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A Rickety Global House of Cards   (October 20, 2005)

If you want to understand the risks of a dollar/bond collapse and ensuing global depression, I recommend getting a copy of the Wall Street Journal's October 19 edition and reading Econoblog: Global Balancing Act. (Online subscription required, but you can always read it at your local library for free.)

There's a lot of heavy-lifting going on in this exchange between two very knowledgeable real-world economists, but I'll try to summarize the basic dynamic. Developing Asian countries, particularly China, have a surplus of labor, and a political need to put all these people to work. Hoping to be like Japan in another decade, they seek growth through exports. Every other Asian government has the same model, so there's fierce competition to find consumers for all the goods being made. While Asian economies are growing, it isn't consumer spending which is growing so much as exports and investment. So who's buying all the stuff Asia makes? The West, of course. Alas, the European Union nations all depend on exports for growth, too, except for Britain, and so their consumer sectors are languishing as well. Who's left? The redoubtable American consumer.

OK, so how can China encourage the American consumer to buy its output and keep its workers employed? Well, it can keep the yuan cheap versus the dollar, so Chinese goods remain cheap, and it can keep U.S. interest rates low so Americans can readily borrow money to keep buying more stuff. How does China do this? By buying American Treasury bonds. Like everything else, currencies and bonds are ruled by supply and demand: lots of supply and no demand, the price drops. So if China started selling dollars, the dollar would drop, and if they didn't keep buying bonds, the interest rate would rise until enough buyers were tempted to invest in U.S. Treasury debt.

So far so good, but the imbalances in the system are growing. Asian and E.U. consumer spending has been weak for years, and so the entire world is counting on the U.S. consumer. To keep propping up U.S. consumer spending, China and other exporters (of goods or oil) have been pouring basically their entire nations' savings into U.S. bonds. To quote from the article: "Reserve accumulation by the (exporting nations) went from $116 billion in 2001 to $517 billion in 2004 and maybe $600 billion this year, while the U.S. current-account (trade) deficit went from $390 billion to $800 billion."

In other words, as the U.S. trade deficit grows to unprecedented levels, the exporting nations are "in for a nickel, in for a dime"--they have no choice but to keep funneling hundreds of billions of dollars into U.S. bonds to keep U.S. interest rates cheap, enabling U.S. consumers to buy more of their goods.

But the entire edifice is a house of cards; as the imbalances increase, a variety of other distortions appear. You might think that all these cheap interest rates would have sparked an investment boom in the U.S. Exactly the opposite has occurred: U.S. corporations are hoarding their cash like no tommorrow, amassing unpredented cash reserves of over a $1 trillion. If they were so sure that global growth was going to be great, then why aren't they investing in new plants and R&D? Obviously, they aren't so optimistic.

So where has all this unprecedented flow of foreign money into the U.S. ended up? In real estate, which has experienced an unprecedented bubble valuation. All the savings of Asia and oil-exporting nations have flowed into what is the ultimate non-productive asset: U.S. housing. Even worse, it's the Chinese taxpayers who are bearing the burden; the Central Government could be using all their savings to fund a social security system or other benefits for the Chinese citizenry. Instead, it buys and holds dollars and U.S. bonds paying a lousy 4%-- a low-return form of "dead money" if there ever was one.

The key take-away here is that some 80% of the entire world's savings is flowing into the insatiable maw of U.S. debt in order to keep U.S. interest rates low and the dollar stable. There are alternatives; Asian governments could give up the export-growth model and start boosting their homegrown consumption. But the export model has worked so spectacularly to date that they cling desperately to it, no matter what the cost. But what happens when their key market, the millions of credit-mad U.S. consumers, finally run out of credit and rising real estate equity and stops borrowing and buying? The exporting nations don't have a Plan B. Meanwhile, it will take the same huge chunk of world savings just to maintain the dollar and U.S. interest rates at their current levels, even if no additional growth occurs.

In other words, the U.S. Federal debt of $8 trillion requires constant refinancing as bonds come due. If exporting nations such as China, Russia and OPEC ever pull the plug and just stop buying dollars and U.S. debt, the weight of existing U.S. debt will cause the dollar to plummet and interest rates to rise dramatically in order to entice savers (of which we have none) to gamble on the safety and return of U.S. bonds.

Some economists claim this house of cards is a win/win situation for both exporters and the U.S., so there's no end in sight; they can just keep pouring all their savings to fund our borrowing for the next 10-20 years. The wild card no one planned on is the U.S. housing bubble and the consequences of its collapse. That bubble is stiil inflating, ensuring the "pop" will be more devastating than anyone expects; housing starts are still rising, building a classic over-supply where there's far more houses on the market than buyers. As builders drop prices in a desperate bid to dump inventory, they will lower prices not just of new houses but existing housing as well. Not a pretty dynamic, but it's the one which always plays out in housing booms and busts.

Here are some relevant quotes from the WSJ Econoblog:
Net private financial flows are not large enough to finance a $800 billion-plus U.S. current account deficit. And with $600 billion or so in global reserve accumulation this year -- about the same as last year, once adjustments are made for valuation -- the private sector doesn't have to. Remember, private investors put about $150 billion more into emerging economies last year than they took out. Emerging economies are financing the U.S. because their central banks want to finance the U.S.; private investors are quite willing to finance the emerging world.

A lot therefore hinges on the willingness of a few actors, and in particular China, to keep on financing the U.S. The amount China has had to spend to keep the yuan from rising has grown every year for the past four years; it will reach 15% of China's GDP this year. If China continues to intervene at that pace, its reserves would reach $2 trillion, or 75% of its GDP, by the end of 2008.

China has to keep on intervening not to support an expanding export sector, but just to hold on to its existing export sector. The U.S. needs continued reserve inflows from China not to allow housing prices to keep on rising, but to keep them from falling. The winners from the current U.S.-China trade don't realize that U.S.-China trade is responsible for their success. Home owners in Orange Country and real estate brokers in Florida are not lobbying for China to hold on to the yuan peg. The U.S. Treasury -- the biggest winner of all in some sense -- is lobbying China to change the peg.

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copyright © 2005 Charles Hugh Smith. All rights reserved in all media.

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