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Inflation, Deflation, and China

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James Bibbings of Commodity News Center on why your dollars are safe.

Earlier I suggested that the Fed’s decision to drastically increase the money supply would debase the dollar, and ultimately render it worthless. When considered along with our debt to China,  the monetary “magic” the Fed has just engaged makes fears of inflation, even of a prolonged inflationary cycle, rather justified. And yet the people who forge our financial policy, the businessmen of Citigroup, AIG, Goldman, et al. will not even entertain the notion of such an event. The link above outlines the major arguments they use to convince themselves of the impossibility that the dollar should significantly inflate. They are compelling, no doubt, but ultimately fallacious. Though they make liberal use of popular economic misconceptions  (then again, so do most squealers of hyperinflation), their arguments do not stand to reasonable scrutiny.

The first and most powerful argument put forth by the anti-inflationists (most powerful because for the moment it happens to be true), is that we are nowhere near an inflationary cycle – in fact, prices are in a free-fall: what we are experiencing right now is deflation, on a large scale. In one sense such claims are undoubtedly correct – the whole reason for this crisis was the rapid, irrevocable deflation of securitized assets. Bundles of loans including sub-prime and prime mortgages, credit cards, student loans, car loans, etc. which in June 2008 were worth, say, $100,000, found themselves trading for pennies by November. Thus our banks saw their entire profits for the last decade totally cleared from their books. They panicked, and held a gun to our tax-paying heads, threatening economic devastation if they did not get the cash infusions needed to become profitable once again. Since securitized assets were our banks’ prized possessions, their losses compelled the financial sector to hoard whatever cash they had left on hand. Thus the mantra repeated by the Treasury Department that the economy’s major problem is that “our banks won’t lend”. Lower credit implies lower industrial output, so commodities began to deflate in price as well. By this argument, whatever currency the Obama Administration happened to print is insignificant compared to the wealth that had just been “destroyed”, and inflation should present no worry whatsoever. The numbers analysts generally float are $ 4 Trillion in “destroyed wealth” vs. $2 Trillion in printed money. The created funds don’t cover the destroyed funds, so we shall deflate if we don’t create more.

Of course that line of reasoning employs several fallacies, the most glaring of which I highlighted in quotation marks. Wall Street’s greatest sorrow over the last year has been what they termed “destruction of wealth”. They refer, in that buzzword euphemism, to the fact that AAA-rated pieces of paper once worth millions are now so worthless that only a child would want one (so that he may draw on the back). Banks that once thought themselves to be doing so well that they handed out million-dollar bonuses to the mail clerk, abruptly learned of their financial ruin one sad day in September. Their wealth had been “destroyed”, so to speak, by the vagaries of the market.

But did such “wealth” really exist in the first place? It is not a trivial question. A country who has had its factories bombed can rightfully declare that its wealth was “destroyed”. Once there was a factory churning out products, now it is a smoky ruin. But if a few friends and I decide at one point to treat Monopoly dollars as real cash for inter-group transactions, slave for it, fight for it, think ourselves rich for it, and then suddenly realize it’s only Monopoly money and worthless after all, was our perceived wealth “destroyed”? Wouldn’t it be more accurate to say that it never existed in the first place? This analysis is more plausible than it would first appear – since our departure from the gold standard, our fiat currency has essentially been Monopoly money agreed upon by all. Of course, the US purchased such unanimous agreement by military means.

The question becomes less academic and more concrete when considered in context of our Treasury’s commitment to the financial sector. It would be useful to summarize briefly what the Treasury Dept. and the Fed have done over the past year. The stated goal of their actions, in numerous speeches from President Obama, Treasury Sec. Geithner and Fed Chair Bernake, was to infuse enough Federal Dollars into the financial industry to make up for the losses they incurred via asset deflation and to “get our banks lending again”. To that end, the Federal Reserve has exerted all its twofold powers (controlling the interest rate and injecting cash into the economy) in an effort to make our banks appear profitable, when in fact they had just spent their money on imaginary assets. That was the ultimate goal of every bailout we have seen so far. Their worries assuaged, their books balanced, the financial sector should once again issue credit (“the lifeblood of our economy”, as President Obama said), greasing  the wheels of commerce and setting the economy right in its ever-upward spiral.

So in short: The US Treasury is printing trillions dollars to distribute amongst the financial sector in order to make investments which they once thought valuable – but in reality turned out to be worthless – worth trillions once more. When a petty criminal turns worthless paper into dollars, most people call it counterfeiting, but a venerable establishment such as the United States Government deserves a more benign phrase – fine, call it a “bailout”. Spending of this sort is inflationary by its very nature: we are re-creating “destroyed wealth” that never existed in the first place. I have heard counter-arguments posit that securitized assets are surely worth something, even if the value is not so high as it reached at the height of the bubble. But such claims are beside the point. Our government is not trying to restore those assets to some reasoned “real” value – they are trying to restore them to the value they attained just before the crash: several orders of magnitude higher than the “real” value would be.

Then why no inflation already? The money has been printed, yet asset and commodities still deflate in dollar-terms. Here is where the second major fallacy of the anti-inflationists comes in. They either refuse to believe in or decline to mention the iron grip China has over our economic livelihood. China owns us, in every sense of the phrase. The dollar still trades at nominal value, still holds its place as the currency of global commerce solely by the good graces of its eastern benefactor. As the single largest holder of US Treasury assets, the world looks to China in order to gauge the US economy’s health. The moment they decide to divest from the US, it is reasonable to assume many other nations will also. That is when this round of Treasury printing will make its effects known. Our inflation rate is kept low and our dollar remains valuable only for China’s willingness and ability to absorb our debt. Once this is no longer true, we may as well start papering our walls with Benjamin Franklin’s handsome likeness.

The big question is “when”, and while I admit I have heard many self-proclaimed economists predict dollar hyperinflation within a year or two, I have not heard any reasonable explanation for why it should occur then, and not in ten years. The truth is that the timing depends entirely on China, whose motives are inscrutable. China owns $2 Trillion in US debt now and continues to buy it. I think the only true statement one can make about when China will decide to sink the US economy is that they will do so when the perceived benefit of such an action (priced in dollars) outweighs the value of their US assets.

International politics and global finance are largely a resource game. If China were of the opinion, for instance, that scuttling the US would gain them influence in resource-rich countries, and the value of said resources would be greater than $2 Trillion, then out those Treasury assets would go! One can think of a dozen similar scenarios. Though such a day may be hard to predict exactly, I don’t think there should be any doubt that one year hence or ten, it is coming.

One parting thought: Why is it that China agreed to finance our adventures in Iraq and Afghanistan? Did they somehow also think it would be a good idea? Or was it only a good idea for them?


Written by pavanvan

August 1, 2009 at 1:06 am

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