Pacific Symbiosis

The "Sino Bubble" is beginning to blossom, your Paris editor has warned you. "Not surprisingly, then," writes the Fleet Street Letter’s Brian Durrant, "the focus of U.S. financial diplomacy has shifted from the Atlantic to the Pacific…"

In the era after the Second World War, the U.S.’s most important overseas relationship was with Europe. Marshall Aid helped rebuild the west of the continent and Western Europe was of vital strategic importance during the Cold War. During the period up to the 1960s, U.S. trade deficits provided the capitalist world with welcome liquidity. However, America then embarked on an increasingly costly war in Asia (Vietnam) and the twin trade and budget deficits ballooned.

Sound familiar? But back then America’s trade imbalance was principally with Europe, with the continent holding 40% of global foreign exchange reserves. One country in particular began to resent the US ability to finance its ambitions by printing dollars. You’ve guessed it – France.

The French threatened Washington by selling dollars for gold, which at the time was pegged at $35/oz. Private selling followed. For three years, the U.S. used financial diplomacy to contain European selling pressure on the dollar. But the U.S. was not willing to accept external constraints on its economic or military actions…so ultimately, the dollar-based fixed exchange rate system broke down in 1971.

Over 30 years on, Europe means much less to the U.S.. The Cold War is over and Europe’s economic star is in decline. A look at growth prospects for this year rams home the point. According to the latest IMF forecasts, the US is expected to grow by 2.4% this year, Japan by 2.0%, Britain by 1.7% and the eurozone by a measly 0.5%. The reasons for Europe’s malaise are well documented: malfunctioning labor markets, red tape, mismanagement of the single currency project, all combined with the strong euro. Meanwhile, the poor performance of Euroland has a bigger impact on the U.K. than any other major economy.

Financial Diplomacy: Bright News from Asia

But the really bright news is coming from Asia. East Asia was poised to embark on a full-scale consumer boom at the beginning of this year, only for confidence to be hit by SARS and Iraq. Now, Asian economies are making up for lost time. China is expected to grow by 7.5% this year.

Not surprisingly, then, the focus of U.S. financial diplomacy has shifted from the Atlantic to the Pacific. The countries of East Asia now account for 70% of global foreign exchange reserves. The relationship between the U.S. and East Asia is symbiotic. Spending considerably more than it produces, the U.S. has watched its trade deficit yawn frighteningly wider in past years. The counterbalance is that East Asian economies produce more than they consume, giving rise to a huge trade surplus.

But these imbalances do not matter if these economies remain, of their own free will, happy to finance America’s overspend. As it happens, they are more than happy to do so, as buying vast quantities of dollars holds down their currencies, maintaining the competitiveness of their export industries. Japan, China and other Asian governments buy roughly $1bn of U.S. securities every single day. Most of this money ends up in either in U.S. Treasury bonds (helping to fund Bush’s budget deficit) or into mortgage bonds (helping to keep U.S. mortgage rates low).

Financial Diplomacy: An Unlikely Diplomatic Lever

The governments and central banks of Japan, China, Hong Kong, Singapore and South Korea own about $700bn of U.S. Treasury securities and provide about the same in mortgage financing for American homeowners. Moreover, the supply of cheap goods will keep Middle American Wal-Mart customers happy. At the same time, China does not want to give up 35% export growth when its banking system is riddled with problem loans and when state-owned companies would have to shed even more jobs if its currency (the renminbi yuan) was revalued. The high level of economic integration between East Asia and the U.S. suggests that it is very unlikely that China will ever use its foreign exchange reserves as a diplomatic lever against Washington…in the near term.

But keeping the renminbi artificially low against the dollar does produce unwelcome side effects. There is a historical precedent. In the late 1980s, Japan fuelled its booming economy by keeping the yen low against the dollar. This led to a huge bubble in asset prices, principally equities and property, but also golf club memberships.

Right now, China’s support for the dollar is producing monetary growth of 20% and a runaway investment boom. It will no doubt provide the basis for a very persuasive story that will capture the imagination of investors. But as always, you should be on your guard…what goes up, must come down.


Brian Durrant
for the Daily Reckoning

September 16, 2003

Brian Durrant is a Cambridge economics graduate with nearly 20 years experience in and around the London Stock Exchange. He’s worked as a stockbroker, a financial journalist and headed the research department of London’s leading futures and options broker. He is also the lead writer for the UK version of The Fleet Street Letter.

Not yet. Not now.

No, dear reader, the end of the world has been postponed.

How do we know? We read it in the paper!

First, we left you on the edge of your seats yesterday. Would guru Carole Caplin tell all she knows about the Blairs…thus destroying America’s only major ally in the Iraq war? Would she bring a sordid and ‘cataclysmic’ end to Britain’s charmed couple with details on their personal lives not even they were aware of?

‘No!’ says she on the front page of today’s Times of London. Speaking by way of her lawyers, the former topless model said she would not betray their secrets. At least not today…and not for a million pounds. A million two? We’ll see…

As for the English economy…"House prices are rising strongly," says the Times, after a weak period in the spring.

And in America, "hopes of a full-blown upturn are in the air," says Stephen Roach.

But hopes do not an upturn bring. For that it would take consumer buying or corporate investment. Not that either is impossible, but where would they come from?

Normally, an upturn happens when savings are released. Consumers, who have held back during the downturn, begin to spend. Their washing machines and automobiles have worn out. They are ready for something new…and they have the money to buy them. Businesses sense the rise in spending and rush to provide new and better products. They invest savings in new plant and equipment. And they hire new workers to man the assembly lines during the extended hours.

And thus begins the up part of the business cycle.

Today’s "upturn," by contrast, is an imposter; like a cross- dresser, it has all the attributes of a pretty woman – except the essential ones. There are no savings and no pent-up demand.

Instead, the U.S. economy depends upon the kindness of strangers, mostly those in Asia, just to keep going. Foreigners now own nearly half of all Treasury bonds. It is they who fund the mortgage market in the U.S.. And they who pay for the Iraq war. And they who allow Americans to continue spending.

They produce; Americans consume. They lend; Americans borrow. They accumulate credits; Americans build debits.

And we wonder…how long can this go on?

A USA Today article elaborates:

"Credit-card debt for middle-income families is soaring – up 75% to $5,031 between 1989 and 2001, according to a new report by Demos, a non-partisan public policy organization. ‘Middle-class families are using credit cards to fill in a gap between their income and costs,’ says Tamara Draut, director of the economic opportunity program at Demos. ‘It’s more about maintaining their standard of living than frivolous consumption…’

"Average card debt declined somewhat in 2001, according to Federal Reserve data. But some experts don’t see much cause for optimism. Many families traded high-interest card debt for lower-rate home equity loans. That lowers debt payments but puts homes at risk. The percentage of homeowners facing foreclosure in the second quarter was 1.12%, down only slightly from the record 1.2% in the first three months of the year, according to the Mortgage Bankers Association of America…

"American consumers shoulder more debt; bankruptcy filings have exploded. Nearly 90% of families with children who file for bankruptcy cite three reasons: job loss, divorce or medical problems, according to the Consumer Bankruptcy Project at Harvard University, the largest study of consumer bankruptcy in America. About one-third of the families owed an entire year’s salary on their credit cards."

"Not forever" is the answer to the question: "How long can this go on?"

"The worse it gets" is the predicate to "the longer it goes on."

"We don’t know" is our reply to "When does the end finally come?"

"Right now," is when we turn this discussion over to our man in New York, Eric Fry:


Mr. Fry, getting down with his bad self, in the Big Apple…

– The Dow slumped 23 points yesterday to 9,449, while the Nasdaq dipped half a percent to 1,846. Bonds barely budged, the dollar gained slightly and the gold price dropped slightly. All in all, American capitalism accomplished almost nothing yesterday.

– This morning, Alan Greenspan and the rest of the Federal Open Market Committee hope to accomplish something more than nothing, just by tweaking one itty-bitty interest rate…or not. The FOMC is convening at this very moment to discuss the state of the U.S. economy and whether to adjust short-term interest rates. As it stands, the Fed funds rate sits at a 45-year low of 1%, so there isn’t much of an interest rate left to adjust.

– And besides, the Fed’s last rate cut on June 13th has done far more harm than good to the bond market. Long-term interest rates have been soaring ever since, in the process killing the mortgage-refi boom that had been single-handedly sustaining the economy.

– But the corporate sector is struggling heroically to pick up the slack. Here in the capital of capitalism, a little color is returning to the local economy’s cheeks. The Empire State index of economic conditions swelled to 18.4 in September from 10.0 in August. We don’t know exactly what these numbers mean, but a jump from 10.0 to 18.4 has to be a good thing, doesn’t it?

– On the other hand, Goldman Sachs’ latest information technology spending survey – taken in mid-to-late August – indicates that tech spending is recovering slowly, if at all. "Goldman surmised that technology capital spending would probably close out the year ‘at or slightly below’ zero percent growth," CBS Marketwatch notes. "Projections for 2004 currently stand at 3.9 percent growth. Goldman added that the timing of a spending recovery is being ‘pushed out’ beyond the near-term horizon."

– Ironically, the tech-stock buying recovery has arrived already. The buyers of richly priced tech stocks don’t seem to care that the technology spending recovery lies far beyond the visible horizon. That’s because investors can plainly see, right here in the immediate foreground, that tech stocks rise almost every day…What else does an investor need to know?

– For nearly a year, tech stocks have been rallying, even while most hi-tech industries have been languishing. The Nasdaq Composite has jumped a dazzling 65% from its lows of 2002. Perhaps the Fed’s single-minded ambition to rekindle inflation is having an effect…on share prices.

– The Fed’s pro-inflation campaign is also exerting a favorable influence over the gold price. A little bit of inflation – like a little wildfire – is a difficult thing to contain. And the gold market seems to have caught a whiff of inflationary smoke.

– "Gold is not an ‘investment’ per se," your New York editor opined last week, "It is insurance." James Grant agrees. The editor of Grant’s Interest Rate Observer not only considers gold to be a terrific insurance against monetary calamity, but darn cheap insurance at that. "If gold isn’t a bargain, what is it? It is a hedge," Grant explains. "However, in my opinion, it is a hedge bargain. The value of a hedge should vary according to the cost and evidence of the risks being hedged against. In the case of gold, the risks are monetary. They are potentially very costly, and they are more than imminent. They are upon us in the shape of burgeoning deficits and a radically reflationary policy stance. Owning gold, you are insuring not against what may be but against what already is…"

– In other words, says Grant, the dollar’s value is already slipping away, and yet, gold at $375 an ounce remains a relatively inexpensive insurance policy against continuing, perhaps calamitous, dollar depreciation. "The price of fire insurance would be out of reach if the homeowner started shopping for it after his house was billowing smoke. Yet, in my opinion, the price of monetary insurance is still reasonable in view of the risks posed to the purchasing power of the dollar by the dollar’s own stewards…

– "I have been bullish at long, unprofitable intervals during the gold bear market that began before the birth of Britney Spears," Grant concludes. "[But] I wake up every morning in the belief that the international monetary system is one day closer to breakdown. I am certain that posterity will look back at this episode in monetary history with a mixture of mirth and amazement…"

– Keep the insurance policy in force, Grant advises. Buy gold.


Bill Bonner, bringing it back to London:

*** The Swedes voted "No" to the euro, practically stepping over the cold body of the euro’s most prominent supporter. Did the euro collapse on Sunday’s news? No, it soared to a multi-week high of $1.132! Though it fell slightly yesterday, it is still trading at $1.1270. Sell the dollar, buy the euro and gold.

*** "What would happen if U.S. government debt were ever downgraded?" The question was put to Jim Bianco, of Bianco Research at a luncheon hosted by Arbor Research here in London last Friday.

"It will never happen…" came the reply. "That would mean the end of the modern financial system."

"Jim then," Addison Wiggin reports, "reminded Dan [Denning] and me that Fannie Mae has issued more debt in the last two years than the U.S. government…and that because of its ‘social charter,’ five of its twelve sitting board members are appointed by the president."

Fannie Mae declared insolvency once, back in 1979…and was then rescued by the U.S. government, giving rise to the myth that any time Fannie, Freddie or Sallie got thrown in the hoosegow, Uncle Sam would come down to the station with his taxpayer’s checkbook and bail them out.

With all that debt…and the mortgage market getting the kibosh…do you think Uncle Sam will stick out his neck again for Fannie? Can he afford to usher in ‘the end of the modern financial system’?

*** We reported, many months ago, that the war against Iraq could cost more than $1 trillion. "Ridiculous!" came the comments. "Absurd…b.s….nonsense…" Readers couldn’t believe it. We didn’t really believe it ourselves, but we had read it somewhere…

Well, now it’s beginning to look every bit as absurd…but much less unlikely. $166 billion is the bill so far, according to the NYTimes. George W. Bush allowed as to how another $150 billion or so is in the works. A "generational commitment" is how advocates describe it. ‘Loading our grandchildren with debt’ is another way to look at it. But who cares…it’s not our money anyway. As long as the Asians continue to lend…we Americans will do our part…Spend, spend, spend…until Daddy takes the credit card away…

*** Shui Pao! The bubble is on in China. McDonald’s franchiser in China, Sanyuan Foods, went public the other day. Shares skyrocketed 300% on the first day of trading and now trade at a P/E of 56. In the U.S., meanwhile, Mickey D’s trades at 30 times earnings.

Shui pao! Shui pao! Shui pao!

The Daily Reckoning