Monday, June 21, 2004

will the fed save the debtors or creditors?

The Federal Reserve is ultimately a banks bank. They are really out there for the interest of banks in general - money center banks in particular.

On one hand the Federal Reserve has created a massive wave of debt financed economic expansion via the lowering of the entire spectrum of government debt (just look at the M2). Debt in the US is now 300% of GDP. Added on to this is the fact that we have been (since 1986 or so I believe) a net debtor to the world (the rest of the world has more money lent to us than we have lent to the rest of the world). Interestingly enough - a full 10 trillion of the 30 trillion debt that the US has is in financial sector debt - essentially money borrowed on the assumption that they can get a better return than what the debt cost, a risky proposition in my book.

Supposedly the first step when stuck in a hole is to stop digging. Instead the Federal Reserve has decided over the past 3 years or so (especially) to dig even more furiously. So has the Federal Government. We now have a fiscal deficit in the area of 500 billion dollars per annum - when accounted for properly (Social Security and Medicare surpluses are counted as obligations, not taxes) then it blows up to an astounding 700 billion bucks.

For now this is being financed by China, Japan, South Korea and Taiwan. A nice system - we buy products made in those countries with money that they lend us - except when it stops working.

Why would that happen? Well - I can think of two simple reasons - our debt becomes so obviously a terrible risk that they cant buy it any longer would be the first.

This is how that could play out -

The aforementioned countries continue to buy our debt. Our deficits expand exponentially as the interest on the debt mounts and our current account deficit (5% of GDP btw) causes our hole to be dug even deeper.

Then China or Japan (the two largest buyers) starts to get cold feet. They wonder what happens if the other stops lending money to the US - how would the US ever pay back the debt that they hold in their banks? (Essentially, who would then lend the US money so that the US can pay them back)

This causes them to stop buying so much US debt. The other country sees this and curbs their appetite for US debt. The US is put in a bind as the dollar is devalued - at this point both partys are trying to get out US debt at the same time before the other party can kill the value of their fund. It would be like two massive VLCC oil tankers trying to move through a very narrow passage. The result would be calamity in the US as interest rates rise, the dollar devalues or inflation spikes (or some combination of it).

Much like the Cold War it seems - one side moves an inch, the other side moves a bit more, and before anyone can stop and think everyone is running towards each other at breakneck speed. It would be in neither nations interest for this to happen, Japan and China still have major export interests to the US - but that doesnt matter - once it starts the other party would not want to be left holding the bag.

Another scenario is less catastrophic - but more likely;


Since the Bank of Japan and China are printing Yens and Yuan's to finance the buying of US debt this printing may eventually cause inflation in their nations. In Japan this may not seem so terrible since they are going through crippling deflation, but in China this is already happening.

So the inflation causes them to raise interest rates - which would decrease their ability to fund current account surpluses (since more money would be kept at "home") either forcing the US to raise interest rates (which would cripple demand, and maybe pop the housing/equity/debt, bubble) or forcing the Fed to actually print a lot of money, causing inflation and a devaluation of the dollar.

Which may lead to the first described situation.


What's this Got to Do With the Fed?


Well the debate now is whether the Fed would be ultra vigilant on inflation, or would allow it to get up a bit before trying to prevent further damage.

I for one would bet that the Fed knows exactly who is financing our debt - namely foreign centeral banks - and would see them as "Not American Banks" and not really care about them. This is if we accept the proposition that inflation is a sort of "tax" on creditors and a great help to debtors.

Ask the simple questions - who is the debtor in this situation? Americans and American financial institutions. Who is the creditor? NOT Americans.

If the Fed is really going to act in the best interest of Americans (in the short run interest it should be noted) then it would inflate away, allowing China and Japan to take the hit in their debt portfolios. In the mean time American's debt service ratios will be lowered as their 5% mortgages suddenly seem trivial when they are getting 5% annual cost of living adjustments at their jobs. The centeral banks of Japan and China will lose - American debtors will win.

So now what? Uh...I'm not really sure...how could I profit off of it? I would go with what PIMCO is doing. Get out of "dodge" as in the US. Go to Europe. Or buy stocks that are inflation sensitive (I have yet to find such stocks that are consitently better in higher inflation environments). Or if you still trust the US government go with Treasury Inflation Indexed Securities.

I'll post it if I can think of something (aside from the most obvious, and therefore probably not correct, gold and oil, those are too mainstream now).

Anyhow...Good luck.
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