Thursday, November 5, 2009

The Fat Man at the End of the Table

The US has a huge unmanageable deficit and growing debt. Twelve trillion and counting. This coincidentally is bumping up against their legislated debt ceiling. It will be ignored. This needs to be financed by selling more bonds at Treasury auctions. China and Japan have been the primary foreign purchasers of US debt so the big question is whether or not they will continue to feed the fat man at the end of the table? While they haven't stopped buying bonds yet, they are buying less and in shorter durations. Their confidence in the US is waning. Their actions speak of a lower tolerance for risk. To prevent an embarrassing auction failure, the Federal Reserve began a quantitative easing program, which is a fancy way of saying they participated at the auction by buying up the available debt with new money. New money dilutes the value of the existing pool of money. This explosion of money/debt creation, with it's attached interest, will be a growing burden for the taxpayer as debt servicing will consume a growing portion of the declining tax revenues. Normally this should signal a policy shift toward less government spending, instead the Obama government is expanding it's waistline. The U.S. is moving swiftly towards more government control. This is extremely concerning for investors around the world who have served up cheap credit over the past decade.

The currency markets are pricing in the weakening US dollar. It has been in a long term downward trajectory since it's high in 2002 when it topped at $1.20. After a few temporary interruptions it's now sitting around 75 cents. The Fed hasn't tried to defend the dollar by raising the interest rates to entice risk takers to buy more of their debt, nor has the government attempted to show any kind of fiscal restraint. So despite talking about their desire for a strong dollar, the actions display a willingness to let the dollar depreciate. This is likely on purpose as the preferred strategy to pay back the debt with devalued dollars and to promote exports. Debts are static. The conventional wisdom is that while the US buys time, the economy will hopefully recover, tax revenues will improve, and the debt will begin to shrink. It's a desperate gambit of a desperate nation. If this strategy fails, the dollar will be destroyed as the Fed will likely pump out as much money as the Treasury requires to prevent a default of some kind, making a mockery of the US dollar.

The effect of this hyper-inflationary monetary policy is that US imports will become more expensive. Think of oil in particular. As the cost of oil shoots up, costs of manufacturing and transportation rise in tandem, and while businesses will be reluctant to pass on that cost to a cash strapped consumer, margins will eventually get squeezed to the point where inflation of goods and services must take take hold. Many businesses will go bankrupt during this period of monetary inflation if they are unable lure enough customers into the stores. More layoffs, higher unemployment, less income, less income tax, weaker dollar and one can see how a death spiral manifests itself as assets deflate in value while costs inflate. A monetary collapse will wreck havoc on the global economy but the impact will most acutely be felt by the fat man. After decades of gluttony, he will have a heart attack. The US exported most of it's manufacturing base. They are proud, patriotic consumers and to this day feel they were doing the world a favour by eating it's products. This is the depth of their egocentricity. Now they are lecturing that we, the world, cannot rely on the US consumer anymore and we need to step up to the table and start consuming domestically while they digest the debt.

Other countries linked to the economy of the US need to react to this devaluation. China's growth is dependent on exporting cheap products to the US. They need to keep their currency pegged to the dollar to keep their exports viable. This takes a toll on their imports. Again think oil and commodities involved in manufacturing all that stuff they produce. They will feel the pinch as they struggle to stay competitive. They propped up the US dollar by churning the money made from it's exports back into Treasuries, thus financing the US government, keeping interest rates low, by keeping the demand for them artificially high. This investment flows back to them as long as the trade continues. As significant holders of US dollars, devaluation will impact the value of their large US dollar reserves. China will likely reduce it's activity in future Treasury auctions and keep the purchases on the short term duration to keep their long term risk contained. They will also diversify out of their US dollars by purchasing hard assets. Buying real resources with US dollars while it still has some value. Stock piling reserves of oil, copper, gold and other commodities for future production would be prudent and expected. As the US economy drags, their exports will diminish, having a significant impact on their economy. The Chinese government is resisting this rebalancing by keeping the Yuan pegged to the Dollar. As long as their currency is below the US, their exports will remain competitive. They are preferring to take the hit of inflation rather than gain the advantage of buying cheaper imports with a stronger Yuan but with a weaker economy. Other countries that got mired in debt have similar problems. They too are in the quantitative easing mode in order to buy some time, and are devaluing their currency to keep their exports competitive as well. Any country with a strong currency will see it's exports get priced out of reach. This unhealthy dependence on the US for it's own economic well being is a sore spot. Competition is fierce as they all race to the bottom.

While the money supply is inflating, it is being contained within the banking system as they hoard the reserves at low risk. They borrow from the Central banks at zero per cent, while collecting a small tidy interest while they keep it on reserve. They need this cash in order to have any semblance of solvency because most of the big banks are taking a huge loss on real estate loans. The Fed is also buying much of their toxic mortgages. The big banks are being propped up while many of the smaller regional banks are going bankrupt. The 'too big to fail' banks are getting bigger. Financial power is being concentrated. The expected hyper-inflationary scenario won't play out until these reserves get loaned out into the general economy, however for that to occur, the demand for credit from businesses and individuals need to emerge. The consumer is maxed out, so the demand is not there, and they have already pulled forward future needs with credit, thus most of the needs are satiated. The governments feels they need to stimulate the economy by being the spender of last resort. Thus the supposed need for stimulus programs which puts more debt onto the already overburdened taxpayer. It all becomes rather circular.

The US will not have the funds and resources to maintain all it's obligations. The quantitative easing must end to prevent a complete loss of trust in the currency, if it's not already too late. In order to attract much needed investment back into the country, interest rates will have to rise. This will squeeze the indebted citizen. This will curb any chance of a recovery and this will not be politically popular. The other strategy to stimulate demand for US debt is to induce a stock market crash. This would hopefully push the money back into the traditional safe havens. Wealth will be wiped out but the government will have it's money to service the loans. One way or the other, the bills will have to be paid. As the citizenry get more desperate and angry, civil unrest will become more prevalent. Global trade will likely collapse as governments will feel pressured to keep jobs within it's borders. Economies will become leaner and more local. The rebalancing will occur. Meanwhile the fat man at the end of the table will suffer the hunger pains once he realizes the days of living off cheap super-sized junk food has ended, and hopefully he gets off the chair and starts working again to produce something for a change. Let us hope it isn't a war.

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