22 June 2007
By Julian Delasantellis
In Greek mythology, one of the most effective methods the gods used to punish impudent and hubristic humans was to grant them their most fervent desires.
Inevitably, the weak and feckless mortals would find that getting everything they ever desired would lead to their total ruination, as befell King Midas when granted the wish to have everything he touched turn to gold. The implicit lesson to be learned from these stories was that mortals must temper their wishes and desires, lest they suffer the same fate.
Is the administration of US President George W Bush learning the same fate as regards its trading policy with China?
The big news currently roiling the financial markets is the rapid rise in yields for long-term government bonds issued by the world's major industrial powers. The benchmark US Treasury 10-year note has risen 0.85 percentage points in yield, from 4.50% to almost 5.35% (in bond trader lingo, that's 85 "basis points") from early March to early June, with most of that rise coming since just late May. This represents the highest level of US 10-year rates since 2002.
Other major-traded government debt issuances have risen in yield (and thus fallen in price) along with US notes. After yielding about 1% for the better part of a decade, Japanese government bonds have risen more than 50 basis points over the same period to yield just under 2% now. British government bonds, called gilts, have risen 70 basis points.
Euro bonds, called "bunds" (from their origins as debt obligations of the German Federal Republic, the Bundesrepublik) have also risen more than 80 basis points since late winter. There is concern that these interest rate hikes, by raising the price of investment capital, will finally act to cool down the current white-hot global economy.
In my March 6 article Rocking the subprime house of cards, I explained how the issue of causation, of "why" something happens in the financial markets, is frequently hard to answer, especially when analyzing something other than individual stocks. This is the case with the current government-debt rout.
When bond-market investors hand over their money to buy a government bond they have to hold for an extended period of time, be it one, five, 10 or 30 years, they want to be confident that inflation will not eat away at the purchasing power of what they will receive back at the bond's expiration. If they think that might be the case, they will demand higher interest rates of return before forking over their wealth.
However, in this case, the standard explanations/conventional wisdom for rising interest rates, a spreading market perception among bond investors that economic growth is accelerating, soon to be followed upon by rising inflation, don't seem to have been sufficient to have engendered interest-rate rises this high this quick.
US economic growth for the January-May period was a measly 0.6%, the slowest rate since late 2002. As the US economy gets pulled down by the heavy weight of the subprime mortgage crisis (explored in my March 6 article, as well as in my March 16 article The subprime dominoes in motion), recent reports are showing that growth has not merely slowed in the US real-estate sector, it is now in full-throttle reverse, as some localized real-estate markets are showing double-digit average price declines from last year.
The problems in the real-estate sector, along with the fact that anemic sales reports from many US retailers seem to be indicating that the once super-avaricious US consumer seems finally to have been banished from the malls by high energy prices, do not seem to portend the rapidly accelerating economic growth that could be causing the rising government-bond yields, neither in the United States nor in the other major industrial capitalist economies.
The "economic growth causing rising rates" argument is not confirmed by certain internal market indicators, either. There are three major traded instruments that professional traders watch to see if inflationary fears are seeping into the markets. These are the so-called "TIPS spread" (the difference between standard Treasury bond yields and newer, inflation-indexed TIPS - Treasury Inflation-Protected Securities - bonds), the price of gold, and the levels of various commodity basket indices.
You would expect the prices of all three to be appreciating should inflationary fears be spreading, but, surprisingly, all three have in essence been stable to minimally higher throughout the worldwide bond-market rout. Something has been causing the recent rising bond yields, and it has nothing to do with the conventional wisdom.
It may not seem so now, but in the future, George W Bush will probably go down foremost in history as the US president who sat by with his cowboy boots up on the table (as he shoveled what will probably turn out to be the better part of a trillion dollars into the bloody furnace called Iraq) as world economic dominance passed from the US to China.
At first, the corporate elite class that put its man in the White House probably thought the rise in Chinese economic power was at least serendipitous, since its main cause, US manufacturers offshoring production to China, was putting intense pressure on wages; this is a central factor in the fact that a proportion of US national income going to owners of capital (business and stock owners), as against labor, has now skewed dramatically in favor of capital.
No one saw it at the time, but a central manifestation of the freedom revolution that spread across the world upon the fall of the Berlin Wall in 1989 was that First World employers were now free to put their employees in an employment pool to compete for their jobs with about a billion other employees from nations with much lower standards of living, especially China and India. Wages might be being pressured downward, but on the other side of the seesaw, profits were soaring.
As economists Lawrence Mishel and Jared Bernstein of the Economic Policy Institute put it, "Over prior business cycles, profits (including interest income) have accounted for 23% of the growth in corporate-sector income, on average, with total compensation accounting for the remaining 77%. In the current business cycle, the distribution is almost reversed: profits have claimed nearly 70% of total growth in the corporate sector, while increases in compensation (from increased employment and higher hourly compensation) have received just over 30% of total income growth."
This is the dynamic that has fueled China's explosive recent economic progress, with first-quarter year-over-year economic growth a more than healthy (in fact, a rather inflationary) world-leading 11.1% rise in gross domestic product. The GDP growth rate has been in double-digit territory since early 2005; figures for industrial production growth, currently at 18.1% year over year, also lead the world. This growth is far and away export-led; Chinese internal consumption, while growing steadily, is a very small part of the story of the Chinese economic miracle. In May, China reported a $22.5 billion trade surplus, up 73% from the previous year. More than half of that trading surplus is with the United States.
Naturally, this has resulted in a tremendous shift of wealth from the US to China. Chinese economic officials would not allow this tremendous surge of First World wealth to be loosed upon a Third World economy, with the limited domestic consumption opportunities of the Third World. It was feared, probably correctly, that this tremendous wave of cash hitting the underdeveloped markets for domestically traded goods would cause a dramatic spike in inflation.
Therefore, the Chinese have decided to let most of their export proceeds rest comfortably as reserves, currently at a world-topping $1.2 trillion (growing at a rate of a billion dollars a day), at the central People's Bank of China.
When, as World War II drew to a close, it became obvious that a new international financial architecture would be needed to fund the postwar world, allied financial chiefs gathered at Bretton Woods, New Hampshire, to hammer out what became known as the Bretton Woods accords.
These replaced the gold-centered prewar international financial structure with fixed exchange rates focused around the US dollar. When this system collapsed in the early 1970s, it led to the introduction of the current system of variable, market-derived exchange rates. In this system, the currencies of countries that run large trade surpluses, such as the China, were supposed to appreciate in value, thus making it cheaper for their citizens to purchase imports; countries that ran big trade deficits, such as the US, would see their currencies fall in value so that, eventually, they would not be able to afford so many imports.
Like the water levels in the opened locks of a canal, eventually, the system intended that the countries with trade surpluses and deficits would see their numbers equalize, and the system would eventually balance itself without any government intervention.
This has not happened with the Chinese/US trading relationship of this decade. The Chinese currency, the yuan, does not "float" in value, as do such currencies as the euro or pound. For many years it was fixed at a rate of about 8 yuan to the dollar (meaning that each individual yuan was worth 12.5 cents). Over the past year or so, it has been allowed to rise to 7.62 yuan per dollar, meaning that each individual yuan has gone up all the way to be now worth 13.1 US cents.
This meager yuan appreciation is not nearly enough to reverse Chinese trade surpluses, which are still growing. Instead, a new international financial architecture seems to have developed, one that economists Nouriel Roubini and Brad Setser, on their weblog RGE Monitor, call Bretton Woods 2.
Here's how Bretton Woods 2 works. China (or the other, lesser players in this game, Japan, Taiwan and South Korea) does not sell its export-earned dollars. Rather, it banks them. Without this excess selling pressure, the dollar does not fall in value against the yuan; it remains stable, which allows American consumers to continue their monthly billion-dollar overseas spending spree. Chinese factories keep humming, employment is strong, the Chinese people are far too content buying new stuff to come out to protest again at Tiananmen Square, and China's Communist Party rulers are very happy about that.
This is much like what happened with the billions of petrodollars that were raised by oil-exporting countries after the oil-price rises of the 1970s. The billions of dollars of China's current export earnings get sent back to the US, mostly to be invested in Treasury securities. This keeps dollar interest rates, including mortgage rates, lower than they would have been, and this keeps the US economy humming and the consumer, still fat, dumb and happy, flush with cash and plastic to keep the cycle going for at least one more round.
But no human agency or endeavor lasts forever. The internal contradictions of Bretton Woods 1 caused it to fall, and the same seems to be happening with Bretton Woods 2. Specifically, what if China doesn't want 1.2 trillion in US dollar reserves?
Bretton Woods 2 greatly benefited Bush administration officials, by both pressuring wage rates to help out their business buddies and spurring the economic growth that got them re-elected in 2004. Still, it is somewhat embarrassing to be the president of the nation with the most massive trade deficits in history. Like spoiled rich kids since time immemorial, the Bush administration is blaming somebody else.
The administration, along with its mouthpieces in the corporate conservative media machine, is arguing that, even with a huge budget deficit and virtually non-existent national savings, the trade deficit is not America's fault. It's not that the US is spending too much and saving too little, it's that the surplus countries, especially China, are saving too much and spending too little.
This interpretation of savings as bad is certainly new in the working theory of capitalist economies; in classical economics, savings are a very good thing, since the market can direct them to future investments that will maintain economic growth. A rough parallel would be an inebriate claiming that he doesn't have a problem, it's the rest of the world that suffers from inadequate alcohol consumption syndrome.
But in business, the customer is right even when he's not, and the United States is now far and away China's biggest customer. For example, it is now estimated that up to 70% of Wal-Mart's inventory is of Chinese origin; a remarkable turnaround for a company that until this decade broadcast advertisements that trumpeted the red, white and blue all-American manufacture of its products. Wal-Mart's current trade with China alone, estimated at more than $25 billion a year, surpasses the GDP of the smallest 112 national economies of the world.
In letting the yuan appreciate, although maddeningly slowly, China is responding to demands for action from US officials, especially in Congress. Another demand is that China stop just letting its huge stash of foreign-currency reserves sit around earning interest. They should go out and buy American stuff, preferably goods and services, so that the trade balance can start to equalize.
But as the Greek gods warned, be very careful what you wish for.
In my July 6, 2006, article Hedge funds: Playing dice with the universe, I explained how hedge funds, very lightly regulated pools of private capital used as high-octane investment vehicles to the world's supranational moneyed elite, were having more and more impact on events in the world's financial markets. I postulated that hedge funds acting in unison may have been a prime cause of the May 2006 cross-border equity-market meltdown. It was estimated then that, collectively, the thousands of the world's hedge funds had more than $1 trillion in assets under management.
That's just about what the single personage of Zhou Xiaochuan, the governor of the People's Bank of China, has at his disposal for investment from foreign-exchange reserves.
Last year, the big chatter in the world's financial markets was over the growing power of hedge funds, and how their huge concentrated financial resources had the possibility of dwarfing any or all governments' ability to regulate national markets. This year, a new specter haunts the markets, one whose potential impact on markets far exceeds the puny $1 trillion-plus that the hedge funds have at their disposal.
They're called sovereign wealth funds (SWFs). Basically, it seems that many of the countries that lately have accumulated huge foreign-exchange reserves exporting to the United States are getting bored with just having their money sit around earning interest at US Treasury rates. China and the other big exporters, which until recently were seemingly happy at lending back to the US the dollars to continue to buy their stuff, now see the need to earn greater rates of return than the 5% that US Treasuries currently earn.
Many of them are facing demographic time-bombs consisting of their growing elderly populations needing eventual pension support, and, for all the glamour and glitz of today's Shanghai, going beyond China's big cities still reveals grinding rural poverty that the central government knows it must address.
SWFs will act as super-hedge funds, in that they will look for opportunities all across the investment spectrum. China is in the process of setting up its own SWF, which reportedly will be funded with some $300 billion of reserves.
And that's $300 billion that will not make its way into the market for Treasury securities.
In my March 24, 2006, article US living on borrowed time - and money, I introduced readers to the US Treasury's monthly TIC (Treasury International Capital) report, the data that enumerate just how much foreign capital the US is importing every month to finance its extravagant lifestyle. During much of 2005, the US was net-importing more than $100 billion of investment capital every month, but the bottom line net number is falling sharply; last December, the US actually failed to attract any capital at all.
One TIC data set of particular interest to bond players is just how great the investment in US government securities by foreign governments is each month. These numbers are the core of the flows that constitute Bretton Woods 2, for they derive mostly from US dollar reserves held at foreign central banks.
They've been falling, too. From averaging more than $6 billion a month in 2006, foreign government purchases of US Treasury have fallen to average just over $1 billion a month for the first four months of 2007.
It is of course far from coincidental that, when US Treasury 10-year notes were at their lows in yield, in mid-2005, TIC data were showing foreign flows into Treasuries at their highest. The central reality of the bond market is that the yield of bonds traded in it go down as more people buy them; more important for the current moment, yields go up as fewer people buy them.
If China has sharply curtailed its US Treasury purchases, unless other buyers step up to the plate, then Treasury securities prices have nowhere to go but down, and yields have nowhere to go but up - just as they have recently.
The US Treasury will not release May TIC data until mid-July, but there are indications that suggest that is precisely what is happening here. A recent Treasury auction of new 10-year notes had the lowest rate of foreign government purchase participation in years. On some financial trader blogs it is being noticed that, on many days during the current market rout, the US Treasury market has opened, at 8:20am New York Time (when the Treasury futures markets open in Chicago), with large order imbalances to the sell side.
The speculation here is that this results from Chinese sellers putting in big sell orders before they retire for the night (Shanghai time is 12 hours ahead of New York) so they can see whether, or how significantly, their orders moved the market.
Of particular significance to the future is the connection between SWFs and interest rates. On May 21, China's still-nascent SWF announced its first prospective investment; it was going to take a $3 billion stake in the upcoming initial public offering of the Blackstone Group, the huge US private equity buyout firm (I wrote about the current mania for private equity in my February 22 article The highs and lows of buyouts). It was after that announcement that the fiercest selling befell the world's Treasury markets, as if traders suddenly realized that the long-feared prospect of Asian central banks abandoning bonds for other investments was finally coming true.
World equity markets stuttered a bit in the face of the world bond selloff, but they soon recovered their footing and are once again moving up. That should not be surprising; if SWFs are about to pounce on the world's stock markets, that will be unquestionably good news for share prices.
But will it be too much of a good thing? Even with buying support from SWFs, can world stock markets appreciate much further in the face of rising bond yields? Or would continued equity-market appreciation in the face of rising bond yields be prima facie evidence of what Alan Greenspan once called irrational exuberance? Right now the only world stock market that Chinese prosperity is supporting is the Shanghai Stock Exchange A-share exchange.
That market has tripled in 14 months, and academic economists the world over are frightened that when this speculative bubble finally bursts, as all speculative bubbles must inevitably do, it will take the world's economy with it. Specifically, with so many ordinary Chinese citizens playing the Shanghai market like a never-losing roulette wheel, will the Chinese government feel threatened by the rapid destruction of domestic wealth that a burst stock market would cause? Will they try to support the shares with reserves, either from the People's Bank of China or from its SWF? What will that do to the investments in the West that the reserves had been supporting?
A more frightening prospect is if non-China stock markets start acting like Shanghai - if SWF money starts supporting or, more likely, deluging them. Trading volumes in Shanghai are still small enough, compared with Western equity markets, that the Chinese government probably could backstop a Shanghai crash, but if the world's other stock markets, supported by Asian SWF money, start replicating Shanghai's parabolic, meteoric rise, then all the reserves, tea, or anything else in China will not be sufficient to support them when their towers finally topple.
This decade's boom started in China. Will it end there too?
Will the economic historians of the future, when tracking back to ascertain the cause of the world crash of 2007, find that the dominoes were put in motion when George W Bush started urging the Chinese to buy more American stuff, and the Chinese responded with purchases of US companies and stocks?
Like the Sorcerer's Apprentice of legend, perhaps it would have been better if, while an business-administration graduate student at Harvard in the early 1970s, the future president would have actually read the instructions on how to run the world economy.
Thursday, September 20, 2007
US living on borrowed time - and money
24 March 2006
By Julian Delasantellis
In 1987, Yale historian Paul Kennedy published The Rise and Fall of the Great Powers, in which he argued that "military overstretch" - where conquering nations engaged in more foreign military adventures than their economic resources could support - led to the eventual decline and fall of empires.
So far, the US attempt at dominion that commenced in 2001 has not been threatened in this manner because, in essence, the nation has been able to borrow the costs simultaneously to maintain both its new empire and its avaricious middle-class consumerist lifestyle.
But the times, they are a-changing. Buried deep in the arcanum of some recently released economic statistics are indications that the world is tiring of its role as America's charge card.
So far the United States has easily financed its endeavors in Iraq, as well as undiminished levels of domestic social-welfare spending, not by the traditional solution of raising taxes (in fact, taxes have been cut numerous times since 2001, an occurrence unheard of during previous wars) but by running huge budget deficits, such as fiscal year 2006's projected shortfall of US$423 billion.
Accompanying the federal budget deficit is the huge US trade deficit, burgeoning out of control as more and more of previously domestically produced consumption items are outsourced to foreign, mostly Chinese, manufacture. The stimulative US budget fiscal position assures that Americans will have all the money needed to buy them.
Standard economic theory since the adoption of floating foreign exchange rates in 1973 states that big trade deficits auto-correct by having the currency of the profligate nation depreciate. Thus if Brazil is buying more from, say, South Korea than South Korea is buying from Brazil, there will be more South Koreans with Brazilian reals (earned from the exports to Brazilians ) than there will be Brazilians with won.
In most cases, this would lead to selling of the currency of the deficit country, since there will be a surplus of the deficit country's currency in these foreigners' hands. The selling will drive down the value of the deficit currency; that will eventually make consumption of the shiny foreign goodies too expensive, and eventually the trade deficit will equalize.
This has traditionally not happened with foreigners holding US dollars. The United States dollar is what is called a "reserve currency", ie, foreigners are willing to hold dollars even though they can't easily use them as the domestic currency in their home markets. Without the selling that would accompany all the exporters to the United States trading their dollars for their home currencies, the US dollar stays higher than the economic fundamentals would theorize it should, and the great American global shopping spree can continue.
The ledger of how much more capital the US sucks in to finance its consumption as compared with how much it sends out to invest is called the current account deficit. The money that foreign exporters hold in US dollars and then invest in US government or private bonds, stocks or short-term bills is entered in the minus column on the current account. As the US domestic savings rate is so pitifully low, the United States must import a huge amount of foreign capital just to finance that huge federal government budget deficit.
From an even then huge $531 billion in 2003, the current-account deficit has been rising in recent years by more than 20% a year, last year's was $805 billion, and the projection for 2006 is more than $975 billion - that's almost 7% of gross domestic product. In other words, America's spending addiction, from DVD players to destroyers, means that the nation consumes 7% more than it produces.
But until very recently, financing this hunger wasn't all that much of a problem.
The most important US government economic statistical report that you've never heard of is called the Treasury International Capital (TIC) report. The current-account data report how much the US needs to finance its lifestyle; the monthly TIC data report what it actually gets.
Thus in 2003, the current-account deficit meant that the US needed to entice $531 billion from the rest of the world. TIC data reported that what it actually got was $747 billion. For 2004, the need was $666 billion; it actually got $915 billion. For 2005, the need was $801 billion; $1.025 trillion was actually received. Many economic commentators believe that as this excess foreign capital started sloshing around and through the US banking and financial system, it kept US interest rates low and thus fired the tremendous rallies in real-estate and stock-equity prices that have occurred in the past few years.
But nothing good lasts forever. From reaching a high of $117.2 billion in August 2005, the TIC reports are showing a steady decline in foreign inflows, down to $74 billion in December, and $78 billion for January, the last month for which data are available. The nasty thing about this is that with a projected $975 billion current-account deficit for this year, the US is no longer getting what it needs from the world to maintain its lifestyle. The foreign-capital food supply is dwindling just as the hunger increases.
True, the actual shortfall is not yet very large, right now less than $5 billion a month. But I see the salient fact here as not being the current-account deficit minus TIC-inflow shortfall right now, but the rather significant 35% absolute reduction in inflows since last summer. As the US political system shows absolutely no indication of being either desirous or even able to deal with its fiscal profligacy (the recent congressional farce surrounding the increase in the debt ceiling being an example), the current-account deficit will only rise; unless US households are willing to increase their savings rates massively (very unlikely, since I haven't seen any "going out of business" signs on Best Buy or Circuit City lately) or the declining-TIC-inflow trend reverses, there's trouble ahead for the latest US experiment in cut-rate conquest.
There are many ways this trouble could manifest itself. Since much of this foreign-capital inflow finds its way into long-term US Treasury securities, it's hardly surprising that, with the recent shortfall in TIC inflows, Treasury interest rates are rising to their highest levels in two years. If demand is falling, then the market is marking down prices, and the basic rule of bond markets is that yields move in inverse directions to prices. Rising mortgage rates will put the US real-estate boom in real jeopardy, and it has been US homeowners pulling spendable cash out of the inflated values of their homes that has generated much of the consumption component of recent US growth.
It is also possible that this could lead to a sharp selloff in the US dollar, as has been happening in the dollar-euro market since November. If foreigners with export earnings from the US do not put it back into US assets, they will not just keep it stuffed in their mattresses; they will look around for interest-bearing instruments denominated in euros, sterling, yen, or a dozen other currencies.
This will cause these currencies to appreciate in value, and the dollar to fall. If you've ever looked at the back page of The Economist magazine you'll have seen the huge foreign-exchange reserves being built by countries that have recently been the winners in the global trading game. As of December, the International Monetary Fund lists Japan's reserves at $847 billion, China's at $819 billion, Taiwan's at $253 billion, South Korea's at $210 billion, Russia's at $194 billion, and India's at $137 billion. These reserves, held overwhelmingly as US dollars, are the potential gasoline just waiting for the match to set alight a huge global economic conflagration.
If somebody starts selling his dollar reserves, even if it's only a portion of his dollar portfolio, other countries could be forced into panic selling of their huge dollar reserves. The foreign-exchange markets are the biggest and most liquid in the world, but whether they would be able to absorb the amount of selling that could emerge from portfolio adjustments this large is a very open question.
More likely there would be a sharp overshoot in the dollar-selling, leading to a perhaps 20-30% decline in dollar values within a very short time. For the US, this would mean a sharp rise in the prices of everything it imports, especially crude oil. That would mean inflation, with the Federal Reserve raising interest rates to contain it, or maybe the economy would bypass the intermediate inflationary phase and head straight into deep recession or depression.
Either way, the great run of US prosperity would be over. Worldwide, along with the global contractionary effects of US economic growth suddenly stopping or going into reverse, the effect of an almost instantaneous 20% haircut in the value of the world's financial reserves would be no picnic, either.
On the first day of class, business teachers like me love to introduce our sleepy students to the concept of TANSTAAFL - there ain't no such thing as a free lunch. The United States may soon be introduced to the concept of TANSTAAFE - there ain't no such thing as a free empire. Specifically, will the nation still think it's so important to control the sands of Samarra, or the streets of Fallujah, or, for that matter, those of Baghdad if, like the signs say in US doctors' offices, "payment is expected at the time of service"?
By Julian Delasantellis
In 1987, Yale historian Paul Kennedy published The Rise and Fall of the Great Powers, in which he argued that "military overstretch" - where conquering nations engaged in more foreign military adventures than their economic resources could support - led to the eventual decline and fall of empires.
So far, the US attempt at dominion that commenced in 2001 has not been threatened in this manner because, in essence, the nation has been able to borrow the costs simultaneously to maintain both its new empire and its avaricious middle-class consumerist lifestyle.
But the times, they are a-changing. Buried deep in the arcanum of some recently released economic statistics are indications that the world is tiring of its role as America's charge card.
So far the United States has easily financed its endeavors in Iraq, as well as undiminished levels of domestic social-welfare spending, not by the traditional solution of raising taxes (in fact, taxes have been cut numerous times since 2001, an occurrence unheard of during previous wars) but by running huge budget deficits, such as fiscal year 2006's projected shortfall of US$423 billion.
Accompanying the federal budget deficit is the huge US trade deficit, burgeoning out of control as more and more of previously domestically produced consumption items are outsourced to foreign, mostly Chinese, manufacture. The stimulative US budget fiscal position assures that Americans will have all the money needed to buy them.
Standard economic theory since the adoption of floating foreign exchange rates in 1973 states that big trade deficits auto-correct by having the currency of the profligate nation depreciate. Thus if Brazil is buying more from, say, South Korea than South Korea is buying from Brazil, there will be more South Koreans with Brazilian reals (earned from the exports to Brazilians ) than there will be Brazilians with won.
In most cases, this would lead to selling of the currency of the deficit country, since there will be a surplus of the deficit country's currency in these foreigners' hands. The selling will drive down the value of the deficit currency; that will eventually make consumption of the shiny foreign goodies too expensive, and eventually the trade deficit will equalize.
This has traditionally not happened with foreigners holding US dollars. The United States dollar is what is called a "reserve currency", ie, foreigners are willing to hold dollars even though they can't easily use them as the domestic currency in their home markets. Without the selling that would accompany all the exporters to the United States trading their dollars for their home currencies, the US dollar stays higher than the economic fundamentals would theorize it should, and the great American global shopping spree can continue.
The ledger of how much more capital the US sucks in to finance its consumption as compared with how much it sends out to invest is called the current account deficit. The money that foreign exporters hold in US dollars and then invest in US government or private bonds, stocks or short-term bills is entered in the minus column on the current account. As the US domestic savings rate is so pitifully low, the United States must import a huge amount of foreign capital just to finance that huge federal government budget deficit.
From an even then huge $531 billion in 2003, the current-account deficit has been rising in recent years by more than 20% a year, last year's was $805 billion, and the projection for 2006 is more than $975 billion - that's almost 7% of gross domestic product. In other words, America's spending addiction, from DVD players to destroyers, means that the nation consumes 7% more than it produces.
But until very recently, financing this hunger wasn't all that much of a problem.
The most important US government economic statistical report that you've never heard of is called the Treasury International Capital (TIC) report. The current-account data report how much the US needs to finance its lifestyle; the monthly TIC data report what it actually gets.
Thus in 2003, the current-account deficit meant that the US needed to entice $531 billion from the rest of the world. TIC data reported that what it actually got was $747 billion. For 2004, the need was $666 billion; it actually got $915 billion. For 2005, the need was $801 billion; $1.025 trillion was actually received. Many economic commentators believe that as this excess foreign capital started sloshing around and through the US banking and financial system, it kept US interest rates low and thus fired the tremendous rallies in real-estate and stock-equity prices that have occurred in the past few years.
But nothing good lasts forever. From reaching a high of $117.2 billion in August 2005, the TIC reports are showing a steady decline in foreign inflows, down to $74 billion in December, and $78 billion for January, the last month for which data are available. The nasty thing about this is that with a projected $975 billion current-account deficit for this year, the US is no longer getting what it needs from the world to maintain its lifestyle. The foreign-capital food supply is dwindling just as the hunger increases.
True, the actual shortfall is not yet very large, right now less than $5 billion a month. But I see the salient fact here as not being the current-account deficit minus TIC-inflow shortfall right now, but the rather significant 35% absolute reduction in inflows since last summer. As the US political system shows absolutely no indication of being either desirous or even able to deal with its fiscal profligacy (the recent congressional farce surrounding the increase in the debt ceiling being an example), the current-account deficit will only rise; unless US households are willing to increase their savings rates massively (very unlikely, since I haven't seen any "going out of business" signs on Best Buy or Circuit City lately) or the declining-TIC-inflow trend reverses, there's trouble ahead for the latest US experiment in cut-rate conquest.
There are many ways this trouble could manifest itself. Since much of this foreign-capital inflow finds its way into long-term US Treasury securities, it's hardly surprising that, with the recent shortfall in TIC inflows, Treasury interest rates are rising to their highest levels in two years. If demand is falling, then the market is marking down prices, and the basic rule of bond markets is that yields move in inverse directions to prices. Rising mortgage rates will put the US real-estate boom in real jeopardy, and it has been US homeowners pulling spendable cash out of the inflated values of their homes that has generated much of the consumption component of recent US growth.
It is also possible that this could lead to a sharp selloff in the US dollar, as has been happening in the dollar-euro market since November. If foreigners with export earnings from the US do not put it back into US assets, they will not just keep it stuffed in their mattresses; they will look around for interest-bearing instruments denominated in euros, sterling, yen, or a dozen other currencies.
This will cause these currencies to appreciate in value, and the dollar to fall. If you've ever looked at the back page of The Economist magazine you'll have seen the huge foreign-exchange reserves being built by countries that have recently been the winners in the global trading game. As of December, the International Monetary Fund lists Japan's reserves at $847 billion, China's at $819 billion, Taiwan's at $253 billion, South Korea's at $210 billion, Russia's at $194 billion, and India's at $137 billion. These reserves, held overwhelmingly as US dollars, are the potential gasoline just waiting for the match to set alight a huge global economic conflagration.
If somebody starts selling his dollar reserves, even if it's only a portion of his dollar portfolio, other countries could be forced into panic selling of their huge dollar reserves. The foreign-exchange markets are the biggest and most liquid in the world, but whether they would be able to absorb the amount of selling that could emerge from portfolio adjustments this large is a very open question.
More likely there would be a sharp overshoot in the dollar-selling, leading to a perhaps 20-30% decline in dollar values within a very short time. For the US, this would mean a sharp rise in the prices of everything it imports, especially crude oil. That would mean inflation, with the Federal Reserve raising interest rates to contain it, or maybe the economy would bypass the intermediate inflationary phase and head straight into deep recession or depression.
Either way, the great run of US prosperity would be over. Worldwide, along with the global contractionary effects of US economic growth suddenly stopping or going into reverse, the effect of an almost instantaneous 20% haircut in the value of the world's financial reserves would be no picnic, either.
On the first day of class, business teachers like me love to introduce our sleepy students to the concept of TANSTAAFL - there ain't no such thing as a free lunch. The United States may soon be introduced to the concept of TANSTAAFE - there ain't no such thing as a free empire. Specifically, will the nation still think it's so important to control the sands of Samarra, or the streets of Fallujah, or, for that matter, those of Baghdad if, like the signs say in US doctors' offices, "payment is expected at the time of service"?
The case for a Fed rate cut
By Thomas Palley
With Wall Street beset by a crisis of confidence and the mortgage-backed securities market seizing up, there is urgent need for an immediate emergency interest-rate cut by the US Federal Reserve. This sudden need has also revealed how today's financial system places monetary policy in bondage to markets. That system has evolved over the past 25 years with the Fed's approval, and the current crisis starkly reveals need for reform.
An emergency rate cut is needed to prevent the subprime-mortgage meltdown from spiraling into a full-blown recession. By immediately lowering the base cost of credit, a rate cut could make existing mortgage securities more attractive to investors and also encourage continued flows of mortgage finance for the housing market.
Such continued financing is critical. In its absence, mortgage availability will shrink and mortgage rates rise, thereby deepening the US housing-market slump. That is likely to trigger additional mortgage defaults and reductions in construction activity, thereby perhaps even causing a recession. In this event, the spiral of credit deterioration stands to deepen, jumping from the subprime-mortgage market to the entire US housing sector and the US economy more broadly.
In response to this threat, the Fed has already moved to inject significant temporary additional liquidity into money markets, in effect lending billions of dollars to banks to prevent their having to make further asset sales under distressed conditions. Central banks in Europe, Japan and elsewhere have done the same. However, because the costs of recession promise to be so large, the Fed must also move to cut rates.
Less than two weeks ago, Fed policy was focused on containing inflation. Now, within the blink of an eye, the evaporation of confidence among Wall Street lenders has created conditions warranting an emergency rate cut to save the US economy. This power of financial markets is rooted in a new business cycle that emerged in the 1980s and which has made the US economy increasingly dependent on debt to fuel expansions. The creation of debt in turn relies on highly leveraged financial intermediaries that package and repackage loans while promising liquidity they are unable to deliver. As a result, the system has become fragile.
Increased financial fragility is one feature of the new system. A second and worse feature is that increased debt is part of a complex for shifting value from the real sector to the financial sector - a phenomenon known as "financialization". This increases profits in the financial sector at the expense of the real economy. Meanwhile, the new structure also implicitly compels monetary policy to rescue the financial sector if it gets into trouble. This amounts to a policy stick-up whereby the Fed is forced to provide the getaway car for fear that not doing so will result in even greater economic damage.
Today's system places monetary policy in a double bind. In good times the Fed is forced to raise interest rates to maintain lender beliefs that inflation will remain low. Those beliefs ensure that investors are willing to make the loans needed to fuel the system. However, the result is higher interest rates and curtailed expansions that hold down wages and employment, thereby limiting the share of productivity growth going to working families.
In bad times, such as we are now experiencing, the Fed is obliged to come to the rescue of lenders for fear that if they stop lending the US economy will tank. Moreover, this fear deepens the greater the level and burden of debts. Worse yet, such intervention creates a problem known as "moral hazard" that can aggravate the need for rescues.
Having the Fed intervene to prevent financial meltdowns tacitly puts a floor under financial markets. That floor acts as a form of insurance for investors and speculators who, knowing that they are protected against large losses, then channel more funds into even higher-risk investments and loans. The Fed has actively promoted the new system through deregulation. Its claim has been that the risks of the financial system imploding are less because risk is spread. That claim is now being shown to be false.
For two decades, working families in the US have felt the effects of the policy head-lock imposed by financial-market demands for ultra-low inflation. Now, financial markets are exercising their other demand for interest-rate cuts to preserve asset values to prevent recession.
The threat posed by the current crisis is such that the Fed should meet this demand. That means immediately cutting rates and continuing to provide emergency liquidity judiciously. However, once the storm passes, the US Congress and the Fed must address the systemic problems and policy distortions that have been exposed by the current crisis.
Thomas Palley is the founder of the Economics for Democratic and Open Societies Project.
With Wall Street beset by a crisis of confidence and the mortgage-backed securities market seizing up, there is urgent need for an immediate emergency interest-rate cut by the US Federal Reserve. This sudden need has also revealed how today's financial system places monetary policy in bondage to markets. That system has evolved over the past 25 years with the Fed's approval, and the current crisis starkly reveals need for reform.
An emergency rate cut is needed to prevent the subprime-mortgage meltdown from spiraling into a full-blown recession. By immediately lowering the base cost of credit, a rate cut could make existing mortgage securities more attractive to investors and also encourage continued flows of mortgage finance for the housing market.
Such continued financing is critical. In its absence, mortgage availability will shrink and mortgage rates rise, thereby deepening the US housing-market slump. That is likely to trigger additional mortgage defaults and reductions in construction activity, thereby perhaps even causing a recession. In this event, the spiral of credit deterioration stands to deepen, jumping from the subprime-mortgage market to the entire US housing sector and the US economy more broadly.
In response to this threat, the Fed has already moved to inject significant temporary additional liquidity into money markets, in effect lending billions of dollars to banks to prevent their having to make further asset sales under distressed conditions. Central banks in Europe, Japan and elsewhere have done the same. However, because the costs of recession promise to be so large, the Fed must also move to cut rates.
Less than two weeks ago, Fed policy was focused on containing inflation. Now, within the blink of an eye, the evaporation of confidence among Wall Street lenders has created conditions warranting an emergency rate cut to save the US economy. This power of financial markets is rooted in a new business cycle that emerged in the 1980s and which has made the US economy increasingly dependent on debt to fuel expansions. The creation of debt in turn relies on highly leveraged financial intermediaries that package and repackage loans while promising liquidity they are unable to deliver. As a result, the system has become fragile.
Increased financial fragility is one feature of the new system. A second and worse feature is that increased debt is part of a complex for shifting value from the real sector to the financial sector - a phenomenon known as "financialization". This increases profits in the financial sector at the expense of the real economy. Meanwhile, the new structure also implicitly compels monetary policy to rescue the financial sector if it gets into trouble. This amounts to a policy stick-up whereby the Fed is forced to provide the getaway car for fear that not doing so will result in even greater economic damage.
Today's system places monetary policy in a double bind. In good times the Fed is forced to raise interest rates to maintain lender beliefs that inflation will remain low. Those beliefs ensure that investors are willing to make the loans needed to fuel the system. However, the result is higher interest rates and curtailed expansions that hold down wages and employment, thereby limiting the share of productivity growth going to working families.
In bad times, such as we are now experiencing, the Fed is obliged to come to the rescue of lenders for fear that if they stop lending the US economy will tank. Moreover, this fear deepens the greater the level and burden of debts. Worse yet, such intervention creates a problem known as "moral hazard" that can aggravate the need for rescues.
Having the Fed intervene to prevent financial meltdowns tacitly puts a floor under financial markets. That floor acts as a form of insurance for investors and speculators who, knowing that they are protected against large losses, then channel more funds into even higher-risk investments and loans. The Fed has actively promoted the new system through deregulation. Its claim has been that the risks of the financial system imploding are less because risk is spread. That claim is now being shown to be false.
For two decades, working families in the US have felt the effects of the policy head-lock imposed by financial-market demands for ultra-low inflation. Now, financial markets are exercising their other demand for interest-rate cuts to preserve asset values to prevent recession.
The threat posed by the current crisis is such that the Fed should meet this demand. That means immediately cutting rates and continuing to provide emergency liquidity judiciously. However, once the storm passes, the US Congress and the Fed must address the systemic problems and policy distortions that have been exposed by the current crisis.
Thomas Palley is the founder of the Economics for Democratic and Open Societies Project.
US rate cuts: Like a blow to the head
By Julian Delasantellis
Zhou Xiaochuan, the governor of the Bank of China, must sympathize with the plight of poor Raoul, the waiter whose good service is rewarded with a brick to the back of his head.
In a 2004 episode of the US cable network series The Sopranos , New Jersey mafia boss Tony Soprano takes the senior leadership of his crime family to an expensive dinner at a casino restaurant in Atlantic City, New Jersey.
There they enjoy multiple rounds of the best cuts of steak, lobster and the finest beverages; it is Tony's nephew and heir apparent, the sobriety-, impulse-control-, fidelity- and literary-talent-challenged would-be part-time Hollywood screenwriter and full-time thug Christopher Moltisanti who gets stuck with the US$1,184 check.
Christopher is none too happy with this situation; he is particularly enraged that his fellow goomba Paulie "Walnuts" Gualtieri sent over an expensive bottle of Cristal to two young ladies he classified as "skanks" at an adjoining table. He leaves a $16 tip, for an even $1,200. The waiter, Raoul, is none too pleased with this, and he comes out to the parking lot to complain to Christopher about his stinginess.
There was no problem with his service; he feels he deserves more. Standard American tipping protocol calls for gratuities to amount to about 15% of the check, which, in this case, would have called for a $177.60 tip.
Christopher is in no mood for interlocution. As in most scenes in The Sopranos up to and including solemn religious observations, the situation rapidly descends to exchanges of rank obscenities. As Raoul turns away to return to work, Christopher throws a brick that hits the waiter in the head. As Raoul writhes on the ground, unconscious in an epileptic-type fit, for good measure, Paulie comes over, shoots and kills him.
I bet that, in the middle of the night Beijing time, after he became aware of the results of Tuesday's meetings of the US Federal Reserve Board, Zhou Xiaochuan, the man in charge of China's one and a half trillion dollars of foreign exchange reserves, sympathized with the plight of poor Raoul. After all, in deploying its foreign exchange reserves to buy US Treasury securities to keep US interest rates low, and by not converting its US dollar export proceeds into other currencies, China has served the US well.
And the thanks he gets is Fed chief Ben Bernanke hitting him on the head with a brick.
In an extraordinary meeting of the United States Federal Reserve on Tuesday, the board shocked the financial world (very much including me) by announcing interest rate cuts far more extensive than previously expected. The expectation was that the cuts would have been limited to just a single 0.25-percentage-point (25 basis point) cut in the benchmark Federal Funds target rate; instead, the Fed reduced the target rate 50 basis points, along with a second 50 basis point cut (the first was on August 17) in a less commonly reported but possibly more important rate that the Federal Reserve also controls, the Federal Reserve discount rate.
This is a complete rejection of the policy of former Fed chief Alan Greenspan of slow and gradual interest rate changes so as to assure the markets that they will not be continually surprised by unexpected Federal Reserve actions, a policy that Bernanke had been maintaining during the previous 19 months of his tenure.
The contrast between Tuesday's meeting result and the sunny optimism of the previous Fed meeting on August 7 is breathtaking; it is far and away the most ominous portent of the future prospects of the US economy since the current "subprime crisis" broke into the market's consciousness earlier this year. Comparing the results of the August meeting with Tuesday's is like going to the doctor wanting to have a hangnail removed and having the physician start his conversation by asking how you feel about cremation.
Clearly, this is an indication that the Fed feels that the surface calm that has returned to world equity markets since the discount rate cut is illusory. Contributing to this must be the actions by the Bank of England to once again bail out the troubled Newcastle-based Northern Rock bank. A crisis that began in the overheated condominium markets of southern California and Florida has spread across the globe.
The fact that the Fed chose to lower both the funds and discount rates is indicative of the uniquely serious nature of this crisis.
As I explained (in my August 21 Asia Times Online article, When the big guns fail, call in China), the discount rate and the Federal Funds rate are two very separate monetary policy instruments. The funds rate (lowered on Tuesday, for the first time in four years, to 4.75%) is customarily the lower of the two; it governs the interest paid by big banks when they initiate short-term lending and borrowing between each other.
The Federal Reserve sets a "target" point for this rate; when they think that the economy is growing too fast, threatening inflation, they raise the target, as they did 17 times between 2004 and 2006. Likewise, when they are fearful of an economic slowdown, they lower the target, as they did on Tuesday. The Fed effects these target rate changes through either buying or selling Treasury securities in its portfolio, to either provide or drain sufficient liquidity from the system to move the market rate to the target rate.
The discount rate is always meant to be higher than the funds rate. This is the rate at which the Federal Reserve will directly lend to banks shut out of the private Federal funds market due to concerns about their soundness; it is higher than the Federal Funds rate because the Fed wants to be available, but not easy. Lowering the Fed Funds rate is the preferred policy choice when the problem the Fed wants to address is feeling that there is generalized economic weakness.
Discount window borrowing is considered the most effective tool for times such as now, when certain banks and other financial institutions are being denied access to Federal funds loans because of fears of their connection with the subprime market. However, the Fed had already lowered the discount rate 50 basis points on August 17, to 5.75%. If they had lowered it another 50 basis points without lowering the funds target, the funds target would have been even with the discount rate, at 5.25%. So what we really saw on Tuesday was another discount rate cut masked by a Federal Funds target rate cut.
To me, the most remarkable thing about these events is that they demonstrate the breathtaking disregard that US economic policy makers have regarding the value and fate of their own national currency. Richard Nixon-era secretary of the treasury John Connolly, speaking to European economic officials, once said that the US dollar was "our currency, but your problem". The country could get away with that back in the early 1970s, when the US was the world's biggest lender; now that this situation is reversed, and the country must borrow $2-3 billion from foreigners each and every day just to feed its overconsumption addiction.
The market reaction to this Fed move was about as expected as the day's sunrise - a sharp fall in the US dollar. The greenback finally breached the record 1.4 level versus the euro; it has now fallen 15% against the euro since early 2006, 63% since early 2001.
Still, none of this had any effect on the drunken bacchanalia that erupted on Wall Street following the announcement. The Dow Jones Industrial Average soared 336 points, 2.51%, to 13,739; CNBC's Maria Bartiromo was so gushingly giddy in her coverage of the rally that you would have thought that Starbucks had opened a coffee stand in her electroshock therapy suite.
Shares of broker/dealer industry companies had a particularly fine afternoon; Goldman Sachs rose 7%. If you accept the thesis from my article of this past Monday, September 17, A rate cut with a shoeshine and a smile that Federal Reserve chiefs are, in reality, nothing but glorified salesman for the US financial services
industry, then Tuesday saw a particularly glowing employee evaluation placed in Bernanke's file.
Very few other countries have ever been able to make such whoopee as their national currencies are being debased. In 1981, newly elected French socialist president Francois Mitterrand had to abandon his campaign promises for an ambitious social equality program when currency traders started to sell the franc hard against the West German mark.
In 1993, when US labor secretary Robert Reich urged an expansive social welfare/jobs reflationary fiscal program; newly elected president Bill Clinton nixed this idea when treasury secretary Robert Rubin advised the president that this would cause both the US dollar and bond prices to fall. When their currencies were hit by speculative attacks, the countries most affected by the 1997 East Asian financial crisis, primarily Thailand, Indonesia and South Korea, were forced to make painful cuts in their national social welfare spending.
But it seems that the US is never forced to face such dolorous consequences as its currency weakens. Its policymakers initiate policies that they know full well will weaken the US dollar, and they just don't care. It's almost as if the nation can pay for goods with checks it knows the other party will never cash; if you could do this, you'd probably be living pretty large too.
This is particularly true in the case of China. China's foreign exchange reserves are now approaching the trillion and a half dollar level, and this massive wad of cash is mostly kept as US dollars. China has earned this treasure through being the gleaming supermall for the shop-till-you-drop obsession that has swept the US, and to a lesser extent the rest of the Western world, this decade.
What Ben Bernanke is saying with his sharp interest rate cuts, and what the nation is affirming its approval of with the orgiastic stock market response that followed, is that it continues to hold no other value higher than the pleasure to be attained through its own excess consumption. In depreciating the value of the currency it uses to pay China for its goods, the US is telling China that it has no intention of paying China the full value for what it buys from it; that would be unacceptable, it would mean that there would be less money to buy even more stuff.
Of course, China does not have to continue to put up with this. It could stop accepting the funny money dollars, the depreciating greenbacks with Mickey Mouse's picture on the face instead of George Washington's. China could convert its foreign exchange reserves into other currencies by selling its dollars. As this would severely reduce the demand for US Treasuries in which China parks its reserves, US interest rates would have to rise sharply to re-attract the securities demand lost from China, and there would be little or nothing that Bernanke, Treasury Secretary Henry Paulson, President George W Bush, or even the US's first infallible-by-decree army general staff officer, the Blessed Holy Father General St David Petraeus, could do about it.
This would not be an easy thing for China to do, so the US feels China will not do it. If China actually did try to publicly sell all or a large part of its dollar portfolio the prices of the dollar assets remaining in the portfolio would undoubtedly fall sharply; China could lose a lot more than it gained. Still, Bernanke has just told China that, come hell or high water, he fully intends to filch away the value of their reserves. Maybe China could decide that it's a choice between losing a lot of money, fast, by selling its dollars, or losing a lot more, slowly, by keeping its dollars.
Like pulling off a Band-Aid, it probably hurts less to do it fast. Or, China could do it smart, slow and gradual; that's the way China likes to manage change. There are some indications that this is exactly what is happening. From a level of over $160 billion a year in 2006, Tuesday's US Treasury Department's Treasury International Capital (TIC) report, released a few hours before the Fed meeting and so thus totally ignored, showed that foreign (like the Chinese central bank) buying of US government securities actually turned negative in July. (I wrote about the implications of TIC data in my March 24, 2006 ATol article, US living on borrowed time - and money).
China probably is already diversifying away from the US dollar, but among all the cacophonous noise of the glorious roiling tsunami of inanity that is US public life, the actual signal information is being missed.
There were a few disquieting responses to the Fed move. Crude oil continued its recent record breaking rise, topping $82 a barrel. This market knows that, unlike China, the members of the Organization of Petroleum Exporting Countries (OPEC) long ago made clear that they would not accept depreciating dollars in exchange for their non-renewable export assets; oil prices go up as the US dollar goes down. China seems to be learning from OPEC's example.
The most interesting aspect of Tuesday's market responses to the Fed cuts may be the most massively under-reported - the fact that the only one of the Dow 30 stocks that did not rally on the news was, curiously enough, Boeing. Boeing got some bad news on Tuesday with some press questions regarding the potential crash survivability of its new 787 Dreamliner, but, in a market move like Tuesday's, even that type of report is usually ignored. The market wisdom for rally days like Tuesday is that these are times when "even the [scatological term] floats to the top".
I see the Boeing stock price divergence as more of an indication that, with Boeing so dependent on Chinese airline demand, the company may be in big trouble if China really does act to reduce its economic relationship and dependence on the US.
On an episode of the old 1970s CBS-TV situation comedy The Mary Tyler Moore Show, it once was suggested in the fictional television newsroom where the show was set that, since the previous night's newscast had done so well in the ratings, they should get out the script and broadcast it again - why mess with success?
In that spirit, since this Federal Reserve move has apparently gone over so well, (with the only constituency that really matters in the US, upper and upper middle class investors) there will probably be more cuts at the next Fed meeting in late October should there be further bad subprime or economic news, which there undoubtedly will be.
How long will the nation get away with the debasement of its own currency and the defrauding of its lenders? I have no idea. I find it most amazing that, in its actions, the nation is ignoring the very principle at the heart of the subprime crisis the Federal Reserve's actions are trying to remedy. To their own misery, the subprime borrowers have learnt the lesson that the nation has yet to learn. You can't forever live in a house, or in a consumer lifestyle, that you cannot afford.
Zhou Xiaochuan, the governor of the Bank of China, must sympathize with the plight of poor Raoul, the waiter whose good service is rewarded with a brick to the back of his head.
In a 2004 episode of the US cable network series The Sopranos , New Jersey mafia boss Tony Soprano takes the senior leadership of his crime family to an expensive dinner at a casino restaurant in Atlantic City, New Jersey.
There they enjoy multiple rounds of the best cuts of steak, lobster and the finest beverages; it is Tony's nephew and heir apparent, the sobriety-, impulse-control-, fidelity- and literary-talent-challenged would-be part-time Hollywood screenwriter and full-time thug Christopher Moltisanti who gets stuck with the US$1,184 check.
Christopher is none too happy with this situation; he is particularly enraged that his fellow goomba Paulie "Walnuts" Gualtieri sent over an expensive bottle of Cristal to two young ladies he classified as "skanks" at an adjoining table. He leaves a $16 tip, for an even $1,200. The waiter, Raoul, is none too pleased with this, and he comes out to the parking lot to complain to Christopher about his stinginess.
There was no problem with his service; he feels he deserves more. Standard American tipping protocol calls for gratuities to amount to about 15% of the check, which, in this case, would have called for a $177.60 tip.
Christopher is in no mood for interlocution. As in most scenes in The Sopranos up to and including solemn religious observations, the situation rapidly descends to exchanges of rank obscenities. As Raoul turns away to return to work, Christopher throws a brick that hits the waiter in the head. As Raoul writhes on the ground, unconscious in an epileptic-type fit, for good measure, Paulie comes over, shoots and kills him.
I bet that, in the middle of the night Beijing time, after he became aware of the results of Tuesday's meetings of the US Federal Reserve Board, Zhou Xiaochuan, the man in charge of China's one and a half trillion dollars of foreign exchange reserves, sympathized with the plight of poor Raoul. After all, in deploying its foreign exchange reserves to buy US Treasury securities to keep US interest rates low, and by not converting its US dollar export proceeds into other currencies, China has served the US well.
And the thanks he gets is Fed chief Ben Bernanke hitting him on the head with a brick.
In an extraordinary meeting of the United States Federal Reserve on Tuesday, the board shocked the financial world (very much including me) by announcing interest rate cuts far more extensive than previously expected. The expectation was that the cuts would have been limited to just a single 0.25-percentage-point (25 basis point) cut in the benchmark Federal Funds target rate; instead, the Fed reduced the target rate 50 basis points, along with a second 50 basis point cut (the first was on August 17) in a less commonly reported but possibly more important rate that the Federal Reserve also controls, the Federal Reserve discount rate.
This is a complete rejection of the policy of former Fed chief Alan Greenspan of slow and gradual interest rate changes so as to assure the markets that they will not be continually surprised by unexpected Federal Reserve actions, a policy that Bernanke had been maintaining during the previous 19 months of his tenure.
The contrast between Tuesday's meeting result and the sunny optimism of the previous Fed meeting on August 7 is breathtaking; it is far and away the most ominous portent of the future prospects of the US economy since the current "subprime crisis" broke into the market's consciousness earlier this year. Comparing the results of the August meeting with Tuesday's is like going to the doctor wanting to have a hangnail removed and having the physician start his conversation by asking how you feel about cremation.
Clearly, this is an indication that the Fed feels that the surface calm that has returned to world equity markets since the discount rate cut is illusory. Contributing to this must be the actions by the Bank of England to once again bail out the troubled Newcastle-based Northern Rock bank. A crisis that began in the overheated condominium markets of southern California and Florida has spread across the globe.
The fact that the Fed chose to lower both the funds and discount rates is indicative of the uniquely serious nature of this crisis.
As I explained (in my August 21 Asia Times Online article, When the big guns fail, call in China), the discount rate and the Federal Funds rate are two very separate monetary policy instruments. The funds rate (lowered on Tuesday, for the first time in four years, to 4.75%) is customarily the lower of the two; it governs the interest paid by big banks when they initiate short-term lending and borrowing between each other.
The Federal Reserve sets a "target" point for this rate; when they think that the economy is growing too fast, threatening inflation, they raise the target, as they did 17 times between 2004 and 2006. Likewise, when they are fearful of an economic slowdown, they lower the target, as they did on Tuesday. The Fed effects these target rate changes through either buying or selling Treasury securities in its portfolio, to either provide or drain sufficient liquidity from the system to move the market rate to the target rate.
The discount rate is always meant to be higher than the funds rate. This is the rate at which the Federal Reserve will directly lend to banks shut out of the private Federal funds market due to concerns about their soundness; it is higher than the Federal Funds rate because the Fed wants to be available, but not easy. Lowering the Fed Funds rate is the preferred policy choice when the problem the Fed wants to address is feeling that there is generalized economic weakness.
Discount window borrowing is considered the most effective tool for times such as now, when certain banks and other financial institutions are being denied access to Federal funds loans because of fears of their connection with the subprime market. However, the Fed had already lowered the discount rate 50 basis points on August 17, to 5.75%. If they had lowered it another 50 basis points without lowering the funds target, the funds target would have been even with the discount rate, at 5.25%. So what we really saw on Tuesday was another discount rate cut masked by a Federal Funds target rate cut.
To me, the most remarkable thing about these events is that they demonstrate the breathtaking disregard that US economic policy makers have regarding the value and fate of their own national currency. Richard Nixon-era secretary of the treasury John Connolly, speaking to European economic officials, once said that the US dollar was "our currency, but your problem". The country could get away with that back in the early 1970s, when the US was the world's biggest lender; now that this situation is reversed, and the country must borrow $2-3 billion from foreigners each and every day just to feed its overconsumption addiction.
The market reaction to this Fed move was about as expected as the day's sunrise - a sharp fall in the US dollar. The greenback finally breached the record 1.4 level versus the euro; it has now fallen 15% against the euro since early 2006, 63% since early 2001.
Still, none of this had any effect on the drunken bacchanalia that erupted on Wall Street following the announcement. The Dow Jones Industrial Average soared 336 points, 2.51%, to 13,739; CNBC's Maria Bartiromo was so gushingly giddy in her coverage of the rally that you would have thought that Starbucks had opened a coffee stand in her electroshock therapy suite.
Shares of broker/dealer industry companies had a particularly fine afternoon; Goldman Sachs rose 7%. If you accept the thesis from my article of this past Monday, September 17, A rate cut with a shoeshine and a smile that Federal Reserve chiefs are, in reality, nothing but glorified salesman for the US financial services
industry, then Tuesday saw a particularly glowing employee evaluation placed in Bernanke's file.
Very few other countries have ever been able to make such whoopee as their national currencies are being debased. In 1981, newly elected French socialist president Francois Mitterrand had to abandon his campaign promises for an ambitious social equality program when currency traders started to sell the franc hard against the West German mark.
In 1993, when US labor secretary Robert Reich urged an expansive social welfare/jobs reflationary fiscal program; newly elected president Bill Clinton nixed this idea when treasury secretary Robert Rubin advised the president that this would cause both the US dollar and bond prices to fall. When their currencies were hit by speculative attacks, the countries most affected by the 1997 East Asian financial crisis, primarily Thailand, Indonesia and South Korea, were forced to make painful cuts in their national social welfare spending.
But it seems that the US is never forced to face such dolorous consequences as its currency weakens. Its policymakers initiate policies that they know full well will weaken the US dollar, and they just don't care. It's almost as if the nation can pay for goods with checks it knows the other party will never cash; if you could do this, you'd probably be living pretty large too.
This is particularly true in the case of China. China's foreign exchange reserves are now approaching the trillion and a half dollar level, and this massive wad of cash is mostly kept as US dollars. China has earned this treasure through being the gleaming supermall for the shop-till-you-drop obsession that has swept the US, and to a lesser extent the rest of the Western world, this decade.
What Ben Bernanke is saying with his sharp interest rate cuts, and what the nation is affirming its approval of with the orgiastic stock market response that followed, is that it continues to hold no other value higher than the pleasure to be attained through its own excess consumption. In depreciating the value of the currency it uses to pay China for its goods, the US is telling China that it has no intention of paying China the full value for what it buys from it; that would be unacceptable, it would mean that there would be less money to buy even more stuff.
Of course, China does not have to continue to put up with this. It could stop accepting the funny money dollars, the depreciating greenbacks with Mickey Mouse's picture on the face instead of George Washington's. China could convert its foreign exchange reserves into other currencies by selling its dollars. As this would severely reduce the demand for US Treasuries in which China parks its reserves, US interest rates would have to rise sharply to re-attract the securities demand lost from China, and there would be little or nothing that Bernanke, Treasury Secretary Henry Paulson, President George W Bush, or even the US's first infallible-by-decree army general staff officer, the Blessed Holy Father General St David Petraeus, could do about it.
This would not be an easy thing for China to do, so the US feels China will not do it. If China actually did try to publicly sell all or a large part of its dollar portfolio the prices of the dollar assets remaining in the portfolio would undoubtedly fall sharply; China could lose a lot more than it gained. Still, Bernanke has just told China that, come hell or high water, he fully intends to filch away the value of their reserves. Maybe China could decide that it's a choice between losing a lot of money, fast, by selling its dollars, or losing a lot more, slowly, by keeping its dollars.
Like pulling off a Band-Aid, it probably hurts less to do it fast. Or, China could do it smart, slow and gradual; that's the way China likes to manage change. There are some indications that this is exactly what is happening. From a level of over $160 billion a year in 2006, Tuesday's US Treasury Department's Treasury International Capital (TIC) report, released a few hours before the Fed meeting and so thus totally ignored, showed that foreign (like the Chinese central bank) buying of US government securities actually turned negative in July. (I wrote about the implications of TIC data in my March 24, 2006 ATol article, US living on borrowed time - and money).
China probably is already diversifying away from the US dollar, but among all the cacophonous noise of the glorious roiling tsunami of inanity that is US public life, the actual signal information is being missed.
There were a few disquieting responses to the Fed move. Crude oil continued its recent record breaking rise, topping $82 a barrel. This market knows that, unlike China, the members of the Organization of Petroleum Exporting Countries (OPEC) long ago made clear that they would not accept depreciating dollars in exchange for their non-renewable export assets; oil prices go up as the US dollar goes down. China seems to be learning from OPEC's example.
The most interesting aspect of Tuesday's market responses to the Fed cuts may be the most massively under-reported - the fact that the only one of the Dow 30 stocks that did not rally on the news was, curiously enough, Boeing. Boeing got some bad news on Tuesday with some press questions regarding the potential crash survivability of its new 787 Dreamliner, but, in a market move like Tuesday's, even that type of report is usually ignored. The market wisdom for rally days like Tuesday is that these are times when "even the [scatological term] floats to the top".
I see the Boeing stock price divergence as more of an indication that, with Boeing so dependent on Chinese airline demand, the company may be in big trouble if China really does act to reduce its economic relationship and dependence on the US.
On an episode of the old 1970s CBS-TV situation comedy The Mary Tyler Moore Show, it once was suggested in the fictional television newsroom where the show was set that, since the previous night's newscast had done so well in the ratings, they should get out the script and broadcast it again - why mess with success?
In that spirit, since this Federal Reserve move has apparently gone over so well, (with the only constituency that really matters in the US, upper and upper middle class investors) there will probably be more cuts at the next Fed meeting in late October should there be further bad subprime or economic news, which there undoubtedly will be.
How long will the nation get away with the debasement of its own currency and the defrauding of its lenders? I have no idea. I find it most amazing that, in its actions, the nation is ignoring the very principle at the heart of the subprime crisis the Federal Reserve's actions are trying to remedy. To their own misery, the subprime borrowers have learnt the lesson that the nation has yet to learn. You can't forever live in a house, or in a consumer lifestyle, that you cannot afford.
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