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It is of particular interest to many investors and traders these days which of the following scenarios will prevail:

  1. Is the United States bound to have a fast economic recovery followed by hyperinflation due to the political unwillingness of our politicians, the Fed and, ultimately, the average American (we live in a republic after all) to rein in spending and tighten money supply when the bell rings?
  2. Or, are we going to have the infamous L-shape recovery marked with deflation, prolonged depression in the housing markets and steadily high unemployment?

Many people who know me would argue that I have been a “perma-bear” ever since the dot com crash of 1999 destroyed my visions of retirement at the age of 21. What the last 10 years have taught me nevertheless is the contrary: It is possible to have an ill-fated economy with a constantly-contracting manufacturing sector, yet also have a stock market, a housing market and any other asset market on the up and up, all courtesy of a combination of a fiat currency system and a determined central bank.

So where does all this leave us?

I am still a strong believer that the United States is a society destined to economic Armageddon. The demographics and numbers are clearly supportive of this hypothesis. The baby boom generation is rapidly approaching retirement age. President George W. Bush expanded Medicare by signing Part D with bi-partisan support and cut taxes. It seems that the American people elected a new Congress and President that have visions of expanded health coverage, expanded government but no way to effectively pay for any of it.

Even worse on the fiscal front: energy reform, the expanded stimulus, “healthcare reform” and other massive government spending programs seem to have popular and bipartisan support. In fact, the party lines have been blurred. Nobody is really a fiscal conservative any more because of the pure fact that fiscal conservativism is the stuff lost elections are made of. There is a massive political cost to raising taxes or cutting spending.

If one looks at the estimates for the Federal Budget from the Congressional Budget Office for the next few decades, the picture is grotesque. In the 2008 Federal Budget, spending for Social Security, Medicare and Medicaid totaled 44% and Interest on the National Debt was 8% of the total. These numbers are only expected to increase.

According to the Office of Management and Budget, the deficit for this coming year is expected to be 12% of GDP and next year to be 8.5% of GDP. Short of radical political action, which I do not foresee happening due to various reasons, it is obvious that there is only one way that we will be able to finance our reckless spending and ballooning trade & budget deficits: Borrowing.

But who will lend us the money? Let’s take a look at who currently owns the majority of US Federal Debt. As of June 2008, 47% was owned by the Federal Reserve and other Intragovernmental holdings and 28% was owned by foreign parties, mostly China, and Japan.

There has been a lot of debate regarding who needs who more. Does China need the United States to export its products or does the United States need China to buy its debt? In any debt-creditor relationship (unless someone sends in the Navy to clear things up on another level), usually the creditor has the upper hand.

But let’s examine this relationship more closely.

China has a current policy of a sliding peg of the RMB to the USD. That is because China is an export-oriented developing economy. It depends on exports to support its ongoing economic growth. From 2005, when the RMB was allowed a controlled slide against the USD, to 2008, exports were relatively steady and accounted for approximately 35-40% of Chinese GDP.

Similarly, the United States before WWI was also dependent on European economies for its growth. China is running a huge trade account surplus vis-à-vis the US. It does not repatriate its capital into RMB. Instead, it buys US Debt, managing the exchange rate in order to prevent a shock to its economy by a rapid appreciation of its currency.

Therefore, it is clear that China is aware that it is dependent on the US to maintain its own well-being.

However, with the Great Recession of 2008-2009, policy moves by China have shown that Beijing is accelerating its decoupling policy and its move towards a domestically-driven mature economy. The massive domestic stimulus package announced is part of this.

In global circles, Beijing is also hinting that it is not happy with the USD being the world’s reserve currency, prodding the seeking of alternatives. As China grows its domestic market (China is still expected to grow in terms of real GDP this year), it will be less and less dependent on exports for its economic growth and less susceptible to shocks by foreign economies collapsing.

It’s only reasonable to seek diversification of its holdings as it will let the RMB slowly appreciate against the USD.

In the meantime, as we saw above, the United States has no exit strategy from the massive borrowing to finance our current way of life. We are projected to continue spending and borrowing. With China eventually scaling back purchases of US Government Debt, there are only two ways to finance our spending. One would be to let the markets work and interest rates rise.

But we cannot do that because that will mean tight money supply and possibly devastating deflation. We will have an extended economic contraction, which represents a political suicide for whoever is the incumbent.

It has also been made clear to us that the Fed is more concerned about deflation than inflation. The only other solution would be to once again resort to the buyer of last resort for US Government Debt: The Federal Reserve.

In a normalized economy, not hit with a massive confidence shock, as the Fed continues to buy Bonds, money supply will keep expanding resulting in runaway inflation. Asset prices will remain steady or rise.

So, keep looking for stocks to do well, the housing market to rebound and rise. With one caveat. The price of the dollar will fall. That would be inevitable as more money will be in circulation chasing the same amount of goods and assets.

The backdrop to all this is that the United States has destroyed its manufacturing base. We do not make real products any more because we are not competitive. The only way to regain competitiveness vis-à-vis the rest of the world is to lower our real wages. The way to do that with the least political cost is to slowly devalue the dollar. We still live in the most affluent country in the world with what one could argue is the highest standard of living. We will however have to readjust to the mean.

As the relative standard of living in other countries will rise along with their currencies, ours will fall.

Source: More Asset Bubbles and a Dollar Primed for Collapse