Archive for September 2009

World Economy in Crossroads

September 6, 2009

CrossroadsNYC Let’s look at the hard facts again before going deeper. The amount of USD in circulation is the driving factor now. Like discussed earlier the USA must get the external value of USD down, which means devaluated against other currencies. The key here is the money supply. The history data shows that money supply and inflation are directly related with each other. This is of course debated amongs scholars, but we accept this relationship here as a basic fact.  Therefore, one of the major tasks of any central bank is to control inflation and therefore the money supply. This is valid also for the FED. The Central Bank controls physical currency and governmental money which is called M0. In 2008 the total amount of USD in circulation was around $ 833 billion, of which 70% outside of the USA.

Now it has been estimated that the money supply in the USA will grow during this and coming yerar from $ 262 billion to around 4 trillion – 15 fold. This is a lot! Therefore, we are going to see two major things happening: first the devaluation and secondly inflation.  The problems outside of the USA will start because of the devalution, but the inflation will hit on inland. In order to control inflation, the FED must start to break development at certain point through curbing interest rates up. When will that be – most likely during 2010 when employment starts to pick up again.  Whatsoever, the prices will go up and the average John Doe must look more carefully how to spend his dollars – the consumption might suffer from inflation. A part of consumtion will anyhow get cut off through a higher savings rate than in the past. This is certainly good, but slows down the economy a bit.

Now to the problem that will come up outside of the USA. The USA has a negative trade balance and deficit in the federal budget. These both must get compensated some how. That has been done by borrowing money by printing bonds and selling them to foreign institutions like other central banks, and attracting foreign investors to the USA. Investment capital has flown to the USA in expectation of higher return than outside of the USA. Now it is getting cheaper to buy assets in the USA, but low interest rates are not helping. So in this respect the interest rates should go up  at least for two reasons: to hinder inflation and to attract investments. This is self evident.

However, foreign central banks, governments, institutions, and companies are sitting on a hoard of greenbacks already. They don’t want to hear about devaluated USD. When the value of USD goes down, so will do their reserves on USD and receivables in dollars as well. The parties outside  the USA want to see a gradual and controlled drop in the external value of USD – a crash would be a horror story for them. At that moment when the USD gets truly devaluated, the assets must get depreciated to their true value, and that would mean huge losses in Japan, China, Europe, Brazil, South-Afrika, Arabic countries, and Russia. We can estimate that other nations are printing more of their currencies as well, but most like not in the same pace with the FED. I have projected an exchange rate of 1,6 USD to 1 €, but now I wouldn’t be surprised of a 1 to 2 ratio. A drop of 40-50% in dollar’s external value is like poison to lenders and foreign reserve banks holding USD assets. My estimation is that on the long-run the USD will have only 25% of the value it has today.  This would be around 2,4 dollars per 1 €!

The outcome would include national disasters in several countries by crashing banks and financial system, loss of jobs in tens or even hundreds of millions globallay etc. In order to linder effects something must happen up-front. BRIC-nations (Brazil, India, Russia, China) have demanded a new world currency, some OPEC (oil producing countries) consider to change from dollar to euro, more nations are joining EU and euro-zone, and China has demanded the USA to hold the value off USD stable. This is controversial then all these nations have lots of dollars in their reserves, have lended to US, or have USD receivables. On the other hand they want to keep up supplying and selling goods and services to the USA. At the same time they want to sell their assets in USD in order to reduce the risk of devaluation. By selling USD they increase the amount of USD in circulation – the money supply (M0). There are no easy ways out. The hard medicine is know to everybody and the time is near to start to take it. It is very difficult with USD assets – their value will drop anyhow,  so a write-offs must happen now or later.

All nations who have large surplusses in their trade with the USA must now find a way to balance the trade. The lower value of USD will automatically reduce imports by US companies and helps exports from the USA at the same time. The task is to increase trade between other nations and balance it out with the USA. Every nation must look at their home markets and their neighbor countries and focus on those relationships. Any dependence on exports to the USA is highly risky now and in the future as well. I’m saying both sides need the balance! The US economy will heal steadily, but it cannot be based on borrowing any longer.  The same is valid for others – the growth and wealth cannot be made only by selling to the USA and financing that by borrowing to them. In the meantime the USA will become again a very cost competitive and growing nation, and that is good for the whole world.

As a base-line the trade balance and growth of global economy can get handled somehow, but  avoiding the write-off of assets in USD is close to impossible. The headache is predicted and the medicine linders only, but doesn’t remove the cause. The change is irresistable.