As we near the end of the year, I'd like to make an overview of my current views of where we might find ourselves next year. This is an aggregation of much of recurring themes in this blog plus some additional points made by similarly-oriented blogs in recent weeks. First the set-up:
The US is a consumption and finance and investment-oriented economy. The US has already ceded most of its production and manufacturing industries abroad, and has recently been outsourcing most of its service industries. The economy has hollowed out and the only way the economy managed to hum along in the last few years is by people continuing to consume and to make financial investments. Because people were losing income due to outsourcing activities of companies, they managed to continue their consumption activities by getting into more debt. They were able to secure debt because they were able to borrow against the increasing values of heir homes and investments. This increasing value was only possible for as long as more people were chasing into houses as an appreciating asset, but had to stop when many people can no longer realistically afford the increasing prices. This was an unsustainable source of growth for the economy and unsustainable source of consumption funds for the people. Everything started to unravel last year.
But since the US remains a hollowed out economy, the only way for the government and the Fed to keep the economy afloat was to support the continuing of investment activities. Financial institutions that stand to lose a lot due to loan delinquencies are being kept afloat because the fed is buying all their assets and providing them with liquidity. This is resulting in an increase in money supply, and has been supporting the rally in equities in the US. It is also supporting a massive dollar carry trade that has resulted in rallies in emerging economies, commodities, and emerging economy currencies.
This is again unsustainable. The only reason that the US economy has not imploded is because it has managed to export its loose monetary policies abroad.
China is the largest holder of US debt. Since it has been the largest surplus nation that benefited from US trade deficits, it ended up with the most US denominated IOUs. China is a production oriented economy. It is managing its currency by pegging it to the US dollar. This has kept its exports to the US competitively priced. Now that the dollar has been depreciating, both because of the US recession, and more so because of the loose US monetary policy, the yuan has followed it in debasement. China keeps the currency peg so that its can continue its exporting activities. It needs to do so because it needs to provide employment for millions of rural Chinese people migrating to the urban areas looking for work. If they do not find work, the government is concerned they will rebel against the Communist government. So as an integral part of its stimulus during the current global economic downturn, much stimulus money has gone into investing for more factory production capacity. This is in the hope that a recovery will result in exports rising again, leading to more employment for rural migrants.
But because the US recovery policy has only benefited capitalistic investors and financial institutions, many Americans still do not have the stable income to buy goods from China. For this reason, economists are worried that China will export its excess capacity. In other words, it will flood the world with its goods which it will likely sell below cost.
This will be the final nail in the coffin for many manufacturing industries world wide and will result in more job losses. This means less people able to buy goods, further feeding the bad feedback loop.
So we see the deflation coming very soon in manufactured goods that will lead to many losses to companies involved in the production economy. But we also see inflation coming in investment assets due to the US exporting its loose policy.
Some economists are worried that China will stop buying US Treasuries because the US is debasing its currency. A debased currency helps a debtor because the value of the debt goes down. If the US cannot earn enough to pay for its debt it simply prints more money. If China stops buying US Treasuries as a result, the dollar will go down in value steeply.
But there is now a growing sentiment that China cannot do it without hurting itself more. This is like the saying “Owe the bank $100 and the banks owns you. Owe the bank $100 Million and you own the bank”. There is also the belief that if China will suddenly sell its dollar holdings in the market, the US will simply resort to capital controls. That means the US will stop buying its own currency, and hence no nation will want to buy China’s dollar holdings.
But China has slowly been getting rid of its US dollars, by using it to buy into global commodities, global companies, and even global companies producing commodities. This is further leading to the global inflation in commodities .
This will increase the cost of the most basic inputs of production, so that even more businesses will suffer and probably close. The poorest economies of the world will bear the strongest brunt of this commodity inflation. Food will become too expensive for the poorest people.
This is going to be most problematic for countries that have been mirroring the US’ loose monetary policy. Canada has been mirroring the loose policy because it needs to have a competitive currency because the US is its biggest trade partner. But the medium-term effect of this currency debasement is to make the local currencies lose value vs the global prices of these rising commodities.
Since many people are losing income, the government is losing tax revenue. And more people are turning to government safety nets (if there are any) to support themselves. Thus, government finances are deteriorating. Many countries that have to borrow in US dollars are going to have problems down the road, and the only way the government will manage to stay afloat is to raise taxes.
The US government is lucky in that it is able to borrow in its own currency. Also, because it is a global standard currency, it can just print more money to finance its deficits. A problem with that is the debasement of its currency, and the fact that it exports its debasement to countries that mirror the US moves.
Local governments in the US, which cannot print money but can only tax its constituents, are now feeling the pain. Many are already going bankrupt, and California is the leading state going down this road. To raise money, it will need to raise taxes. But if it raises taxes, people will just move out of California, confounding the tax revenue losses.
3 things seem likely to happen next year:
1. Deflation in manufactured goods
2. Inflation in investment assets, most especially commodities
3. Increase in government taxes
The only way to halt this imbalance getting worse is to halt globalization, halt international money flows, halt international trade, and halt the international movement of people.
Nobody knows if the US dollar will be winner in the long-term or a loser, and people are hedging with gold. But gold is already too high. If inflation becomes too high, people will still likely not be paying purchases with gold anyway. Bartering may come into vogue.
If populist sentiment in the US increases, it will probably nationalize the too big to fail banks because they already have national guarantees anyway, and their market making activities are deemed too important (sounding more and more like a social utility rather than a for-profit function). It will therefore likely be safe to put your money as deposits in them but unsafe to invest in their stocks or bonds.
I think countries will retreat into national groupings at the most. So businesses in Asia will focus on regional blocs like the ASEAN, while companies here will have NAFTA all to themselves.