More Bad News for the future of the USD

More news that the countries which hold the largest US Dollar reserves are beginning to “diversify” into other currencies and investments. Friday’s WSJ has an interesting article ($link) about the future of the Kuwaiti sovereign wealth fund:

The Gulf petro-states control a vast hoard of investable funds, one that is sure to grow vaster. Combined, government investment arms in Kuwait, Saudi Arabia, Dubai, Abu Dhabi and Qatar hold an estimated $1.5 trillion. That gives them potential to sway the course of broad global financial markets, including exchange and interest rates, the now-slowed buyout boom and the global credit dislocations stemming from US subprime mortgages.

The Middle East’s government investment arms are at the fulcrum of a longer-term shift in global financial flows from the West’s developed markets to the faster-growing economies of India, China, Southeast Asia and Turkey, places where many Middle Easterners see their fortunes lying in the future. Mr Al-Sa’ad is cutting the portion of the portfolio invested in the U.S. and Europe to less than 70% from about 90%. “Why invest in 2%-growth economies when you can invest in 8%-growth economies?” he asks.

That shift might lower the appetite for low-yielding investments such as the bonds the U.S. government must sell in large numbers to finance its budget and trade deficits. All else being equal, reduced buying of Treasuries and other U.S. securities would tend to weaken the dollar and make U.S. exports more competitive globally, but also burden businesses and consumers in the U.S. by pushing up interest rates.

I highlighted what I think are the most important takeaways of this news, neither of which is positive for the future of the US Dollar:

1. Because of the massive amount of US Dollars and US Treasuries owned by our trading partners, they probably have as much influence on the US economy as does the Federal Reserve.

2. As countries such as Kuwait and China create “sovereign wealth funds”, they will diversify out of US Treasuries into investments with stronger growth potential.

Can printing money create "real" wealth?

There is an interesting op-ed by Bob McTeere in today’s WSJ (subscription required): Don’t Dismiss Our Dismal Savings Rate. Excerpt:

The main fallacy in monetary theory and policy is the confusion of money and wealth. Money is wealth from the individual perspective since individuals can usually exchange it for goods and services. Money -- and financial assets easily converted to money -- may not be wealth for society as a whole if the production of goods and services has not kept pace with claims on it. Early spenders may have some success, but inflation will dilute the buying power of others. The bottom line is that real wealth has to be produced; it can't be printed.

The paradox of thrift says that attempts to save more in the aggregate reduce consumption spending, which, if not offset by increases in other spending, will reduce total spending and income. The paradox comes in when attempts to save more results in reduced saving out of lower incomes. The irony is that policy makers advise more saving but those who take the advice will benefit only if most of us ignore it, and policy makers are implicitly counting on that outcome.

A parallel is the farmer who hopes for a good crop year. But, if all or most farmers have a good crop year, the decline in prices may more than offset higher yields. What our farmer really needs is a good cop in a bad crop year. Then he could look for a popular restaurant that isn’t crowded.

A penny saved may be a penny earned, but it matters whether it was earned by producing more or by a rise in price of existing financial assets. A stock or housing market boom creates apparent wealth in the form of capital gains, but trying to convert it to real wealth en masse can make it disappear.

Alan Greenspan has been one of the few economists to explain these matters correctly and understandably, usually in the context of entitlement reforms. He frequently pointed out that any solution to the problem had to include real economic growth. With claims on output growing rapidly, output has to grow equally rapidly or the claims are bogus. Any solution -- to entitlements or the savings rate -- must include a bigger, more productive economy in the future…

The problem goes beyond government entitlement programs. Consider the baby boomers whose IRAs, 401(k)’s and personal investments helped drive the stock market to record highs. What happens when cash-in time comes? There will be a mountain of paper claims on output, but will there be an equally tall mountain of output?

This simple thesis helps to explain a lot of what confuses me about all of this new “money creation” we hear about constantly. For years now global money supply has been increasing much faster than the rate of global growth. Of course, defining “money” has become so much more difficult because of the velocity effects of increased global trade, not to mention derivatives. This is partly why the Fed has stopped publishing the M3 measure of money supply – it’s just too hard to quantify the broad monetary base.

Nevertheless, most of this new money has sloshed into assets, pushing up their prices. I have commented before that rising asset prices are not good for most people. For lower and middle class people who don’t own a lot of assets, they have not benefited much at all. Many of these people are actually worse off because they borrowed a ton of money against an overvalued asset.

Globalization Creates Secular not Cyclical Inflation

Excerpt from a Financial Post article today:

When Tata Consultancy, the giant Indian computer services firm, says it is hiring 5,000 workers in Mexico because rising wages are pushing up costs at home, it is little wonder investors are beginning to get queasy about inflation.

Only a month or so ago most economists figured the U.S. Fed would cut interest rates to fight off spreading housing doom. Now even long-standing bears Merrill Lynch and Goldman Sachs have rubbed out their forecasts for U.S. cuts, the European Central Bank is hinting at further increases after yesterday's hike, the Bank of Canada is poised to pull the rate trigger, and investors are beginning to worry that even low-cost giants such as India and China are losing their disinflationary might.

But before markets succumb fully to a good old-fashioned inflation scare, it is worth taking a dispassionate look at where global inflation is actually heading. While it may be heading up after several years of gangbuster global growth, the uptick is likely more cyclical than structural.

The long-term forces that have been holding inflation down -- globalization, the adoption of free-market policies and more sophisticated central bank policies -- are unlikely to unravel overnight. (Though the biggest dividends from falling inflation may behind us.)

The conclusion that this round of inflation is cyclical rather than structural is ridiculous. It brings us to the central debate – is globalization inflationary or deflationary? As the article implies, the growth of low-cost India and China has been a deflationary force on labor prices and certain manufactured goods. While this is undoubtedly true, this growth also has created inflation in many other sectors of the global economy.

India and China are consuming massive quantities of energy and other commodities. Since the supply of commodities is not unlimited (unlike the capacity of Chinese companies to produce junk for Walmart), their prices have risen dramatically across the board. As they grow richer, they become accustomed to a higher standard of living and they have more money to spend on food and other consumables. This is why we’ve seen increases in everything for which supply/capacity is not very elastic: energy, food, metals, transportation, construction, etc. The net result is a dramatic increase in aggregate demand.

Globalization has also had a major impact on asset price inflation. The increase in trade (and a host of other factors) has led to a massive increase in the money supply. Much of this new money has sloshed into stocks, bonds, real estate and other “assets.”

As prices for energy, food, shelter, and commodities rise, it’s only a matter of time before wages rise along with them. We are seeing this in a dramatic fashion in India and China, where wage growth in many sectors is in the double digits.

This phenomenon is not a cyclical trend, it is a structural trend and one we will be facing until India & China are done “emerging” and become mature economies.

Base Metals in the Nickel Are Worth More Than a Nickel

We first hit on this subject last summer in my old blog. One year later and the nickel is worth even less. The details are in this week’s Barron’s (Nickels Are the New Dimes – Subscription Required):

According to United States Mint Specifications, the U.S. nickel must weigh five grams, be 21.21 millimeters in diameter and consist 25% nickel and 75% copper. It’s the latter metallic value that’s of most interest. Earlier this month, the nickel reached a value of 9.7 cents as a result of the rising value of its constituent copper and nickel.

But lest you think of collecting bushels of nickel and melting them for a tidy profit, don’t. The Mint introduced interim rules late last year to head off any such shenanigans and profiteering. Violators can be punished with a fine of up to $10,000, five years in prison or both.

The obvious truth is that the USD, as illustrated so perfectly by the nickel, has been “debased.” But let’s look at the flipside of that argument: since the Dollar is a fiat currency, it is not based on anything tangible such as gold or silver. Therefore, it would make sense for the government to create the currency from the cheapest, most readily available materials, provided they met stringent durability requirements. The nickel just so happens to be made of nickel and copper, which today are very pricey. They could just as easily make the nickel out of clay or pig iron… it would be still be worth 5 cents because the US government says so.

Book Review Part I: The Great Wave by David Hackett Fisher

All major price revolutions in modern history began in periods of prosperity. Each ended in shattering world-crises and were followed by periods of recovery and comparative equilibrium. (page 9)

In this fascinating book, Fisher documents four different periods of European history in which prices rose steadily for decades, followed by periods of relative “equilibrium”:

1) Later-Medieval: 1180-1350

2) 16^th Century Price Revolution: 1470-1650

3) Industrial Revolution: 1730-1815

4) 20^th Century Price Revolution: 1896-present

His primary thesis is that the fundamental cause of inflation is an increase in aggregate demand due to population growth. Once the secular inflation begins, prices rise in a long wave until a crisis of some sort leads to a reduction in population and thus in aggregate demand.

Note: quotes from the book are in maroon italics.

Each wave has similar characteristics:

1. Each wave begins after a period of relative “equilibrium”: After decades of flat prices, population growth begins to put pressure on aggregate supply, especially of food, fuel, land and shelter. Naturally, it is more expensive to bring new supply to market because the “low hanging fruit” has already been picked. As a result, returns on capital begin to increase. If eggs are worth more, it stands to reason that the hen would be more expensive too. Same thing for land, slaves, coal mines, oil wells, real estate, etc.

The rich benefit enormously while everybody else suffers a decline in real wealth. In the beginning of the wave, the secular nature of the price increases is imperceptible. In fact, the price rises might be mistaken for general price volatility. To be sure, in times of price equilibrium, prices fluctuated due to any number of factors – largely supply driven – but they returned to normal once the supply disruption ceased. Instead, this is a demand-driven rise in prices.

2. Money supply begins to increase soon after prices start to rise. Many forces drive money supplies higher. Velocity of money increases: more money changes hands and more things, such as credit instruments, are used as money. Second, governments try to create more money to mitigate the rise in prices. It makes sense that if there is more money chasing the same number of goods, the prices for those goods should fall. Another method of increasing the money supply is to debase the currency. Fischer describes the money debasement methods of the Medieval price wave:

Metal coins were also systematically debased. In Italy and France particularly, mint-masters reduced the content of silver in their coins, and increased the quantity of base metal.Individuals acted in other ways to diminish the value of money that passed through their hands. Coins were clipped, filed, scraped, and washed despite ferocious penalties (page 25)

This growth in money supply fuels and aggravates the already-existing inflation. With all the ways – public and private – that the money supply is increasing, the supply of it
invariably rises more and faster than what would have been required to keep prices down.

3. Material decreases in the standard of living for the poor: The economic situation for the poor and middling classes gets steadily worse as they lose purchasing power. By this point, there is widespread understanding that prices are rising. The social order begins to break down – there is more crime, domestic violence, and wars.

4. Eventually, as a result of years of social and economic crisis, populations begin to decline. Since population has declined, so too has aggregate demand. During this period of equilibrium, real wages for the poor and middle class increase and returns on capital fall. The gap in wealth between rich and poor shrinks.

5. After some period of relative equilibrium, which is not surprisingly marked by social and political stability, populations rise again and the cycle starts anew.

I’m sure that many economists would strongly disagree with some of Fischer’s conclusions. In particular, monetarists such as the late Milton Friedman have argued that “inflation is always and everywhere a monetary phenomenon.” Fischer might say “inflation is always and everywhere an aggregate demand phenomenon.”

Before reading this book, I used to subscribe to the monetarist logic because it has a certain intuitive appeal. Essentially, if the supply of money goes up faster than the supply of goods available to purchase them, prices will go higher. Fischer is trying to explain why money supply tends to go up in the first place.

In tracing the roots of the 20^th Century Price Revolution (which continues today), Fischer acknowledges the monetarist argument but concludes that the root of the price wave was an increase in aggregate demand, not growth of the money supply (see pages 184 – 186):

Some attributed the increase in price levels to an expansion in the supply of gold and silver. In 1886, the fabulous gold mines of Johannesburg had been discovered, entirely by accident. In 1890, gold was found on Cripple Creek in Colorado.... Canadian gold began to flow from the Klondike in 1896. The Alaskan gold rush began in 1898. But these events were part of a long continuum of gold discoveries that had happened through the nineteenth century without rising prices. The rate of growth in gold production throughout the world was roughly the same before and after 1896. Moreover, the pace of secular increase in silver production actually declined during the 1890’s.

Monetary factors would play a major role in the price-revolution of the twentieth century, but the great wave itself grew mainly from a different root. It was primarily (not exclusively) the result of excess demand, generated by accelerating growth of the world’s population, by rising standards of living, and by limits on the supply of resources, all within an increasingly integrated global economy.

The demand-driven inflation argument does so much to explain today’s inflation. The government pretends that there is practically no inflation through hedonically adjusting the CPI and through its reliance on the "core" number. In other words, there is lots of room for the government to mess with the numbers to arrive at an inflation number favorable to them.

To be continued in Part II

Asset Price Inflation is Not a Good Thing for Most People

What's not to love about rising asset prices? The Fed has oft argued that to the extent they do not cause an increase consumer prices, lofty home values and stock markets do not lead to inflation. Thus, central banks only aim to stop consumer price inflation, not asset price inflation/appreciation. Given that central banks operate in democracies, this is a politically wise move. However, asset price inflation is not benign and is indeed inflationary. The Buttonwood column of this week's Economist, gives a few examples of why this is true.

The victims of rising asset prices:

Rising home prices are great for "middle-class people who started climbing the property ladder 20 years ago. But they make life difficult for young people wanting to buy their first home and for those trying to create affordable housing for low paid, but vital, workers, such as nurses."

For young people starting out in places such as DC, CA, NY/NJ, & Boston, this necessarily means that they have to load up on debt in order to afford an over-valued house. Presumably they will save even less because a large portion of their income goes to pay the mortgage.


High asset prices Now imply lower Future returns:

"The second problem is that, when asset prices are high and yields are low, future returns are likely to be subdued. It thus takes a lot more effort to generate a given lump sum for retirement."

Given today's rich valuations in nearly every single asset class I can think of, perhaps "past performance will not be indicative of future results." Indeed, the best performing asset class for the next ten years is most likely not even on the radar of the ordinary investor in the developed world.

Conclusion: high asset prices are exacerbating the looming retirement crisis

As defined benefit pension plans go the way of the dodo, the rich world will be split into four categories of retirees:

"Haves"

1. Already wealthy people
2. Government workers whose retirement is funded by taxpayers

"Have Nots"

1. Private sector workers who did not save enough
2. Poor people who rely on government for their subsistence

"The more numerous losers may demand higher taxes to penalize the lucky winners. What the market hath given, investors may find a future government taketh away."

In one way or another, this almost certain to be the outcome in the United States. The first step could be to take away Social Security and Medicare benefits from the "haves." The tax code could be modified to penalize people who have "too much" socked away in tax-advantaged accounts. Or perhaps people with passive incomes might have to start paying some form of payroll taxes.

So if this looming retirement crisis is worsened by asset price inflation, then why doesn't the Fed do something to stop it? Two reasons I can think of. First, there would be blood in the streets if the housing market declined markedly. Same thing if the Fed set out to crash stock & bond markets. The second reason is that, as a nation, we have way, way too much debt. Lower asset prices is deflationary -- there is nothing worse to a heavily indebted person (or government) than deflation. To the contrary, inflation is a gift for debtors because it shrinks the "real" value of the debt and interest payments.