China Moves Away from Euro as Central Bank Balance Sheet Balloons

* The markets are moving in spasms as the ebb and flow of information hits the tape. Yesterday’s big story was an FT report that China, with $600 billion in euros, was going to diversify away from the euro, and this morning, this story was reversed by China in a press statement. Earlier this morning, Spain’s parliament passed a 19 billion euro austerity package by a margin of only 1 vote. And what will the affect be from these austerity measures? The austerity measures, while necessary, is going to be bad news for the economies of those countries enacting these measures. And while these countries might intend on cutting their budgets, there are two impediments to this strategy:


1>    While countries might cut budgets, or enact tax increases, actual revenues might not improve according to plan, as new taxes might not get collected, or spending cuts might not get implemented as hoped for; and


2>    There is a negative feedback loop which the austerity plans will cause in these economies, which in turn will reduce tax revenues, and subsequently, could undermine the intent of the austerity plans.


The affects of these austerity measures are deflationary, and will push the global economy back into the depression which started 3 years ago.


Right now there is only one country which is talking about increasing spending via  deficit spending, and that is the US. I think this is completely ridiculous that Larry Sommers thinks this is a viable idea. Of course, since the world is fleeing to the dollar, and pushing US interest rates down, he has the cover to do so. As you know, I have been flying around on my broomstick about US deficit concerns for some time. The ascendency of the tea party movement in the US will gather steam as the grass roots efforts to halt the “spend and pretend” Obama administration. It is also possible that elevating the deficit issues into the debate for the fall elections could also feed into a market response against US bonds, with a resulting increase in interest rates. And once that starts to happen, it can quickly become game over. 10 year treasury rates over 5% would be the first signal that the debt crisis has landed in the US. That is something to consider as the summer unfolds, not a problem today.


The only country which has earned the right to run deficits is China, which is sitting on $2.6 trillion of foreign currency reserves. When the economies of the rest of the world falls into a hole, as will begin soon enough in Europe, and eventually the US, China will be faced with an interesting dilemma. They will have to spend their reserves in support of domestic growth. And here is the fine print: they will create more local currency out of thin air. China is similar to Holland in the 1600′s. Holland experienced the tulip bubble in the 1630s, as gold and silver, discovered in America, flowed to the Bank of Holland, which issued metal backed currency notes. The surge in the supply of the local currency fueled the infamous tulip bubble, just as China’s trade surplus is fueling the growth of their monstrous money supply, and inflation in a variety of domestic asset sectors. As I have chronicled before, China’s Central bank’s balance sheet is $3.3 trillion, which is 50% greater than the US’s balance sheet, although the US economy is almost 3 times the size of the China’s. 


(For those not familiar with the mechanism of central bank balance sheets, here is a quick explanation: Central Bank’s own various assets, which in the case of the US Federal Reserve, amounts to treasury and MBS securities, currencies and Gold. On the other side of their balance sheet these banks issue local currency, or credit to the banking system. In the case of the Chinese, their primary asset is $2.6 trillion of foreign currency assets, against which they have issued local currency and bank credit).


In any event, China is the only large country out there which will have the ability to grow their economy without relying on deficit spending. The only problem with this out-come, is that the basis for the China’s money and bank credit, is the currency of economies which will be going into a depression, and in reality, these countries are not in a position to pay back their debts to the Chinese. And even if China launches a campaign to stimulate the local economy, this will not likely do anything to reverse their trade surplus, in support of the rest of the world’s economies, as they seem to be the low cost producer of many products which the world uses. Perhaps China’s surplus goes down as it did in 2008-2009, but it is unlikely that China will become a net importer.


At this point, the extrapolation gets a bit stretched, as most of my forward looking assumptions do not add up to a balanced budgets in concert with a growing world economy. My guess is that the need for the US to cut deficits will become quite topical as the second half of 2010 unfolds. China might be able to save themselves, but the basis for their economy are the currencies of the world, which will prove to be of questionable value going forward. And this brings us to contemplate the end game. I am not sure what that is, but I can tell you, I do not think it will be pretty.


In the meantime, I will hang my hat on the idea that the stock market is in the early phases of a resumption of the bear market which began in 2007, and this will play itself out as 2010 unfolds as well. Specifically, what will cause the next leg down, after we get tired of the European story. Well, there are many possibilities which I have enumerated in blogs past, and I promise you that you will hear about them in the futures as well. Just not today.


* EU Debt crisis humor – a couple of readers sent this link in. Take a look, it will only take you 3 minutes:


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