Dead Money - The Consequences of Printing Money and Inflation

* Yesterday I touched on the ‘Dead Money’ concept which I want to expand on this morning. My comment was that China’s accumulation of US dollars, or by any other Central Bank represents ‘Dead Money‘. While these countries are accumulating these dollars, chances are that they have invested these funds in US Treasuries. Effectively, this allows the US to run trade deficits, without having to worry about the day that the holders of the dollars want their money back. And when I say they want their money back, in reality, all they can do is convert their horde of dollars into other things of like value. In the current context, this boils down to how fast any country can spend the money which has been accumulated, on products, resources or other goods which they use in their economies. Regardless of their efforts to spend their dollar hordes, countries who hold theirforeign currency reserves in dollars, and most countries do, have allowed their dollar holdings to just sit in low yielding US treasuries.


And this gives the US lots of cover to run trade and budget deficits, and to print money. Over the course of the last 25 years, the US has run a cumulative trade deficit of $7.5 trillion. In some cases, portions of these amount of deficits have been re-invested in the US. The Japanese for example, have been very prolific about building car factories in the US, as a way to circumvent protectionist tendencies against their exports to the US. In the process, these activities have constructively recycled their trade surplus back into the US economy, and in my view of the world, this is not ‘Dead Money’. I do not know how much of the $7.5 trillion cumulative trade deficit has been productively re-invested in the US, versus how much is being held by foreigners as a store of value as central bank reserves. 


The Treasury Department’s website shows that foreign central banks own $2.8 trillion of US Treasuries, and foreign holders own $3.8 trillion of treasuries in total. Of course, this does not include holdings of agency debt securities, or other, near government debt. In fact, there is a approximately a $1 trillion discrepancy with the reported holdings by China, which only shows $895 billion of treasury holdings, while it is believed they own about $2 trillion of dollar assets. Nonetheless, the point is obvious that there is a huge reservoir of “dead money” which is held by our trading partners.


Dead Money represents a potential claim on the assets of the US. While that money is sitting there, the Fed does not have to worry that these reserves will cause inflation down the road because these assets are invested in securities, and is not cash. Or so they think. China is a perfect example where this pool of Dead Money does have an inflationary outcome. China uses their treasury holdings (and FX reserves) as backing for their local currency and domestic bank credit, which has been growing at double digit rates. In turn, this feeds into demand for the commodities which fuels their economy. The prices of iron ore, the principal ingredient of steel, has doubled in price this quarter, based on new contracts established between China and the exporters of iron ore. In turn, this should push up the price of steel by 30%, according to some forecasts. In turn, the prices for domestic US steel, which is a primary component in cars, and commercial building construction, will rise accordingly. The same can be said about the Chinese demand for oil, copper, and other resources which are used by the global economy. Even though this is dead money on the balance sheet of the Chinese, it is still having an impact on the prices of various commodities, via the translation of these reserves into the local currency. While the same concept applies to other countries which hold US treasuries and dollars as their primary reserve asset, the Chinese is the largest and most obvious example to talk about.


The next question which comes to mind is how long will these markers remain relatively benign? By that I mean, what happens if the holders of US debt decide they want to own something else instead? The current conundrum for many is that there are no alternatives which they can easily embrace as an alternative to the dollar. And to think that many of the countries which hold dollars as backing for their local currency are completely at risk to what could happen as the US’s fiscal and monetary policies spin out of control. For a while, the Euro was thought to be a good second choice, and alternative to the dollar. Recent events have taken the euro out of contention.


And this brings me back to gold, which has been the worlds reserve asset for millennium. There are two ways to look at gold’s recent rise; see attached log-normal graph. To many, gold is at an all-time high, is over-bought, and its price action is symptomatic of a bubble, whose time has come to burst. To others, like me, gold’s rise is symptomatic of its return to relevancy in the global universe of investment alternatives. It seems as if the primary purchasers of gold have been individual investors, while the 800 pound gorillas are the world’s central banks. So far, we have seen only a modest amount of central bank buying, as the countries of India, Russia, China and Sri Lanka have acknowledged adding to their gold reserves over the last year. The flow of dollars into gold by Central Banks has yet to rival that of the individual investors, who have been buying the various gold ETF’s, and minted coins, by the billions. This article is not about gold, so I will say little more here, except to acknowledge that the $3+ trillion in dollar denominated assets, which otherwise is ‘Dead Money’ could come alive if a small portion of it were to shift to gold. If that ever happens, it will spell trouble because that will also cause concerns about the viability of the US government to roll its $10 trillion of publicly held debt. 


* A couple of comments from Europe:


* Silvia Wadhwa, a German correspondent for CNBC made a very interesting comment about Germany’s attitude towards the EU and the current crisis, this morning: She pointed out that Germany thinks of itself as Germany and not the EU, when in fact, they are the most significant player in the EU. Her conclusion is: until the German’s wake up and embrace the problems as being their problem, and not some other countries problem, the crisis in confidence is going to persist and likely worsen.


* A European friend and reader, who lives in the US, believes that the real problems for the EU are going to become more exacerbated in the fall, after summer vacations. Her point is that most Europeans are focused right now on their summer vacations, and are busy planning trips. They will be actively spending money towards these pursuits, instead of focusing on the main problems which need to be dealt with. Her contention is that when the summer is over, the EU will be forced to deal with the reality of their current predicament, and that ties into the idea that the worse consequences are yet to come from the Euro-zone, most likely in the September/October time period. 


Some technical folks who I follow have very dire thoughts about how bad things could get this fall. September and October are seasonally bad times for the markets, and the logic of the reader above could explain why problems are pushed away from the summer months and into the fall. That logic could also explain the prevalence of a summer stock market rally. Nonetheless, I have great misgivings as to what the risk markets will be doing over the next few months, and especially during the September/October time frame.