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Wednesday, February 5, 2014

Expansion or a Big Crunch?

In the fall of 2012, Grady Means made a bold prediction that the economy would crash in March 2014.
The central problem is that America is the bank of the world. What this means, simply, is that the dollar is the world’s currency (often termed the “reserve currency”). 
Throughout the world, nearly all traded goods, oil, major commodities, real estate, etc., are denominated in dollars. 
The world needs dollars, and the U.S. provides them and provides confidence that the dollar is the “safest” currency in the world. Countries get dollars by trading with us on attractive terms, which enables Americans to live very well. 
Countries support this system and cover their risk by investing in dollars through T-bill auctions and other mechanisms, which enables us to run budget deficits — up to a point.
The central issue is confidence in America, and the world is losing confidence quickly.
 
At a certain point, soon, the United States will reach a level of deficit spending and debt at which the countries of the world will lose faith in America and begin to withdraw their investments. 
Many leading economists and bankers think another trillion dollars or so may do it. A run on the bank will start suddenly, build quickly and snowball. 
At that point, we will need to finance our own deficit, and we will not be able to do so. We will raise bond rates to re-attract foreign investment, interest rates will go up, and businesses will fail. Unemployment will skyrocket. 
The rest of the world will fully crash along with us. Europe will continue to decline, and the euro will not replace the dollar. Russia will see a collapse in oil prices as market demand softens, and Russia will collapse along with it. 
China will find nowhere to export and also will collapse. The Russian and Chinese governments, which see all this coming and have been stockpiling gold to hedge against such a dollar collapse, will find that you cannot eat gold. 
There will be uprisings — think of the streets in Spain and Greece today — everywhere. Technological advances that traditionally drive productivity increases and economic growth will not be able to keep up with this collapse.
So is Means correct? After all, we've seen a dramatic sell-off stocks in just the last few weeks (although some analysts are saying it is just a market correction). Well, it is not yet March, so anything could happen. But, strangely, even though the deficit and debt have exploded, and the Fed has been "printing" money like there is no tomorrow, the current problem isn't that investors are fleeing the dollar, but that people are fleeing other currencies to buy the dollar.

At the Atlantic, they explain a bit about the fall in value of currencies in the so-called "emerging market" countries:
Here we go again.

First, money poured into emerging markets when it looked like they offered juicy returns. Then it poured out after they didn't. Currencies are collapsing. Stock markets are falling. And central banks are sacrificing the real economy to save the exchange rate.

We've seen this movie before. It was called the East Asian financial crisis, back in 1997. But, for once, the sequel won't be worse than the original. Emerging markets don't have enough foreign-money debt this time around to make their falling currencies much of a concern. What is a concern is whether their central bankers realize this. They might overreact—they might already be—and raise rates to prop up their currencies, when they should be lowering them to prop up their economies.

Now, emerging market currencies have been in a world of pain since last May. That's when Ben Bernanke first hinted that the Fed would soon draw down—or "taper"—its bond purchases. If that meant the Fed would start raising rates sooner too, as markets assumed it did, there wouldn't be any need to park money overseas to get a decent return. You could do that in the U.S. So investors pulled their money out just as quickly as they had moved it in—and emerging market currencies fell. ...
 This doesn't mean the U.S. will necessarily remain untouched. Ambrose Evans-Pritchard writes at the Telegraph that the currency issues could cause push Europe and the US into a deflationary spiral.
Half the world economy is one accident away from a deflation trap. The International Monetary Fund says the probability may now be as high as 20pc. 
..."We need to be extremely vigilant," said the IMF's Christine Lagarde in Davos. "The deflation risk is what would occur if there was a shock to those economies now at low inflation rates, way below target. I don't think anyone can dispute that in the eurozone, inflation is way below target." 
It is not hard to imagine what that shock might be. It is already before us as Turkey, India and South Africa all slam on the brakes, forced to defend their currencies as global liquidity drains away.
 He notes that several countries, including Turkey and South Africa, were already raising repurchase rates to stop capital flight, with the risk that their economies will come to a standstill. However, China, he believes, also poses a deflationary trap, although it is not as heavily dependent on foreign currencies.
China is marching to its own tune with a closed capital account and reserves of $3.8 trillion, but it too is sending a powerful deflationary impulse worldwide. Last year it added $5 trillion in new plant and fixed investment - as much as the US and Europe combined - flooding the global economy with yet more excess capacity. 
Markets have a touching faith that the same Politburo responsible for a spectacular credit bubble worth $24 trillion - one and a half times larger than the US banking system - will now manage to deflate it gently with a skill that eluded the Fed in 1928, the Bank of Japan in 1990 and the Bank of England in 2007. 
Manoj Pradhan, from Morgan Stanley, says that China's central bank is trying to deleverage and raise rates at the same time, which "amplifies risks to growth". This is a heroic undertaking, like surgery without anaesthetic. It is the exact opposite of what the Fed did after 2008 when QE helped cushion the shock. Morgan Stanley says that 45pc of all private credit in China must be refinanced over the next 12 months, so fasten your seatbelts. 
Moreover, China is struggling to keep its industries humming at the current exchange rate. Patrick Artus, from Natixis, says surging wages - and falling productivity - mean that it now costs 10pc more to produce the Airbus A320 in Tianjing than it does in Toulouse. 
The implications are obvious. China may at some stage try to steer down the yuan to hold on to market share, whatever they say in the US Congress, partly to stop Japan stealing a march with its 30pc devaluation under Abenomics. Albert Edwards from Societe Generale say this may prove the ultimate deflationary shock, dwarfing the 1998 Asia crisis.
China, moreover, is not completely immune to the outflow of foreign investments. The Sidney Morning Herald reports:
Figures published by the Bank for International Settlements (BIS) in October showed foreign currency loans booked in China, as well as cross-border borrowing by Chinese companies, had reached $US880bn as of March 2013, up from $US270bn in 2009. 
Analysts say this figure is now likely to exceed $US1 trillion and is continuing to grow, raising the prospect of the potentially dangerous vulnerability of the Chinese financial system to a rising dollar.
I guess we will see in the next month or so whether Means was correct.

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