jonny

    The link I was basing my thinking is below. Had to dig deep into browser history to find it now, so apologies for not posting it before.

    http://www.marketskeptics.com/2009/01/gold-becoming-money-once-again.html

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  16. @Jonny

    I based my thinking on the below link. Had to dig deep into browser history to find, so apologies for not posted before

    http://www.marketskeptics.com/2009/01/gold-becoming-money-once-again.html

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  17. Interesting link here from an investment company that predicted the crash (I am not a member of the company, I post because of the interesting points it makes)

    http://www.sovereignsociety.com/portals/0/svs/fullpromo_MSVSK105.html

    It paints a dismal picture of the Credit Default Swaps, and it makes me wonder if the deleveraging of derivatives at the time of the first crash has already covered some or most of the CDS's or if the worst is yet to come.
    "This new CDS market now stands at a size larger than the entire capitalization of all the world’s stock markets combined."

    Also it paints an interesting picture of the role of the Yen in the credit bubble. Basically Japan gave out loans at near 0% interest in order to try to stimulate its economy, US companies borrowed in vast amounts, and used the money to buy derivatives. As the yen grew, interest payments grew, leading to selling, flooding more money to japan and hiking the Yen even higher. The article predicts that when the CDS start tumbling it will send the Yen to unbelievable heights.

    This in not good for Japans export market however, and recently there were rumors of currency controls to be put into place

    http://www.forexhound.com/article.cfm?articleID=123247

    So one thing you can take from this is that if the US stocks tumble, and the Yen suddenly skyrockets, the CDS market has started to collapse, and the fun will really start.

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  18. Good point on FDR confiscating gold.

    Although I posted before on gold, I wasn't "hawking" it so much as pointing out that it indicates a shacking of confidence in currency worldwide, and that not even the dollar is immune to it.

    Didn't FDR need the gold so he could back the currency under the gold standard? Unless Obama decided to put the dollar back on the gold standard what real reason would he need to confiscate it?

    I could be missing something, but I am not sure that would happen this time round.

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  19. Once again, clearly argued sense. Now that MSM commentators are starting to see the real issues the debate becomes increasingly political. You explain the economic position of USA, China etc., but the important questions now relate to how the political responses of the various parties affect the long term future of the world economy.

    I am increasingly disturbed by the way in which so-called green agendas are being pursued for political rather than scientific & economic reasons. Your comment about development of electric cars as a precondition of support for GM illustrates this point perfectly. It worries me that advocates of electric cars never tell us how all the extra electricity will be generated.

    There may well be good scientific & economic reasons for doing much more to protect the environment (it is very difficult to find considered comment on this), but the green agenda seems more driven by knee-jerk emotionalism than rational assesment of risks and benefits.

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  20. Another article about gold (from the same author of the one entitled Gold Becoming Money Once Again)

    http://www.marketskeptics.com/2008/12/gold-backwardation-that-shook-world.html

    Beyond my limited grasp of finance, so if anyone can put it in simpler terms It would be helpful.

    I made my first post to show how I thought erosion in confidence in currencies has led to gold being in such demand it is in danger of the supply chain of physical gold breaking down through excessive demand.

    The authors claims of gold becoming money, and that the breakdown of the gold market causing the dollar to crash I am not able to judge.

    The talk of backwardation http://en.wikipedia.org/wiki/Backwardation

    Is a futures term that means an item for future delivery costs LESS than one for immediate delivery, which seems strange, but "backwardation is a signal that the item in question is in short supply"

    I wonder what your analysis of this is CE?

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  21. Big Inflation Coming

    http://www.safehaven.com/article-12403.htm

    Rather technical, but worth reading just to see the graph of the incredible spike in inflation.

    "M0 has gone parabolic! Year-over-year in December 2008, it was up 98.9%"

    "How did such a crazy inflation spike happen? After Bernanke's Fed foolishly ran interest rates to zero to try and force investors out of Treasuries and back into stocks, it ran out of conventional ammunition to fight the panic. So it started buying securities directly, which is purely inflationary. When you buy a bond, you have to first raise the cash to do it. When the Fed buys a bond, it literally creates the money out of thin air with the stroke of a keyboard. Every security the Fed buys is paid for with pure inflation, new money."

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  22. Ron Paul on the death of the dollar.

    Don't know how good a president he would have made, but a good honest speaker.

    http://www.marketskeptics.com/2009/01/ron-paul-on-death-of-dollar.html

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  23. @anonymous 11.24 25/01/09

    I know exactly what you mean about some people revelling in the prospects of chaos which may be about to befall us. I am one of those people! I am a parent so it tempers my enthusiasm slightly, of course, and I'll probably change my mind as soon as it happens, but the prospect of the bland, predictable 9-to-5 rat race going up in smoke fills me with joy. My feelings are probably best summed up by the first episode of 'The Good Life', believe it or not, where Richard Briers' character decides to become self-sufficient when the absurdity of spending his life designing plastic mouldings to go into cornflake packets becomes too much for him. That's exactly how I feel about free market capitalism as it exists at the moment: people working very hard at producing pointless, useless rubbish to be bought by other people to relieve the tedium and pain of their own pointless existences. The future may be a very frightening place, but at least with the pieces being thrown in the air like this, we may eventually know what it is like to be alive. Or something like that.

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  24. Another nice post.
    Couple of questions here....

    1)Even if China were to continue buying Treasuries would they not still run the risk of a loss should a nation that holds significant dollar holdings decide to 'dump' them?

    2)With the pound going the way it is, should the pound tank, how is the UK going to pay for imports? Especially foods?

    3)Aren't most countries going the way of the US, albeit at a slower rate? Countries like Italy have been running defecits for ages but as the ratio was low in the past no-one worried, now that it's reached a substantial level doubts have come.
    There's certainly a lot of developed countries like Italy.

    4)Can't the Chinese just exchange their Treasuries for dollar-denominated imports?

    5)What's the risk of some countries dumping their Treasuries but deciding to invest that in lowly-priced American stocks considering a loss would be worth that gain.

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  25. Economic theory uses the comparative advantage when explaining why it makes sense to trade but in what respect is that still useful that China can produce almost anything very cheap? I just don't see how you can compete with them, especially now that they're moving up the value-chain the pain will kick in in countries like Germany.
    So far, for countries like the UK globalization lead to a loss of industries that produced value.

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  26. @Lemming,

    Hope you own a few good acres, and a gun...

    I do empathise with the desire to see the bad stuff erased, but fear that the misery we exported for the last 50 years is simply coming home to stay. 21st century Westerner is poorly equipped to deal with privation.

    Anyway, perhaps human beings have only two possible conditions: wretched poverty or meaningless affluence?

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  27. This is pure conjecture, but I could easily envision the current plan to purchase $300 billion of US treasury notes as cover for China to sell an equivalent amount, or perhaps it is just a pre-emeptive measure of sorts to compensate for a net selling of notes by foreign holders.

    Given the precarious position of the US, I do not believe such a reckless policy change is simply a measured effort to reduce mortgage rates, as it has been advertised.
    Time will tell.

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