China´s social bomb

BBC News - Social unrest 'on the rise' in China

Social unrest 'on the rise' in China
By Shirong Chen
BBC News China analyst

Burned out bus in Urumqi, China 6/7/09
Large-scale violence, like Urumqi's riots, have spread in 2009

Social unrest is on the rise in China, according to an analysis by a Chinese think-tank.

The country is grappling with more acute social problems than ever before, according to a report from the Chinese Academy of Social Sciences.

Crime is also up, despite a nationwide campaign to shore up social stability.

Although continued economic growth has provided a greater number of jobs, China has seen more social conflict in 2009 than before.

The report on China's social trends sounds a stark warning to policy makers.

The authors believe deep resentment has been accumulating over the past few decades against unfairness and power abuses by government officials at various levels.

They quote six large-scale popular protests - from taxi strikes to unrest in central China in June - involving tens of thousands of people.

This does not include the rioting in the north-western region of Xinjiang, where nearly 200 people were killed in early July.

Urban-rural gap

There has been more crime too - official figures for January to October 2009 show more than four million recorded criminal cases, an increase of about 15% above last year.

The report admits some of China's policies have prevented more people from sharing the benefits of the economic development.

The urban-rural income gap, for example, has become even bigger and the country's phenomenal GDP growth has been achieved at the expense of the rural population, the environment and overall social cohesion.

The report is a damning indictment on the authorities' slogan of building a harmonious society.

But there is one ray of hope in the report - while the Chinese authorities are taking tighter control over the media, people are turning more and more to the internet to expose official failings and abuses.

In the past 12 months, nearly a third of the top stories originated from the internet, pushing the boundaries of press freedo

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UKs drama

FT.com / Columnists / Martin Wolf - Britain’s dismal choice: sharing the losses

Britain’s dismal choice: sharing the losses

By Martin Wolf

Published: December 15 2009 22:11 | Last updated: December 15 2009 22:11

The UK is poorer than it thought it was. This is the most important fact about the crisis. The struggle over the distribution of the losses is going to be brutal. It will be made more so by the second most important fact about the crisis: it has had a huge effect on the public finances. The deficits are unmatched in peacetime.

Happily, the general election would appear to offer a golden opportunity for a debate. Is that not the discussion the country ought to have? Yes. Is it the discussion it is going to have? No. What the government would do if re-elected remains, even after the pre-Budget report, “a riddle, wrapped in a mystery, inside an enigma”, as Churchill said of Stalin’s Russia.

On the Treasury’s current forecasts, the economy will regain 2008 levels of economic activity in 2012. Four years of expected growth would have vanished. In last week’s pre-Budget report, the Treasury forecast growth of 1.25 per cent next year, 3.5 per cent in 2011 and 2012, then 3.25 per cent in 2013 and 2014. Suppose that growth were to continue at 3.25 per cent a year thereafter. It would still take until 2031 before the economy was as big as it would have been if the 1998-2007 trend had continued. The cumulative loss of output would be 160 per cent of 2007 gross domestic product. If growth after 2014 were at the pre-2008 trend rate, lost GDP would be almost three times 2007 GDP by 2030 (see chart). It is easy to imagine worse possibilities.

These losses in output have had a severe impact on the public finances. Indeed, the fiscal deterioration in the UK has been far bigger than in any other member of the Group of Seven leading high-income countries.

  The proximate explanation has been the collapse in government revenues. Between the 2008 Budget and the 2009 pre-Budget report, the forecast of total spending for this financial year has risen by just 4.4 per cent. The forecast of nominal GDP has indeed fallen by 9.1 per cent. But the forecast of revenue has collapsed by 18.1 per cent.

Yet the UK’s recession has not been more severe than that of other high-income countries. As Alistair Darling, the chancellor of the exchequer, noted in his speech on the pre-Budget report, the cumulative contraction in this recession, up to the third quarter of 2009, has been 3.2 per cent in the US, 5.6 per cent in Germany, 5.9 per cent in Italy, 7.7 per cent in Japan and only 4.75 per cent in the UK. The reason this not particularly dramatic decline in output, by the standards of this “Great Recession”, has had an exceptionally big impact on revenues is that, in the UK, the financial sector played a huge role in supporting consumer expenditure, property transactions and corporate profits. No less than a quarter of corporate taxation came from the financial sector alone. Receipts from corporate taxes fell by 26 per cent between the 12 months to October 2008 and the 12 months to October 2009. Receipts from value added tax fell by 17 per cent over the same period. Over and above the general effect of the recession, this is, to a significant extent, a result of the vulnerability of the UK economy to the disruption in credit and collapse in profits of financial businesses.

What does this imply for the UK’s future? A good way of thinking about this question is that the UK has not only had a financial crisis, with the usual severe impact on output and the public finances, but that the UK has also been a “monocrop” economy, with finance itself acting as the “crop”.

Countries that depend heavily on output and exports of commodities whose markets are volatile are all too familiar with the cycles these can create. In booms, export revenues and government revenues are buoyant, the real exchange rate appreciates and marginal producers of tradeable goods and services are squeezed out – a fate sometimes known as the “Dutch disease” after the impact of discoveries of natural gas on the economy of the Netherlands. Often, both government and the private sector borrow heavily in these good times. Then comes the crash: exports and government revenues collapse, fiscal deficits explode, the exchange rate falls and, quite often, inflation surges and the government defaults.

The biggest mistake one can make in macroeconomics is to confuse the cycle with the trend. In monocrop economies, the danger is particularly big, because cycles can be so large. This, in retrospect, is the mistake the UK made. Thus, the Treasury has decided that the UK’s potential output suddenly fell by 5 per cent during this crisis. This is nonsense, as Robert Chote, director of the Institute for Fiscal Studies, has suggested. What the Treasury used to consider sustainable output was, instead, the product of the bubble in the UK’s monocrop financial sector, spread, directly and indirectly, to the economy and the public finances.

If this view is right, it has three painful implications: first, properly measured fiscal policy was far looser than was thought during much of Gordon Brown’s period as chancellor; second, it is likely that the UK will suffer not only from a permanent loss of output, but also a permanent decline in the trend rate of economic growth; and, third, a huge fiscal tightening cannot be avoided.

At present, the government envisages a structural fiscal tightening of 5.4 per cent of GDP over two parliamentary terms, much of it unspecified (see chart). It now expects that a third of this will be achieved through higher taxes and two-thirds through cuts in spending. To make this credible, it envisages a fiscal consolidation plan that would, in some incomprehensible manner, be legally binding. Would a defaulting chancellor be taken to the Tower of London? But the problem with the plans is not only that they are barely credible, but also that the envisaged tightening is probably too little and the final level of public sector net debt, at around 60 per cent of GDP, too high for comfort, given the likelihood of further adverse shocks. Even so, cuts in spending are larger than in similar episodes in the postwar period.

While the chancellor has presented overall numbers, he has shied away from exploring the full implications and, still more, the nature of the choices the country faces. This is the debate the UK must have. It must start from a realisation: the country is poorer than was thought. So how should these losses be shared in ways that minimise both the harm done to vulnerable people now and to the country’s economic prospects for the longer term? Those are the big questions in UK politics. Serious politicians must not duck them.

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Inflation, yes inflation

Paper Probes Fed Nightmare — Inflating Away U.S. Debt - Real Time Economics - WSJ

Paper Probes Fed Nightmare — Inflating Away U.S. Debt
By Michael S. Derby

While it may be the stuff of nightmares for central bankers and dollar defenders, a new paper describes how the U.S. could use inflation to reduce the burden of record-high and rising government debt.

The research, published by the National Bureau of Economic Research, is based on a historical look at the interplay between rising prices and government debt burdens. It’s an issue sure to strike a few nerves, as the U.S. government’s debt moves to 50% of the nation’s gross domestic product, amid fears it could rise to 100% within the next decade.

What may lie ahead evokes the experience of the years right after World War II, when the U.S. debt burden did breach 100% of GDP. Much of that weight was taken off the nation by way of inflation. If back then, the U.S. could ride rising price pressures to make its problem go away, then why not now?

To be sure, the paper, which was written by economists Joshua Aizenman and Nancy Marion, isn’t advocating that the U.S. pursue a particular policy path. Federal Reserve officials, for their part, have been worrying in public about what they see as an unsustainable path of long-term government deficits. They believe those deficits could end a multi-year stretch of decidedly low inflation levels.

Others worry for different reasons. Some fear that inflating the nation’s debt away is the path of least resistance for political leaders who can’t make the hard choices on taxation and spending. The paper notes that “inflation reduced the 1946 debt/GDP ratio by almost 40% within a decade” as a sign of the temptation the strategy represents. In any case, there is widespread agreement that the current fiscal outlook is a grim one, even as short-term economic realities make increased government spending logical and welcome.

For those who detest inflation–and that’s most economists and policy makers–the bad news comes first. The paper says a review of the U.S. experience since World War II shows “eroding the debt through inflation is not farfetched.” If the U.S. now had inflation levels of 6%, it could grind the U.S. debt-to-GDP burden down by a meaty 20% in a mere four years. The paper notes that this level of inflation isn’t that far off the average level of price pressures seen since 1945.

It’s even possible that a stillborn recovery could do some of the work. “When economic growth is stalled, the U.S. debt overhang may trigger an increase in inflation of about 5% for several years,” and that “would significantly reduce the debt ratio,” the paper says.

There are notable differences between now and the immediate post-war period. Whereas the average maturity of U.S. debt is now shorter and much more of it is held overseas, in the wake of the war the debt maturity was longer and nearly all was in domestic hands, the paper notes. That said, the two periods both feature “a large debt overhang and low inflation” and that together increases “the temptation to erode the debt burden through inflation.”

But there are also reasons why trying to inflate the debt away might not be viable now. The research says the balance between who holds the debt and its maturity is important. Whereas the fact that more foreigners hold government debt can make it more attractive to inflate your way to a lower debt burden, the shorter maturity of the debt makes it a more expensive proposition over the longer run to do it.

Ultimately, it’s a risky strategy, the paper warns. It notes that there is a decent chance that “modest” inflation can give way to the double-digit percentage inflation that is painful to contain. In the current environment, the U.S. would also run the chance of making foreign creditors angry, and it could also exacerbate the move away from the dollar as the world’s chief reserve currency.

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The end of America

Elizabeth Warren: America Without a Middle Class

Can you imagine an America without a strong middle class? If you can, would it still be America as we know it?

Today, one in five Americans is unemployed, underemployed or just plain out of work. One in nine families can't make the minimum payment on their credit cards. One in eight mortgages is in default or foreclosure. One in eight Americans is on food stamps. More than 120,000 families are filing for bankruptcy every month. The economic crisis has wiped more than $5 trillion from pensions and savings, has left family balance sheets upside down, and threatens to put ten million homeowners out on the street.

Families have survived the ups and downs of economic booms and busts for a long time, but the fall-behind during the busts has gotten worse while the surge-ahead during the booms has stalled out. In the boom of the 1960s, for example, median family income jumped by 33% (adjusted for inflation). But the boom of the 2000s resulted in an almost-imperceptible 1.6% increase for the typical family. While Wall Street executives and others who owned lots of stock celebrated how good the recovery was for them, middle class families were left empty-handed.

The crisis facing the middle class started more than a generation ago. Even as productivity rose, the wages of the average fully-employed male have been flat since the 1970s.

2009-12-03-warren12.jpg

But core expenses kept going up. By the early 2000s, families were spending twice as much (adjusted for inflation) on mortgages than they did a generation ago -- for a house that was, on average, only ten percent bigger and 25 years older. They also had to pay twice as much to hang on to their health insurance.

To cope, millions of families put a second parent into the workforce. But higher housing and medical costs combined with new expenses for child care, the costs of a second car to get to work and higher taxes combined to squeeze families even harder. Even with two incomes, they tightened their belts. Families today spend less than they did a generation ago on food, clothing, furniture, appliances, and other flexible purchases -- but it hasn't been enough to save them. Today's families have spent all their income, have spent all their savings, and have gone into debt to pay for college, to cover serious medical problems, and just to stay afloat a little while longer.
2009-12-03-warren34.jpg

Through it all, families never asked for a handout from anyone, especially Washington. They were left to go on their own, working harder, squeezing nickels, and taking care of themselves. But their economic boats have been taking on water for years, and now the crisis has swamped millions of middle class families.

The contrast with the big banks could not be sharper. While the middle class has been caught in an economic vise, the financial industry that was supposed to serve them has prospered at their expense. Consumer banking -- selling debt to middle class families -- has been a gold mine. Boring banking has given way to creative banking, and the industry has generated tens of billions of dollars annually in fees made possible by deceptive and dangerous terms buried in the fine print of opaque, incomprehensible, and largely unregulated contracts.

And when various forms of this creative banking triggered economic crisis, the banks went to Washington for a handout. All the while, top executives kept their jobs and retained their bonuses. Even though the tax dollars that supported the bailout came largely from middle class families -- from people already working hard to make ends meet -- the beneficiaries of those tax dollars are now lobbying Congress to preserve the rules that had let those huge banks feast off the middle class.

Pundits talk about "populist rage" as a way to trivialize the anger and fear coursing through the middle class. But they have it wrong. Families understand with crystalline clarity that the rules they have played by are not the same rules that govern Wall Street. They understand that no American family is "too big to fail." They recognize that business models have shifted and that big banks are pulling out all the stops to squeeze families and boost revenues. They understand that their economic security is under assault and that leaving consumer debt effectively unregulated does not work.

Families are ready for change. According to polls, large majorities of Americans have welcomed the Obama Administration's proposal for a new Consumer Financial Protection Agency (CFPA). The CFPA would be answerable to consumers -- not to banks and not to Wall Street. The agency would have the power to end tricks-and-traps pricing and to start leveling the playing field so that consumers have the tools they need to compare prices and manage their money. The response of the big banks has been to swing into action against the Agency, fighting with all their lobbying might to keep business-as-usual. They are pulling out all the stops to kill the agency before it is born. And if those practices crush millions more families, who cares -- so long as the profits stay high and the bonuses keep coming.

America today has plenty of rich and super-rich. But it has far more families who did all the right things, but who still have no real security. Going to college and finding a good job no longer guarantee economic safety. Paying for a child's education and setting aside enough for a decent retirement have become distant dreams. Tens of millions of once-secure middle class families now live paycheck to paycheck, watching as their debts pile up and worrying about whether a pink slip or a bad diagnosis will send them hurtling over an economic cliff.

America without a strong middle class? Unthinkable, but the once-solid foundation is shaking.

Elizabeth Warren is the Leo Gottlieb Professor of Law at Harvard and is currently the Chair of the Congressional Oversight Panel.

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Dollar

FT.com / Comment / Opinion - We must get ready for a weak-dollar world

We must get ready for a weak-dollar world

By Jeffrey Garten

Published: November 29 2009 20:02 | Last updated: November 29 2009 20:02

The two most significant structural consequences of the recent financial debacle are the massive deficits and debts of the US and the shift of economic power from west to east. There is only one effective way for governments to address the combined impact of both: press for a sea change in currency relationships, especially a permanently and greatly weakened dollar.

The roots of this situation are well known. The American budget deficit of this past fiscal year reached 10 per cent of gross domestic product, the largest since the aftermath of the second world war. Meanwhile, the net external debt of the US nearly tripled last year to $3,500bn and it is projected to increase by nearly $1,000bn every year for the next decade. All this underestimates the problems of a country where unfunded liabilities for baby boomer entitlements are in the stratosphere, infrastructure deterioration is scandalous and many large states are out of money. To close the gaps, taxes would have to be raised to sky-high levels and spending brutally slashed. It would take a miracle if America’s political system – one rife with vicious partisanship and riddled with well-financed special interests – could do either, let alone both.

Washington will therefore have little choice but to take the time-honoured course for big-time debtors: print more dollars, devalue the currency and service debt in ever cheaper greenbacks. In other words, the US will have to camouflage a slow-motion default because politically it is the easiest way out.

There is another factor pushing America towards a weaker dollar: lacking the domestic consumer demand that came with the unrestrained credit of the past 15 years, the US is desperate to find buyers abroad, especially in emerging markets where the middle class is growing and infrastructure requirements are soaring. A cheaper dollar could make US products and services more competitive.

Meanwhile, in the coming decade, the big emerging markets of Asia will be growing twice as fast as the US and three times faster than the European Union. By 2020, China, India, Indonesia, Korea and Vietnam together could generate more wealth than the the US, Japan and the EU combined. China, India, and South Korea have all been amassing dollar reserves and will be looking to reduce them. While imports into leading industrial countries have slowed, intra-Asian trade is booming and need not be financed only in dollars. The bottom line: Asian currencies are likely to strengthen against the dollar.

A much cheaper dollar is a sad development for the US, even though it is inevitable. It will make the US poorer, since Americans will pay higher prices for everything they buy from abroad – clothes, computers, cars, toys, food, you name it. It will make the US military presence abroad more expensive, since the cost of contractors and local suppliers will escalate in dollar terms. It will slow imports, removing competition that is essential to hold down the general price level in America, thereby making inflation more likely. It will send the wrong price signals for a country that prides itself on creating sophisticated, highly valuable products, for a low dollar will encourage producers to compete on price more than quality. It will diminish the political influence and prestige that the US has had while the dollar has been king.

Moreover, the US dollar has been at the heart of the global economy for well over half a century. Its demise, if not smooth and gradual – hardly certain – could lead to an era of competitive devaluations and other mercantilist trade policies.

An alternative to a global monetary system that has been centred on the dollar is now imperative. That means a multi-currency framework including the euro, the yen, the renminbi and significant issuance of an IMF-backed currency called “special drawing rights”. This regime will take time to devise, but it should start now.

That is why Tim Geithner, US Treasury secretary, should invite his colleagues in the UK, eurozone, Japan and China to meet secretly, perhaps between Christmas and New Year, to start discussions out of the public spotlight (to avoid spooking markets). The big question: what kind of monetary system will best serve the world given deep-seated changes in the balance of economic power, and what process can be followed to develop it?

Since the late 1980s I have believed that a strong dollar was in the US and world interest. Now, however, the context has fundamentally changed. The issue is no longer whether the dollar is in long-term decline but which of two options will be taken. Should Washington and other capitals calmly and deliberately manage the transition to a new era, or, by default, should they let the market do it, with the risk of massive financial disturbances. Today, governments have a choice. Soon they may not.

The writer is the Juan Trippe professor of international trade and finance at theYale School of Management

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Goodbye America

An Empire at Risk | Print Article | Newsweek.com

An Empire at Risk
We won the cold war and weathered 9/11. But now economic weakness is endangering our global power.

By Niall Ferguson | NEWSWEEK

Published Nov 28, 2009

From the magazine issue dated Dec 7, 2009

Call it the fractal geometry of fiscal crisis. If you fly across the Atlantic on a clear day, you can look down and see the same phenomenon but on four entirely different scales. At one extreme there is tiny Iceland. Then there is little Ireland, followed by medium-size Britain. They're all a good deal smaller than the mighty United States. But in each case the economic crisis has taken the same form: a massive banking crisis, followed by an equally massive fiscal crisis as the government stepped in to bail out the private financial system.

Size matters, of course. For the smaller countries, the financial losses arising from this crisis are a great deal larger in relation to their gross domestic product than they are for the United States. Yet the stakes are higher in the American case. In the great scheme of things—let's be frank—it does not matter much if Iceland teeters on the brink of fiscal collapse, or Ireland, for that matter. The locals suffer, but the world goes on much as usual.

But if the United States succumbs to a fiscal crisis, as an increasing number of economic experts fear it may, then the entire balance of global economic power could shift. Military experts talk as if the president's decision about whether to send an additional 40,000 troops to Afghanistan is a make-or-break moment. In reality, his indecision about the deficit could matter much more for the country's long-term national security. Call the United States what you like—superpower, hegemon, or empire—but its ability to manage its finances is closely tied to its ability to remain the predominant global military power. Here's why.

The disciples of John Maynard Keynes argue that increasing the federal debt by roughly a third was necessary to avoid Depression 2.0. Well, maybe, though some would say the benefits of fiscal stimulus have been oversold and that the magic multiplier (which is supposed to transform $1 of government spending into a lot more than $1 of aggregate demand) is trivially small.

Credit where it's due. The positive number for third-quarter growth in the United States would have been a lot lower without government spending. Between half and two thirds of the real increase in gross domestic product was attributable to government programs, especially the Cash for Clunkers scheme and the subsidy to first-time home buyers. But we are still a very long way from a self--sustaining recovery. The third-quarter growth number has just been revised downward from 3.5 percent to 2.8 percent. And that's not wholly surprising. Remember, what makes a stimulus actually work is the change in borrowing by the whole public sector. Since the federal government was already running deficits, and since the states are actually raising taxes and cutting spending, the actual size of the stimulus is closer to 4 percent of GDP spread over the years 2007 to 2010—a lot less than that headline 11.2 percent deficit.

Meanwhile, let's consider the cost of this muted stimulus. The deficit for the fiscal year 2009 came in at more than $1.4 trillion—about 11.2 percent of GDP, according to the Congressional Budget Office (CBO). That's a bigger deficit than any seen in the past 60 years—only slightly larger in relative terms than the deficit in 1942. We are, it seems, having the fiscal policy of a world war, without the war. Yes, I know, the United States is at war in Afghanistan and still has a significant contingent of troops in Iraq. But these are trivial conflicts compared with the world wars, and their contribution to the gathering fiscal storm has in fact been quite modest (little more than 1.8 percent of GDP, even if you accept the estimated cumulative cost of $3.2 trillion published by Columbia economist Joseph Stiglitz in February 2008).

And that $1.4 trillion is just for starters. According to the CBO's most recent projections, the federal deficit will decline from 11.2 percent of GDP this year to 9.6 percent in 2010, 6.1 percent in 2011, and 3.7 percent in 2012. After that it will stay above 3 percent for the foreseeable future. Meanwhile, in dollar terms, the total debt held by the public (excluding government agencies, but including foreigners) rises from $5.8 trillion in 2008 to $14.3 trillion in 2019—from 41 percent of GDP to 68 percent.

In other words, there is no end in sight to the borrowing binge. Unless entitlements are cut or taxes are raised, there will never be another balanced budget. Let's assume I live another 30 years and follow my grandfathers to the grave at about 75. By 2039, when I shuffle off this mortal coil, the federal debt held by the public will have reached 91 percent of GDP, according to the CBO's extended baseline projections. Nothing to worry about, retort -deficit-loving economists like Paul Krugman. In 1945, the figure was 113 percent.

Well, let's leave aside the likely huge differences between the United States in 1945 and in 2039. Consider the simple fact that under the CBO's alternative (i.e., more pessimistic) fiscal scenario, the debt could hit 215 percent by 2039. That's right: more than double the annual output of the entire U.S. economy.

Forecasting anything that far ahead is not about predicting the future. Everything hinges on the assumptions you make about demographics, Medicare costs, and a bunch of other variables. For example, the CBO assumes an average annual real GDP growth rate of 2.3 percent over the next 30 years. The point is to show the implications of the current chronic imbalance between federal spending and federal revenue. And the implication is clear. Under no plausible scenario does the debt burden decline. Under one of two plausible scenarios it explodes by a factor of nearly five in relation to economic output.

Another way of doing this kind of exercise is to calculate the net present value of the unfunded liabilities of the Social Security and Medicare systems. One recent estimate puts them at about $104 trillion, 10 times the stated federal debt.

No sweat, reply the Keynesians. We can easily finance $1 trillion a year of new government debt. Just look at the way Japan's households and financial institutions funded the explosion of Japanese public debt (up to 200 percent of GDP) during the two "lost decades" of near-zero growth that began in 1990.

Unfortunately for this argument, the evidence to support it is lacking. American households were, in fact, net sellers of Treasuries in the second quarter of 2009, and on a massive scale. Purchases by mutual funds were modest ($142 billion), while purchases by pension funds and insurance companies were trivial ($12 billion and $10 billion, respectively). The key, therefore, becomes the banks. Currently, according to the Bridgewater hedge fund, U.S. banks' asset allocation to government bonds is about 13 percent, which is relatively low by historical standards. If they raised that proportion back to where it was in the early 1990s, it's conceivable they could absorb "about $250 billion a year of government bond purchases." But that's a big "if." Data for October showed commercial banks selling Treasuries.

That just leaves two potential buyers: the Federal Reserve, which bought the bulk of Treasuries issued in the second quarter; and foreigners, who bought $380 billion. Morgan Stanley's analysts have crunched the numbers and concluded that, in the year ending June 2010, there could be a shortfall in demand on the order of $598 billion—about a third of projected new issuance.

Of course, our friends in Beijing could ride to the rescue by increasing their already vast holdings of U.S. government debt. For the past five years or so, they have been amassing dollar--denominated international reserves in a wholly unprecedented way, mainly as a result of their interventions to prevent the Chinese currency from appreciating against the dollar.

Right now, the People's Republic of China holds about 13 percent of U.S. government bonds and notes in public hands. At the peak of this process of reserve accumulation, back in 2007, it was absorbing as much as 75 percent of monthly Treasury issuance.

But there's no such thing as a free lunch in the realm of international finance. According to Fred Bergsten of the Peterson Institute for International Economics, if this trend were to continue, the U.S. -current-account deficit could rise to 15 percent of GDP by 2030, and its net debt to the rest of the world could hit 140 percent of GDP. In such a scenario, the U.S. would have to pay as much as 7 percent of GDP every year to foreigners to service its external borrowings.

Could that happen? I doubt it. For one thing, the Chinese keep grumbling that they have far too many Treasuries already. For another, a significant dollar depreciation seems more probable, since the United States is in the lucky position of being able to borrow in its own currency, which it reserves the right to print in any quantity the Federal Reserve chooses.

Now, who said the following? "My prediction is that politicians will eventually be tempted to resolve the [fiscal] crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar."

Seems pretty reasonable to me. The surprising thing is that this was none other than Paul Krugman, the high priest of Keynesianism, writing back in March 2003. A year and a half later he was comparing the U.S. deficit with Argentina's (at a time when it was 4.5 percent of GDP). Has the economic situation really changed so drastically that now the same Krugman believes it was "deficits that saved us," and wants to see an even larger deficit next year? Perhaps. But it might just be that the party in power has changed.

History strongly supports the proposition that major financial crises are followed by major fiscal crises. "On average," write Carmen Reinhart and Kenneth Rogoff in their new book, This Time Is Different, "government debt rises by 86 percent during the three years following a banking crisis." In the wake of these debt explosions, one of two things can happen: either a default, usually when the debt is in a foreign currency, or a bout of high inflation that catches the creditors out. The history of all the great European empires is replete with such episodes. Indeed, serial default and high inflation have tended to be the surest symptoms of imperial decline.

As the U.S. is unlikely to default on its debt, since it's all in dollars, the key question, therefore, is whether we are going to see the Fed "printing money"—buying newly minted Treasuries in exchange for even more newly minted greenbacks—followed by the familiar story of rising prices and declining real-debt burdens. It's a scenario many investors around the world fear. That is why they are selling dollars. That is why they are buying gold.

Yet from where I am sitting, inflation is a pretty remote prospect. With U.S. unemployment above 10 percent, labor unions relatively weak, and huge quantities of unused capacity in global manufacturing, there are none of the pressures that made for stagflation (low growth plus high prices) in the 1970s. Public expectations of inflation are also very stable, as far as can be judged from poll data and the difference between the yields on regular and inflation-protected bonds.

So here's another scenario—which in many ways is worse than the inflation scenario. What happens is that we get a rise in the real interest rate, which is the actual interest rate minus inflation. According to a substantial amount of empirical research by economists, including Peter Orszag (now at the Office of Management and Budget), significant increases in the debt-to-GDP ratio tend to increase the real interest rate. One recent study concluded that "a 20 percentage point increase in the U.S. government-debt-to-GDP ratio should lead to a 20–120 basis points [0.2–1.2 percent] increase in real interest rates." This can happen in one of three ways: the nominal interest rate rises and inflation stays the same; the nominal rate stays the same and inflation falls; or—the nightmare case—the nominal interest rate rises and inflation falls.

Today's Keynesians deny that this can happen. But the historical evidence is against them. There are a number of past cases (e.g., France in the 1930s) when nominal rates have risen even at a time of deflation. What's more, it seems to be happening in Japan right now. Just last week Hirohisa Fujii, Japan's new finance minister, admitted that he was "highly concerned" about the recent rise in Japanese government bond yields. In the very same week, the government admitted that Japan was back in deflation after three years of modest price increases.

It's not inconceivable that something similar could happen to the United States. Foreign investors might ask for a higher nominal return on U.S. Treasuries to compensate them for the weakening dollar. And inflation might continue to surprise us on the downside. After all, consumer price inflation is in negative territory right now.

Why should we fear rising real interest rates ahead of inflation? The answer is that for a heavily indebted government and an even more heavily indebted public, they mean an increasingly heavy debt-service burden. The relatively short duration (maturity) of most of these debts means that a large share has to be rolled over each year. That means any rise in rates would feed through the system scarily fast.

Already, the federal government's interest payments are forecast by the CBO to rise from 8 percent of revenues in 2009 to 17 percent by 2019, even if rates stay low and growth resumes. If rates rise even slightly and the economy flatlines, we'll get to 20 percent much sooner. And history suggests that once you are spending as much as a fifth of your revenues on debt service, you have a problem. It's all too easy to find yourself in a vicious circle of diminishing credibility. The investors don't believe you can afford your debts, so they charge higher interest, which makes your position even worse.

This matters more for a superpower than for a small Atlantic island for one very simple reason. As interest payments eat into the budget, something has to give—and that something is nearly always defense expenditure. According to the CBO, a significant decline in the relative share of national security in the federal budget is already baked into the cake. On the Pentagon's present plan, defense spending is set to fall from above 4 percent now to 3.2 percent of GDP in 2015 and to 2.6 percent of GDP by 2028.

Over the longer run, to my own estimated departure date of 2039, spending on health care rises from 16 percent to 33 percent of GDP (some of the money presumably is going to keep me from expiring even sooner). But spending on everything other than health, Social Security, and interest payments drops from 12 percent to 8.4 percent.

This is how empires decline. It begins with a debt explosion. It ends with an inexorable reduction in the resources available for the Army, Navy, and Air Force. Which is why voters are right to worry about America's debt crisis. According to a recent Rasmussen report, 42 percent of Americans now say that cutting the deficit in half by the end of the president's first term should be the administration's most important task—significantly more than the 24 percent who see health-care reform as the No. 1 priority. But cutting the deficit in half is simply not enough. If the United States doesn't come up soon with a credible plan to restore the federal budget to balance over the next five to 10 years, the danger is very real that a debt crisis could lead to a major weakening of American power.

The precedents are certainly there. Habsburg Spain defaulted on all or part of its debt 14 times between 1557 and 1696 and also succumbed to inflation due to a surfeit of New World silver. Prerevolutionary France was spending 62 percent of royal revenue on debt service by 1788. The Ottoman Empire went the same way: interest payments and amortization rose from 15 percent of the budget in 1860 to 50 percent in 1875. And don't forget the last great English-speaking empire. By the interwar years, interest payments were consuming 44 percent of the British budget, making it intensely difficult to rearm in the face of a new German threat.

Call it the fatal arithmetic of imperial decline. Without radical fiscal reform, it could apply to America next.

Ferguson is Laurence A. Tisch professor of history at Harvard and the author of The Ascent of Money.

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Correction

Dubai Crisis Means ‘Correction’ to Mobius, Risk Aversion to Das - Bloomberg.com

Dubai Crisis Means ‘Correction’ to Mobius, Risk Aversion to Das

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The yuan is coming

Project Syndicate - The Irresistible Rise of the Renminbi

Chinese officials have targeted 2020 as the date by which both Beijing and Shanghai should become leading international financial centers, with deep and liquid financial markets open to the rest of the world. By implication, that is the date by which they want to see the renminbi become a leading international currency.

Can the renminbi become a major international currency in as little as a decade? Only time will tell. But US history suggests that this schedule, while ambitious, is not impossible.

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Decline but not fall?

FT.com / Comment / Analysis - Decline but no fall

Decline but no fall

By John Plender

Published: November 11 2009 19:55 | Last updated: November 11 2009
As US president Barack Obama begins a tour of Asian capitals, the standard assumption in the west is that his meetings will be with leaders of nations that rank as America’s junior partners. Yet the reality is more complex. Amid the rubble of the financial crisis, the US position as singular superpower and global economic top dog looks increasingly under threat.

In particular, when he reaches Beijing next week, nothing will be able to disguise the fact that Mr Obama is paying a visit to his country’s biggest creditor.

Those who take pleasure in America’s discomfort point out that this global economic colossus has become shackled to the world’s largest pile of international debt and pulled down by a sinking currency. By common consent China is the chief beneficiary of the financial debacle and a serious challenger to US hegemony.

Since economic might so often goes hand in hand with military strength, this shift in economic power, along with the recent weakness of the dollar, has been heralded as a harbinger of US national decline. Neatly catching this mood was the title of Fareed Zakaria’s recent best-selling book, The Post-American World And The Rise Of The Rest. Then came Mr Obama’s reference in his inaugural speech to “a sapping of confidence across our land; a nagging fear that America’s decline is inevitable, that the next generation must lower its sights”.

Paul Volcker, former chairman of the Federal Reserve and an adviser to the president, chipped in with remarks in a recent interview with PBS, the US public broadcaster, that the rise of emerging markets was “symbolic of the relative, less dominant position the US has, not just in the economy but in leadership, intellectual and otherwise”.

Central banks in the developing countries have rubbed salt in the wounds of the ailing giant. The Reserve Bank of India last week joined the central banks of China, Russia, Mexico and the Philippines in choosing to boost its reserves of gold in preference to dollar-denominated securities. A veritable chorus of policymakers in countries running current account surpluses has declared that the reserve currency role of the dollar is unsustainable.

At which point, it is important to remember that we have been here before. Back in the late 1980s, Paul Kennedy of Yale University stunned the world’s chattering classes with his assertion in The Rise And Fall Of The Great Powers that “the only answer to the question increasingly debated by the public of whether the United States can preserve its existing position is ‘no’.”

This downbeat verdict came around the time of the 1987 stock market crash, when there was continuing concern about the twin US budget and current account deficits. The country had become an international debtor for the first time and was increasingly dependent on European and Japanese capital inflows. A supremely confident Japan was in the ascendant. Declinist sentiment in the US came close to hysterical when Japanese companies snapped up New York’s Rockefeller Center, Columbia Pictures in Hollywood and Pebble Beach golf course in California. “Who owns America?” demanded ABC News.

In one sense Prof Kennedy’s thesis was right. As China, India and the other emerging markets catch up with the developed world, the US is bound to suffer relative economic decline in the shape of a falling share of global gross domestic product, even as it grows faster than most of the developed world’s larger economies and remains the world’s biggest economy in absolute terms.

Globalisation and domestic liberalisation have given these developing countries the chance to establish a share of global GDP commensurate with their size and history. Chinese economic performance before 1978 was, after all, an aberration viewed from the perspective of centuries.

In a study of leading economies, Angus Maddison of the University of Groningen has calculated that China’s share of global GDP in 1820, before the industrial revolution in Europe gathered pace, was more than 30 per cent, which is well above the US’s current share. A return to something more normal may thus be under way.

Where the Kennedy thesis appeared wide of the mark was in suggesting the US was seriously at risk of imperial overstretch, as with Spain in 1600 or Britain in 1900. The more obvious case of overstretch in the 1980s was in fact the Soviet Union, which collapsed, while the US succeeded soon after in restoring its budgetary position under the Clinton presidency without a full-scale retreat from its international commitments.

The Japanese economic challenge, meantime, wilted as equity and property bubbles burst and deflation threatened. The US media’s panic over the Japanese invasion proved a perfect, if inadvertent, indicator of a turning point.

The question now is whether the overstretch thesis was wrong or simply premature. Yet predicting the timing of the rise and fall of nations and economies is notoriously difficult. Charles Kindleberger, the late economic historian, was one of many who believed that national vitality moved in a life cycle. Among the internal causes of decline he identified were increased consumption, decreased savings, resistance to taxation, inequality, corruption, mounting debt and finance becoming more dominant in the economy than industry.

Yet if this chimes with current circumstances, note that many of these things were also present in the US in 1929 when an earlier financial crisis coincided with the long transition from British to American economic hegemony. When Kindleberger wrote his World Economic Primacy 1500-1990 in 1996, he believed the US was slipping. But he had no idea which country was likely to emerge as the next primary world economic power and regarded China as merely a dark horse for the role.

The most powerful argument supporting the declinist hypothesis concerns what Prof Kennedy called “the age-old task of relating national means to national ends”. Since there is a significant long-term correlation between productive and revenue raising capacity, and military strength, much hinges on the sustainability of fiscal policy. Here the omens are not good for the US.

Under the twin pressures of the financial crisis and the longer-term problem of ageing baby boomers, official projections point to budget deficits on an unprecedented scale. The Peterson Institute for International Economics in Washington estimates that after nearing $1,500bn (€1,000bn, £905bn) in the current fiscal year – more than three times the previous record – the deficit is likely to remain close to an annual $1,000bn until 2020 or later.

Looked at from the perspective of the flow of funds in the economy, the counterpart to these deficits will largely be found on the current account of the balance of payments. Here the institute reckons the current account deficit could rise from a previous record of 6 per cent of GDP to an awesome 15 per cent or more by 2030, equivalent to more than $5,000bn annually. It expects net external debt to rise from $3,500bn today to as much as $50,000bn, or 140 per cent of GDP, over the same period.

Such figures pose a daunting challenge for the Obama administration and a conspicuous threat to the dollar, since there is a huge overhang of dollar reserves in foreign hands. From the end of 2000 to mid-2009 the International Monetary Fund estimates that official foreign exchange reserves rose from $1,900bn to $6,800bn, of which $2,300bn is held by China alone. More than 60 per cent of these reserves are in dollars.

Recent Chinese rhetoric, including a call for the replacement of the dollar as the world’s main reserve currency by special drawing rights – an accounting unit used by the IMF in its dealing with its members – suggest a worrying loss of confidence in US monetary and fiscal policy. At the same time Fred Bergsten, the Peterson Institute’s director, argues that it is now very much in the US interest to reduce the role of the dollar and encourage a greater flow of reserves into euros, renminbi and SDRs.

Yet the threat to the dollar can be overstated. China is rattling the bars of a cage of its own making, since the reserves are a consequence of colossal intervention to stop its currency appreciating. In effect, it is trapped in the economic equivalent of the mutually assured destruction described by theorists of nuclear deterrence in the cold war. With exports amounting to two-fifths of GDP, it has been beholden to the US as borrower and spender of last resort in the global economy. And it cannot abandon the dollar without slashing the value of its own dollar reserves.

As for the potential of the Chinese currency to challenge the reserve role of the dollar, it may exist in the very long run but, in the absence of developed financial markets and a much stronger commitment to internationalise the renminbi, it remains pretty remote.

In fact, the weakest element of the declinist view of the US may be the high current estimates of the strength of the Chinese challenge. These have been elegantly punctured in a recent essay in foreign affairs by Josef Joffe, co-editor of Germany’s Die Zeit. China, he says, is a place where the rest of the world essentially rents workers and workspace at deflated prices and distorted exchange rates. Its export dependence, as well as being an economic Achilles’ heel, has political consequences. These include 70,000 civil disturbances each year that are not factored into the linear growth forecasts beloved of investment bankers.

China’s demographics are unhelpful: it will, points out Mr Joffe, grow old before it grows rich. While on Goldman Sachs’s numbers China will long have overtaken the US by 2050 with a GDP of $45,000bn compared with $35,000bn for the US, the median age in the US will by then be the lowest of any of the world’s large powers except India. Indeed, the US’s working age population will have grown by about 30 per cent, whereas China’s will have dropped 3 per cent.

Together with export dependence, this amounts to a huge challenge for Chinese policymakers in what is a very poor country. The US, meantime, still has an unmatched research and higher education establishment. And in 2008 its military budget was $607bn, representing almost half of the world’s total military spending. The military budget of China, so often touted as the next superpower, is less than one-seventh of that.

Nobody can gainsay the extraordinary achievement wrought by China in the fastest industrial revolution in human history. We are clearly moving towards a multipolar world and a multi-currency reserve system, in which US power will be more constrained. Yet the US remains the most flexible of the large economies by far. History does not, except for Marxists, move on tramlines. If US policymakers rise to the fiscal challenge and Americans bring themselves to save more, there is every chance that the country will escape meaningful decline and remain the world’s pre-eminent economic and military power for a long time yet.

That is a very big if. But for many people’s money, the next generation of Americans will not be lowering its sights any time soon.

Imperial overstretch: ‘It has not been given to any one society to remain ahead’

The theory of imperial overstretch, outlined by Paul Kennedy in The Rise and Fall of the Great Powers, asserts that if too large a proportion of the state’s resources is diverted from wealth creation into military spending, national power will be weakened over the long term. The question is whether a given state can strike a reasonable balance between perceived defence requirements and economic means.

That task becomes harder when a nation is suffering relative economic decline. Professor Kennedy argued, too, that the US could not preserve its relative position because “it simply has not been given to any one society to remain permanently ahead of all the others, because that would imply a freezing of the differentiated pattern of growth rates, technological advance, and military developments which has existed since time immemorial”.

He concluded that it was incumbent on American statesmen to recognise this broad underlying trend and to manage the country so that the relative erosion of US ascendancy took place slowly and smoothly, rather than implementing policies for short-term advantage that would be detrimental in the longer term.

This carries a notable echo of the remark by Lord Armstrong, the distinguished British mandarin, who said in the 1970s that “the business of the civil service is the orderly management of decline”.

China, though seen by many as the chief beneficiary of potential US overstretch, has already had its own experience of decline. Until the middle of the previous millennium, it was technologically more advanced than Europe with a more efficient agriculture, and its mandarin class was unrivalled in its professionalism. Even after the west overtook it in economic and technological performance between the 16th and 18th centuries, China’s economy was still the world’s biggest when the industrial revolution began.

Between 1820 and 1952, however, when Europe experienced rates of economic growth unprecedented in history, China’s output per head actually fell while its share of global gross domestic product plunged from one-third to one-twentieth. Per capita income fell from level pegging with the world to a quarter of the global average over the period*.

This dreadful performance has been attributed to several causes, including foreign colonial intervention, internal disorder and the inflexibility of the bureaucracy in the face of the challenges of the western renaissance and enlightenment.

*All figures from Chinese Economic Performance In The Long Run by Angus Maddison (OECD, 1998)

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The Dollar Will Lose Its Status As A Reserve Currency

The Dollar Will Lose Its Status As A Reserve Currency: "I don't think we should have a reserve currency. Well, it's led to a lot of problems in the global economy. When the dollar was backed by gold, and was redeemable by gold, it being the reserve currency was OK. But at the moment, there are no currencies backed by gold. So I think that foreign central banks should hold gold as their key reserve, and not another currency. They can also have some foreign currencies as part of their overall reserves, but I think that gold should play a much bigger role in giving value to currency.

Because remember, you can't have a monetary system without money. And money is gold. Just printing paper—there's nothing behind that. There's nothing intrinsic there. It always leads to chaos. If you can just print money at will, it has no scarcity. Then you have inflation; you have these asset bubbles; and you don't have a well-functioning global economy. Hopefully we don't anoint another reserve currency.

Peter Schiff`s comments on the economy, stock markets, politics and gold. Schiff is the renowned writer of the bestseller Crash Proof: How to Profit from the Coming Economic Collapse.

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The real value of gold

FT.com | Willem Buiter's Maverecon | Gold - a six thousand year-old bubble

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Gold - a six thousand year-old bubble
November 8, 2009 6:02pm

Gold is unlike any other commodity. It is costly to extract from the earth and to refine to a reasonable degree of purity. It is costly to store. It has no remaining uses as a producer good - equivalent or superior alternatives exist for all its industrial uses. It may have some value as a consumer good - somewhat surprisingly people like to attach it to their earlobes or nostrils or to hang it around their necks. I have always considered it a rather vulgar metal, made for the Saturday Night Fever crowd, all shiny and in-your-face, as opposed to the much classier silver, but de gustibus… .

The total stock of ‘above-ground’ gold is about 160,000 metric tonnes (a metric ton is 2,204 lbs. or 35,264 oz, for those of a non-decimal mind-set). About 50 percent of this existing stock of above-ground gold is kept as a pure store of value (for investment purposes), most likely somewhere below-ground, for security reasons. The other 50 percent exists as jewellery. I would argue that most of this jewellery demand is simply small-scale store of value (investment) demand by households, rather than demand driven by aesthetic considerations or other intrinsic sources of joy associated with having gold hanging from your extremities.

From a social perspective, gold held by central banks as part of their foreign exchange reserves is a barbarous relic (Keynes used the expression to refer to the Gold Standard, but close enough is close enough). The same holds for gold held idle in private vaults as a store of value. The cost and waste involved in getting the gold out of the ground only to but it back under ground in secure vaults is considerable. Mining the ore is environmentally damaging, especially if it involves open pit mining. Refining the gold causes further environmental risks. Historically, gold was extracted from its ores by using mercury, a toxic heavy metal, much of which was released into the atmosphere. Today, cyanide is used instead. While cyanide, another toxic substance, is broken down in the environment, cyanide spills (which occur regularly) can wipe out life in the affected bodies of water. Runoff from the mine or tailing piles can occur long after mining has ceased.

Even though, from a social efficiency perspective, the mining of new gold and the costly storage of existing gold for investment purposes are wasteful activities, they may be individually rational. There is no invisible hand here (or elsewhere) to ensure that the aggregation of individually rational behaviour adds up to anything desirable or sensible.

Because to a reasonable first approximation gold has no intrinsic value as a consumption good or a producer good, it is an example of what I call a fiat (physical) commodity. You will be familiar with fiat currency. Unlike what Wikipedia says on the subject, the essence of fiat money is not that it is money declared by a government to be legal tender. It need not derive its value from the government demanding it in payment of taxes or insisting it should be accepted within the national jurisdiction in settlement of debt. Instead the defining property of fiat money is that it has no intrinsic value and derives any value it has only from the shared belief by a sufficient number of economic actors that it has that value.

The “let it be done” literal meaning of the Latin ‘fiat’ should be taken in the third sense given by the Online Dictionary: 1. official sanction; authoritative permission; 2. an arbitrary order or decree; 3. Chiefly literary any command, decision, or act of will that brings something about.

The act of will in question is the collective attribution of value to something without intrinsic value. Being declared legal tender by a government may help achieving that status, but it is neither necessary nor sufficient.

Gold is very close therefore to the stone money of the Isle of Yap. This stone money, known as Rai, consists of large doughnut-shaped, carved disks, consisting usually of calcite, that can be up to 4 m (12 ft) in diameter, although most are much smaller. Apparently, the total stock of Rai cannot be augmented any further. It also depreciates very slowly. This intrinsically useless form of money in the Isle of Yap is in all essential respects equivalent to gold today in the wider world. Another example would be pet rocks, as long as the rock in question is rare and costly to get into its final shape.

Gold has become a fiat commodity or a fiat commodity currency, just as the US $, the euro, the pound sterling and the yen (and a couple of hundred other currencies) are fiat paper currencies. The main differences between them are that gold is very costly to produce, while the production of additional paper money has an extremely low marginal cost. If we count the deposits of commercial banks with the central banks, which together with currency in circulation make up the monetary base, as fiat money, then the incremental cost of fiat base money creation is zero.

The outstanding stock of physical gold, at 160,000 tonnes or thereabouts, is very large relative to the maximum amount of new gold that can be mined and refined during a year. The short-run supply curve of new gold is steep and becomes vertical at a volume of production that is small relative to the oustanding stock (annual gold production has been declining from a peak of just over 2,500 tonnes in 2001 to 2330 tonnes in 2008 - only 1.5% of the outstanding stock).[1]

The good news for gold bugs

Since gold is a fiat commodity currency, its value will be determined largely by its attractiveness relative to other fiat currencies - the fiat paper currencies issued by central banks. Gold should not be analysed as one of a set of intrinsically valuable commodities (silver, iron, lead, zinc, platinum, aluminium, titanium etc. etc.) but as part of a set of intrinsically useless and valueless fiat currencies - the US dollar, the yen, the yuan, the euro, sterling, the rupee, the rouble etc. etc.). It is therefore in times that market participants are nervous about the future value of most other fiat currencies, that gold will be at its most attractive.

Such a time is what we are going through now. Many systemically important central banks have expanded their base money stocks and balance sheets massively. The Fed has doubled the size of its balance sheet. The Bank of England has tripled the size of its balance sheet. Many central banks have bought vast amounts of public debt. In the UK, out of the initial £175 bn of quantitative easing, as much as £173 was spent on gilts. The Fed has purchased only about €300 bn worth of Treasury securities, but has acquired a much larger amount of Treasury-guaranteed agency debt.

Although in most of the overdeveloped world (except the UK), deflation is the immediate threat, there is a medium and long-term threat of much higher inflation in all countries with enlarged central bank balance sheets and the prospect of large future fiscal deficits. The great advantage to investors of gold is that, although it is not intrinsically valuable, it is very costly to increase its stock. The tap can be opened at the drop of a hat for fiat paper and electronic currency. The tap produces never more than a trickle in the case of gold.

So when fiscal incontinence threatens price stability in some of the main industrial countries (especially the US and the UK) because the central banks in these countries may be forced to monetise both the stock and large new net flows of public debt, the one fiat money whose quantity cannot be varied at will by a monetary authority will do well. We see that with gold today. We also see that, to a lesser degree, in the strength of the euro. The ECB is by far the most independent of the leading central banks. They also have a heavily asymmetric de-facto interpretation of price stability: inflation is unacceptable, deflation is OK.

So until the risk of serious inflation is removed from the medium-term outlook for the US, the UK and other fiat currencies, gold will be a relatively attractive store of value despite the cost of storing it.

The gold bug’s nightmare

An economy with fiat money can have many different equilibria. To make the point as clearly and simply as possible, consider a stationary economy. Population, endowments, technology, government spending, taxes and preferences are constant. The government budget is balanced. Prices are flexible. There is a constant stock of fiat money (which could be paper money, gold, Rai or pet rocks. This fiat money is perfectly durable and therefore can serve as a store of value. It pays no interest. Assume that, for whatever reason, society prefers it (or even has decided to require) it as a medium of exchange or means of payment.

With a bit of further work, such an economy will have an equilibrium with a positive, constant price of money (a constant general price level). Economists call this the fundamental equilibrium. This stationary economy will, however, also have many other (in fact infinitely many other) non-stationary equilibria, called (speculative) bubbles. They always have equilibria in which the value of money starts at a positive value but falls steadily towards zero - the general price level rises without bound even though the quantity of money is constant. The holders of money anticipate the future inflation and reduce the real stock of money balances they want to hold. This further increases the actual and expected rate of inflation, and the real stock of money balances goes to zero: the general price level goes to infinity or the price of money goes to zero. We have Zimbabwe.

What is often ignored is that this economy has an equilibrium that is even more ‘fundamental’ than the fundamental equilibrium. That is the equilibrium in which the price of money is zero in every period, not just in the long run (as with the speculative inflationary bubble equilibria). Remember, fiat money, including gold, is intrinsically useless. It has value only because people believe it to have value. If everyone expects that money will have no value in the next period, it will have no value this period, because no-one will be willing to take receipt of money to carry it into the next period where it will be valueless. So fiat money with a zero value is always an (unfortunate) fundamental equilibrium.

I would actually call it the only fundamental equilibrium. All other equilibria with a positive price of money - an asset with no intrinsic value - are benign (relatively speaking) bubbles. The constant price of money (constant general price level) equilibrium is also a bubble, based entirely on belief and trust - a beneficial bootstrap equilibrium, lifting itself by its hair, like the Baron von Münchhausen.

In a world with multiple fiat moneys, the zero value of money equilibrium lurks for each of the fiat currencies, including gold. Admittedly, as regards gold, so far so good. Gold has positive value. It has had positive value for nigh-on 6000 years. That must make it the longest-lasting bubble in human history.

I don’t want to argue with a 6000-year old bubble. It may well be good for another 6000 years. Its value may go from $1,100 per fine ounce to $1,500 or $5,000 for all I know. But I would not invest more than a sliver of my wealth into something without intrinsic value, something whose positive value is based on nothing more than a set of self-confirming beliefs.
[1] Since gold is very durable, it is reasonable to assume that virtually all the gold that was ever refined is still out there somewhere. There is no gold ‘consumption’, just its transformation into jewellery and no significant depreciation of the stock.

November 8, 2009 6:02pm in Economics, Environment, Finance, Financial Markets, Monetary Policy | 12 comments

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You can´t buck the market

Which will come out on top: paper or gold? | William Rees-Mogg - Times Online

Gold will be a stronger reserve currency than paper, and the market will increasingly decide national policies. “You can’t buck the market”, whether in taxes, in dollars or in gold.

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Carry trade bubble

FT.com / Comment / Opinion - Mother of all carry trades faces an inevitable bust

Mother of all carry trades faces an inevitable bust

By Nouriel Roubini

Published: November 1 2009 18:44 | Last updated: November 1 2009 18:44

Since March there has been a massive rally in all sorts of risky assets – equities, oil, energy and commodity prices – a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply , while government bond yields have gently increased but stayed low and stable.

This recovery in risky assets is in part driven by better economic fundamentals. We avoided a near depression and financial sector meltdown with a massive monetary, fiscal stimulus and bank bail-outs. Whether the recovery is V-shaped, as consensus believes, or U-shaped and anaemic as I have argued, asset prices should be moving gradually higher.

But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally. While asset prices were falling sharply in 2008, when the dollar was rallying, they have recovered sharply since March while the dollar is tanking. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage-backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.

So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

While this policy feeds the global asset bubble it is also feeding a new US asset bubble. Easy money, quantitative easing, credit easing and massive inflows of capital into the US via an accumulation of forex reserves by foreign central banks makes US fiscal deficits easier to fund and feeds the US equity and credit bubble. Finally, a weak dollar is good for US equities as it may lead to higher growth and makes the foreign currency profits of US corporations abroad greater in dollar terms.

The reckless US policy that is feeding these carry trades is forcing other countries to follow its easy monetary policy. Near-zero policy rates and quantitative easing were already in place in the UK, eurozone, Japan, Sweden and other advanced economies, but the dollar weakness is making this global monetary easing worse. Central banks in Asia and Latin America are worried about dollar weakness and are aggressively intervening to stop excessive currency appreciation. This is keeping short-term rates lower than is desirable. Central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies, as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse: if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies. So the perfectly correlated bubble across all global asset classes gets bigger by the day.

But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.

This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.

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Steel bubble

China Can't Cool Down Its Steel Bubble | Research Reloaded

China Can't Cool Down Its Steel Bubble
10/22/2009 by Vincent Fernando

Still going... we're still waiting to see the massive value destruction that overcapacity could realize.

BEIJING – Despite China's campaign to slim down its steel industry, the country's crude steel production in September was the second-highest ever in terms of volume, underscoring the formidable challenge Beijing faces in curbing capacity.

The National Bureau of Statistics said Thursday that steel output rose 29% in September from September 2008 to 50.71 million metric tons.

"The signs point clearly to overcapacity, and we expect output will be maintained at high levels" in the coming months, said Ma Haitian, senior steel analyst with state-owned metals consultancy Antaike Development Co.

In the last three weeks, China's top policy-making bodies -- the State Council and the National Development and Reform Commission -- have singled out overcapacity in the steel sector as a top reform priority, intensifying a campaign that has dragged on fruitlessly for years.

But directives have proven difficult to enforce on the ground, and steel mills have continued to pump out more product, racking up a record 52.3 million tons of crude steel output for August.

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Landowners will be barons again

Food will never be so cheap again - Telegraph

The world's grain stocks have dropped from four to 2.6 months cover since 2000, despite two bumper harvests in North America. China's inventories are at a 30-year low. Asian rice stocks are near danger level.

Yet farm commodities have largely missed out on Bernanke's reflation rally in metals, oil, and everything else. Dylan Grice from Société Générale sees "bargain basement" prices.

Wheat has crashed 70pc from early 2008. Corn has halved. The "Ags" have mostly drifted sideways over the last six months. This divergence within the commodity family is untenable, given the bio-ethanol linkage to oil.

For investors wishing to rotate out of overstretched rallies – Wall Street's Transport index and the Russell 2000 broke down last week – this is a rare chance to buy cheap into a story that will dominate the rest of our lives.

Barack Obama has not reversed the Bush policy on biofuels, despite food riots in a string of poor countries last year and calls for a moratorium. The subsidy of 45 cents per gallon remains.

The motive is strategic. America is weaning itself off imported energy at breakneck speed. It will not again be held hostage by oil demagogues, or humiliated by states that cannot feed themselves. Those Beijing students who laughed at US Treasury Secretary Tim Geithner may not enjoy the last laugh. The US is the agricultural superpower. Foes will discover why that matters.

The world population is adding "another Britain" every year. This will continue until mid-century. By then we will have an extra 2.4bn mouths to feed.

China and Southeast Asia are switching to animal-protein diets as they grow wealthy, as the Koreans did before them. It takes roughly 3-5kgs of animal feed from grains to produce 1kg of meat.

A report by Standard Chartered, The End of Cheap Food, said North Africa and the Middle East have already hit the buffers. The region imports 71pc of its rice and 58pc of its corn. It lacks water to boost output. The population is growing fast. It will have to import, and cross fingers.

The UN says global farm yields must rise 77pc, which means redoubling Norman Borlaug's "green revolution". It will not be easy. China's trend growth in crops yields has slipped from 3.1pc a year in the early 1960s to 0.9pc over the last decade

"We've all heard the stark anecdotes: precious topsoil weakened by over-farming, dust clouds darkening the Asian skies, parched land becoming desert and rivers running dry," said Mr Grice.

Since 2000, China has lost nearly 1,400 square miles each year to desert. Urban sprawl is paving over fertile land in the East. Water supply from Himalayan glaciers is ebbing. The Yellow River has been reduced to "an agonising trickle". It no longer reaches the sea for 200 days a year.

Farmers are draining the aquifers. Environmentalist Ma Jun says in China's Water Crisis that they are drilling as deep as 1,000 metres into non-replenishable reserves. The grain region of the Hai River Basin relies on groundwater for 70pc of irrigation.

China's water troubles are not unique. North India lives off Himalayan snows as well. Nor can we take fertiliser supply for granted any longer since "peak phosphates" threatens.

One can be Malthusian about this. Grizzled commodity guru Jim Rogers certainly is. "The world is going to have a period when we cannot get food at any price, in some parts." He advises youth to opt for a farm degree rather than an MBA, if they want to make serious money.

Mr Grice remains an optimist, believing that human ingenuity will rescue us. You can trade the "Ag" rally by investing in exchange traded funds (ETFs), but this amounts to speculation on food. There are ancient taboos against this practice.

Or you can invest in the bio-tech, fertiliser, and land services companies that will both make money and help to solve the problem. Monsanto, Syngenta, and Potash are popular, but trade at high price to book values. Golden Agri-Resources, Yara, Agrium, and Bunge are at better multiples.

Kingsmill Bond at Moscow's Troika Dialog suggests the Baltic company Trigon Agri as a way to play the catch-up story in the Eurasian steppe. He likes sunflower processor Kernel, grain group Razgulay, and fertiliser firm Uralkali.

Strictly speaking, the world has enough land to feed everybody. The Soviet Union farmed 240m hectares in Khrushchev's era. The same territory now farms 207m hectares. Troika says crop yields could be doubled in Russia, and tripled in the Ukraine using modern know-how. Africa's farms could come alive with land registers, allowing villagers to use property as collateral for credit.

None of this can be done with a flick of the fingers. What seems certain is that the terms of trade between country and city will revert to the norms of the Middle Ages. Landowners will be barons again.

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Grantham prediction for 2010

Grantham: Markets getting silly - The Globe and Mail

“I have some modest hopes for a collective sensible resistance to the current Fed plot to have us all borrow and speculate again,” he said. “I would still guess (a well-informed guess, I hope) that before next year is out, the market will drop painfully from current levels.”

For him, “painfully” implies a dip of 15 per cent – but a drop below fair value is more likely, and that could bring a 22 per cent setback.

“Unlike the really tough bears, though, I see no need for a new low,” he said.

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Economic indicators

7 hidden economic indicators to watch - MarketWatch

7 hidden economic indicators to watch
To get the best view of economy, sometimes you have to 'peel the onion'

By Rex Nutting, MarketWatch

WASHINGTON (MarketWatch) - Anyone who follows the markets or the economy knows about gross domestic product and the consumer price index, but sometimes those well-known indicators don't give us the clearest view of where the economy has been or where it is going.

Like a jeweler using a magnifying glass to look into a gem to see its virtues and flaws, the best analysts dig deeper into the economic reports.

"If you peel back the onion, it can help you figure out what the bigger picture is," said Stu Hoffman, chief economist for PNC Financial. "Sometimes it makes you cry," he said, but you can get a better view.
Seven hidden economic indicators

* 3-month average of durable-goods orders
* Trimmed mean CPI
* Retail sales excluding autos and gasoline
* The U6 unemployment rate
* Core capital equipment orders
* Building permits for single-family homes
* Final sales to domestic purchasers

/conga/economy-politics/hidden-indicators.html 37474

Every analyst has favorite hidden indicators. Here are seven favorites you can use to get a better understanding of the economy.
Look at averages

The first trick, one that can be used with almost any economic indicator, is to use a three-month running average to smooth out monthly fluctuations.

Many of the better-known indicators - such as housing starts, durable-goods orders and retail sales -- can be extremely volatile on a month-to-month basis. They have a high noise-to-signal ratio.

Unless you are a trader who needs volatility in order to profit, it's the underlying trend that matters most.

"To look at any one month is meaningless," Hoffman said. A smoothing average tells you what the trend is. "That's the information that matters; the rest is noise."

Economists often speak about year-over-year changes, essentially a 12-month average. Year-over-year changes are useful in portraying long-term trends, but they can mask turning points that can be revealed by three-month averages.
Look at the core

Many indicators are noisy because one special factor can have an outsized influence on a monthly basis. Gasoline prices go up one month and down the next. Aircraft orders swell in one month, and then shrink the next.

That's why economists talk about "core" measures of indicators such as consumer prices, retail sales or durable-goods orders. Core measurements exclude or ignore special factors in order to focus on underlying trends. It's like an X-ray that shows only bones, not the soft tissues.

The core CPI is the best-known and most widely misunderstood example. The core CPI excludes food and energy costs, which are among the most volatile components in the consumer price index. Economists study the core not because food and energy don't matter, but because they matter too much on a month-to-month basis.

Because of the extreme volatility in food and energy prices, the headline CPI has swung from a 4.9% inflation rate a year ago to a 1.3% deflation rate now. By contrast, the core CPI has slowed more moderately, from a 2.5% inflation rate a year ago to 1.5% now. That's probably a better reflection of the disinflationary environment than the headline CPI.

The Cleveland Fed has a better idea for a core CPI: Rather than automatically excluding food and energy prices, its core gauge excludes only the items that rose or fell the most in any given month. Sometimes it would be gasoline, sometimes tobacco, sometimes chicken.

This so-called trimmed mean CPI published by the Cleveland Fed is probably the best way of looking at the trend in consumer prices. The trimmed mean CPI is up 1% in the past year.

For retail sales, economists look at sales excluding autos and gasoline. For durable-goods orders, it's good to pay attention to capital equipment orders excluding aircraft and defense goods, which tracks business investment trends closely.
Go deeper

Some economic reports are chock full of interesting information that one number cannot do justice to.

The monthly employment report is a prime example of a report where the parts are greater than the whole. Most people pay attention to the number of payrolls lost or gained, and maybe to the unemployment rate.

But the report reveals more about the job market than can be summed up in one or numbers. It has information about different demographic groups, industries and occupations. It can tell us something about hours and wages.

The alternative unemployment rate (also known as the U6 rate) has become a favorite because, unlike the regular (or U3) unemployment rate, it measures underemployment; people too discouraged to look for work, or people whose hours have been cut back.

The GDP report is also worth a deeper dig.

GDP -- the total value of all goods and services produced within the United States -- is a useful accounting concept. But it can be misleading during big inventory swings.

A better gauge of the economy's strength is the number that's reported as final sales. Final sales, as the name implies, counts the goods and services that were actually sold, rather than the number that were produced and stuck in a warehouse someplace. A related concept is final domestic sales, which counts goods and services sold within the United States.

"The balance between final sales and inventories is an excellent leading indicator," said John Silvia, chief economist for Wells Fargo Securities.
Don't be distracted

Sometimes, the government, the media and the markets just focus on the wrong number. Instead of paying attention to housing starts, for instance, it'd be better to look at the number of building permits for single-family homes.

Why? Because the monthly housing starts figures are ridiculously inaccurate, compared with the permits figures that are statistically more reliable. Multi-family housing construction is too volatile on a monthly basis to be meaningful.
Avoid the pitfalls

It's fine to find favorite hidden indicators, but you should beware of cherry picking the data to fit pre-conceptions. If you're being honest about trying understanding the economy, you have to be consistent. If you use the three-month averages to prove your point one month, you shouldn't switch to crowing about the monthly figure the next time, if that number suits your argument better.

On the other hand, it's all too easy to cling too tightly to a favorite indicator and become oblivious to trends that are obvious in the headline indicators. Don't let your agenda blind you.

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Value

FT.com / Columnists / Martin Wolf - How mistaken ideas helped to bring the economy down

Mr Smithers proposes two fundamental measures of value – “Q” or the valuation ratio, which relates the market value of stocks to the net worth of companies and the cyclically adjusted price-earnings ratio, which relates current market value to a 10-year moving average of past real earnings. The two measures give similar results (see chart). Professional managers use many other valuation methods, all of them false. As Mr Smithers remarks sardonically: “Invalid approaches to value typically belong to the world of stockbrokers and investment bankers whose aim is the pursuit of commission rather than the pursuit of truth.”

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