Understanding the Euro crisis

[Brother Mark]

I really enjoy economics. Here's an article I recently read. It's actually a news letter that is free to anyone who wants to subscribe. {Yea, I am geeky like that sometimes. } John Mauldin wrote it. It's long but if you really want to understand debt and how it plays a role in our economy, it's a good read.

To Solve the Crisis You Must Solve Three Problems

There are three main problems in Europe. The first is that most of the banks are massively insolvent, because they have 30 times their capital invested in the second problem, which is the sovereign debt of countries that are going to have trouble paying that debt. If the banks have to mark down the debt to what its real value is – or to what it will soon be – they will be bankrupt on a scale that makes 2008 look like a waltz in the park.

Countries simply cannot function in a manner that can be called normal without viable banking systems, which is why the authorities spend so much time worrying about them. If banks can't make loans, then businesses must cut back, which means fewer jobs, products, and services, which quickly becomes an ugly spiral. Losses in the private sector mount up. This obliges the treasury secretary to get on one knee and beg some elected official who has no understanding of how business and economics work to save the world as he knows it.

But if countries must step in and save their banks, then they have to assume some of the losses. (I am assuming that this time shareholders get completely wiped out, as do most bondholders. Taxpayers – read voters –are actually paying attention this time. They are in no mood to bail out bankers.) But most of the countries in Europe with the worst banks simply do not have the money to invest. They already have too much debt. Where do they get the capital? (More on that later.)

For most of the past two years, European leaders have tried to deal with the problems as though they were short-term liquidity problems: "If we just find the money to buy some more Greek bonds, then Greece can figure out how to solve its problems and then pay us back. Given enough time, the problem can get solved.

"They have now arrived at the understanding that it this not a short-term problem. Rather, it's a solvency problem of the various governments, which of course creates a solvency problem for their banks. They are now addressing the problem of solvency and providing capital until such time as certain countries can get their budgets under control and the bond market sees fit to provide the capital they need.

But they are completely ignoring the third and largest problem, and that is massive trade imbalances. Germany exports products to the peripheral European countries, which run trade deficits. As I have shown in several letters, a country cannot reduce private-sector leverage, reduce public-sector leverage and deficits (balance its budget), and run a trade deficit all at the same time. That is simple, unavoidable math, based on 400 years of accounting understanding. Ultimately, there must be a trade surplus if leverage and debt are to be reduced.

Greece runs a trade deficit of about 10% of GDP. Until they can stop that bleeding, they cannot get their government and private budgets under control. It is not simply a matter of cutting budgets or raising taxes. Indeed, their economy will continue to shrink, making it more difficult buy foreign goods without increasing their own production of goods and services. It is a vicious spiral. And that same spiral will spin up to take in all of Europe. Again, more on that later, as we consider what their choices are.

But for now, let's start with my contention that if you do not solve all three problems you do not solve the real problem. Greece cannot "stand on its own" without a change in its cost of production relative to Northern Europe. Neither can Portugal, et al., unless Germany either changes how it exports and consumes more, or Germany is willing to fund Greek (and Portuguese and Italian and…) debt, so those countries can continue to run large deficits.

Let's resort to something I have done in the past, and that is to create a simple model to help us understand the issues involved. As always, when we make simple assumptions we are ignoring the real complexities. I know things are vastly more complicated than the following simple analogies, but the underlying truths are basically the same.

Getting Simple About Europe

Let's assume a country that has a gross domestic product (GDP) of $1,000. In the beginning it taxes its citizens about 25% of GDP and spends the money for the public's benefit. But alas, it spends about 30% of GDP, so it must borrow the overage (about $50) from its citizens or from the citizens of other countries. Because the country starts out with relatively little debt, interest rates on this loan are low, because those who buy the debt can easily see that the the country can pay them back. If the debt of the country is only 5% of GDP ($50) and the interest rate is 4%, then the amount that must be paid as interest is only about $2 per year. Not a whole lot, about 0.2% of GDP.

But this goes on year after year. Sometimes the deficits get smaller and sometimes they get larger, depending on the economy; but government expenditures grow at the same rate as the country grows, and the debt keeps growing at an average of 5% of GDP per year. Now, if the country is growing at 3% a year, after 24 years the economy will have doubled to $2,000 GDP. That means the debt has grown (roughly) to a total of $1,800, which is now a debt-to-GDP ratio of 90%. Debt has grown faster than the country's economy. Note that if the country had held its budget down to where it grew slower than GDP, thus reducing its need for debt, that ratio would be lower, even if the debt had grown. You can indeed grow your way out of a debt problem if the growth of government spending is less than the growth of the economy.

But what if the size of government grows to about 50% of GDP, rather than 25% or 30%, over the 24 years, as politicians decide to spend more money and voters decide they want more benefits? (Think France.) Then the private sector must pay about 50% of its production to the state – plus, the debt is now growing unwieldly. The private sector has less to invest in new businesses and tools, and the growth of the economy slows.

And then along comes a very nasty recession. The revenues of the government fall as the economy shrinks. If the economy shrinks by 3% and total taxes are 50%, then tax revenue falls to $970. But the government does not cut back; and indeed, because it must pay unemployment benefits and welfare (because unemployment rises in a recession), its expenses actually rise by 5%! So it now needs $1,050 to pay all its budgeted expenses. And it must now borrow $80 to pay everyone it has promised to pay, in addition to the $100 it was already borrowing every year to cover its deficit, or a total of $180 a year, which is 9% of GDP.

(Yes, I know that debt must change as a percentage over time and nothing is stagnant, but work with me here.)

Now debt-to-GDP is rising by about 5% a year. Not a large number in the grand scheme of things, and everyone knows that the recession will soon be over and the deficits will come down. Sovereign governments never default on their debts – our government leaders assure us of that. They can always raise taxes or cut spending, can't they?

And things rock along just fine, and the bond market continues to buy the debt, until one day you look up and the debt is 120% of GDP. Then the bond market gets nervous and says that instead of 4% it wants 7%. Now the interest payments are over 8% of GDP and 16% of government spending, which means the government must either cut back on services or salaries or benefits, or raise taxes, or borrow more money. But cutting spending and raising taxes have consequences. They reduce GDP growth over the following 4-5 quarters as the economy adjusts.

What if that interest rate cost rose to 10%? Then the interest cost to the government would become 20% of its expenses and be rising faster than the country could grow, even in the best of times. And if they continued to borrow at 7% and the country did not grow, those interest expenses would rise at least 7% a year – as long as interest rates didn't go up.

And what if the other countries who had been buying the government's debt looked at the basic math and realized that, another step or two down the current path of government spending, there was no way they would be able to get their money back?

How Much Risk Do You Want in a Government Bond?

Now, government bond investors are a curious breed. They invest in government bonds because they actually think there is not supposed to be any risk. They want their money to be safe. If they wanted risk, there are lots of opportunities to invest with the potential for more reward.

The moment that government bond investors begin to think they might be at risk, they leave. And history suggests they tend to leave seemingly all at once. It is the Bang! moment. Someone fires the starting gun, and they all head for the exits. They start selling their bonds to speculators at discounts, which makes the effective interest rates in the market rise, sometimes by a lot. That means that if a country wants to borrow more money, it will have to pay the effective price in the market, or maybe as much as 15-20% IF – a big IF – it can even get someone to buy the bonds, which of course makes it even more difficult to pay their debt as interest costs rise.

Now, let's add a twist. The other countries that have bought those bonds are not actually countries, but banks in other countries. And because the regulators of those banks knew it was impossible – inconceivable – that a sovereign country might default, they allowed their banks to buy 30 times as much sovereign debt as they had capital in their banks. They did not have to reserve against any losses, so these were "free" profits for the banks. You pay 2% on deposits or short term commercial paper and buy bonds paying at 4%. You make a 2% spread, which you then do 30 times. Now you are making 60% profits on your capital and deposits. It is a very nice business – as long as everyone pays the interest. And because it is such a good business, you just roll over the debt every time the bond comes due, because you want more easy profits.

Let's say that banks bought up to 10% of their total government sovereign-debt holdings in our problem country. If the country gets into trouble and says, we will only pay 50% of our debt (we will discuss why below), then that means the banks lose 5% of their total assets. But they only have about 3% capital, because they were allowed to leverage. That means they are functionally bankrupt.

Without a functioning banking system, other countries now have to step in and take the losses (and perhaps wipe out the shareholders and owners of their banks). That would be bad for the other countries, as that much spare cash is not just lying around in government coffers. They are ALL borrowing money already and have their own deficits to worry about.

So everyone gets together and they tell the bankrupt country (because that is what it really is), we will lend you more money to keep you alive, but you must agree to balance your budget. And since that is the only way the problem country can get more money, they initially say, "Sure. We can do that. Just give us some money now so we can get it figured out and get everything under control."

In the world of government, living within your means is called austerity. And it's an uphill slog. Let's say your deficit started out at 15% of GDP (somewhat like Greece's). If you agree to cut that deficit by 4% a year for four years running, if everything stays the same, you could be back in balance. But the other counties would have to agree to lend you the difference between what you budgeted to spend and what you took in as tax revenues. Just to keep things going. Otherwise you'd have to default on your debt. If the countries simply have to guarantee the loans and not actually spend the money, it is a lot easier than having to find real money to save their banks, so they agree.

But the cuts you have to make are not as easy as everyone hoped. It seems that employees don't like having their pay cut, and unions don't want pensions cut, and retirees certainly expect the government to fulfill its promises; and don't even get started on cutting healthcare, which is a God-given right.

So you raise taxes and cut spending by about 4% the first year. But a funny thing happens. That reduces the private economy by about 4%, so the base on which taxes are collected is reduced, which means less revenue is raised, which means that the deficit is much worse than projected. And then the following year you have to make another 4% in cuts, plus the last shortfall, just to make your plan and get to the agreed-upon deficit, in order to get more loan money. It becomes a very vicious circle.

And let's look at the endgame. That debt-to-GDP ratio will rise to at least 150%, while the economy is actually shrinking. If interest rates settle to a mere 7% (hardly likely), it means the people of the country are going to have to pay over 10% of their total production to foreign banks each and every year for decades, never mind paying down the principle.

Let's throw in one more twist. The country has been buying about 10% of GDP more from other countries than it sells to them. That is because the relative wages in the problem country are about 30% higher than in the "good" countries. The good countries get the money from what they sell and have a nice surplus. The problem country soon runs through its savings, trying to buy the goods and service it wants; and the private sector, as well as the government, must cut back.

What happens is that you are locking in what feels like a depression initially, and then you have a slow- or no-growth economy for many years, as so much of your work goes just to pay back that debt to the banks of other countries.

Understand, your government has freely obligated itself to pay that debt. But it means that its citizens in effect become debt slaves for a generation or two to foreign banks. Not a very popular platform for a politician to run on for re-election.

Long-time readers know I think the neo-Keynesians do not have a proper view of the world. They live in a theoretical world divorced from what really happens. But in this respect they are deadly right. Austerity on the scale needed by many countries will only reduce potential GDP. The Keynesian prescription is to therefore run deficits and borrow money until you get growth again; but when you have already exhausted your ability to borrow money, it just doesn't work.

More debt makes if far more difficult to grow your way out of the problem. If you are already drunk, you can't get sober by drinking more whiskey. If Greece cuts its deficit by 15% of GDP, the reality is that GDP over time will be reduced by about 20%, and the debt will grow, both in real terms and as a percentage of GDP. A 20% decline in GDP is by any standard a depression and makes it even harder to grow, as so much of what you do make has to go to basic expenses and not productive capital. And if you have the burden of massive debt it becomes damn near impossible.

That is why individuals can file for personal bankruptcy. We no longer force people into slavery or debtor's prison to pay their debts, at least in most places.

So our problem country goes to its lenders and says, "We think you should share our pain. We are only going to pay you back 50% of what we owe you, and you must let us pay a 4% interest rate and pay you over a longer period. We think we can do that. Oh, and give us some more money in the meantime. And if you refuse, we won't pay you anything and you will all have a banking crisis. Thanks for everything."

The difficult is that if our problem country A gets to cut its debt by 50%, what about problem countries B, C, and D? Do they get the same deal? Why would voters in one country expect any less, if you agree to such terms for the first country?

So now let's return to the real world of Europe. Greece cannot pay its debt without a major depression. So its wants to pay only 50%, but it doesn't even want to guarantee that in any meaningful way; so bondholders scream, "We get nothing in return for agreeing to take a 50% haircut?!" Which is today's headline.

Greece cannot print its own money, so unless it leaves the Eurozone, it's stuck. They can default on their debt, but that means they are shut out of the bond market for some period of time. That would force them to make the spending cuts they are now resisting, as they would simply not have enough money to pay their bills. Even with a 100% haircut they're looking at a shorter but very real depression. And because no one will sell them products they need, like energy and food and medicine, unless they can sell or trade something in return (that trade-deficit problem), they will be forced to change their lifestyles. Wages must drop or productivity rise to be competitive with northern Europe. And that differential is about 30%. I am not certain, as I have not been to Greece in a long time, but my bet is, you won't find many Greeks who think they are overpaid by 30%.

But that is what the market is going to say. And that is the third problem, which Europe is not addressing. Germany and the northern tier are simply more productive than the Southern periphery. (With the possible exception of Northern Italy, but Italy all gets lumped together, which is why many Northern Italians want to be their own country and not have to pay taxes that go to Southern Italy. I am not taking sides, just observing what we read in the papers.) Until Germany consumes more from the peripheral countries or the peripheral countries become more productive, the imbalance will not allow a positive solution.

Prior to the euro, the imbalances would be handled by currency exchange rates. The value of the drachma would go down relative to the value of the deutschmark. Things would balance over time. Now, all of the eurozone countries are effectively on a gold standard, with the euro standing in for gold this time. Britain, the US, and Japan print their own currencies. Their currencies can rise or fall over long periods of time, based on national accounts and the desires of foreigners to buy goods or invest in their countries.

Greece and the other peripheral countries face a difficult choice. Do we stay in the euro and pay as much as we can, and watch our economy drop; pay nothing and watch our economy drop (as we get shut out of the bond market); or leave the euro and go back to our own currency and watch our economy drop?

They have no choices that allow them to grow and prosper without first suffering (for perhaps a long time) some very real economic pain. As I have written in previous letters, leaving the eurozone has severe consequences; but the economic pain of leaving would go away sooner and allow for quicker adjustments, than if they stayed. However, the initial pain would be worse than the slow pain they'd suffer by staying in the euro. Their choice is, simply, which pain do they want – or maybe, which pain do they think they want? Because whatever they choose, they are not going to like it.

And just as I was finishing this section, this note came from Naked Capitalism:

"The three Troika inspectors—Poul Thomsen from the IMF, Mathias Morse from the EU, and Klaus Mazouch from the ECB—are supposed to head to Greece next week to inspect its books; the budget deficit is once again higher than the revised limit that Greece had vowed to abide by. And they're supposed to negotiate additional 'structural reforms.' But there probably won't be three inspectors, according to senior IMF sources. Missing: Poul Thomsen. The IMF has had enough.

"Already, according to more leaks, IMF Managing Director Christine Lagarde had warned German Chancellor Angela Merkel and French President Nicolas Sarkozy that the fiscal and economic situation in Greece had deteriorated. Hence, the 'voluntary' haircut on Greek bonds held by private sector investors should be increased to more than 50% to maintain the goal of bringing Greece's debt load down to 120% of GDP. And the second €130 billion bailout package, agreed upon on October 26, should be enlarged by 'tens of billions of euros.'

"The German reaction was immediate. 'There has to be a line somewhere,' said Michael Fuchs, deputy leader of Merkel's party, the CDU. 'This cannot be a bottomless barrel.' Even if Merkel were amenable to committing more taxpayer money to bail out Greece, she'd face a wall of opposition in her own party. And he wasn't brimming with optimism: 'I don't think that Greece, in its current condition, can be saved,' he said."

The article goes on with a description of the chaos in Greece. It is worse than I have described. Really. And so terribly sad.

Here's a link if you want to read the article online.

http://www.johnmauldin.com/frontline...-end-of-europe

[Brother Mark]

If you read the article close, you'll see what having a gold standard is a really bad idea. Also, it will point out some problems with Keynesian economics.

[Clavicula_Nox]

Yes, wouldn't a Gold Standard permanently restrict the size of an economy?

[Brother Mark]

Yes, wouldn't a Gold Standard permanently restrict the size of an economy?

It can, sort of unless you can find more and more gold. What really happens is it limits the governments ability to value the currency to the point you can get out of a recession. That's what's going in Europe right now. Greece can't allow it's currency to fluctuate because it is fixed to the Euro. So if the rest of Europe does well, then Greece gets squeezed because she can't keep up. Same thing can happen to a country on the gold standard. If gold goes up, and your currency is tied to it, then your currency goes up with it and if your economy is tanking, then you are in big, big trouble. It's part of what happened in the great depression.

One problem with Keynesian economic theory is it was developed when countries were still on the gold standard. Now that we have a floating currency and debt is financed by bonds, it's a different ball game. It's one reason many economist are saying that additional debt won't help as much as it once could. Once you cross the line in the sand concerning debt, it's a vicious cycle that can take a generation to get out of.

[Dravenhawk]

Spending more than a government takes in in revenue is the source of all grief. Wether you are on a gold standard or a floating currency tied to the bond markets the end result is the same. Our 50 states are arranged somewhat similar to Europe which are all tied to the dollar as opposed to the euro. Because the dollar is used as a world reserve currency many of the debt driven ills europe has can be somewhat cloaked by the fact that over the short term the Federal Reserve is able to buy up excess debt in the form of quantative easing measures. The resulting inflation shows up in food and energy prices which are convienantly omitted from PPI (producer price index) and CPI (consumer price index) data tables. If anyone has been to the grocer or the gas station you will have noticed an increase of 50% for food and 100% for gasoline over a three year period. Ronald Reagan had it figured out that by reducing both the tax rate and government spending the economic rot created by debt could be reversed by effectively moving government out of peoples way and putting more money in the pockets of the makers of society. The United States is rapidly closing in on that 100% of GDP to debt ratio as our elected officials spend like drunkards to buy votes with lavish promises that could not be funded even with all the money in the world. Debt has to be serviced with interest payments. The more debt an entity carries the greater the servicing cost. There is a funny little truth about paying out interest is that you get absolutly NOTHING for it... except more debt. Take our 16 trillion debt even at the tiny .5% rate paid out on a garden variety T-bill and that stacks up to a whopping chunk of the fiscal budget. God had the right idea of insuring that debt did not go snowball through Jubilee where on the seventh year all debt was forgiven and financial systems reset to a zero ballance on a seven year cycle. I wonder how how a modern economy would thrive if it took council in the Lord? - - - - Dravenhawk

[Faithful One]

.... If gold goes up, and your currency is tied to it, then your currency goes up with it and if your economy is tanking, then you are in big, big trouble. It's part of what happened in the great depression.

.

What do you mean "if Gold goes up"? ...If the dollar is tied to an ounce of gold, then how can "its price go up" ?
I guess you mean if gold "goes up in price IN OTHER COUNTRIES".

I think you may be taking only the negative side of the gold standard argument Mark. There are plenty of positive reasons of going back on the gold standard, for one, it really has a tendency to thwart the most dreaded economic disease of all.... INFLATION.
It stops the government from deflating your income (and savings) by artificially devaluing your money by printing massive amounts of dollars)!


"In the absence of the gold standard, there is no way to protect
savings from confiscation through inflation. ... This is the shabby
secret of the welfare statists' tirades against gold. Deficit spending
is simply a scheme for the confiscation of wealth. Gold stands in the
way of this insidious process. It stands as a protector of property
rights. If one grasps this, one has no difficulty in understanding the
statists' antagonism toward the gold standard." - Alan Greenspan.

Yea, Alan Greenspan....come back to the hill please!

I think when we are in a recession we only see the negative side of Gold standard, namely, "How are we gonna get out of a reccession?... Gold standard won't help"....and we forget about the real killer... inflation... since it SEEMS so distant. However, we need to realize that after implimenting such a foolish solution of printing zillions of dollars to reinflate the economy (which floating currency has made possible) inflation is inevitable.

Just my 2 cents (which by the way is only worth about 1 cent since pennies are now made of zinc).

Faithful

[Brother Mark]

What do you mean "if Gold goes up"? ...If the dollar is tied to an ounce of gold, then how can "its price go up" ?
I guess you mean if gold "goes up in price IN OTHER COUNTRIES".

Or based on commodities. For instance, if you price commodities in gold, as one would with a gold standard, then as gold went up, the cost of commodities would go down.

I think you may be taking only the negative side of the gold standard argument Mark. There are plenty of positive reasons of going back on the gold standard, for one, it really has a tendency to thwart the most dreaded economic disease of all.... INFLATION.

Inflation can be handled without a gold standard.

It stops the government from deflating your income (and savings) by artificially devaluing your money by printing massive amounts of dollars)!

It an also limit growth in many ways and wealth can be tied up easier in the hands of the few.

"In the absence of the gold standard, there is no way to protect
savings from confiscation through inflation. ... This is the shabby
secret of the welfare statists' tirades against gold. Deficit spending
is simply a scheme for the confiscation of wealth. Gold stands in the
way of this insidious process. It stands as a protector of property
rights. If one grasps this, one has no difficulty in understanding the
statists' antagonism toward the gold standard." - Alan Greenspan.

Yea, Alan Greenspan....come back to the hill please!

Inflation will be present in any debt as money society. It almost has to be. But there are benefits to a gold standard. IMO, the risk far outweigh the benefits. The great depression would have been MUCH shorter if the currency would have been allowed to float instead of being tied to gold.

I think when we are in a recession we only see the negative side of Gold standard, namely, "How are we gonna get out of a reccession?... Gold standard won't help"....and we forget about the real killer... inflation... since it SEEMS so distant. However, we need to realize that after implimenting such a foolish solution of printing zillions of dollars to reinflate the economy (which floating currency has made possible) inflation is inevitable.

What you say is partly true. Right now, inflation is not the true worry. It's deflation. Commodities are going up because of the increased demand for them in the BRIC (Brazil, Russia, India and China) countries. But housing is down. Savings are down. We lost approximately 14 trillion dollars in the money supply in 2008. The government has printed about $2 trillion. We are no where close to putting (or printing) as much money as people think we are when it comes to such things. It was the easy money that caused the "inflation" of housing that we now call a bubble. But it wasn't called inflation back then nor now.

Just my 2 cents (which by the way is only worth about 1 cent since pennies are now made of zinc).

Glad for the input. Makes for a good conversation.

[NHL Fever]

Boy you are really on with the economics lately Mark. I enjoyed this article. I think this man really knows what he's talking about. No government shenanigans can make the bottom-line real value of labor and goods change.

One question I am somewhat confused about that maybe someone could answer, or if the author has written about please direct me:
China pegs its currency to the USD. But, its currency can still fluctuate relative to other nations. One would assume that with the high demand, wage inflation would occur and standards of living would increase in China, and therefore they would buy goods from other parts of the world thereby normalizing the trade deficit. Why is this not happening?

The other questions is regarding the US. The standard of living also needs to go down in the US, to correct the deficit. The options are to raise taxes, reduce spending waste, or devalue the currency. All reduce purchasing power. I would favour a combination of printing money to devalue the currency and the debt, combined with standardizing tax rates regardless of source of income. This means capital gains should be taxed at the same rate as normal income tax. This would increase the tax burden of wealthy individuals, but should not affect jobs because the corporate tax rates would remain low. Why personal income from capital gains should be taxed less - is a truly a mystery without any conceivable economic benefit.

[Brother Mark]

Boy you are really on with the economics lately Mark. I enjoyed this article. I think this man really knows what he's talking about. No government shenanigans can make the bottom-line real value of labor and goods change.

One question I am somewhat confused about that maybe someone could answer, or if the author has written about please direct me:
China pegs its currency to the USD. But, its currency can still fluctuate relative to other nations. One would assume that with the high demand, wage inflation would occur and standards of living would increase in China, and therefore they would buy goods from other parts of the world thereby normalizing the trade deficit. Why is this not happening?

This would be true except for a few things... one is the US debt. China would be stuck with those dollars and have to buy US goods, or would have to invest in the US (which would show up in the monthly tic report). But because the US has such debt, they can instead buy US treasuries and peg their currency. If it wasn't for that, what you say would happen.

It's one reason I get upset with our politicians fussing about China and pitching a fit about "trade imbalance". IF the US would stop running a budget deficit, the trade deficit and TIC sheet would both improve. Now, it might have to go the long way around. For instance, because the US currency is a reserve currency, there are advantages and disadvantages to that. China might not fix her trade deficit with the US. She may use that money to buy oil from Saudi Arabia. The Saudis would then use that money to buy copper from Australia and so on. But sooner or later, that dollar has to come back to the US to be honored. It will either come back through a purchase of goods or through investment in the US (i.e. buying land, building factories, hiring, etc.) But when there's a huge budget deficit, there's a third way for that money to return and that way is in government bonds.

Because of those bonds, China can peg their currency and not worry so much about inflation compared to US from a trade perspective.

Now with that out of the way. Another thing is that China has so many poor people, that it has been able to grow for a long, long, long time. It's only when home demand gets really going, that inflation becomes a problem. If you start out with 100,000 people having an increase in a standard of living, that's a good start. But how long will it take you to grow to where all 1,000,000,000 are experiencing an increase in a standard of living? All China has to do when one of the original 100,000 demands higher pay is to go and hire one of the poor 999,900,000 other people. So inflation at home is not a problem.

They are however, experiencing inflation for commodities in the same way the US is experiencing it. They would anyway because of the dollar issue. But world wide demand is world wide demand. It impacts everyone regardless. There are some that believe China's economy will have problems this year. We'll see.

(On another note, Germany has drug this euro thing out because a cheap euro works well for an exporting country. But those chickens are about to come home to roost.)

Not sure that I fully answered your question. It was a good one. As for the economics thing, I read that stuff for pleasure. It's a hobby. If I was younger and just getting started, I would probably study economics. It's fascinating to me.

[NHL Fever]

This would be true except for a few things... one is the US debt. China would be stuck with those dollars and have to buy US goods, or would have to invest in the US (which would show up in the monthly tic report). But because the US has such debt, they can instead buy US treasuries and peg their currency. If it wasn't for that, what you say would happen.

It's one reason I get upset with our politicians fussing about China and pitching a fit about "trade imbalance". IF the US would stop running a budget deficit, the trade deficit and TIC sheet would both improve. Now, it might have to go the long way around. For instance, because the US currency is a reserve currency, there are advantages and disadvantages to that. China might not fix her trade deficit with the US. She may use that money to buy oil from Saudi Arabia. The Saudis would then use that money to buy copper from Australia and so on. But sooner or later, that dollar has to come back to the US to be honored. It will either come back through a purchase of goods or through investment in the US (i.e. buying land, building factories, hiring, etc.) But when there's a huge budget deficit, there's a third way for that money to return and that way is in government bonds.

Because of those bonds, China can peg their currency and not worry so much about inflation compared to US from a trade perspective.

Now with that out of the way. Another thing is that China has so many poor people, that it has been able to grow for a long, long, long time. It's only when home demand gets really going, that inflation becomes a problem. If you start out with 100,000 people having an increase in a standard of living, that's a good start. But how long will it take you to grow to where all 1,000,000,000 are experiencing an increase in a standard of living? All China has to do when one of the original 100,000 demands higher pay is to go and hire one of the poor 999,900,000 other people. So inflation at home is not a problem.

They are however, experiencing inflation for commodities in the same way the US is experiencing it. They would anyway because of the dollar issue. But world wide demand is world wide demand. It impacts everyone regardless. There are some that believe China's economy will have problems this year. We'll see.

(On another note, Germany has drug this euro thing out because a cheap euro works well for an exporting country. But those chickens are about to come home to roost.)

Not sure that I fully answered your question. It was a good one. As for the economics thing, I read that stuff for pleasure. It's a hobby. If I was younger and just getting started, I would probably study economics. It's fascinating to me.

Ok all clear except for the bonds part. Can you elaborate on why buying bonds has anything to do with pegging the currency, and how this prevents inflation in China?

[Brother Mark]

Ok all clear except for the bonds part. Can you elaborate on why buying bonds has anything to do with pegging the currency, and how this prevents inflation in China?

Well, buying bonds is what allows China to peg it's currency to the US. Without that, China would be forced to do something else with the dollars. She either has to buy US goods, invest in the US, or buy US bonds. US bonds are only sold to finance US debt.

Since China trades with the US, by pegging the yuan to the dollar, there will not be any inflation between those two nations. IOW, China only experiences inflation in the same way the US does. Because it's currency doesn't float with against the dollar. It floats with it. It mimics the dollar. Since China and the US do trade, any US products that go over there will not be inflated. The price doesn't change unless the cost of manufacturing the good in the US changes.

China does experience inflation in natural resources or commodities. That's why she is being so wise about buying them up. Watch how she is cutting deals everywhere with nations rich in resources. When commodity prices tumbled in 08, China was quick to make a deal with Australia for metals and minerals. She bought low. These kinds of deals also keep inflation from happening to her for a while.

She will inflate. But pegging to the dollar allows her to inflate in the same way the US does. Once her economy is big enough, she won't be able to piggy back anymore. Right now, she will inflate like the US does because she is tied to the dollar (enabled because of US debt) and she has many more people still in poverty that can be hired.

Look at it this way, the world trades with the US. The US economy is HUGE. Compared to the rest of the world, there is simply no comparison. (I know that sounds weird, but it's true.) For instance, California alone is something like the worlds 7th largest economy and that is just one state. So China still has a smaller economy. She influences prices world wide less than the US does. She pegs her currency to the dollar and therefore, everything she buys is priced in dollars. If things don't go up in dollars, then they don't go up for China.

But the dollar has been going down for years. So China really is experiencing inflation. Just not run away inflation. To repeat, it's like piggy backing on a larger economy. It's the large economy that really influences the prices. When China gets big enough, rich enough, she'll be forced to change because then SHE will be causing the prices to change more so than the US.

It's like a big rock in the pond causing waves. No one notices a pebble has been thrown in the water too.

[NHL Fever]

Well, buying bonds is what allows China to peg it's currency to the US. Without that, China would be forced to do something else with the dollars. She either has to buy US goods, invest in the US, or buy US bonds. US bonds are only sold to finance US debt.

Since China trades with the US, by pegging the yuan to the dollar, there will not be any inflation between those two nations. IOW, China only experiences inflation in the same way the US does. Because it's currency doesn't float with against the dollar. It floats with it. It mimics the dollar. Since China and the US do trade, any US products that go over there will not be inflated. The price doesn't change unless the cost of manufacturing the good in the US changes.

China does experience inflation in natural resources or commodities. That's why she is being so wise about buying them up. Watch how she is cutting deals everywhere with nations rich in resources. When commodity prices tumbled in 08, China was quick to make a deal with Australia for metals and minerals. She bought low. These kinds of deals also keep inflation from happening to her for a while.

She will inflate. But pegging to the dollar allows her to inflate in the same way the US does. Once her economy is big enough, she won't be able to piggy back anymore. Right now, she will inflate like the US does because she is tied to the dollar (enabled because of US debt) and she has many more people still in poverty that can be hired.

Look at it this way, the world trades with the US. The US economy is HUGE. Compared to the rest of the world, there is simply no comparison. (I know that sounds weird, but it's true.) For instance, California alone is something like the worlds 7th largest economy and that is just one state. So China still has a smaller economy. She influences prices world wide less than the US does. She pegs her currency to the dollar and therefore, everything she buys is priced in dollars. If things don't go up in dollars, then they don't go up for China.

But the dollar has been going down for years. So China really is experiencing inflation. Just not run away inflation. To repeat, it's like piggy backing on a larger economy. It's the large economy that really influences the prices. When China gets big enough, rich enough, she'll be forced to change because then SHE will be causing the prices to change more so than the US.

It's like a big rock in the pond causing waves. No one notices a pebble has been thrown in the water too.

Ok I understand that China buys US debt in the form of bonds. And I understand that China pegs its currency to the USD, and therefore maintains its trade advantage. But I still don't understand how those two things are related.

Are you saying that China buys bonds in order to increase the demand for US currency, and therefore prevent USD from devaluing thus maintaining the exchange rate with the Yuan?

[Brother Mark]

Ok I understand that China buys US debt in the form of bonds. And I understand that China pegs its currency to the USD, and therefore maintains its trade advantage. But I still don't understand how those two things are related.

Are you saying that China buys bonds in order to increase the demand for US currency, and therefore prevent USD from devaluing thus maintaining the exchange rate with the Yuan?

No. I am saying that if China pegs it's currency to the US dollar (which it can ONLY do through bonds) that it will experience inflation at the same rate the US does. It is not at full employment so there is not internal pressure for inflation. Therefore, the only pressure is external. That comes in two ways... price of currency or price of commodities.

For all practical purposes, goods in China are pegged to the US dollar because the yuan (or rembini) is pegged to the US dollar. So when a person in China buys a gallon of gas, they pay for it at about the same rate that US citizen does excluding local and national taxes. Same for a doll or a computer, etc. The only way for inflation to kick in is if the US experiences inflation because they are effectively using the same currency and the US is the big fish in the water. Now, if China was fully employed, that would not matter because more demand and same supply would mean higher prices even if the currency was pegged. The black market would see to that.

For instance, on a smaller scale. If country A has 1000 dollars. And country B has 100 yuan. And country B says "I will keep my yuan as weak as the dollar" they can do so if there is a trade imbalance between the countries and debt for the larger country and the trade imbalance and debt are big enough to allow it. Now, if China spends 1 yuan and the US spends 100, which country impacts prices more? The big country does. So prices don't change in the little country if they don't change in the big country because the currencies are pegged to one another. This is changing and it's a poor model. But it helps understand what is happening. Oil is much higher now because of China and India so already we see the model isn't perfect but at least you get the idea.


China doesn't experience inflation for the same reason Texas does not or California does not excepting for local demand. They all use the same currency. So inflation of commodities impacts all the same. It's similar to what is going on in Europe. Just as Greece is being forced out, eventually, China will be too, or the US will be forced to deal with. It won't go on forever.

[NHL Fever]

Why is it that China can only peg its currency to the USD by buying bonds? What is it about bonds that make them the mechanism for pegging the currency?

[Brother Mark]

Why is it that China can only peg its currency to the USD by buying bonds? What is it about bonds that make them the mechanism for pegging the currency?

It's about money flow. China is not the only one that can do it. They are just the only one that choose to.

Only England will guarantee and honor the pound. If you have a pound, it is only as good as England says it is. So if you are going to spend it, or keep it, or trade it, you must depend on England to honor it. Same with the US.

So when companies trade, the currency must eventually find it's way back to the country that honors it because no other country will honor that currency. (The rules are slightly different for a reserve currency but the model is still mostly the same.) When a US consumer buys a Chinese product, China must convert that dollar to a yuan. To do so, they have to go out on the market to make the conversion. When they do, that impacts the price of the yuan and the dollar. They are selling the dollar and buying a yuan so ordinarily, that would make the price of the dollar go down. In this way when people buy products from another country, they are indirectly causing the price of the other countries currency to go up and their currency to go down. Imagine if the US citizen only bought Chinese goods to the tune of $10,000,000 a year and China never bought any US goods. Well, then China would have to take that money on the market and buy $10,000,000 worth of Yuan from someone they traded with every year. That would do two things. It would cause the dollar to go down as there are now $10,000,000 dollars for sell, and it would cause the yuan to go up because that is what is being bought.

Well, China doesn't want to do that. Another option is to turn right around and buy $10,000,000 worth of US goods a year. China doesn't want to do that either.

So what are they going to do with that $10,000,000 a year (in dollars) they have? Well, they could just sit on it but that's like putting cash in a pillow. Another option would be to build factories in the US with it, or to buy US office space, or land, or something it the US. This often shows up in what is called the TIC sheet. Japan and Germany both have done this.

Now, if you don't do any of those, what's the next thing you can do? Well, you buy US treasury bonds. When you do, you cause the dollar to go up and your currency to go down. So as long as a country deficit spends, it will have a trade imbalance and it's currency will slowly go down. If you peg yours to it, you will need to put your currency back on the market (i.e. sell your currency) and take some of those dollars off the market (i.e. buy some dollars). You can do that by buying treasury bonds. Buying bonds means selling Yuans and buying dollars thus, you make the yuan fall in price and the dollar rise.

If you have enough resources, you can do this for a long, long time. If the other country stops deficit spending, then you are forced to either buy their goods with those dollars thus fixing the trade deficit, buy offices, land, build factories, etc. or just put the money in a sack. You could also try to loan it back to private business through banking in the US and then it would go to building factories, buying offices, etc. which would make the economy grow.

In the end, the only way the US can have a negative trade balance over a long period of time is if we deficit spend. Stop deficit spending and the trade balance HAS to go away or investment in the US HAS to go up. Either that, or dollars just go into mattresses and that will cause dollars to rise making your goods cheaper. But then you have nothing to show for selling your goods. So it's worthless to you that way.