The Economic Dirty Dozen

Today, I expand some of my thinking on a few of the topics of concern which I raised in my previous posting, from last Wednesday. In addition, I add one more topic to my list of concerns, which encompasses concerns about the risk of a major war in the middle east.


* As a follow-up to my last article, I realized that I left out one other significant concern: the shifting global balance of power in the middle east, and the likelihood that the current power configuration will degenerate into a broader war. This is not something which has to happen today, tomorrow, or even next year. But the situation is not stable, and there is a risk that the current imbalances results in a war which restricts the flow of oil to the world economy. The point of bringing this up is to be inclusive of this possible scenario to my list of my dirty dozen.


* Along the lines of Wednesday’s list of concerns, a reader sends in the following link:

Jim Rickards Treasury Bills -The New Opium

This article compares the Chinese addiction to US Treasury Bills as being similar to the Englands Opium trade with China from 1790 to 1830. In short, England exported opium to China, in exchange for all sorts of goods which China exported to them. The only thing which England had to export to China was Opium; according to this author, England did not want to send Silver to China, so instead focused on Opium. This went on until Opium addiction in China became so severe, that the Chinese governmenttried to shut down the Opium trade, and ultimately resulted in the “Opium Wars” of the mid-1800s.


Analogous to the 19th century opium trade, China is addicted their export driven economy, and in place of opium, accumulate US Treasury securities, in exchange for their exports. The interesting analogy worth noting is the insular Chinese view of trade, which has them less interested in imports, and more focused on their own domestic economy which benefits from being a net exporter.


The author then goes on to suggest that China can substitute Gold for US treasuries, but, if this were to happen, the equilibrium price for Gold could go as high as $40,000 an ounce. In un-official comments by Chinese officials, they have rejected Gold as a reserve asset, although they do own over 1,000 tonnes of the metal, which puts them as the 7th (or so) largest holder in the world. Still, gold just represents approximately 1% of China’s currency reserves, and it would be impossible for them to convert their dollars to gold, without causing the price of gold to sky-rocket.


My guess is that China is quietly accumulating gold from their domestic mines. In fact, it was a 2009 announcement which stated that China’s gold reserves increased by 150% over the preceding few years, based on accumulation of the metal from domestic mining sources. Perhaps China truly does not care about gold, or does not know how to go about accumulating it without dramatically pushing up the price. The fact that China is accumulating gold is evidence enough that Gold is relevant to them,despite what they say.


As the Chinese build a US treasury prison around themselves, I cannot tell you what is going to cause the current deficit imbalances to correcting itself. Both the US and the Chinese now understand the uneasy high-wire balancing act they have allowed themselves to enter into. As long as China accepts our treasury debt as a marker against our imports, all is well. But there are so many other things going on in the world trade configuration to suggest that these imbalances cannot continue in-definitely. If it wasn’t for the fact that the Chinese are willing to accept our IOUs, in exchange for their hard goods, I would say that tensions over trade would have reached a breaking point by now. The fact that China has announced a managed (and floating) exchange rate peg between the yuan and the dollar tells us that they are aware of our concerns about this aspect of their trade policy. But the fact that the yuan/dollar exchange rate has not moved even 1% since China’s flexible exchange rate policy was announced in June means they really do not want to let the yuan appreciate. The Chinese are more concerned about supporting their domestic economic economy, than they are about owning the largest pile of IOU’s ever assembled.


* Another word about de-leveraging – everyone likes to talk about de-leveraging, but few people really understand how this translates to the economy. So I thought I’d spend a moment on the subject. Here is how it works in a nutshell:


1> Consumers spend less than they make, which allows them to save some money, or pay down some debt.


2> As consumers shift to being a net saver, then they contribute less to the economy than the income they earn. This is the exact opposite to what occured over the last 40 years, as debt in the economy expanded dramatically, and this fueled a good portion of the economic expansion.


3> For the time being, governments around the world have stepped in to make up for pull back in private spending, and now risk putting themselves in harm’s way, due to the increasing debt burden they are assuming. While countries such as the US and Japan world standing seems to be impervious to the massive budget deficits they are running. 


Nonetheless, governments cannot be the cause of economic prosperity when it is debt which is enabling this prosperity. Perhaps if the world was not so indebted to begin with, then debt would cause growth for a time. But it seems as if we are at the end of a long debt binge, and that this party needs to stop sometime soon. We already have US consumers reducing debt, and have been hearing from the countries of the Euro-zone, about reducing debt on a national level. The governments of Japan and the US are the lone hold-outs. We will see how long the world continues to buy their ever expanding debt. In the mean time, these two governments are swimming upstream against a strong de-leveraging current. Also in line with this general theme, the central banks of the world have been working over-time infuse as much credit (debt) into the system to support individuals and corporations to spend money and support the local economy.


* Mudding through – I am often asked about the timing of when all these bad items will come to a head, and wreak economic havoc on the current world order. Unfortunately, I cannot be precise about when this will occur. There are many dynamics at work, and it is hard to tell how these factors will play out. Also, the exact sequence in which events occur will also determine the nature of the outcome. Typically the fall is a bad time period for equities, and while the last 2 weeks have been strong, we are still in a time zone when an adverse and strongly lower move in stocks are possible. 


However, we must be open to a muddling through process for an in-definite amount of time, until these factors tip the scale towards the negative scenario(s). There is nothing which says that the current imbalances cannot continue. In the meantime, government deficit spending will cushion the adverse effects of my dirty dozen concerns. In the meantime, take advantage of the fact that the world is still a stable place.