“Inflation has long been the weapon of choice in sovereign defaults on domestic debt and, where possible, on international debt.”
By Peter T Treadway, PhD
Historical Analytics LLC
US and Chinese interest rates going up at the same time? Can things get worse?
As I have been arguing for the past two years in The Dismal Optimist, the dollar- based international monetary system is broken. That has now become the accepted view, in governments and in the markets, as the system has become progressively more broken. Investors, now face unprecedented volatility and uncertainty.
The markets in the last few days have experienced a rise in US and Chinese interest rates. Considering that low rates have been baked into asset prices globally, this is big.
Let’s start with the US.
It’s Our Currency, Your Problem
The above heading of course is a perennial favorite quote, courtesy of Nixon’s Treasury Secretary, John Connolly. Helicopter Ben Bernanke, in the Connolly tradition, has launched QE2 with the assumption that the US could do what it damn pleased regarding monetary policy and the world would put up with it. Ordinary countries might experience higher interest rates and currency collapses if they engaged in irresponsible money printing. Their currency, their problem. The US doesn’t have to worry about such trivia.
But this time we got a hint things might be different in the future. As President Obama discovered at the recent G 20 Meeting, Bernanke’s QE2 has evoked global outrage. And not only that. US longer term Treasury rates, if only momentarily, moved up.
Once upon a time in the good old pre-1914 days when gold underpinned both national and international monetary systems, central banks had only two tasks related to what today would be called monetary policy. The first was to buy and sell gold at an unchangeable fixed rate against their national currency and the second was to nudge short term interest rates up or down so as to encourage or discourage capital flows so as to maintain their country’s gold exchange rate. Actually in that blissful time the US didn’t even have a central bank. (The run on US gold in the Panic of 1893 was in part caused by fears that silver would partly replace gold in the US and the US would leave the gold standard) Central banks at that time were privately owned and profit making. The tasks of promoting full employment, softening the impact of deflationary bubbles, targeting inflation rates, or even targeting money supply, were not their problems. It was only after 1914, when the vast killing machines of an interminable war required endless financing, did the central banks morph into their current dual roles of national monetary central planner and agent of monetary debasement.
The world is well aware of two things: One, the US has borrowed in its own currency. Two, it is headed towards fiscal insolvency. Distinctions between US international and domestic sovereign debt are meaningless. The US will never default via non-payment of principal or interest. It can always print more dollars. If the US defaults, it will be via inflation.
I have been of the view that the Fed would not move up US interest rates in the next 12 months because the US consumer was mired in a massive real estate focused debt deflation. This is still my view. I have assumed the Fed could get away with this for at least another year and that its inflationary money printing would first hit outside the United States and in the global commodity markets.
This recent move-up in US Treasury rates may indeed just be a blip. In the last two years we have experienced occasional backups in US Treasury rates. Like summer thunderstorms, they’ve gone away. But in my opinion the back-up in US rates is an early warning even if reversed for now. The US, unlike Japan (the other low interest rate major debt deflation country) is dependent on foreign buyers to buy its debt. Bernanke has thrown sand in the eyes of the markets and world political leaders. He may discover that the Fed doesn’t quite control US long term Treasury rates the way he thought it did. As I write this, some are even speculating that Bernanke will have to curtail his QE2 plans.
Investors have to face this fact: With the Fed printing high powered money with wild abandon and with the US fiscal situation (including the states) continuing to worsen, sooner or later US longer term interest rates will trend upward.
For investors this is a nightmare. Zero to low US Treasury rates have been baked into asset prices around the world. Bond yields have come down. Investors, earning next to nothing in short term instruments, have been forced to reach for risk. In Asia, that has meant buying real estate. If US rates trend upwards, asset valuations will require recalculation – downwards. The Bernanke bubbles will deflate.
Economists and policy makers around the world expect a wall of QE2 money to hit global asset markets. That certainly has been my expectation. Perhaps this is too simple. Markets have a way of fooling us when “everybody” expects something. Prices get bid up in advance, money flees the oncoming wall, governments react with sometimes very stupid measures.
For example, capital controls are now becoming acceptable. Governments will not hesitate to interfere with markets when they feel threatened. Remember the ill-fated interest equalization tax instituted by President Kennedy in July1963 in response to brewing US balance of payments problems. The following quote from Wikipedia is worth noting:
“Interest Equalization Tax was a domestic tax measure implemented by U.S. President John F Kennedy in July 1963. It was meant to make it less profitable for U.S. investors to invest abroad by taxing the interest on foreign securities.”
Think about this. The Bernanke Fed has already made it less profitable for US investors to invest in domestic fixed income securities with its policy of near zero short rates and quantitative easing. Why not screw US investors on their international investments?
Meanwhile Back in the Middle Kingdom
In the last week China has announced a number of measures including increased reserve requirements on banks and higher bank deposit rates. All of this in response to an ever higher rate of consumer price inflation. More measures are expected including price controls on food (ugh!). All this occurring at the same time the world is in an uproar about QE2 and Ireland has become a global problem. The Chinese stock market—and to a lesser extent all of Asia — as a result has suffered a sharp drop.
Along with many others, I have been expecting a ratcheting upward in Chinese inflation. All this comes back to the Chinese exchange rate policy of undervaluing the renminbi. Keeping the renminbi below what the market would require has forced the Chinese to buy dollars, thereby increasing Chinese bank reserves and domestic money supply. All part of the broken international monetary system.
The last Dismal Optimist reviewed what I consider the mercantilist and misguided features of the East Asian Economic Model, a version of which China espouses. It should be clear now to the authorities in Beijing that the current policies have their cost in terms of increased inflation and consumer unhappiness.
I believe China has reached a crossroads, perhaps as momentous as that faced by Deng Xiaoping in the early 1980s when he successfully reoriented his nation towards a more market oriented approach. The East Asian Economic Model of an undervalued exchange rate, overreliance on investment and exports, significant tariff and non-tariff barriers and massive accumulation of definitely risky US dollar reserves is on its last legs.
Japan with its sclerotic political system has been unable to find a way out of the dead end into which the East Asian Model eventually leads. Japan was lucky. It started thirty five years before China when a robust US economy could suck in Japanese exports. China, at this point with a much lower standard of living than Japan, doesn’t have the luxury of wallowing in Japanese indecision and paralysis, especially with a much weakened US now an unreliable engine of global growth. The bull case for Chinese stocks – and indeed for Hong Kong, Taiwan, Singapore and Korea – assumes that China will make the tough decisions and move away from this Model. That is my view but the next few years could be bumpy as China, to use Deng’s famous expression, makes its way across the river and “feels the stones.”