Krugman Surprises!

Well, the arch stimulator, the deficit spender in chief, has accepted that there is a limit to government deficits and money printing. This is from Krugman:

So there is a maximum level of debt you can handle. In practice, if it makes sense to say such a thing with regard to a stylized model, at some point lower than the critical level implied by this model the government would decide that default was a better option than hyperinflation.

Krugman is responding to Jamie Galbraith, who appears to believe that money printing and deficit spending can resolve all ills (a regular commentator on the blog appears to hold similar beliefs). I must also add Krugman's caveat to his acceptance that massive deficit spending and money printing might cause hyperinflation:

Now, I’m sure I’m about to get comments and/or responses on other blogs along the lines of “Ha! So now Krugman admits that deficits cause hyperinflation! Peter Schiff roolz” Um, no — in extreme conditions they CAN cause hyperinflation; we’re nowhere near those conditions now. All I’m saying here is that I’m not prepared to go as far as Jamie Galbraith. Deficits can cause a crisis; but that’s no reason to skimp on spending right now.

I highlight this from Krugman, as his analysis is very interesting, and I would recommend reading the article in full. It has a few equations, but is largely user friendly. When you are finished reading, you can come back to this post.

The reason I highlight this is that Krugman accepts the principle of seigniorage, an inflationary taxation, and accepts that (somehow) 'the government must persuade the private sector to release real resources'. However, there is an almighty assumption in the entire article that he is looking at a closed system, one in which the resources are closed. He does not exclude the consideration that the 'private sector' might include overseas provider of resources, but seems to believe that they will accept the seigniorage that those within the country might accept. He also fails to note that, even those within the country indulging in money printing have an option of moving their funds to a currency that is not subject to seigniorage.

Here is the problem for, for example, the United States. About $US 4 trillion of US government debt is held overseas, and the US is reliant on continued overseas provision of 'resource' being funded by overseas creditors. If these creditors believe that seigniorage will result in inflation, a tax on their holdings of $US, they will start to find better investments, unless the interest rate offered exceeds the seigniorage. At present, the US has been benefiting from the safe haven/reserve currency status to offset these fears in troubled times. However, as I have long argued, this can only last so long. This view is now starting to become mainstream. This from HSBC (1):

It’s not hard to see how in six months time we will all say it was obvious that the dollar would eventually fall. The US has a highly indebted economy, the global imbalances needed to unwind as the US needs to export more, and EM countries need to import more. Meanwhile, the Europeans have aired their dirty debt in public and taken some measures to address it, whilst the US has not. By this time everyone would have forgotten about the risk on/ risk off fad just as quickly as Dubai disappeared off our radars. As the US economy slows and others in the world raise rates to fend off inflation the dollar will come under pressure. The euro break up premium is coming out and the next phase in this rotation will be a weaker USD and we very well may have seen the first signs of this – the worm is turning.

In this scenario, of a falling $US, the US is left in the uncomfortable 'Chimerica' system, in which China continues to fund deficits in order to keep their export machine turning. Again, as I have long argued, China will eventually reach a limit, the point at which they will no longer continue to subsidise the US with credit that will never be fully repaid (or paid at all?). This is the real 'resource' that Krugman is discussing. Having a borrower tax you on your lending to the same borrower is not really a very attractive prospect, especially where the tax leaves you lending at real negative interest rates.

Then we come to the creditors within the US economy (see graphic here). Just over 60% of US government debt is held by the Federal Reserve and 'intragovernmental holdings', and a further 6.2% held by state and local governments. We then have the curiosity of the circularity of government taxing other branches of government with seigniorage. All I can say to such an idea is 'Huh?'

Then there are the other domestic holders of US government debt, such as pension funds, mutual funds and so forth. If they are lending money to the US government, they do so in the interests of their own investors. Just as with overseas lenders, they might reasonably expect a positive real return on their investments, and there is no real block to moving their investments into currencies that might offer such a real return, except habit and a fear of greater risks in overseas investments. The point at which fear of domestic risk is enough to overturn fear of overseas risk and habit is a difficult one to pinpoint, but nevertheless there is such a point - it is just a question of where? Volatility in world markets has served to reinforce fears of overseas investment, but expectations for the US economy, and US government policy, are a factor in the volatility. It would not take much for a panic to commence.

To put this into context, China is once again pulling back on investments in treasuries:

China reduced its holdings of U.S. Treasury debt in May as total foreign holdings of government debt posted a slight increase.

China's holdings fell by $32.5 billion to $867.7 billion, the Treasury reported Friday.

There is increasing speculation that the Federal Reserve is about to restart the printing presses, and this will only serve to undermine confidence in the $US, as this means more seigniorage:

The US Federal Reserve has already pumped some $1.2 trillion (£780bn) into the US economy to try to promote recovery.

The continued fall in prices will add to pressure on the central bank to take further unconventional measures to push inflation into positive territory.

These measures may include increasing the money supply via further quantitative easing or intervening in the US government bond markets to hold down long-term interest rates.

In recently released minutes from the Fed's June meeting, policymakers raised the possibility of further action later this year, if the economy slows down further.

For the moment, lets play with the scenario that just overseas creditors stop the purchases of treasuries, and that the 'resources' of these overseas lenders will not be available in the US economy. The first impact will be that the demand for US dollars will fall, and with it the value of the $US. This will, of itself, be an inflationary impetus, as all imported goods, services and commodities will increase in price. The second impact will be that, the resources which were formerly entering the US economy (as a result of overseas credit) will no longer be available within the economy. You then have a situation within the economy of a greater supply of money, and less resources available within the economy.

As an offsetting factor, the supply of credit within the economy may be contracting at the same time, due to a wider reluctance of overseas creditors to provide credit in the US economy, except at interest rates that might offset the devaluation of the $US. However, that reluctance will further fuel inflation by reducing demand for $US for private lending into the US economy (further devaluation), and by increasing the cost of credit more broadly within the economy.

All of this will take place whilst the US economy is working under a burden of the existing debt, meaning that a proportion of internally generated resource will be needed to service the existing overseas debt. Even if the size of the debt is being diminished by inflation, there will still need to be an extraction of that internally generated resource to provide payments for overseas debts, and that will be proportional to the level of inflation. The relationship is this; the more resources going to overseas, the higher the inflation in the economy, the higher the inflation in the economy the less resource will be extracted to overseas. Whichever way it is regarded, it is an inflationary impetus - at least until the debt is repaid.

Now let's add in the private domestic investors in government debt. If they start to worry about achieving such poor returns on government debt, they may overcome their fear of overseas investments. In this case, we have an additional problem of capital flight. US dollars will appear in larger numbers on the currency markets, and further depress the $US, and this will provide a further pressure for devaluation of the $US. Likewise, private investment overseas will appear more attractive, depressing investment in private businesses, which will already be suffering from the withdrawal of the use of overseas resource in the economy, due to the lack of credit being provided to the US government. In other words, there will not be credit available to expand the resource generated within the US economy, and make up for the shortfall of resource that was previously provided from overseas.

The only answer for the government is to print yet more money, which will short term ameliorate the problems, but will medium term just heighten the problems. The problem is that it is only possible to go so far with massive deficits and printing money. The US economy is currently reliant on a combination of habit and fear, the 'safe haven' effect, and the inherently unstable 'Chimerica' system.

Krugman is right that there is a limit. The key point in his analysis is he has accepted something close to my own analysis, that money must relate to the provision of privately provided 'resource'. In other words, he seems to accept one of the key arguments of this blog; which is that abstracting money from real goods and services is delusional. In so doing, he is accepting that, in the long term, currency valuations and wealth must be determined by output within an economy. He simply fails to see that, in a world of mobile capital, that there is no such thing as domestic policy acting in isolation. As long as investors have choice, they will seek the best or safest returns.

Real negative interest rates for investors are the danger for economies indulging in deficit spending and money printing, as investors will only accept these up to a point. Words like 'safe haven' and 'reserve currency' are evaluations, and evaluations might change. I recall some time back, an analyst suggested that the $US was nitroglycerin, and we are seeing the US government packing ever more explosive under their currency. In reality, the $US has been nitroglycerin for a long time. It seems that it has just taken more of the explosive to be added for analysts to realise the dangers. Who knows, perhaps even Krugman might get there?

Note 1:

I have been noting that there has been ever more widespread talk about a Chinese property bubble, and this was something I discussed in July of 2008. I can not find an article that mentions this, but I have recently read about the problem of investors keeping apartments empty, and this reminded me of one of my first commentaries on China. I went back to the original article, and found this:

My essay was focused just on the UK and one of the assumptions was that the UK was going to suffer more than any other economy in the current downturn. I knew that the US was going to hurt, and hurt badly. However, the US economy has greater flexibility than the UK, and I therefore expect the pain to be shorter lived, albeit it will still be very bad indeed. I believed Germany and France would hurt, but not too badly. For Italy, I believe that they will suffer very badly indeed. They no longer have the freedom to use their currency to save their economy, and many of their businesses are facing tough competition from the emerging economies. They lack the flexibility or will to rise to this challenge, and will need a crisis before they can even think of rebuilding their economy.

As for Spain, this country was largely off my radar. I was aware that their economic growth was largely built on construction. However, I did not realise how reliant. I read an article in the Telegraph which suggests that Spain may be a candidate for the hardest hit in the current turmoil. It seems that they have allowed a property and construction bubble to rage out of control, and the popping of the bubble will be catastrophic.

Japan I will leave for one side, as I plan to talk about it more at a later date. I also plan to discuss China at a later date, but will just mention a couple of points for the moment. The first point is that it is quite possible that China has a construction bubble. Whilst I was in China I noted that there were lots of apartment blocks being built, and that it was very popular for these to be purchased by investors. In many cases the investors were leaving the apartments empty (Chinese people like to buy property brand new, once it has been lived in the value falls), and they were holding on to the apartments in an expectation of increases in value. In addition to this there has been a boom in the construction of shopping malls, and I noted that they were already (back in January) starting to exceed demand. If the Chinese economy is pulled back due to world demand for exports dropping, it is likely that such investments will lead to a bust. It is also worth considering the state of the Chinese banks. If they are lending into construction in this way, will there be a repeat of the previous Chinese bad lending problems of a few years ago? What other bad lending is buried in their books?

Set against this is that the finances of the Chinese government are very healthy, as are the levels of savings in China. The real question with China is how much their continued growth is reliant on exports, and how much growth can be sustained within China. I will readily admit that I am not sure on this at all. I am not sure that anyone is. My best guess is that China will also hurt, and hurt badly, with a significant potential for civil unrest as a result.

I was wrong about the US, whose policy has gone in the opposite direction to that which I expected. As for the other points, I think I have mostly been right (but missed Greece entirely). With regards to China, I elaborated in the promised later post (again July, 2008) with the following:

So where does this leave the economic future of China? Where would I place my bet? Would it be on ongoing growth, recession and instability, or what outcome? The honest answer is that I would not place the bet at all but, with a gun to my head forcing me to to make the bet, I would choose continued economic growth, albeit at a slower pace than before.

However, I should also mention that I expected a $US collapse a long, long time ago, and was absolutely wrong (the optimism expressed in the first post quoted above rapidly dissipated in the face of actual US policy responses). However, the reason I gave for the problems with the $US are exactly the reasons that analysts are now discussing. As for Japan, I struggled for a long time to 'get' Japan, and never delivered on the article. Perhaps some time in the future....as I think I do now have a rough handle on the Japanese economy.


(1) HSBC Global Research, July 2010, Currency Outlook.

The Underlying Size of the US Economy

I would like to start this post with a hypothetical item of government spending, such as building an extension to a government building, and track some of the money that might be spent. The example uses the US, but the principles apply to any country. The reason for this example will become apparent later, and may be a little disturbing.

As soon as the money for the extension is approved, there will be a surge in economic activity. Project management groups will be formed, an architect firm hired, contractors will be tendering, and medical suppliers will be preparing for large orders. In this case, I will just track some of the spending as it passes to the firm of architects. Depending on the nature of the contract, money will eventually start being passed to the architect firm, and that money will arrive in the firm's bank account. Once in the account, the money will be used for a range of purposes, such as the cost of operations, cost of office space, and legal and other services. All of these economic activities will be partially supported by the government expenditure. For the next movement of the money, I will concentrate on the salary paid to the workers in the firm, and in particular one of the architects.

Let us imagine that one of the the less senior architects is a man who works on the project for 6 months, and all of his pay is therefore coming from the hospital extension project. We might imagine that the architect is an average type of individual in a professional occupation, and that he is married with a young family and earns $100,000 per year. We can therefore imagine his spending, with his income covering a mortgage, payment on a car loan, and fairly large expenditure on consumer items, and consumption of services like trips to restaurants. All of these will be paid with government money. If we just consider the example of expenditure on consumer items, we might think of a toy purchase for one of the architects. He will visit a store, and we can imagine that he spends $50 on a toy for his daughter's birthday.

The $50 originates in government money for the extension, and it now lands in the till of the retailer selling the toys. The retailer then banks the money, and the money will then be utilised for a range of purposes. If we imagine that the toy has a $25 mark-up, then $25 of the money will be used to reorder the toy. The toy is made by a company based in the US, but with manufacturing overseas in China. As such, some of the money will be used to pay for the manufacturing in China, and we will just imagine that $10 covers the cost of manufacturing a replacement. That means that £15 will go to the US company, and will pay for the operations of the company and profit, with $10 'leaking out' of the US economy into the Chinese economy.

As with the architect firm, the $15 that goes arrives in the US toy company will contribute to staff salaries, pay for the costs of the office, pay for business expenses and so forth. If we imagine one of the office staff, part of the pay of the person will come from the sale of the toy, and that money has come from the architect, and that money has come from the building project, and that money has come from government expenditure. The money for the building extension is rippling through the economy creating activity....Whilst the headline amount of the money diminishes at each level, the money is utilised many times over in multiple transactions.

What I am (I hope) showing, is the way in which the money spent by government generates economic activity way beyond the headline figure of the actual expenditure. Each of the activities that the money generates, as the money use multiplies throughout the economy, is recorded in the GDP figures. It is a very complex process to track, and economists have great difficulty in trying to work out how much government spending increases activity throughout the economy. For example, one review of academic literature (see note 1) identifies that different fiscal expenditure in different situations and countries can lead to multipliers of between zero and four.

It is actually quite easy to see why the multiplier effects of government spending are so difficult to calculate. For example, the spending of government money on infrastructure such as a steel bridge might have very different effects according to the individual economy. If the economy has a strong steel industry, then the multiplier will likely be much greater, as otherwise a large portion of the expenditure will rapidly 'leak out' of the economy to pay for the purchase of the steel from overseas suppliers.

What we are therefore left with is a big question mark over how much activity each $1 of government expenditure might generate within the US economy. In light of the estimates of between zero and four, I will proceed on the basis of a multiplier of three, as the study cited suggests higher multipliers occur in larger economies. Furthermore, a large proportion of the US economy is based upon services, which again suggests a high multiplier. This means that the US might even have a multiplier of four, but I will stay with three as a more conservative estimate.

Having come this far, you may be wondering what all of this means, and why I am discussing this in so much detail. The reason is relatively straightforward. I want to give a (very, very) rough estimate of the real size of the US economy - the size if there were no borrowing from overseas. When we see that way that government spending multiplies in the economy, it is apparent that borrowing money from overseas (translated into government spending) will inflate the GDP figures more than the headline borrowing figures suggest.

Starting with the basics, the US economy for 2009 will produce about $14 trillion of GDP, the federal deficit is expected to be something like 12% of GDP for 2009 overall, and according to the Congressional Budget Office the deficit for the fiscal year (just ended)was $1.4 trillion. In order to isolate the effects of overseas borrowing, it is necessary to find out how much debt has been sold overseas. I naively thought that I might find these figures relatively easily, but this has proved to be problematic (see note 2). For example, I searched the Treasury website, and only found an 'estimate' of the overseas holdings of US government debt. Likewise, the St. Louis Federal Reserve (an excellent resource normally) only offers the following chart, for overseas federal debt holdings:



According to the chart, overseas holdings of federal debt have increased in the first six months of 2009 by $305.3 billion, making an annualised rate of overseas accumulation of US debt of around $600 billion (assuming that overseas investors continued to buy US debt at the same rate). It might be noted that the fiscal year in the US does not match the calendar year, so there is some more fudge in the numbers. However, we might make an approximation on the total amount of GDP that is actually due to the multiplier effect, by multiplying the figure by 3, which gives us $1.8 trillion.

Now at this stage, it would be normal to then minus the $1.8 trillion from the overall size of the economy ($US 14 trillion). The first problem is that some of the borrowed money will be servicing interest payments on previous borrowing ($182 billion), such that it will not create activity. The second problem is that there is the question of how much private borrowing is sourced from overseas lenders, in particular consumer borrowing. I have tried to identify how much of this borrowing originates from overseas, but have been unable to come up with any firm figures. I will therefore just take a guess at the impacts of these two factors and raise the overall total to $2 billion, implying something like $127 billion of consumer credit provided by overseas lenders (remember the multiplier of 3), an extremely conservative guess.

With the current figure of $14 trillion, the correction to remove the activity resultant from overseas borrowing would mean that the real size of the economy is just $12 trillion. In other words, something like 17% of the US economy is funded by overseas borrowing. You may note that there is a large amount of 'fudge factor' in all of this, and comments and critiques are therefore welcomed (especially from those who are more numerate than myself - which is most people).

What does this mean?

As I have frequently pointed out, measurement of GDP is flawed in any economy that has a net accumulation of debt, for the very reason that the activity in the economy includes debt activity derived from overseas borrowing. The problem becomes particularly acute when measuring the ratio of debt to GDP, as the activity from debt is included in GDP. Even more curious is the idea of GDP growth, when a country is accumulating debt, but nevertheless economists are predicting 'growth' for 2010.

The real concern is the question of what would happen if the overseas lenders were to stop lending. In this event, the US economy would quickly revert to its real size, and that would be significantly smaller than today. The results of any halt in credit provision for the US are extremely worrying, as support for a large percentage of the economy would disappear. The result would be that unemployment would explode upwards, government could not operate at current levels, and the shock would likely precipitate a broader collapse in the economy.

The problem that is faced by the government is that for the years preceding the economic crisis, the economy was also being flattered by a combination of overseas borrowing for government expenditure, but in combination with consumer borrowing that originated in overseas credit. I am guessing that, if it were possible to strip out the effect of borrowing for the three years preceding the crisis, the same kind of results would emerge. In other words, I believe the problem is structural, meaning the current level of the economy can not be sustained. As such that there is no possibility in the near term of achieving anything near pre-crisis economic conditions unless creditors continue to fund the US at current levels.

This is improbable.

One reason is that the printing of money by the Federal Reserve and size of deficits are already alarming creditors such as China, with China giving implicit threats to stop lending. A devaluation of the $US might provide a solution to the problems by eventually return the US economy to its true size and wealth relative to other countries. However, ongoing $US devaluation will just accelerate the point at which overseas creditors refuse further lending. In other words, it will precipitate a crisis before the adjustment is completed. In the event of no further credit, the US would face the prospect of rapidly transitioning to the real size of the economy.

The only solution that I can see is for the US to first freeze the growth in borrowing, and to then implement a clear and binding plan to reduce borrowing aggressively over the short to medium term, with a clear plan for a return to surplus in five years time. This plan would give confidence to overseas creditors, and allow a more orderly transition to the real size of the economy. Such a plan would be very, very painful, as the economy would still shrink dramatically. However, it would be less painful than the sudden collapse that might take place if overseas lenders were to stop lending.

The problem is that, at present, there are no such plans. Instead, deficits stretch to the horizon, overseas creditors express their doubts, and the $US is steadily sinking. In other words, my very rough estimates may be put to the test.

Note 1: Spilimbergo, A., Symansky, S., Blanchard, O., Cottarelli, C., & Hall, W. (2009) 'Fiscal policy for the crisis', Centre for Economic Policy Research, Paper No. 7130, January 2009.

Note 2: I used the Treasury website here, and downloaded the document titled 'Ownership of Federal Securites'. Actually getting firm numbers on actual sales of new debt is very difficult, and news reports, for example, seem to focus on debt type and/or sales to particular countries. A fairly tpical example is the following report:

WASHINGTON (MarketWatch) -- Net foreign purchases of long-term securities increased to $28.6 billion in August from $15.3 billion in July, the Treasury Department said Friday. Net foreign purchases of long-term U.S. securities were $ 32.9 billion. Of this, private investors purchased $21.3 billion and foreign official institutions bought $11.6 billion. U.S. residents purchased a net $4.3 billion of long-term foreign securities. China's holdings of Treasurys slipped $3.4 billion to $797.1 billion in August. So far in 2009, China has increased its holdings of Treasurys by $57.5 billion

If you have a definitive source of sales to overseas, a link would be appreciated, or more accurate figures. I am surprised that this data is so hard to find....perhaps I am looking in the wrong places..

China and Treasuries - A Puzzle

Perhaps some readers may think that I am obsessed with China as, once again, China is the central subject of this post. A long while back I speculated on what China might do as the current economic crisis unfolds (yes, it is still in full swing). The basis of my speculation was quite simple; I simply thought about what actions I would take if I were in the position of China.

My first thought was that it would be vital to move reserves out of the $US, which would mean offloading treasury positions. I was unsure at the time about how this might be achieved without spooking the entire market, and destroying the value of the remaining holdings. As it was, the exit method is relatively simple and involves shifting holdings from long term debt into short term, and simply not rolling over the existing debt. It turns out that China has been making this shift for some time, but remains a net buyer of treasuries:

For instance, the report showed huge central banks such as Japan and China remained buyers of U.S. assets. China's holdings of U.S. Treasuries rose to $800.5 billion in July from $776.4 billion in June.

The same report showed a net outflow of capital from the US, and this makes the ongoing purchase of treasuries by China ever more curious. Of particular note is a recent article in the Shanghai Daily, which will reflect the official government 'line'.

AS the global economy appears headed toward recovery, concerns are growing that the United States' addiction to massive fiscal stimulus as an economic panacea could eventually lead to an even bigger crisis - a loss of confidence in the US dollar.

Nobel Prize-winning economist Paul A. Samuelson raised the specter of a "truly global financial panic" if countries funding the US deficit, particularly China, decide their investments in US Treasury securities are no longer safe.

Warren Buffett warned in The New York Times that side-effects of the current fiscal intervention could be as dangerous as the financial crisis recently averted - in the form of inflation eroding the dollar's purchasing power.

Preserving the dollar's strength has importance far beyond protecting American tourists from the shock of paying the equivalent of US$25 for a hamburger in London or Tokyo.

Economic experts are concerned about the dollar's health for a number of reasons. Most importantly, the scale of current trade and spending imbalances puts heavy downward pressure on the dollar's value over the long term.

The US imports far more goods and services than it exports, flooding international markets with dollars and undermining their value.

The Chinese 'line' on the $US and the actions of China contradict one another. The standard explanation for this is that China simply can not afford the destruction of the $US, as the two economies are tied inextricably together. Such an assertion would suggest that China sees a future in which it just continues to fund US consumption forever. When the switch into short term debt is considered, this is simply unbelievable. One way or another, China knows that it must move off the treasury treadmill. Why they have not already done so remains a puzzle, but they must begin a retreat soon. In particular, the $US slide seems to be gaining momentum, with Geithner's remarks on the future status of the SDRs as a reserve asset pushing the decline further:

The Dollar Index, which the ICE uses to track the dollar against the currencies of six major U.S. trading partners, dropped to as low as 75.915, the weakest since Sept. 22, 2008, before trading 0.2 percent down at 75.944.

One explanation for the weakness of the $US is that economic recovery is providing an incentive to move into higher yielding assets. This from Bloomberg:

The dollar fell to a one-year low against the euro and weakened versus the yen on speculation the global economic recovery is gathering strength, encouraging investors to buy higher-yielding assets.

A contrast to this explanation was issued a few hours before this post, and comes from China's Xinhua news:

The Fed began its two-day monetary policy meeting on Tuesday and would announce rate decisions on Wednesday. The central bank is widely expected to leave key rates unchanged at historic low level, and its statement after the meeting would be fundamentally same with previous statements.

If the statement is in line with expectations, it means that the Fed would keep its ultra-loose monetary policy for a while, increasing pressures upon the dollar. Any unexpected signal could spark big fluctuations in currency market.

It was reported that U.S. is proposing a broad new economic framework to tackle global economic imbalances on the Group of 20 financial summit due later this week. The framework may lead to weakness in the dollar, analysts said. It prompted investors to take profit from the greenback's gains in previous sessions.

It is very clear that the line in China is that it is US profligacy putting pressure on the $US (a view shared by myself). It is very clear that, if Chinese news sources are following the official government line (the normal practice), the Chinese government has concluded that a $US fall must take place. This makes the ongoing purchase of treasuries ever more puzzling.

I did speculate that perhaps, just perhaps, China is hoping that the US will reverse the current policies (in particular in the face of Chinese complaints). However, the more I thought about this, the less probable it appeared to be as a credible explanation. There has been absolutely no indication from any arm of the US government of any indication of any reversal of current policy. Unless there have been some substantive assurances given behind closed doors, it appears highly improbable that China might hold any hopes for change.

Another line of reasoning I followed was that China simply does not want to be seen as the country that 'pulls the trigger' on a $US collapse. Once the crisis takes hold, they will be able to stand back and suggest that they did all they could to support the world financial system - despite US profligacy. Once again, however, I am not entirely convinced with this argument. Compared with the diplomatic gains, the potential economic losses make this appear to be a very poor trade off. I am also not convinced that China would be that concerned with such niceties, as they will in all cases be able to point to their requests for responsibility from the US and their patience when the US continued to devalue their assets.

The last line of reasoning I considered appears to be the most probable. It is simply that China's wealth is indeed denominated in the $US, and they are just doing enough to hold the $US from free fall. The reason is that this allows them time to use the $US, which they are still accumulating in large quantities, to prepare themselves for the post-$US world. Returning to the speculative post in which I imagined what I might do if I were China, I suggested that they would also diversify their holdings into commodities (in particular gold), other currencies, and would continue and accelerate their purchase and control of commodity/resource companies.

With regards to gold, it is now no secret that China has been purchasing gold (600 tons - though are now planning to buy domestic production of gold), and also other commodities (though there are some suggestions that this is easing back). There are also hints that China is going to restrict supply of some of their own key commodities, which will support a growth in high tech industry. Also, with regards to securing access to resources, China appears to be accelerating a process that had already started at the time I made the speculative post. A friend kindly pointed me to a recent article in the FT on this subject:

China’s sovereign wealth fund is deepening its holdings in commodities by investing about $850m in Noble Group, a Singapore-listed commodity shipping and trading company with deep roots in China.

In the past two years, CIC has shifted its emphasis from dollar investments in financial firms, including Blackstone and Morgan Stanley, to investments in commodities groups and hard assets including real estate.

With regards to currency, the $US 50 billion purchase of SDRs is one form of diversification, and perhaps ties in with the ambition for the RMB to displace the $US as the reserve currency. My aim here though, is not to restate my arguments for why the RMB might succeed, though yet further signs can be found of the ambition in action:

[regarding the purchase of $50 billion of IMF SDRs] But the agreement stated that China will pay the IMF up to 341.2 billion yuan ($50 billion), also known as renminbi, for the SDR bonds, based on the Aug. 25 exchange rate [...]

But Zhang also noted several other, more intriguing possibilities about how the IMF could harness the yuan soon to end up in its hands.

It could use yuan to buy assets from other financial institutions or for issuing loans, hence spreading the Chinese currency more widely.

"This would signify that the renminbi, to a certain degree, would replace the dollar as a global reserve currency. It would be an important impetus for renminbi internationalisation and it would have a negative influence on international demand for the dollar," Zhang wrote in a research note.

What all of these points are driving to is that China might be just providing enough support for the $US through bonds to prevent a free fall of the $US. The motive might be that they are using the time of instability to prepare for a post $US world, and are seeking to position themselves to ride out the storm that would follow a major fall in the $US. It is no more than speculation, but they may simply be preparing for the troubles ahead, whilst their $US have some use and value.

So far, so interesting, as they do appear to be following the most logical strategy for a country in their current position. However, I also speculated previously about the next step in the strategy over and above the points I have already mentioned. In particular, if the $US falls dramatically, and there is plenty of speculation on this end emerging in the mainstream media recently, what would China do in this situation?

My argument was that China would, as soon as a $US rout looked realistic, sell hard and fast into the market, and seek to recover as much value from the $US holdings before hitting the bottom. I speculated that they would likely have a contingency plan in place, including a floor at which they would stop selling and hold. In the event that this kind of scenario took place, the US economy would go into severe shock, along with the institutions of government. No doubt, just as China has prepared for this contingency, I am guessing that the US is likewise prepared. My guess is that they will have a plan to stem the tide, but also that they will be playing the role of King Canute.

In the economic aftershock, China will still be left with significant holdings of US assets. In some respects, these will be of little value. However, my speculation is that this would provide a vital element in China's bid for economic ascendancy. In particular, they could use their new found economic strength to go on a shopping trip in which they would seek to purchase leading US companies, and in particular companies with leading edge technologies. The economic position of the US government will be so dire that they will seek any form of an infusion of capital and overseas currency into the country, and will not be in a position to block any Chinese moves on US companies, with the sole exception of industries that are directly related to the defence sector.

In this scenario, China might be able to jump up the technology ladder at a rate that would otherwise be impossible. It would facilitate the step up the value chain that is necessary for China to achieve economic super power status. This from a recent Xinhau news article, in which they report on the Chinese Premier, Wen Jia Bao, as suggesting that the economic crisis presents risks and opportunities:

China has the capabilities of taking over the commanding heights in the fields of economy and science and technology, said the premier.

He highlighted the importance of choosing the correct new and strategic industries that can play a supportive role for the country's current economic and social development. China must master key technologies, otherwise, the country might be controlled by others, he stressed.

Wen said that China needs industries that have broad prospects, consume less energy, have a larger impact on other sectors, offer more jobs and make more money. "We must select and develop new and strategic industries with an international view and strategic thinking," he added.

A total of 47 academicians, professors, experts, entrepreneurs and industry leaders attended the meeting and gave their views on the issues of these new industries.

It is very clear where China's ambitions are directed and they simply reflect the ambitions of most countries. The difference is that China is increasingly moving into a position where those ambitions might be achieved.

As with my original post, the one in which I speculated on China's actions, I can only speculate here, and would emphasise that it is no more than speculation. There are a few problems in the argument, such as why China might undermine the $US with negative statements, if they seek to prepare for a post $US world, and need the $US for preparation. This appears to contradict the argument, and can not be explained. Many elements of my previous speculation have been enacted by China, but they are nevertheless still net purchasers of treasuries, against my expectations. It may be that I am missing something, but I have yet to find any explanation other than the one that I have suggested here.

As ever, and in particular with such a speculative post, comments and thoughts are welcomed. Perhaps there is a more mundane explanation?

Japan Secretly Selling Smuggled $US bonds?

I need to be very clear before writing this post that it is highly speculative, if not fanciful. As such, I would caution readers to view the post as some wild speculation.

The cause of the speculation is an article on Bloomberg, as follows:

June 12 (Bloomberg) -- Japan is investigating reports two of its citizens were detained in Italy after allegedly attempting to take $134 billion worth of U.S. bonds over the border into Switzerland.

“Italian authorities are in the midst of the investigation, and haven’t yet confirmed the details, including whether they are Japanese citizens or not,” Takeshi Akamatsu, a spokesman for the Ministry of Foreign Affairs, said by telephone today in Tokyo. “Our consulate in Milan is continuing efforts to confirm the reports.”

An official at the Consulate General of Japan in Milan, who only gave his name as Ikeda, said it still hasn’t been confirmed that the individuals are Japanese. “We are in contact with the Italian Financial Police and the Italian Public Prosecutor’s Office,” Ikeda said by phone today.

The Asahi newspaper reported today Italian police found bond certificates concealed in the bottom of luggage the two individuals were carrying on a train that stopped in Chiasso, near the Swiss border, on June 3.

The undeclared bonds included 249 certificates worth $500 million each, the Asahi said, citing Italian authorities. The case was reported earlier in Italian newspapers Il Giornale and La Repubblica and by the Ansa news agency.

If the securities are found to be genuine, the individuals could be fined 40 percent of the total value for attempting to take them out of the country without declaring them, the Asahi said.

The Italian embassy in Tokyo was unable to confirm the Asahi report.

I placed a comment against my last post on first reading the story, in which I speculated on what might be going on, and suggested the following:

If the bonds are genuine (unconfirmed), the big question is who might have such a large sum? The only logical answer is a nation state, and with the individuals being Japanese, that would suggest Japan.

The second question is why they are smuggling them?

I have been speculating on this subject and have come up with some wild scenarios. I would like to emphasise that these are 'wild'.

However, the best answer that I could find is that the Japanese government wants to dump US bonds on the quiet. As such, they sought to transfer them to Switzerland, where they could then sell them, and disguise the point of origin of the selling.

In doing so they would avoid spooking the markets by making a Japanese sell-off of US bonds visible. As a large holder of US debt, any significant sell-off would potentially commence a $US rout.

This might make sense, but why would the smugglers go via Italy?

This is all wild, wild speculation, and it is still unconfirmed that the bonds are genuine.

However, if the bonds are genuine, I can see no other logical explanation. In the (unlikely) event that such speculation were correct, it really would be the start of the end of the $US.

I had picked up the article about the smuggling in my regular trawl through the financial news. A short while after writing the comment, I found an article reporting on the G8 meeting.....which is located in Italy.

This means that senior Japanese financial officials are in Italy, and these are the very people who might wish to undertake the quiet dumping of bonds. I was unable to find out who was attending from Japan, but it is a certainty that it would include all the necessary key players necessary for this kind of undertaking.

Regarding the matter of whether the bonds are genuine, this from the Asia News:

Italian authorities have not yet determined whether they are real or fake, but if they are real the attempt to take them into Switzerland would be the largest financial smuggling operation in history; if they are fake, the matter would be even more mind-boggling because the quality of the counterfeit work is such that the fake bonds are undistinguishable from the real ones.

What caught the policemen’s attention were the billion dollar securities. Such a large denomination is not available in regular financial and banking markets. Only states handle such amounts of money.

Please note that these size of securities are only used in state to state transactions. The problem then arises as to why any counterfeiter might forge such instruments? It is not like forging a $US 100 bill, where it might pass off in a shop. In this case, if you try to use this kind of forgery, then whoever accepts it is going to want to know 100% for certain that it is genuine. They will certainly want to know a lot about it, and no forgery is therefore likely to be of any value whatsoever. As such, why forge such an instrument?

In the meantime, the Japanese have suddenly started talking up the prospects for the $US:

June 12 (Bloomberg) -- Japanese Finance Minister Kaoru Yosano said his government is confident about the outlook for U.S. Treasuries, signaling the second-biggest foreign holder of the securities will keep buying them amid record sales.

“We have complete trust in the fact that the U.S. views its strong-dollar policy as fundamental,” Yosano, 70, said in an interview in Tokyo on June 10 before attending a Group of Eight meeting of finance ministers starting today in Italy. “So our trust in U.S. Treasuries is absolutely unshakable.”

It could be argued that this public statement contradicts any secret selling of US bonds. However, if you are about to dump a large amount of US bonds into the market, the best way to cushion the impact might be to boost the value by suggesting that there is a strong buyer in the market. The fact that the alleged buyer is in fact a seller will not be known until much later. In the meantime, Japan gets brownie points from the US administration.

In all of this, it should be remembered that Japan is the world's second largest holder of US treasuries. Any public selling by Japan would therefore result in a $US crash, and would wipe out the value of much of the value of Japanese reserves. Back in January, I was discussing the $US dilemma for the major creditors of the US as follows:

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.

Selling the bonds without appearing to sell them would be an excellent solution to the standoff. On the one hand you can sound positive, continue to make purchases, reassure the market, and meanwhile offload ever more of the dangerous (toxic) assets through the back door.

Normally, such massive amounts of assets would be impossible to move without regulators noticing, and without alarm bells going off. However, if it is the government and central bank acting, there is no reason why the alarm bells might not be switched off.

For the moment, let's assume that this wild speculation about the story is true. If it is the case that the men who have been arrested are acting in order to commence a sell of US bonds, it is quite likely that they will either be government finance officials, or members of the Naicho (Japanese intelligence service - reports to the prime minister). If it is the former, then a link can be made to the government but, if the latter, then it will be difficult to ever establish a connection.

In the meantime, how will the US and Japan handle the situation, if the bonds are real?

The important point is that it is not in the interest of either country to admit to the operation. For the US, if they point the finger at Japan, they will need to admit that one of the largest holders of bonds is dumping them, and this will cause a run on the $US. For the Japanese, their interest in not revealing what they have been up to is self-evident. If the bonds are genuine, it will need one or both of the governments to confirm that they are genuine. It is in the interests of both governments to deny that this is the case. The most likely story will be that it is a North Korean counterfeiting operation, as they are well known for this kind of activity.

Meanwhile, the Italians will be unable to prove the case one way or another. Without confirmation of the authenticity of the bonds from the US or Japan, how might they establish the truth one way or another? In addition, it is unlikely that the Italians would want to upset the US by pushing the matter.

In short, whether the bonds are genuine or not, I would be very surprised to see that this story goes much further.

The underlying story, if this wild speculation were to be true, is that the Japanese are dumping the $US. If this were the case, then the $US is finished, and we can expect to see it collapse in the very, very near future.

As I have said, this is all wild speculation. However, it does have a kind of painful logic. If the Japanese are, like the Chinese, increasingly dubious about holding $US reserves, then this would be a way of unloading the position whilst gaining the maximum value from the holdings. I have long argued on this post that $US bonds are largely worthless, the Chinese suspect that this may be the case, so why not the Japanese? As another example, Peter Schiff is discussing the absurdity of Japan having faith in the $US.

Once again, I can only emphasise that what I am writing is highly speculative. I have no evidence either way, but can see no other explanation of this rather extraordinary story. If anyone has a less fanciful explanation, then I will welcome comments. This is all very odd, and I do feel that my 'take' on it is quite questionable. It really is moving into the realms of James Bond movies....questions to answer, in particular are...; Is there any reason why anyone might want to forge the bonds? Who, and how might they pass them off? What mechanism might they use to sell the forgeries?

Over to you, the readers, for alternative considerations....