The Money Bubble Gets Its Grand Rationalization

Late in the life of every financial bubble, when things have gotten so out of hand that the old ways of judging value or ethics or whatever can no longer be honestly applied, a new idea emerges that, if true, would let the bubble keep inflating forever. During the tech bubble of the late 1990s it was the “infinite Internet.” Soon, we were told, China and India’s billions would enter cyberspace. And after they were happily on-line, the Internet would morph into versions 2.0 and 3.0 and so on, growing and evolving without end. So don’t worry about earnings; this is a land rush and “eyeballs” are the way to measure virtual real estate. Earnings will come later, when the dot-com visionaries cash out and hand the reins to boring professional managers.

During the housing bubble the rationalization for the soaring value of inert lumps of wood and Formica was a model of circular logic: Home prices would keep going up because “home prices always go up.”

Now the current bubble – call it the Money Bubble or the sovereign debt bubble or the fiat currency bubble, they all fit – has finally reached the point where no one operating within a historical or commonsensical framework can accept its validity, and so for it to continue a new lens is needed. And right on schedule, here it comes: Governments with printing presses can create as much currency as they want and use it to hold down interest rates for as long as they want. So financial crises are now voluntary. They only happen if a country decides to stop depressing interest rates – and why would they ever do that? Here’s an article out of the UK that expresses this belief perfectly:

Our debt is no Greek tragedy

“The threat of rising interest rates is a Greek tragedy we must avoid.” This was the title of a 2009 Daily Telegraph piece by George Osborne, pushing massive spending cuts as the only solution to a coming debt crisis. It’s tempting to believe anyone who still makes it is either deliberately disingenuous, or hasn’t been paying attention.

The line of reasoning goes as follows: Britain’s high and rising public debt causes investors to take fright and sell government bonds because the UK might default on those bonds.

Interest rates then spike up because as less people want to hold UK debt, the government has to pay them more for the privilege, so that the cost of borrowing becomes more expensive and things become very, very bad for everyone.

This argument didn’t make sense back in 2009, and certainly doesn’t make sense now. Ultimately this whole Britain-as-Greece argument is disturbing because it makes the austerity project of the last three years look deeply duplicitous.

If you go to any bond desk in the City that trades British sovereign debt, money managers care about one thing – what the Bank of England does or doesn’t do. If Governor Mark Carney says interest rates should fall and looks like he believes it, they fall. End of story.

Why? Because the Bank directly controls the interest rate on short-term government debt, so it can vary it at will in line with any given objective. Interest rates on long-term government debt are governed by what markets expect to happen to short term rates, and so are subject to essentially the same considerations.

It doesn’t matter if investors get scared and dump government bonds because this has no implication for interest rates – it is what the Bank of England wants to happen that counts.

If investors do suddenly decide to flee en masse, the Bank can simply use its various tools to bring interest rates back into line.

The simple point is that since countries like the UK have a free-floating currency, the Bank of England doesn’t have to vary interest rates to keep the exchange rate stable. Therefore it, as an independent central bank, can prevent a debt crisis by controlling the cost of government borrowing directly. Investors understand this, and so don’t flee British government debt in the first place.

Greece and the other troubled Eurozone countries are in a totally different situation. They don’t have their own currency, and have a single central bank, the ECB, which tries to juggle the needs of 17 different member states. This is a central bank dominated by Germany, which apparently isn’t bothered by letting the interest rates of other nations spiral out of control. Investors, knowing this, made it happen during the financial crisis.

On these grounds, the case of Britain and those of the Eurozone countries are not remotely comparable – and basic intuition suggests steep interest rate rises are only possible in the latter.

Britain was never going to enter a sovereign debt crisis. It has everything to do with an independent central bank, and nothing to do with the size of government debt. How well does this explanation stand up given the events of the last few years? Almost perfectly. The US, Japan and the UK are the three major economies with supposed debt troubles not in the Eurozone.

The UK released a plan in 2010 to cut back a lot of spending and raise a little bit of tax money. The US did nothing meaningful about its debt until 2012, and has spent much of the time before and since pretending to be about to default on its bonds. Japan’s debt patterns are, to put it bluntly, screwed – Japan’s debt passed 200 per cent of GDP earlier this year and is rising fast.

But the data shows that none of this matters for interest rates whatsoever. Rates have been low, stable and near-identical in all three countries regardless of whatever their political leaders’ actions.These countries have had vastly different responses to their debt, and markets don’t care at all.

By the same token, the problems of spiking interest rates inside the Eurozone have nothing to do with the prudence or spending of the governments in charge.

Spain and Ireland both had debt of less than 50 per cent of GDP before the crisis and were still punished by markets. France and the holier-than-thou Germany had far higher debt in 2007, and are fine.

The takeaway is that problems with spiking interest rates amongst advanced countries are entirely restricted to the Eurozone, where there is a single central bank, and have no obvious relation to the state of public finances.

So what we have, then, is a disturbingly mendacious line of reasoning . Back in 2010 the Conservative party made a perhaps superficially plausible argument about national debt that was wrong then and is doubly wrong now. They then – sort of – won a mandate to govern based on this, and used it to radically alter the size of the state. The likelihood that somehow this was all done in good faith beggars belief.

Britain has had a far higher proportion of austerity in the form of spending cuts than tax rises relative to any comparator nation. On this basis austerity is a way of reshaping the state in the Conservative image, flying under the false flag of debt crisis-prevention.

If the British public had knowingly and willingly voted for the major changes made under the coalition in how the government taxes, spends and borrows, this wouldn’t be such a great problem.

Instead, they were essentially conned into it by the ridiculous story of Britain as the next Greece.

Some thoughts
What’s great about the above article is that it doesn’t beat around the bush. Without the slightest hint of irony or historical sense, it lays out the bubble rationale, which is that central banks are all-powerful: “If you go to any bond desk in the City that trades British sovereign debt, money managers care about one thing – what the Bank of England does or doesn’t do. If Governor Mark Carney says interest rates should fall and looks like he believes it, they fall. End of story.”

So this is the end of history. Interest rates will stay low and stock prices high and governments will keep on piling up debt with impunity – because they control the financial markets and get to decide which things trade at what price. Breathtaking! Why didn’t humanity discover this financial perpetual motion machine earlier? It would have saved thousands of years of turmoil.

At the risk of looking like a bully, let’s consider another peak-bubble gem:

“The simple point is that since countries like the UK have a free-floating currency, the Bank of England doesn’t have to vary interest rates to keep the exchange rate stable. Therefore it, as an independent central bank, can prevent a debt crisis by controlling the cost of government borrowing directly. Investors understand this, and so don’t flee British government debt in the first place.”

The writer is saying, in effect, that the value of the British pound – and by extension any other fiat currency – can fall without consequence, and that the people who might want to use those currencies in trade or for savings will continue to do so no matter how much the issuer of those pieces of paper owes to others in the market. If holders of pounds decide to switch to dollars or euros or gold, that’s no problem for Britain because it can just buy all the paper thus freed up with new pieces of paper.

This illusion of government omnipotence is no crazier than the infinite Internet or home prices always going up, but it is crazy. Governments couldn’t stop tech stocks from imploding or home prices from crashing, and when the time comes, the Bank of England, the US Fed, and the Bank of Japan won’t be able to stop the markets from dumping their currencies. Nor will they be able to stop the price of energy, food, and most of life’s other necessities from soaring when the global markets lose faith in their promises.

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China Announces That It Is Going To Stop Stockpiling U.S. Dollars

China just dropped an absolute bombshell, but it was almost entirely ignored by the mainstream media in the United States.  The central bank of China has decided that it is "no longer in China’s favor to accumulate foreign-exchange reserves".  During the third quarter of 2013, China's foreign-exchange reserves were valued at approximately $3.66 trillion.  And of course the biggest chunk of that was made up of U.S. dollars.  For years, China has been accumulating dollars and working hard to keep the value of the dollar up and the value of the yuan down.  One of the goals has been to make Chinese products less expensive in the international marketplace.  But now China has announced that the time has come for it to stop stockpiling U.S. dollars.  And if that does indeed turn out to be the case, than many U.S. analysts are suggesting that China could also soon stop buying any more U.S. debt.  Needless to say, all of this would be very bad for the United States.

For years, China has been systematically propping up the value of the U.S. dollar and keeping the value of the yuan artificially low.  This has resulted in a massive flood of super cheap products from across the Pacific that U.S. consumers have been eagerly gobbling up.

For example, have you ever gone into a dollar store and wondered how anyone could possibly make a profit by making those products and selling them for just one dollar?

Well, the truth is that when you flip those products over you will find that almost all of them have been made outside of the United States.  In fact, the words "made in China" are probably the most common words in your entire household if you are anything like the typical American.

Thanks to the massively unbalanced trade that we have had with China, tens of thousands of our businesses, millions of our jobs and trillions of our dollars have left this country and gone over to China.

And now China has apparently decided that there is not much gutting of our economy left to do and that it is time to let the dollar collapse.  As I mentioned above, China has announced that it is going to stop stockpiling foreign-exchange reserves...

The People’s Bank of China said the country does not benefit any more from increases in its foreign-currency holdings, adding to signs policy makers will rein in dollar purchases that limit the yuan’s appreciation.

“It’s no longer in China’s favor to accumulate foreign-exchange reserves,” Yi Gang, a deputy governor at the central bank, said in a speech organized by China Economists 50 Forum at Tsinghua University yesterday. The monetary authority will “basically” end normal intervention in the currency market and broaden the yuan’s daily trading range, Governor Zhou Xiaochuan wrote in an article in a guidebook explaining reforms outlined last week following a Communist Party meeting. Neither Yi nor Zhou gave a timeframe for any changes.

It isn't going to happen overnight, but the value of the U.S. dollar is going to start to go down, and all of that cheap stuff that you are used to buying at Wal-Mart and the dollar store is going to become a lot more expensive.

But of even more importance is what this latest move by China could mean for U.S. government debt.  As most Americans have heard, we are heavily dependent on foreign nations such as China lending us money.  Right now, China owns nearly 1.3 trillion dollars of our debt.  Unfortunately, as CNBC is noting, if China is going to quit stockpiling our dollars than it is likely that they will stop stockpiling our debt as well...

Analysts see this as the PBoC hinting that it will let its currency fluctuate, without intervention, thus negating the need for holding large reserves of the dollar. And if the dollar is no longer needed, then it could look to curb its purchases of dollar-denominated assets like U.S. Treasurys.

"If they are looking to reduce these purchases going forward then, yes, you'd have to look at who the marginal buyer would be," Richard McGuire, a senior rate strategist at Rabobank told CNBC in an interview.

"Together, with the Federal Reserve tapering its bond purchases, it has the potential to add to the bearish long-term outlook on U.S. Treasurys."

So who is going to buy all of our debt?

That is a very good question.

If the Federal Reserve starts tapering bond purchases and China quits buying our debt, who is going to fill the void?

If there is significantly less demand for government bonds, that will cause interest rates to rise dramatically.  And if interest rates rise dramatically from where they are now, that will set off the kind of nightmare scenario that I keep talking about.

In a previous article entitled "How China Can Cause The Death Of The Dollar And The Entire U.S. Financial System", I described how China could single-handedly cause immense devastation to the U.S. economy.

China accounts for more global trade that anyone else does, and they also own more of our debt than any other nation does.  If China starts dumping our dollars and our debt, much of the rest of the planet would likely follow suit and we would be in for a world of hurt.

And just this week there was another major announcement which indicates that China is getting ready to make a major move against the U.S. dollar.  According to Reuters, crude oil futures may soon be pricedin yuan on the Shanghai Futures Exchange...

The Shanghai Futures Exchange (SHFE) may price its crude oil futures contract in yuan and use medium sour crude as its benchmark, its chairman said on Thursday, adding that the bourse is speeding up preparatory work to secure regulatory approvals.

China, which overtook the United States as the world's top oil importer in September, hopes the contract will become a benchmark in Asia and has said it would allow foreign investors to trade in the contract without setting up a local subsidiary.

If that actually happens, that will be absolutely huge.

China is the number one importer of oil in the world, and it was only a matter of time before they started to openly challenge the petrodollar.

But even I didn't think that we would see anything like this so quickly.

The world is changing, and most Americans have absolutely no idea what this is going to mean for them.  As demand for the U.S. dollar and U.S. debt goes down, the things that we buy at the store will cost a lot more, our standard of living will go down and it will become a lot more expensive for everyone (including the U.S. government) to borrow money.

Unfortunately, there isn't much that can be done about any of this at this point.  When it comes to economics, China has been playing chess while the United States has been playing checkers.  And now decades of very, very foolish decisions are starting to catch up with us.

The false prosperity that most Americans are enjoying today will soon start disappearing, and most of them will have no idea why it is happening.

The years ahead are going to be very challenging, and so I hope that you are getting ready for them.

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