Wednesday, April 23, 2008
a reconsideration of easing
at this point, my eyes turn to china. would a stock market collapse end the inflationary mania that has helped to keep the united states afloat? i think quite possibly so. many chinese companies are doing what american companies did in the 1920s to improve profits -- that is, ignoring their lines of production to borrow and speculate in equities. dumb money had of course already been piling in at record rates. a crash and rapid exit of foreign speculative capital could have massive ramifications across corporate and banking sectors, with banking having been acknowledged for some time as a potential weakness. (more on the subject from brad setser.) and the pattern frankly looks very pessimistic, with chinese 'A' shares down 27% from their highs three months ago and still making new lows.
'a' shares are now down 50% in what is becoming one of the great stock market collapses of the past century. does it now threaten to end the debt supercycle by cutting the united states off from further financing of its current account deficits?
perhaps. foreign pressure to support the dollar is becoming more aggressive in considerable part due to the no-longer-deniable ill effects of american monetary easing on dollar-peg economies as runaway inflation results in food riots. the blame is being squared up on america.
The global food crisis is a monetary phenomenon, an unintended consequence of America's attempt to inflate its way out of a market failure. There are long-term reasons for food prices to rise, but the unprecedented spike in grain prices during the past year stems from the weakness of the American dollar. Washington's economic misery now threatens to become a geopolitical catastrophe.
the premise involved -- that international dollars are seeking stores of value in commodities -- strikes me as an overstatement. but speculative capital, overlaying a general increase in resource demand, is definitely driving the commodities boom. and the search for a scapegoat in china and elsewhere over simultaneous stock market collapses and incipient starvation will be powerful political incentive for governments to reduce dollar recycling and allow currency appreciation while employing the benefits of trade instead to help domestic policy.
the leverage that underlies the boom is, however, being attacked by the global credit contraction now underway. the price explosion that has resulted from speculation should be a relatively transient phenomena, even as recessionary periods are generally characterized by the collapse of the prices of finished goods and assets as compared to raw materials (which is exactly what we're seeing, and in an extreme way). and even the underlying demand may well moderate if a global slowdown isn't avoided. the pressure that results from political instability over food prices may be short-lived if deleveraging and asset collapses continue to deepen.
regardless, the food crisis should be the paramount concern of all involved; there is no motivation for revolution as compelling as hunger, and the governments of dollar-peg economies know it. they must take remediative action. if the dollar continues to decline, i would expect the pressure on the united states to ratchet higher and eventually some sort of multinational currency intervention to take place. in a deflationary environment, it may be more successful than anyone now presumes it could be.
in the long run, though, that doesn't fix the problem. even if the dollar can stage a rally, the solution must be for the united states to stop borrowing against its future, accept a lower standard of living and close its current account deficit. yves smith brings up the possibility of the united states being forced to borrow in another currency, shifting the exchange-rate risk back onto the united states. i wouldn't at all be surprised if foreign creditors, seeking no longer to devalue their own currencies, began to seek exactly that remedy.
There are two commonly referenced effects whose underlying mechanics I have been unable to find satisfactory details on, and this is one of them.
If I as an American sell my Chinese stocks, I then exchange the resulting yuan for dollars, but someone else is left with the yuan. If their propensity to invest in stocks is on average expected to be similar to mine, then they are as likely to buy Chinese stocks with the money as anything else (or if they don't, the next person down the line of monetary exchange might be). Money should flow across all asset classes proportionately based on perceived relative value. So shifts in foreign versus domestic investment seems to be meaningless for asset class prices denominated in a single currency, though it clearly affects exchange rates. Unless propensity to leverage is different between American and Chinese holders of yuan (more leverage giving a higher impact on prices)... but that seems unlikely to have been quantified.
The second common and related statement is that if foreigners fled US treasuries, long term rates would rise. Same deal -- whoever they sell the dollars to has to do something with them, so treasuries are as likely a target as anything. If there is an expectation of continued dollar debasement and import-driven price inflation, that would lower the propensity for holders of dollars to buy bonds versus other asset classes, but that expectation shouldn't persist too long once the flight has occurred. If 70s style cost push inflation took hold the fed would likely have to raise rates to fight it, but can that really be considered an inevitable outcome of any flight from US treasuries by foreigners, given that import prices (impacted by exchange rates) are only a small percentage of our economy?
What am I missing, or which assumption here is wrong?
P.S., I reread your comments on sale of loans in a fractional reserve system and now it's all clear, thanks!
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