- Source, Reluctant Preppers
Friday, February 22, 2019
Alasdair Macleod: Brexit, Bullion and Bitcoin
Monday, February 18, 2019
Why Monetary Easing Will Fail
The major economies have slowed suddenly in the last two or three months, prompting a change of tack in the monetary policies of central banks. The same old tired, failing inflationist responses are being lined up, despite the evidence that monetary easing has never stopped a credit crisis developing. This article demonstrates why monetary policy is doomed by citing three reasons. There is the empirical evidence of money and credit continuing to grow regardless of interest rate changes, the evidence of Gibson’s paradox, and widespread ignorance in macroeconomic circles of the role of time preference.
The current state of play
The Fed’s rowing back on monetary tightening has rescued the world economy from the next credit crisis, or at least that’s the bullish message being churned out by brokers’ analysts and the media hacks that feed off them. It brings to mind Dr Johnson’s cynical observation about an acquaintance’s second marriage being the triumph of hope over experience.
The inflationists insist that more inflation is the cure for all economic ills. In this case, mounting concerns over the ending of the growth phase of the credit cycle is the recurring ill being addressed, so repetitive an event that instead of Dr Johnson’s aphorism, it calls for one that encompasses the madness of central bankers repeating the same policies every credit crisis. But if you are given just one tool to solve a nation’s economic problems, in this case the authority to regulate the nation’s money, you probably end up believing in its efficacy to the exclusion of all else.
That is the position in which Jay Powell, the Fed’s chairman finds himself. Quite reasonably, he took the view that the Fed’s marriage with the markets was bound to go through another rough patch, and the Fed should use the good times to prepare itself. Unfortunately, the rough patch materialised before he could organise the Fed’s balance sheet for its next launch of monetary bazookas.
The whole monetary planning process has had to go on hold, and a mini-salvation of the economy engineered. To be fair, this time it is Washington’s tariff fight with China and its alienation of the EU through trade protectionism that has interrupted the Fed’s plans rather than the Fed’s mistakes alone. But by taking early action the hope is the Fed can keep confidence bubbling along for another year or two. It might work, but it will need a far more constructive approach towards global trade from America’s political-security complex to have a sporting chance of succeeding.
However, buying off a crisis by more money-printing does not represent a solution. It is commonly agreed that the problem screaming at us is too much debt. Yet, the inflationists fail to connect growing debt with monetary expansion. The Fed’s objective is to encourage the commercial banks to keep expanding credit. What else is this other than creating more debt?
Powell is surely aware of this and must feel trapped. However, what his feelings are is immaterial; his contractual obligation is to keep the show on the road, targeting self-serving definitions of employment and price inflation. He will be keeping his fingers crossed that some miracle will turn up.
It is too early to forecast whether the Fed will manage to defer for just a little longer the certainty that the monetary imbalances in the economy will implode into a singularity, whereby debtors and creditors resolve their differences into a big fat zero. That is not the purpose of this article, which is to point out why the underlying assumption, that interest rates are the cost of money which can be managed with beneficial results, is plainly wrong. If demand for money and credit can be regulated by interest rates, then there should be a precisely negative correlation between official interest rates and the quantity of money and credit outstanding. It is clear from the following chart that this is not the case.
This chart covers the most violent moves in Fed-directed interest rates ever, following the 1970s price inflation crisis. Despite the Fed increasing the FFR from 4.6% in January 1977 to 19.3% in April 1980, M3 (broad money and bank credit) continued to increase with little variation in its pace. Falls in the FFR designed to stimulate the economy and prevent recession were equally ineffective as M3 continued on its straight-line path after 1980 without significant variation, and it is still doing so today. There is no correlation between changes in interest rates, the quantity of money, and therefore the inflationary consequences.
Gibson’s paradox disproves the efficacy of monetary policy
From the chart above, it is clear that the central tenet of monetary policy, that the quantity of money can be regulated by managing interest rates, is not borne out by the results, and therefore the role of interest rates is not to regulate demand for credit as commonly supposed. This is confirmed by Gibson’s paradox, which demonstrated that a long-run positive correlation existed between wholesale borrowing rates and wholesale prices, the exact opposite of that assumed by modern economists. This is shown in our second chart, covering over two centuries of British statistics.
Economists dismissed the contradiction of Gibson’s paradox because it conflicted with their set view, that interest rates regulate demand for money and therefore prices[i]. Instead, it is ignored, but the evidence is clear. Historically, interest rates have tracked the general price level, not the annual inflation rate. As a means of managing monetary policy, interest rates and therefore borrowing costs are ineffective, as confirmed in our third chart below.
The only apparent correlation between borrowing costs and price inflation occurred in the 1970s, when price inflation took off, and bond and money markets woke up to the collapsing purchasing power of the currency.
The explanation for Gibson’s paradox, which embarrassingly eluded all the great economists who tackled it, is simple. It stands to reason that if the general price level changes, in aggregate businessmen in their calculations will take that into account when it comes to assessing the level of interest they are prepared to pay and still make a profit. If a businessman expects higher prices in the market, he will expect a higher rate of return and therefore be prepared to pay a higher rate of interest. And if prices are lower, he can only afford to pay a correspondingly lower rate. This holds true when capital in the form of savings is limited by the preparedness of people to save, and businesses have to compete for it.
Today, Gibson’s paradox does not appear to apply, partly because capital is no longer scarce (thanks due to central banks) and partly because the abandonment of the Bretton Woods agreement has led to indices of the general price level rising continually. To these factors must now be added wilful misrepresentation of price inflation in official statistics, a deceit that will almost certainly end up destabilising attempts at economic management even further when discovered.
These points notwithstanding, the belief that interest rates are a price which regulates demand for money is disproved. The mistake is to ignore the human dimension of time preference and assume there is no reason for a difference in intertemporal values, the value of something today compared with later. To understand why the degradation of value over time becomes a necessary element of compensation in lending contracts, we must examine in more detail what interest rates actually represent. Only then can we fully understand why they do not correlate with changes in the general level of prices and the growth of credit, which makes up the bulk of M3 in the first chart...
The current state of play
The Fed’s rowing back on monetary tightening has rescued the world economy from the next credit crisis, or at least that’s the bullish message being churned out by brokers’ analysts and the media hacks that feed off them. It brings to mind Dr Johnson’s cynical observation about an acquaintance’s second marriage being the triumph of hope over experience.
The inflationists insist that more inflation is the cure for all economic ills. In this case, mounting concerns over the ending of the growth phase of the credit cycle is the recurring ill being addressed, so repetitive an event that instead of Dr Johnson’s aphorism, it calls for one that encompasses the madness of central bankers repeating the same policies every credit crisis. But if you are given just one tool to solve a nation’s economic problems, in this case the authority to regulate the nation’s money, you probably end up believing in its efficacy to the exclusion of all else.
That is the position in which Jay Powell, the Fed’s chairman finds himself. Quite reasonably, he took the view that the Fed’s marriage with the markets was bound to go through another rough patch, and the Fed should use the good times to prepare itself. Unfortunately, the rough patch materialised before he could organise the Fed’s balance sheet for its next launch of monetary bazookas.
The whole monetary planning process has had to go on hold, and a mini-salvation of the economy engineered. To be fair, this time it is Washington’s tariff fight with China and its alienation of the EU through trade protectionism that has interrupted the Fed’s plans rather than the Fed’s mistakes alone. But by taking early action the hope is the Fed can keep confidence bubbling along for another year or two. It might work, but it will need a far more constructive approach towards global trade from America’s political-security complex to have a sporting chance of succeeding.
However, buying off a crisis by more money-printing does not represent a solution. It is commonly agreed that the problem screaming at us is too much debt. Yet, the inflationists fail to connect growing debt with monetary expansion. The Fed’s objective is to encourage the commercial banks to keep expanding credit. What else is this other than creating more debt?
Powell is surely aware of this and must feel trapped. However, what his feelings are is immaterial; his contractual obligation is to keep the show on the road, targeting self-serving definitions of employment and price inflation. He will be keeping his fingers crossed that some miracle will turn up.
It is too early to forecast whether the Fed will manage to defer for just a little longer the certainty that the monetary imbalances in the economy will implode into a singularity, whereby debtors and creditors resolve their differences into a big fat zero. That is not the purpose of this article, which is to point out why the underlying assumption, that interest rates are the cost of money which can be managed with beneficial results, is plainly wrong. If demand for money and credit can be regulated by interest rates, then there should be a precisely negative correlation between official interest rates and the quantity of money and credit outstanding. It is clear from the following chart that this is not the case.
This chart covers the most violent moves in Fed-directed interest rates ever, following the 1970s price inflation crisis. Despite the Fed increasing the FFR from 4.6% in January 1977 to 19.3% in April 1980, M3 (broad money and bank credit) continued to increase with little variation in its pace. Falls in the FFR designed to stimulate the economy and prevent recession were equally ineffective as M3 continued on its straight-line path after 1980 without significant variation, and it is still doing so today. There is no correlation between changes in interest rates, the quantity of money, and therefore the inflationary consequences.
Gibson’s paradox disproves the efficacy of monetary policy
From the chart above, it is clear that the central tenet of monetary policy, that the quantity of money can be regulated by managing interest rates, is not borne out by the results, and therefore the role of interest rates is not to regulate demand for credit as commonly supposed. This is confirmed by Gibson’s paradox, which demonstrated that a long-run positive correlation existed between wholesale borrowing rates and wholesale prices, the exact opposite of that assumed by modern economists. This is shown in our second chart, covering over two centuries of British statistics.
Economists dismissed the contradiction of Gibson’s paradox because it conflicted with their set view, that interest rates regulate demand for money and therefore prices[i]. Instead, it is ignored, but the evidence is clear. Historically, interest rates have tracked the general price level, not the annual inflation rate. As a means of managing monetary policy, interest rates and therefore borrowing costs are ineffective, as confirmed in our third chart below.
The only apparent correlation between borrowing costs and price inflation occurred in the 1970s, when price inflation took off, and bond and money markets woke up to the collapsing purchasing power of the currency.
The explanation for Gibson’s paradox, which embarrassingly eluded all the great economists who tackled it, is simple. It stands to reason that if the general price level changes, in aggregate businessmen in their calculations will take that into account when it comes to assessing the level of interest they are prepared to pay and still make a profit. If a businessman expects higher prices in the market, he will expect a higher rate of return and therefore be prepared to pay a higher rate of interest. And if prices are lower, he can only afford to pay a correspondingly lower rate. This holds true when capital in the form of savings is limited by the preparedness of people to save, and businesses have to compete for it.
Today, Gibson’s paradox does not appear to apply, partly because capital is no longer scarce (thanks due to central banks) and partly because the abandonment of the Bretton Woods agreement has led to indices of the general price level rising continually. To these factors must now be added wilful misrepresentation of price inflation in official statistics, a deceit that will almost certainly end up destabilising attempts at economic management even further when discovered.
These points notwithstanding, the belief that interest rates are a price which regulates demand for money is disproved. The mistake is to ignore the human dimension of time preference and assume there is no reason for a difference in intertemporal values, the value of something today compared with later. To understand why the degradation of value over time becomes a necessary element of compensation in lending contracts, we must examine in more detail what interest rates actually represent. Only then can we fully understand why they do not correlate with changes in the general level of prices and the growth of credit, which makes up the bulk of M3 in the first chart...
- Source, Alasdair Macleod via Goldmoney
Wednesday, February 13, 2019
Ten Factors To Look For In Gold In 2019
The following is a list of the ten most important factors likely to affect gold in 2019. I have grouped them under two broad headings, economic developments, and factors affecting gold itself.
Possible economic developments to look for
- It’s late in the credit cycle, and it appears the end of the expansion phase is in sight. This being the case, we can see that government deficits are going to increase, due to lower tax receipts and higher welfare commitments as economic activity contracts. This will be covered by an increase in the rate of monetary inflation, which we are already seeing.
- International trade flows have slowed sharply, as can be seen from China’s slump in demand. There can be no doubt that US tariff policies are having what could turn out to be a catastrophic effect on international trade.
- Besides the decline in global trade being a clear signal that the global economy is in trouble, the budget deficit in the US will rise and therefore the trade deficit will tend to rise as well. If not, an increase in the savings rate must occur, which I think we can rule out, or there has to be a contraction in bank credit. In other words, contracting international trade can be expected to propel the US and other domestic economies into a slump. This is bound to provoke the Fed into financing the US government deficit through yet more QE.
- The main economies in Asia (China, Russia, India and Iran) are all turning their backs on the dollar for trade settlement. This will have a profound effect on central bank reserves not just in Asia, but elsewhere as well, with the dollar being sold. Some countries, notably Russia, are buying gold instead.
- Foreign ownership of dollar assets and cash exceeds US GDP: $18.412 plus $4.22bn equals $22.6tn. This is the highest rate relative to GDP ever seen. When the dollar and US securities markets begin to fall in earnest measured in declining dollars, there is bound to be massive foreign selling of dollars and dollar assets.
Factors directly affecting gold
- Geopolitics – Asia, and Russia publicly, have swapped reserve dollars for gold. Given Russia is the world’s largest energy exporter, she will continue to have dollars to sell for gold. Also, Central Europeans, notably Hungary and Poland, are accumulating gold reserves. It is clear which way the Asian wind is blowing, and the Asians know gold is America’s weak point.
- Price inflation has been badly misrepresented by CPI figures and have been averaging closer to about 8% annually since gold topped in Sept 2011. Since then the purchasing power of the dollar has declined by about 43%, so that in 2011 dollars the gold price is $740. No one seems to have noticed, leaving gold extremely cheap.
- Monetary inflation post-Lehman crisis has not been fully absorbed. FMQ is still over $5tn above the pre-Lehman long-term expansion trend, and the Fed is unable to bring it down. Rather, they are likely to increase the fiat money quantity to save the government from having to borrow at market rates as the recession bites.
- These are exactly the conditions faced by the German government between 1918 and 1923, and the likely response by the Fed will be the same. Print money to fund government deficits. Result, wealth transferred from the productive economy to be destroyed in government spending. The only difference is US and other welfare states have a stronger tax base than post-war Germany, so the rate of monetary expansion relative to the size of the economy will be less. Nevertheless, we are on the slippery slope to currency destruction and it will take much more political courage to address the inflation issue than the current political class appear to be capable of.
- Gold is massively under-owned in the west.
- Source, Goldmoney
Friday, February 8, 2019
Trade Wars: A Catalyst for Economic Crisis
In my last article I used a proven accounting identity to show that the end result of President Trump’s trade tariffs would be to increase the trade deficit, assuming there is no change in the savings rate. The savings rate is important, because if it does not change, then the budget deficit must be financed by any combination of three variables: monetary inflation, the expansion of bank credit, or capital inflows. This is captured in that equation, where the trade balance is the balance of payments, thereby including capital flows as well as goods and services:
(Imports – Exports) = (Investment - Savings) + (Government Spending – Taxes)
It assumes the economy is working normally, and as we shall see, there is no major economic contraction or systemic crisis.
This article explores the implications of the relationship between the twin deficits in the context of the current situation for the United States, which may or may not be on the edge of a significant economic retrenchment. It looks at the detail of how trade tariffs act on the economy at the current stage of its credit cycle and the implications for the economic outlook and for monetary policy. It examines the problem through the lens of sound economic theory, but empirical evidence is invoked as well for confirmation.
(Imports – Exports) = (Investment - Savings) + (Government Spending – Taxes)
It assumes the economy is working normally, and as we shall see, there is no major economic contraction or systemic crisis.
This article explores the implications of the relationship between the twin deficits in the context of the current situation for the United States, which may or may not be on the edge of a significant economic retrenchment. It looks at the detail of how trade tariffs act on the economy at the current stage of its credit cycle and the implications for the economic outlook and for monetary policy. It examines the problem through the lens of sound economic theory, but empirical evidence is invoked as well for confirmation.
The empirical evidence
Looking at history, we find that the effect of tariff increases has depended on the stage of the credit cycle. The best clearest examples are the tariffs introduced after the First World War (the Fordney-McCumber tariffs of 1922) early in the credit cycle, and the Smoot-Hawley Tariff Act of 1930 at the end of it. On the face of it, Fordney-McCumber had little effect, while Smoot-Hawley, it is generally agreed, had a significant effect. Of course, this is in the context of a US-centric viewpoint.
The Fordney-McCumber tariffs were introduced early in the US’s credit cycle. At that time, the US economy still had the legacy of wartime production, whereby imported goods and agricultural products were minimal, having been virtually eliminated by wartime economic planning. The impact of tariffs on the US’s domestic economy was therefore barely relevant to the economic situation. Consequently, unlike the European economies which had been ravaged by war, US agricultural and industrial production were both higher in 1920 than they had been in 1913, the year before the outbreak of war. The effect on Europe was another matter.
European economies found themselves needing dollars to pay reparations (in Germany’s case) and to repay war debt in the case of the Allies. US Tariffs made it extremely difficult for the Europeans to earn those dollars. A number of European economies collapsed into hyperinflation as governments continued the wartime practice of money-printing to finance themselves and service wartime obligations.
Another factor affecting America was the collapse of agricultural prices from inflated wartime levels. By 1921, wheat had collapsed from $2.58 a bushel to 92 cents and hogs from 19 cents per pound to under 7 cents. Tariffs did not help farmers, because at that time, they depended on export markets to a significant degree. And when other countries introduced or increased their tariffs against agricultural products as a response to US tariffs, they proved to be wholly counterproductive for US farmers.
Of course, tariffs were not the sole problem for America’s farmers. Rapid mechanisation increased Canada’s wheat yields, the Argentine was increasing beef production and Cuba exporting large quantities of sugar. Consumers were benefiting from catastrophically lower prices despite tariffs. Other than the pain faced by producers, pain which in free markets is only alleviated by redeploying economic resources away from overcapacity in agriculture, the overall economic effect of the Fordney-McCumber tariffs on America was not significant.
Smoot-Hawley was different. Congress voted in favour of it on 31 October 1929, and the stockmarket clearly saw it coming. The Wall Street Crash commenced on Black Thursday, 24 October, when the market fell 11% that day, before recovering most of the fall. Black Monday followed, when the market fell 13%. By the close on Tuesday 29 October the market had lost over 34% in just fifteen calendar days.
At today’s stock prices, that would be a loss of over 8,000 Dow points. The stockmarket continued its fall to a low on 13 November of 198.7 on the Dow, and after rallying for six months entered a pernicious and continual bear market to a final low of 41.22 on 8 July 1932.
It is always a mistake to attribute a market failure to a single cause: the only certainty was the market fell. However, the importance of the Smoot-Hawley vote to the stockmarket is often missed by economic historians.
The difference between late-1929 and today perhaps, is that Congress voting for it then was a definite event, whereas Trump’s tariffs are progressing as a fluid mixture of bluff and fact. Another key difference was the dollar’s gold exchange standard of $20.67 to the ounce. So long as the exchange rate was defended, a slump would certainly lead more dramatically to widespread bankruptcies. Markets therefore had to discount the enhanced risks from trade protectionism to the economy more immediately compared with today’s fiat currency economy, when it is assumed future investment risk will be ameliorated by monetary expansion.
Pursuing this line of thought is unlikely to lead us to a definite conclusion. A more fruitful approach is to look at the effect of tariffs and trade protectionism in the context of the credit cycle. We have established from our examination of the 1921 Fordney-McCumber tariffs that early in the credit cycle trade protectionism had a limited impact on financial markets and the economy. It stands to reason that an economy floating on a tide of money and credit is in a different position, and more vulnerable to disruption from upsetting events such as the introduction of tariffs.
Adverse changes in trade policy at any time are an upset to market assumptions, and it is clear from both Smoot-Hawley and common sense that Trump’s trade interventions today are a serious spanner in the works of highly valued markets. That is tantamount at the minimum to a claim that Trump has upset the speculators. This is evidently the case, but to understand why Trump’s trade protectionism should be taken more seriously, we need to examine in greater detail the flows implied in the equation at the beginning of this article linking the two deficits.
Looking at history, we find that the effect of tariff increases has depended on the stage of the credit cycle. The best clearest examples are the tariffs introduced after the First World War (the Fordney-McCumber tariffs of 1922) early in the credit cycle, and the Smoot-Hawley Tariff Act of 1930 at the end of it. On the face of it, Fordney-McCumber had little effect, while Smoot-Hawley, it is generally agreed, had a significant effect. Of course, this is in the context of a US-centric viewpoint.
The Fordney-McCumber tariffs were introduced early in the US’s credit cycle. At that time, the US economy still had the legacy of wartime production, whereby imported goods and agricultural products were minimal, having been virtually eliminated by wartime economic planning. The impact of tariffs on the US’s domestic economy was therefore barely relevant to the economic situation. Consequently, unlike the European economies which had been ravaged by war, US agricultural and industrial production were both higher in 1920 than they had been in 1913, the year before the outbreak of war. The effect on Europe was another matter.
European economies found themselves needing dollars to pay reparations (in Germany’s case) and to repay war debt in the case of the Allies. US Tariffs made it extremely difficult for the Europeans to earn those dollars. A number of European economies collapsed into hyperinflation as governments continued the wartime practice of money-printing to finance themselves and service wartime obligations.
Another factor affecting America was the collapse of agricultural prices from inflated wartime levels. By 1921, wheat had collapsed from $2.58 a bushel to 92 cents and hogs from 19 cents per pound to under 7 cents. Tariffs did not help farmers, because at that time, they depended on export markets to a significant degree. And when other countries introduced or increased their tariffs against agricultural products as a response to US tariffs, they proved to be wholly counterproductive for US farmers.
Of course, tariffs were not the sole problem for America’s farmers. Rapid mechanisation increased Canada’s wheat yields, the Argentine was increasing beef production and Cuba exporting large quantities of sugar. Consumers were benefiting from catastrophically lower prices despite tariffs. Other than the pain faced by producers, pain which in free markets is only alleviated by redeploying economic resources away from overcapacity in agriculture, the overall economic effect of the Fordney-McCumber tariffs on America was not significant.
Smoot-Hawley was different. Congress voted in favour of it on 31 October 1929, and the stockmarket clearly saw it coming. The Wall Street Crash commenced on Black Thursday, 24 October, when the market fell 11% that day, before recovering most of the fall. Black Monday followed, when the market fell 13%. By the close on Tuesday 29 October the market had lost over 34% in just fifteen calendar days.
At today’s stock prices, that would be a loss of over 8,000 Dow points. The stockmarket continued its fall to a low on 13 November of 198.7 on the Dow, and after rallying for six months entered a pernicious and continual bear market to a final low of 41.22 on 8 July 1932.
It is always a mistake to attribute a market failure to a single cause: the only certainty was the market fell. However, the importance of the Smoot-Hawley vote to the stockmarket is often missed by economic historians.
The difference between late-1929 and today perhaps, is that Congress voting for it then was a definite event, whereas Trump’s tariffs are progressing as a fluid mixture of bluff and fact. Another key difference was the dollar’s gold exchange standard of $20.67 to the ounce. So long as the exchange rate was defended, a slump would certainly lead more dramatically to widespread bankruptcies. Markets therefore had to discount the enhanced risks from trade protectionism to the economy more immediately compared with today’s fiat currency economy, when it is assumed future investment risk will be ameliorated by monetary expansion.
Pursuing this line of thought is unlikely to lead us to a definite conclusion. A more fruitful approach is to look at the effect of tariffs and trade protectionism in the context of the credit cycle. We have established from our examination of the 1921 Fordney-McCumber tariffs that early in the credit cycle trade protectionism had a limited impact on financial markets and the economy. It stands to reason that an economy floating on a tide of money and credit is in a different position, and more vulnerable to disruption from upsetting events such as the introduction of tariffs.
Adverse changes in trade policy at any time are an upset to market assumptions, and it is clear from both Smoot-Hawley and common sense that Trump’s trade interventions today are a serious spanner in the works of highly valued markets. That is tantamount at the minimum to a claim that Trump has upset the speculators. This is evidently the case, but to understand why Trump’s trade protectionism should be taken more seriously, we need to examine in greater detail the flows implied in the equation at the beginning of this article linking the two deficits.
Why external trade has become central to the whole US economy
Since the oil shocks of the early 1970s, the US has relied on foreign holders of dollars to accumulate US Treasuries issued to finance budget deficits. That recycling of dollars earned by foreigners selling more things to America than America sells to foreigners has through trade imbalances allowed the US Government to run mounting budget deficits.
The Americans have become used to foreigners having no credible alternative to reinvesting their accumulating dollars. However, we can now see that the dollar hegemony behind this proposition is being eroded by China and Russia, acting as the powers which are increasingly directing Asian trade flows. Clearly, as their determination to do away with dollars bears fruit, instead of currently held dollars remaining invested they will be surplus to trade requirements and sold. So far, they have been bought by other foreigners, which is why we see China’s holdings of US Treasuries decline, while those of other foreigners increase, and why Russia’s disposal of cash dollars earned through energy sales has little apparent effect on the exchanges. Meanwhile, the US Government has managed to fund itself without a critical increase in borrowing costs.
This cannot continue ad infinitum, because relative to the volumes of trade concerned and the size of the US economy, there are already large quantities of dollar balances and dollar investments accumulated in foreign hands, which on the last available figures at over $22tn exceed US GDP of around $20tn.
The failure of American trade policy is to not recognise the consequences of upsetting what has become a very delicate balance in capital flows. By imposing aggressively protectionist policies, the Trump presidency has set back cross-border trade significantly, reducing the future availability of dollars from non-domestic sources to fund the budget deficit. Furthermore, US efforts to restrict inward commercial investment by China muddy these waters further.
On these grounds alone, we can see that attempts to restrict Chinese imports are cutting off a vital source of future finance for the US Government. Yet, the accounting identity that explains the twin deficit phenomenon tells us in the absence of an increase in the savings rate the trade deficit will continue. Furthermore, due to tax cuts the budget deficit is still increasing at this late stage of the credit cycle, and an emerging slowdown in the rate of GDP growth tells us it will increase even more rapidly than currently forecast.
Therefore, American protectionist policies risk destabilising the market for US Treasuries, which have increasingly relied on foreign buyers recycling their surplus dollars. The question then arises as to what happens if a contraction in international trade develops out of the current slowdown...
Since the oil shocks of the early 1970s, the US has relied on foreign holders of dollars to accumulate US Treasuries issued to finance budget deficits. That recycling of dollars earned by foreigners selling more things to America than America sells to foreigners has through trade imbalances allowed the US Government to run mounting budget deficits.
The Americans have become used to foreigners having no credible alternative to reinvesting their accumulating dollars. However, we can now see that the dollar hegemony behind this proposition is being eroded by China and Russia, acting as the powers which are increasingly directing Asian trade flows. Clearly, as their determination to do away with dollars bears fruit, instead of currently held dollars remaining invested they will be surplus to trade requirements and sold. So far, they have been bought by other foreigners, which is why we see China’s holdings of US Treasuries decline, while those of other foreigners increase, and why Russia’s disposal of cash dollars earned through energy sales has little apparent effect on the exchanges. Meanwhile, the US Government has managed to fund itself without a critical increase in borrowing costs.
This cannot continue ad infinitum, because relative to the volumes of trade concerned and the size of the US economy, there are already large quantities of dollar balances and dollar investments accumulated in foreign hands, which on the last available figures at over $22tn exceed US GDP of around $20tn.
The failure of American trade policy is to not recognise the consequences of upsetting what has become a very delicate balance in capital flows. By imposing aggressively protectionist policies, the Trump presidency has set back cross-border trade significantly, reducing the future availability of dollars from non-domestic sources to fund the budget deficit. Furthermore, US efforts to restrict inward commercial investment by China muddy these waters further.
On these grounds alone, we can see that attempts to restrict Chinese imports are cutting off a vital source of future finance for the US Government. Yet, the accounting identity that explains the twin deficit phenomenon tells us in the absence of an increase in the savings rate the trade deficit will continue. Furthermore, due to tax cuts the budget deficit is still increasing at this late stage of the credit cycle, and an emerging slowdown in the rate of GDP growth tells us it will increase even more rapidly than currently forecast.
Therefore, American protectionist policies risk destabilising the market for US Treasuries, which have increasingly relied on foreign buyers recycling their surplus dollars. The question then arises as to what happens if a contraction in international trade develops out of the current slowdown...
- Source, James Turk's Goldmoney
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