China's Dollar Dilemma

Just ran across this article, China's dollar dilemma. Articles like this always make me nervous.

China's near $2,000bn (£1,380bn, €1,560bn) in reserves, the world's largest, are often viewed outside the country as a great strength – an insurance policy against economic turbulence. But within China, they are increasingly seen by the public and even some policymakers as something of an albatross – a huge pool of resources not being used at home that will plunge in value if the US dollar collapses. Why, people ask, should such a relatively poor country bankroll such a rich one?

An excellent question. The answer is they shouldn't. Nobody should, unless that money is going towards investment in businesses that will use the money to buy capital and create goods (some services can be included in this). But the majority of the debt we've been accumulating for the last 30 years has been going toward consumption. If you refinance your house and use that money to go on vacation or remodel your kitchen, that money is simply gone. It's not going to make more money for the investor. The only hope is to get some interest off the debt, which right now isn't looking very profitable.

If China would ever decide to start spending their reserve of US dollars, or undergoes a major diversification into other currencies, we will be in for some serious inflation as that $2 trillion starts to come home.

Evidence of Deflation

Here is an article about companies cutting pay checks instead of jobs - More companies, such as Acco Brands, turning to pay cuts to avoid more layoffs. It has to be extremely painful for the employees, and a 47% pay cut for six weeks seems really bad, but it is allowing these companies to keep people employed. Again, anyone with debt will be hurt the worst. It is keeping people employed though, and hopefully allowing these companies to be prepared when the recession ends. And it will end eventually.

Here is the reason why - Economy Strains Under Weight of Unsold Items. A lot of overcapacity and inventory. We've been on a lending and buying spree for so long, everything is out of wack. Now that people are trying to pay off their debt, they are spending far less. Spending probably won't pick up until people feel comfortable with their financed, which means paying off their debt and increasing their savings. It's going to take a while.

I've been reading a book by Murray N. Rothbard called America's Great Depression. I'm just getting into the details about what caused the depression, but the main premise seems to be rapid monetary expansion and inflation in the form of banks loaning too much money to too many people. Back then though, it was the stock market everyone thought would go up forever, not housing. The result was pretty much what we're seeing now. I have yet to get into why the Depression lasted so long, but I have a feeling the main focus will be government intervention. Sounds familiar. It's all making me a little depressed actually.

China Monthly Auto Sales Overtake US

Wealth and money are two different things. We have had a lot of money over the last 30 years because we have been borrowing it from foreign countries. We have been giving away our wealth by sending our capital (manufacturing equipment, factories, etc) overseas and by spending our savings and going into debt.

After WWII, the reason why the United States became so affluent in the world was because we had a massive reserve of manufacturing capacity. Americans sacrificed their standard of living during the war to build factories that could produce the necessary goods to win the war. There were shortages of metal, rubber, nylon, food, you name it. People planted victory gardens for the war effort and women painted lines on the back of their legs so it looked like they had nylons on. After the war we had an amazing capacity for manufacturing. But instead of building tanks and planes, the factories switched to building cars and appliances. We became a net exporter of the goods we produced and became wealthy because of it.

For the last 30 years, we have been shipping that manufacturing capacity overseas, mostly to China. We have become a "service" economy which essentially means we consume more then we produce. Seventy percent of our economy is based on services. Meanwhile, China has been sacrificing their standard of living in order to lend us money and make us goods. There has been a massive transfer of wealth. Some believe that China is now poised to take over as the manufacturer of the world and will become wealthy because of it. Their standard of living will rise while ours falls. You can read more about all this in Peter Schiff's book, "Crash Proof".

Today, the following article caught my attention. China monthly auto sales overtake US for 1st time. It says, "China's vehicle market has grown dramatically in recent years, overtaking Japan in 2006 to become the world's second-largest by annual sales. With 1.3 billion people, China will inevitably leapfrog the U.S., with a population of 300 million, into the No. 1 spot, industry experts say." I think this is evidence that this theory of wealth transfer is correct.

China is also suffering from the world recession, but they are in a far greater position to weather the storm then we are. Their savings rates are near 50% for individuals, and there government has very little debt. Once they realize that they can stop lending us money and start using that money to increase their own standard of living, look out. They'll move into the No. 1 spot for pretty much everything.

Spending Down, Savings Up

More "bad" economic news.

"U.S. consumers cut spending for a sixth straight month in December and their incomes shrank, according to a government report on Monday that underscored the rapid deterioration in the economy."

- Consumer spending falls, savings jump

I think they should have said a "rapid correction" instead of a "rapid deterioration." Also, notice how it talks about incomes shrinking? That goes hand in hand with my previous post. Still, spending only decreased by 1 percent. When you think about it, people are still spending money. There will always be consumption, just a little less of it.

My favorite part of that article, "Personal savings surged in December to 3.6 percent of disposable income from 2.8 percent in November, the largest rate since May 2008." Sounds like we've learned something. Only a few years ago, personal savings was less then 0%.

Why Debt Will Cause Lasting Unemployment

You may not have heard yet, but the United States is in a recession. All recessions are caused by the same thing – artificial growth of the economy followed by a natural contraction. The current recession we are in was caused by government spending, artificially low interest rates, speculation in real estate causing artificially high valuations, debt based on those valuations, and cheap and easy credit. For thirty years, we have spent well beyond our means. Because of this, car companies built too many factories and home improvement big boxes built too many stores. The economy must now contract to its rightful size.

In a recession, many things happen. As the supply of money contracts, consumers consume less. This leaves excess inventory on the shelves. In order for the market to clear out the excess inventory, prices drop and companies cut back on production. This drop in prices is called deflation. With deflation and contraction, less production is needed resulting in a loss of jobs. In a healthy recession, wages would also drop with deflation. This shouldn't be a big deal. As prices go down, people need less money. As wages drop, industry can afford to hire more people and unemployment will subside. Everything should balance out, but this is where the problem causing debt comes in to play.

Debt and deflation don’t mix. If your wages are reduced, you will still have the same sized house payment, credit card payment, and car payment. In fact, if your interest rates aren’t locked in, you may end up paying more. The average American has approximately $8,000 in credit card debt, $14,000 in auto and education debt, $10,000 in home equity debt, and $84,000 in mortgage debt. Because Americans have so much debt, the natural tendency to resist wage rate reduction is greatly strengthened. Unions opposed wage reductions, individuals resist wage reductions, and since debt is so pervasive in our culture, managers (who have debt of their own) will resist it as well. The government is in no better position than its citizens. Lower wage rates mean lower tax income, and due to the massive amount of government debt, it too will resist wage reduction. "More consumption is the answer," they say.

Because of our consumer culture, we have become a nation of indebted people. The economy grew at an unsustainable rate for too long. Now that the economy is contracting, credit is scarce, and people are losing their jobs. And due to our debt, the best remedy for fixing the economy - letting wages fall to create jobs - is really going to hurt. That is, IF the government lets it happen. If they don't, the only option is to try and create another bubble, or raise inflation to the point where our currency becomes worthless. Neither option is very attractive. Still, maybe it's time we take our medicine (no matter how bitter it is), learn a stern lesson, and move on. Let's let the market do its job and resist government intervention instead. The more the government resists market corrections, the more unemployment we will have, and the longer that unemployment will last.

1.5 * (Debt - Payments) = Length of Recession

It would be interesting to find out how much average debt people have, and how long it would take them to pay it off now that they are trying. Multiply that by 1.5 (the time to save some money in order to make future purchases), and that's how long our recession will be at a minimum (my opinion only).

Ok, so I looked it up. The average American (in 2004) owed about $8,000 in credit card debt. If the average person made a minimum payment of $150 per month at 13% interest and stopped incurring new debt it would take 6.67 years to pay off. Multiply by 1.5 and we can reasonably assume our recession will last 10 years minimum. Ok, that may not be a reasonable assumption as it is in no way scientific.

Consumer Spending

Everyone seems to agree that consumer spending is the quickest way to economic recovery, but consumers are holding back.

"You're not going to get a recovery without a faster pace of consumer spending," said Alan Levenson, chief economist for T. Rowe Price Associates.

During some previous recessions, shoppers resumed buying such big-ticket items as appliances, cars and houses despite flat salaries. The difference was that credit was much more available to consumers than it is now.

-Shoppers 'Sidelined' In Long Retail Slump

Everyone needs to rethink their views on economic recovery.

The current lack of credit isn't the problem. Consumers going into more debt won't help. Savings and a lack of credit are necessary adjustments that should have happened long ago. It was the abundance of credit that caused this problem in the first place. Car manufacturers opened to many factories and produced to many cars. Retailers opened to many stores and hired to many people. It was all based on credit - so much credit that it was impossible to sustain. Now these businesses need to deflate to the size they should have been and learn how to survive with fewer customers. Consumers need to pay off their credit cards and start saving for the future. The economic recovery will be slow and painful, but it needs to happen. Let's give the market a chance to fix things instead of having the government try to reinflate this or that bubble, or create a new bubble to take it's place.