Chinese Treasury Contradictions…

One mistake I may have made in the two years I have been writing publicly is taking the rhetoric of the Chinese and Russian governments a little too seriously, particularly over their relationship with the United States and the dollar.

Back in 2011, both China and Russia made a lot of noise about dumping US debt, or at least investing a lot less in it. Vladimir Putin said:

They are living beyond their means and shifting a part of the weight of their problems to the world economy. They are living like parasites off the global economy and their monopoly of the dollar. If [in America] there is a systemic malfunction, this will affect everyone. Countries like Russia and China hold a significant part of their reserves in American securities. There should be other reserve currencies.

And China were vocally critical too:

China, the largest foreign investor in US government securities, joined Russia in criticising American policymakers for failing to ensure borrowing is reined in after a stopgap deal to raise the nation’s debt limit.

People’s Bank of China governor Zhou Xiaochuan said China‘s central bank would monitor US efforts to tackle its debt, and state-run Xinhua News Agency blasted what it called the “madcap” brinkmanship of American lawmakers.

But just this month — almost two years after China blasted America for failing to cut debt levels — China’s Treasury holdings hit a record level of  $1.223 trillion.  And Russian treasury holdings are $20 billion higher than they were in 2012. So all of those protestations, it seems, were a lot of hot air. While it is true that various growing industrial powers are setting up alternative reserve currency systems, China and Russia aren’t ready to dump the dollar system anytime soon.

Now, the Federal Reserve has to some degree further enticed China into buying treasuries by giving them direct access to the Treasury auctions, allowing them to cut out the Wall Street middlemen. Maybe if that hadn’t happened, Chinese Treasury ownership would be lower.

But ultimately, the present system is very favourable for the BRICs, who have been able to build up massive manufacturing and infrastructural bases as a means to satisfy American and Western demand. In that sense, the post-Bretton Woods globalisation has been as much a free lunch for the developing world as it has been for anyone else. And why would China and Russia want to rock the boat by engaging in things like mass Treasury dumpings, trade war or proxy wars? They are slowly and gradually gaining on the West, without having to engage in war or trade war. As I noted in 2011:

I believe that the current world order suits China very much — their manufacturing exporters (and resource importers) get the stability of the mega-importing Americans spending mega-dollars on a military budget that maintains global stability. Global instability would mean everyone would pay more for imports, due to heightened insurance costs and other overheads.

Of course, a panic in the Chinese mainland — maybe a financial crash, or the bursting of the Chinese property bubble — might result in China’s government doing something rash.

But until then it is unlikely we will see the Eurasian holders of Treasuries engaging in much liquidation anytime soon — however much their leaders complain about American fiscal and monetary policy. Actions speak louder than words.

QE ∞

The Keynesians and Monetarists who have so berated the Federal Reserve and demanded more asset purchases and a nominal GDP target to get GDP level up to the long-term growth trend have essentially got their wish.

This is a radical departure:

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.  The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.  These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

The Committee will closely monitor incoming information on economic and financial developments in coming months.  If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.  In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.

I tweeted this earlier in favour of the idea that the Fed would adopt open-ended asset purchases:

Those who didn’t anticipate the possibility of open-ended asset purchases should have looked much more closely at Bernanke’s words at Jackson Hole:

If we are willing to take as a working assumption that the effects of easier financial conditions on the economy are similar to those observed historically, then econometric models can be used to estimate the effects of LSAPs on the economy. Model simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy. For example, a study using the Board’s FRB/US model of the economy found that, as of 2012, the first two rounds of large scale asset purchases may have raised the level of output by almost 3 percent and increased private payroll employment by more than 2 million jobs, relative to what otherwise would have occurred.

Essentially, this is nominal GDP level targeting. The reason why Bernanke has framed it in terms of lowering unemployment is that his mandate relates to price stability and unemployment, not nominal GDP level. But as Bernanke himself noted in his academic days:

Estimates based on data from more recent years give about a 2% decrease in output for every 1% increase in unemployment.

To those who accept Okun’s Law, raising nominal GDP level and lowering unemployment are effectively the same thing. Bernanke seems to believe unemployment will fall in a (roughly) linear fashion as asset purchases increase. By itself, this is a problematic assumption as the past is not an ideal guide to the future.

Yet more importantly the data shows no real job recovery in the post-2008 quantitatively-eased world. This is the prime-age employment-population ratio:

And even if unemployment falls without triggering large-scale inflation as per the Fed’s design, this is no cure for the significant long-term challenges that America faces.

As I wrote back in November 2011, when nominal GDP targeting was just appearing on the horizon America faces far greater challenges than can be solved with a monetary injection. Financial fragility, moral hazard, energy dependency, resource dependency, deindustrialisation, excessive private debt, crumbling infrastructure, fiscal uncertainty, and a world-policeman complex. The underlying problems are not ones that Bernanke really has power to address.

And how long before rising food prices cause more riots and revolutions? After, all handing over more firepower to speculators tends to result in increased speculation.

Meanwhile, US creditors and dollar-holders (particularly China) would seem from past comments to be deeply unhappy with this decision.

President Hu Jintao:

The monetary policy of the United States has a major impact on global liquidity and capital flows and therefore, the liquidity of the US dollar should be kept at a reasonable and stable level.

The dollars they accrued will lose purchasing power to every new dollar printed and handed over to the American banks in exchange for mortgage backed securities. The Chinese perspective on this will be that Bernanke is essentially engaging in theft. On the other hand, they should have considered this likelihood before they went about accruing a humungous pile of fiat dollars that can be duplicated at a press of a button. No, matter; China won’t get burnt like this again.

As PBOC official Zhang Jianhua noted:

No asset is safe now. The only choice to hedge risks is to hold hard currency — gold.

Chances of future trade and currency wars between the United States and China seem to be rising as fast as Chinese gold accruals.

Why is the Fed Not Printing Like Crazy?

I try to read all sides of the economics blogosphere, and try and grasp the ideas of even those who I would seem to radically disagree with.

One thing that the anti-Fed side of the economics blogosphere seems to not fully appreciate is the depth of disappointment with Ben Bernanke from the pro-Fed side. For every anti-Fed post bemoaning Bernanke’s money printing, there is a pro-Fed post bemoaning Bernanke for not printing enough. Bernanke, it seems, is tied to everybody’s whipping post.

And in fairness to the pro-Fed side, the data shows that the Fed is not printing anywhere near as much as its own self-imposed interpretation of its mandate demands. (Of course, I fundamentally disagree that price stability should be interpreted as consistent inflation, but that is an argument for another day).

Scott Sumner notes:

Recall that the Fed tries to keep inflation close to 2.0% and unemployment close to about 5.6% (the Fed’s current estimate of the natural rate.)  One implication of the dual mandate is that they should try to generate above 2% inflation during periods of high unemployment, and below 2% during periods of low unemployment.

In July 2008 unemployment rose above 5.6%, and it’s averaged nearly 9% over the past 46 months.  So the Fed’s mandate calls for slightly higher than 2% inflation during this 46 month slump.  Last month I reported that the headline CPI had risen 4.6% in the 45 months since July 2008.  Now we have the May data, and the headline CPI has gone up 4.3% in the 46 months since July 2008.  So the annual inflation rate over that nearly 4 year period has fallen from a bit over 1.2%, to 1.1%.

Raw data:

Note that downward slope in inflation into 2012?

That’s the Fed not doing QE3 when everyone (especially gold prices) expected them to, and when their own self-imposed interpretation of their mandate calls for them to inflate more. And nobody can say that the Fed is out of bullets; central banks are never out of bullets — there was a time when a central bank was limited to the number of zeroes it could fit on a banknote, but in the era of digital currency, even that limit has been removed.

Here’s the younger Bernanke’s views on the subject:

Franklin D. Roosevelt was elected President of the United States in 1932 with the mandate to get the country out of the Depression. In the end, the most effective actions he took were the same that Japan needs to take — namely, rehabilitation of the banking system and devaluation of the currency to promote monetary easing. But Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and to experiment— in short, to do whatever was necessary to get the country moving again. Many of his policies did not work as intended, but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done. Japan is not in a Great Depression by any means, but its economy has operated below potential for nearly a decade. Nor is it by any means clear that recovery is imminent. Policy options exist that could greatly reduce these losses. Why isn’t more happening?

To this outsider, at least, Japanese monetary policy seems paralyzed, with a paralysis that is largely self-induced. Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work. Perhaps it’s time for some Rooseveltian resolve in Japan.

And here’s Paul Krugman pulling a Bernanke on Bernanke:

Bernanke was and is a fine economist. More than that, before joining the Fed, he wrote extensively, in academic studies of both the Great Depression and modern Japan, about the exact problems he would confront at the end of 2008. He argued forcefully for an aggressive response, castigating the Bank of Japan, the Fed’s counterpart, for its passivity. Presumably, the Fed under his leadership would be different.

Instead, while the Fed went to great lengths to rescue the financial system, it has done far less to rescue workers. The U.S. economy remains deeply depressed, with long-term unemployment in particular still disastrously high, a point Bernanke himself has recently emphasized. Yet the Fed isn’t taking strong action to rectify the situation.

It really makes no sense — except in terms of politics. I really believe that we have reached a point where the Fed is afraid to do its job, for fear of being accused of helping Obama.

I am fairly certain the answer to why Bernanke isn’t increasing inflation when his former self and former colleagues say he should be is actually nothing to do with domestic politics, and everything to do with international politics.

Most of the pro-Fed blogosphere seems to live in denial of the fact that America is massively in debt to external creditors — all of whom are frustrated at getting near-zero yields (they can’t just flip bonds to the Fed balance sheet like the hedge funds) — and their views matter, very simply because the reality of China and other creditors ceasing to buy debt would be untenable.

Why else would the Treasury have thrown a carrot by upgrading the Chinese government to primary dealer status (the first such deal in history), cutting Wall Street’s bond flippers out of the deal?

As John Huntsman (in his days as ambassador to China) reported in a cable back to Washington, China is keen to stop buying low-yield treasuries and start buying other assets, but the US is desperately pushing China back toward treasuries:

The Shanghai-based Shanghai Media Group (SMG) publication, China Business News:

“The United States provoked a trade war again by imposing high anti-dumping duties on Chinese-made gift boxes and packaging ribbon. China has become the biggest victim of the U.S.’s abusive implementation of trade remedy measures.

The United States no longer sits still; it frequently uses evil tricks to force China to buy U.S. bonds.

A crucial move for the U.S. is to shift its crisis to other countries – by coercing China to buy U.S. treasury bonds with foreign exchange reserves and doing everything possible to prevent China’s foreign reserve from buying gold.

Today when the United States is determined to beggar thy neighbor, shifting its crisis to China, the Chinese must be very clear what the key to victory is.  It is by no means to use new foreign exchange reserves to buy U.S. Treasury bonds.  The issues of Taiwan, Tibet, Xinjiang, trade and so on are all false tricks, while forcing China to buy U.S. bonds is the U.S.’s real intention.

And that, in a nutshell, is why Bernanke is not printing nearly as much as Krugman wishes. In my view only a brutal 2008-style collapse can bring on the kind of printing — QE3, NGDP targeting and beyond — that the pro-Fed blogosphere wishes to see, because it is only under those circumstances that China and other creditors will happily support it.

To a heavily-indebted nation, creditors have big leverage on monetary policy.

Why I Still Fear Inflation

Paul Krugman wonders why others worry about inflation when he sees no evidence of inflationary trends:

Joe Wiesenthal makes the well-known point that aside from certain euro area countries, yields on sovereign debt have plunged since 2007; investors are rushing to buy sovereign debt, not fleeing it. I was a bit surprised by his description of this insight as being non-”mainstream”; I guess it depends on your definition of mainstream. But surely the notion that what we have is largely a process of private-sector deleveraging, with government deficits the consequence of this process, and interest rates low because we have an excess of desired saving, is pretty widespread (and backed by a lot of empirical evidence).

And there’s also a lot of discussion, which I’m ambivalent about, concerning the supposed shortage of safe assets; this is coming from bank research departments as well as academics, it’s a frequent topic on FT Alphaville, and so on. So Joe didn’t seem to me to be saying anything radical.

But those comments! It’s not just that the commenters disagree; they seem to regard Joe as some kind of space alien (or, for those who had the misfortune to see me on Squawk Box, a unicorn); they consider it just crazy and laughable to suggest that we aren’t facing an immense crisis of public deficits with Zimbabwe-style inflation just around the corner.

Krugman, of course, thinks it crazy and laughable that in the face of years of decreasing interest rates that anyone would believe that inflation could still be a menace. In fact, Krugman has made the point multiple times that more inflation would be a good thing, by decreasing the value of debt and thus allowing the private sector to deleverage a little quicker.

I remain convinced — even having watched Peter Schiff and Gonzalo Lira make incorrect inflationary projections — that there is exists the potential of significant inflationary problems in the medium and long term. Indeed, I believe elevated inflation is one of three roads out of where we are right now — the deleveraging trap.

In my worldview, this depression — although a multi-dimensional thing — has one cause above all others: too much total debt. Debt-as-a-percentage of GDP has grown significantly faster than productivity:

The deleveraging trap begins with the boom years: credit is created above and beyond the economy’s productive capacity. Incomes rise and prices rise above the rate of underlying productivity. And as the total debt level increases, more and more income that was once used for investment and consumption goes toward paying down debt and interest. This means that inflated asset prices become less and less sustainable, making the economy more and more susceptible to a downturn — wherein asset prices deflate, and the value of debt (relative to income) increases further. Under a non-interventionist regime, once the downturn occurs, this would result in credit freeze, mass default and liquidation, as occurred in 1907.

However, under an interventionist regime — like the modern Federal Reserve, or the Bank of Japan — the central bank steps in to lower rates and print money to support asset prices and bail out failed companies. This prevents the credit freeze, mass default, drastic deflation and liquidation. Unfortunately, it also sustains the debt load — following 2008, total debt remains over 350% of GDP. The easy money leads to a short cycle of expansion and growth, but the continued existence of the debt load means that consumers and businesses will still have to set aside a large part of their incomes to pay down debt. This means that any expansion will be short lived, and once the easy money begins to dry up, asset prices will again begin to deflate. The downward pressure on prices, spending and investment from the excessive debt load is huge, and requires sustained and significant central bank intervention to support asset prices and credit availability. The economy is put on life-support. Debt-as-a percentage of GDP may gradually fall (although in the Japanese example, this has not been the case) but progress is slow, and the debt load remains unsustainable.

A fundamental mistake is identifying the problem as one of aggregate demand, and not debt. Lowered aggregate demand is a symptom of the deleveraging trap caused by excessive debt and unsustainable asset prices. The Fed — and advocates of greater Fed interventionism to support aggregate demand, like Krugman — are mostly advocating the treatment of symptoms, not causes. And the treatment in this case may make the underlying causes worse — quantitative easing and low-interest rates are debt-additive policies; while supporting assets prices and GDP, they encourage the addition of debt. 

There are three routes out of the deleveraging trap; liquidation (destroying the debt via mass default), debt forgiveness (destroying the debt via systematically cancelling it), and inflating the debt away. Liquidation in a managed economy with a central bank is politically impossible. Debt forgiveness is politically difficult, although perhaps the most realistic effective bet. And inflating the debt away at a moderate rate of inflation would seem to be a slow and laborious process — the widely-advocated suggestion of a 4% inflation target would only eat slowly (if at all) into the 350%+ total debt-as-a-percentage-of-GDP load.

All three exit routes seem blocked. So the reality that we are staring at — and have been staring at for the last four years — has been remaining in the deleveraging trap.

So why in a deflationary environment like the deleveraging trap would I fear high inflation? Surely this is an absurd and unfounded fear?

Well,  Japan shows that nations can remain stuck in a deleveraging trap for a long, long time — although Japan has had to take to increasingly authoritarian measures such as mandating the purchase of treasury debt to keep rates low and so to keep the debt rolling. But eventually nations stuck in a deleveraging trap will have to take one of the routes out. While central banks refuse to consider the possibility of a debt jubilee, and refuse to consider the possibility of allowing markets to liquidate, the only route out remains inflation. 

Yet the big inflation that would be required to eject the United States from the deleveraging trap makes creditors — the sovereign states from which the US imports huge quantities of resources, energy, components, and finished goods — increasingly jittery.

According to Xinhua:

The U.S. has long been facing the same problem: living beyond its means. At present, the country has debts as high as 55 trillion U.S. dollars, including more than 14 trillion U.S. dollars of treasury bonds.

And last October:

Economists agree that as the United States’ largest foreign creditor, China should contemplate ways to pull itself out of the “dollar trap,” as the U.S. economy is faltering with its debt piling up and its currency on the brink to depreciate.

China must make fuller use of the non-financial assets in its foreign reserves, as well as speed up the diversification of investing channels to resist a possible long-term weakening of the dollar, said Xia Bing, director of the Finance Research Institutes of the Development Research Center under the State Council.

Zheng Xinli, permanent vice chairman of China Center for International Economic Exchanges, has suggested that Chinese companies boost overseas investment as a way to absorb trade surpluses and fend off the dollar risk.

And it’s not like America’s Eurasian creditors are doing nothing about this. As I wrote earlier this month:

If the exporter nations feel as if they are getting screwed, they are only more likely to escalate via the only real means they have — trade war. And having a monopoly on various resources including rare earth minerals (as well as various components and types of finished goods) gives them considerable leverage.

More and more Asian nations — led by China and Russia — have ditched the dollar for bilateral trade (out of fear of dollar instability). Tension rises between the United States and Asia over Syria and Iran. The Asian nations throw more and more abrasive rhetoric around — including war rhetoric.

And on the other hand, both Obama and Romney — as well as Hillary Clinton — seem dead-set on ramping up the tense rhetoric. Romney seems extremely keen to brand China a currency manipulator.

The Fed is caught between a rock and a hard place. If they inflate, they risk the danger of initiating a damaging and deleterious trade war with creditors who do not want to take an inflationary haircut. If they don’t inflate, they remain stuck in a deleveraging trap resulting in weak fundamentals, and large increases in government debt, also rattling creditors. 

The likeliest route from here remains that the Fed will continue to baffle the Krugmanites by pursuing relatively restrained inflationism (i.e. Operation Twist, restrained QE, no NGDP targeting, no debt jubilee, etc) to keep the economy ticking along while minimising creditor irritation. The problem with this is that the economy remains caught in the deleveraging trap. And while the economy is depressed tax revenues remain depressed, meaning that deficits will grow, further irritating creditors (who unlike bond-flipping hedge funds must eat the very low yields instead of passing off treasuries to a greater fool for a profit) who may pursue trade war and currency war strategies and gradually (or suddenly) desert US treasuries and dollars.

Geopolitical tension would spike commodity prices. And as more dollars end up back in the United States (there are currently $5+ trillion floating around Asia), there will be more inflation still. The reduced global demand for dollar-denominated assets would put pressure on the Fed to print to buy more treasuries.

Amusingly, this kind of scenario was predicted in 2003 by Krugman himself!:

The crisis won’t come immediately. For a few years, America will still be able to borrow freely, simply because lenders assume that things will somehow work out.

But at a certain point we’ll have a Wile E. Coyote moment. For those not familiar with the Road Runner cartoons, Mr. Coyote had a habit of running off cliffs and taking several steps on thin air before noticing that there was nothing underneath his feet. Only then would he plunge.

What will that plunge look like? It will certainly involve a sharp fall in the dollar and a sharp rise in interest rates. In the worst-case scenario, the government’s access to borrowing will be cut off, creating a cash crisis that throws the nation into chaos.

This is not a Zimbabwe-style scenario, but it is a potentially unpleasant one involving a sharp depreciation of the dollar, and a significant change in the shape of the American economy (and geopolitical reality). It includes the risk of costly geopolitical escalation, including proxy war or war.

However, American primary and secondary industries would look significantly more competitive, and significant inflation — while penalising savers — would cut down the debt. Such a crisis would be painful and scary, but — so long as there is no escalation — largely beneficial.

Enter the Swan

Charles Hugh Smith (along with many, many, many others) thinks there may be a great decoupling as the world sinks deeper into the mire, and that the dollar could be set to benefit:

This “safe haven” status can be discerned in the strengthening U.S. dollar. Despite a central bank (The Federal Reserve) with an avowed goal of weakening the nation’s currency (the U.S. dollar), the USD has been in an long-term uptrend for a year–a trend I have noted many times here, starting in April 2011.

That means a bet in the U.S. bond or stock market is a double bet, as these markets are denominated in U.S. dollars. Even if they go nowhere, the capital invested in them will gain purchasing power as the dollar strengthens.

All this suggests a “decoupling” of the U.S. bond and stock markets from the rest of the globe’s markets. Put yourself in the shoes of someone responsible for safekeeping $100 billion and keeping much of it liquid in treacherous times, and ask yourself: where can you park this money where it won’t blow up the market just from its size? What are the safest, most liquid markets out there?

The answer will very likely point the future direction of global markets.

Smith is going along with one of the most conventional pieces of conventional wisdom: that in risky and troubled times investors will seek out the dollar as a haven. That’s what happened in 2008. That’s what is happening now as rates on treasuries sink to all-time-lows. And that’s what has happened throughout the era of petrodollar hegemony.

But the problem with conventions is that they are there to be broken, the problem with conventional wisdom is that it is there to be killed, roasted and served on a silver platter.

The era of petrodollar hegemony is slowly dying, and the assumptions and conventions of that era are dying with it. For now, the shadow of that old world is still flailing on like Wile E. Coyote, hovering in midair.

As I wrote last week:

How did the dollar die? First it died slowly — then all at once.

The shift away from the dollar has quickly manifested itself in bilateral and multilateral agreements between nations to ditch the dollar for bilateral and multilateral trade, beginning with the chief antagonists China and Russia, and continuing through Iran, India, Japan, Brazil, and Saudi Arabia.

So the ground seems to have fallen out from beneath the petrodollar world order.

Enter the Swan:

We know the U.S. is a big and liquid (though not really very transparent) market. We know that the rest of the world — led by Europe’s myriad issues, and China’s bursting housing bubble — is teetering on the edge of a precipice, and without a miracle will fall (perhaps sooner, rather than later).

But we also know that America is inextricably interconnected to this mess. If Europe (or China or both) disintegrates, triggering (another) global default cascade, America will be stung by its European banking exposures, its exposures to global energy markets and global trade flows. Simply, there cannot be financial decoupling, not in this hyper-connected, hyper-leveraged world.

And would funds surge into US Treasuries even in such an instance? Maybe initially — fund managers have been conditioned by years of convention to do so. But how long  can fund managers accept negative real rates of return? Or — much more importantly — how long will the Fed accept such a surge? The answer is not very long at all. Bernanke’s economic strategy has been focussed  on turning treasuries into a losing investment, on the face of it to “encourage risk-taking” (or — much more significantly — keep the Treasury’s borrowing costs cheap).

All of this suggests a global crash or proto-crash will be followed by a huge global money printing operation, probably spearheaded by the Fed. Don’t let the Europeans fool anyone, either — Germany will not let the Euro crumble for fear of money printing. When push comes to shove they will print and fiscally consolidate to save their pet project (though perhaps demanding gold as collateral, and perhaps kicking out some delinquents). China will spew trillions of stimulus money into more and deeper malinvestment (why have ten ghost cities when you can have fifty? Good news for aggregate demand!).

So Paul Krugman will likely get something much closer to what he claims to want. Problem solved?

Nope. You can’t solve deep-rooted structural problems — malinvestment, social change, deindustrialisation, global trade imbalances, systemic fragility, financialisation, imperial decline, cultural stupefaction (etc, etc, etc) — by throwing money at problems. All throwing more money can do is buy a little more time (and undermine the currency). The problem with that is that a superficial recovery fools policy-makers, investors and citizens into believing that problems are fixed when they are not. Eventually — perhaps slowly, or perhaps quickly — unless the non-monetary problems are truly dealt with (very unlikely), they will boil over again.

As the devaluation heats up things will likely become a huge global game of beggar thy neighbour. A global devaluation will likely increase the growing tensions between the creditor and debtor nations to breaking point. Our current system of huge trade imbalances guarantees that someone (the West) is getting a free lunch , and that someone else (the Rest) is getting screwed. Such a system is fundamentally fragile, and fundamentally unstable. Currency wars will likely give way to economic wars, which may well give way to subterfuge and proxy wars as creditors seek their pound of flesh, and debtors seek to cast off their chains. Good news, then, for weapons contractors and the security state.

Chinese Chaos is the Immediate Threat to the Dollar

In twenty or thirty years, I expect future monetary historians looking back on this period of history to frequently misquote Ernest Hemingway:

How did the dollar die? First it died slowly — then all at once.

The slow death began with the dollar’s birth as a global reserve currency. America was creditor and manufacturer to the world, and the capitalist superpower. People around the globe transacted overwhelmingly in dollars. Above all else, people needed dollars to conduct trade, and they were willing to pay richly for them, and for dollar-denominated debt .

By the ’90s America began enjoying a tremendous free lunch — the world provided America with goods, resources and services, and Americans provided the global reserve currency, as well as acting as world military policing global shipping. Why manufacture at home, or produce resources at home when the world wants your currency? To get what you want, all you have to do is run your printing press — which was much easier after 1971, when Nixon ended the gold exchange standard. In a flat free-trade world, supply chains and technology agglomerated wherever the labour was cheapest, which was predominantly Asia. So America let her industrial base and her domestic supply webs degenerate, to enjoy the free lunch that the dollar brought:

The next leg of the story is that foreigners realised that actually maybe the necessity of the dollar was an illusion. With America no longer the world’s manufacturer or creditor, who needs America? If you need a consumer, there are billions of people and trillions of dollars, and trillions of dollars worth of resources in Asia, and South America, and Europe. America’s government is deeply-indebted, and its military is bogged-down in difficult conflicts around the world.

As Ron Paul noted:

We are like a man who used to be rich and is in the habit of paying for everybody’s meals and announces at a lavish dinner that he will pay the bill, only to then turn to the fellow sitting nearby and say, “Can I use your credit card? I will pay you back!”

While fund managers continue to refer to the dollar and the US treasury as a safe haven, America’s sovereign creditors seem to feel quite differently.

As Zhang Jianhua of the People’s Bank of China put it:

No asset is safe now. The only choice to hedge risks is to hold hard currency — gold.

The shift away from the dollar has quickly manifested itself in bilateral and multilateral agreements between nations to ditch the dollar for bilateral and multilateral trade, beginning with the chief antagonists China and Russia, and continuing through Iran, India, Japan, Brazil, and Saudi Arabia.

So the ground seems to have fallen out from beneath the petrodollar world order.

Yet at the same time, the powers moving away from the dollar have a lot invested in the system. The two biggest sovereign holders of US treasuries are Japan and China. China alone holds $3 trillion of US currency, and $1 trillion of debt. They have no reason to crash the value of their own assets. Their planned endgame appears to be a slow, phased and managed transition to a new global reserve currency. China wants to gradually reduce their exposure to America, transferring to harder assets.

Yet history rarely turns out how nations have planned, and China itself seems increasingly beset with domestic problems.

From Bloomberg:

China’s biggest banks may fall short of loan targets for the first time in at least seven years as an economic slowdown crimps demand for credit, three bank officials with knowledge of the matter said.

A decline in lending in April and May means it’s likely the banks’ total new loans for 2012 will be about 7 trillion yuan ($1.1 trillion), less than an estimated government goal of 8 trillion yuan to 8.5 trillion yuan, said one of the officials, declining to be identified because the person isn’t authorized to speak publicly. Banks are relying on small and mid-sized companies for loan growth after demand from the biggest state- owned borrowers dropped, the people said.

The drying up of loan demand attests to the severity of China’s slowdown and may add pressure on Premier Wen Jiabao to cut interest rates and expand stimulus measures. The economy may grow in 2012 at its slowest pace in 13 years, a Bloomberg News survey showed last week, as Europe’s debt crisis curbs exports, manufacturing shrinks and demand for new homes wanes.

China may be a manufacturing powerhouse, and the spider at the heart of global trade, but its domestic and social order looks in a state of disarray, pock-marked with ghost citiesindustrial accidents and ecological disasters. And throwing stimulus money into an economy already recording screeching inflation will be like throwing fuel onto a fire.

As the Chinese (and wider Asian) economic picture becomes bleaker, pressure will grow on politicians to take more drastic and rash measures. They may try to rally the disaffected behind them with an increasingly confrontational nationalistic attitude to America. And unable to match America militarily, their major outlet would be economic warfare — competitive devaluation, threats, tariffs, export controls, and an all-out assault on the dollar reserve standard. Additionally, American policymakers also encumbered with huge economic problems may look to economic warfare as policy — the standout example is Mitt Romney’s desire to brand China as a currency manipulator for accumulating US treasuries and impose tariffs, even while the Treasury upgrades the PBOC to primary dealer status.

This brewing firestorm suggests that rather than the gradual transition that all parties claim to desire we are likely to see a much faster and more volatile one. I don’t know which straw will break the camel’s back, but it is likely to come sooner, rather than later. First slowly — now all at once.

Is China Really Liquidating Treasuries?

The news that China has become the first sovereign to establish a direct sales relationship with the U.S. Treasury (therefore cutting out the middleman and bypassing Wall Street ) raises a few interesting questions.

From Reuters:

China can now bypass Wall Street when buying U.S. government debt and go straight to the U.S. Treasury, in what is the Treasury’s first-ever direct relationship with a foreign government, according to documents viewed by Reuters.

The relationship means the People’s Bank of China buys U.S. debt using a different method than any other central bank in the world.

The other central banks, including the Bank of Japan, which has a large appetite for Treasuries, place orders for U.S. debt with major Wall Street banks designated by the government as primary dealers. Those dealers then bid on their behalf at Treasury auctions.

China, which holds $1.17 trillion in U.S. Treasuries, still buys some Treasuries through primary dealers, but since June 2011, that route hasn’t been necessary.

The documents viewed by Reuters show the U.S. Treasury Department has given the People’s Bank of China a direct computer link to its auction system, which the Chinese first used to buy two-year notes in late June 2011.

The biggest Chinese outflows in U.S. Treasuries occurred in the months following the establishment of this relationship:

Which begs the question for some analysts — was China really selling? Or was China stealthily buying direct from the U.S. Treasury (unrecorded) and selling back into Wall Street (recorded)?

Well, according to the Treasury, the Treasury International Capital data seeks to record foreign holdings of U.S. securities, not just the flows, and given that the Treasury was the seller in these direct transactions (and so obviously was aware of them) there’s no reason to believe that they wouldn’t include any such direct outflows in the data. That suggests very strongly that yes, China really was selling.

And maybe the real reason that the Treasury offered China direct access (thus cutting out the middleman and offering China cheaper access than ever) was precisely because China was selling, and because the Treasury was concerned about the effect on rates, and wanted to give China some incentive to keep buying. As Jon Huntsman noted in a 2010 cable leaked by Wikileaks, the PBOC has felt pressured to keep buying, and as various PBOC officials have hinted in recent months, China is actively seeking to convert out of treasuries and into gold. And that makes sense — treasuries are yielding ever deeper negative real rates. People holding treasuries are losing their purchasing power. No wonder the treasury is willing to cut Wall Street out of the deal.

And it isn’t like the Treasury would have taken this move lightly — cutting Wall Street out of the equation is a slap in the face to Wall Street.

This raises a much more interesting question — now that the PBOC has effectively been upgraded to primary dealer status, would the Fed start buying treasuries directly from the PBOC in order to manage rates downward and prevent a spike in Treasury borrowing costs should China choose to quicken the pace of a future liquidation, potentially bursting the treasury bubble?