US housing starts at record highs -

In my lengthy post from September 2011 (The "Inflation Storm", initially posted on bearparadigm.com, now discontinued, but re-published on this site, below) I assigned a high probability to the US housing market would turning in 2012.

The housing market has now turned. September 2012 building starts are the highest in 4 years, and house prices have increased about 2.2% in the second quarter of 2012 (up 1.2% year on year, according to the Case-Schiller index).

With the Fed recently mandated to buy $40 billion of mortgage backed obligations per year, this is likely to continue. Banks have massive un-used ability to lend and the velocity of money (how fast new funds trickle into the economy) is at an all time low (see the below chart).



With housing prices now poised to rise at rates that are higher than the cost of financing, funds will continue to be deployed in the housing market, driving up prices, creating expectations concerning future price increases etc. Unemployment (latest figures reported at 7.8%) will continue to decline as the construction sector picks up, and consumer credit grows again. If the US government can continue to finance (and increase) its debt burden, 2013 may be a boom year, instead of the depressing recession currently predicted by so many (Nouriel Roubini, Jim Rodgers etc). T-bonds and T-bills have yields at all-time lows, so it seems like the market (e.g. the Chinese central bank, sovereign wealth funds etc) are willing to do just that.

Many people have been predicting US hyperinflation since year 2000, the voices becoming stronger and stronger over the years. However, in spite of massive monetary increases by the Fed, inflation has failed to materialize. The divergence from the historic relationship between domestic monetary supply increases and inflation is due to the massive US' trading deficit versus the rest of the world, and the strong interest of major national governments to keep their currencies pegged to the US dollar. This factor is completely overlooked by most economic commentators.

The future welfare of US citizens is as such in the hands of Chinese policymakers. Luckily for them, both the US and China have an interest in allowing for the imbalances to continue, as correcting them would imply a painful restructuring in both economies, inevitably leading to social un-rest and regime changes. A prediction of hyperinflation in the US (which can easily materialize) thus becomes a question of game-theory more than anything else.

It is clear however, that the imbalances at some point must be corrected. The larger they become, the more painful the correction will be. The most likely trigger is inflation in countries with currencies pegged to the USD coming out of control, which is already happening; food prices are increasing all over the world, certain metal prices are near all-time highs. Rising food prices have the potential of toppling regimes everywhere; they were a significant factor in motivating the public during the Arab Spring, just as they were during the French revolution in 1789.

Bad Bank in Spain - so far just window dressing.

On October 3rd, the Spanish government announced the implementation of a Bad Bank in December, to relieve domestic banks of their toxic real estate assets.

The model was successfully applied in Sweden and Norway in aftermath of the 1992 banking crises, which followed during a period of collapse in real estate markets. The implementation of a Bad Bank allowed for the restoration of the balance sheets of banks, with two distinct benefits:

1. Removing the risk of a systematic collapse should one of them fail, and;

2. Allowed the countries' banks to lend out to deserving companies and individuals again.

Though the concept of a Bad Bank as has historic evidence that it can be an effective initiative for restoring credit market liquidity and reducing risk, there are some significant differences that imply the Spanish initiative is nothing more than window-dressing:

• In Norway and Sweden in the 1990s, shareholder equity in distressed banks was nulled with shareholders loosing all of their investments. Bond-holders were the only ones protected. After the banks had been restructured and were showing profits again, government capital outlays were recovered by re-privatizing the banks.
  
• The Bad Bank was funded with public sector money. The transfer of assets to the Bad Bank happened at market rates. There was a minimal element of negotiation between the Bad Bank and the bankrupt banks; as all entities became government owned they had the same shareholder. Bankrupt commercial banks were re-capitalized by the government only to regain sufficient capital adequacy ratios.

In Spain, banks will not be forced into bankruptcy and have even made public statements that they will be co-financing the Bad Bank. This undermines the entire principle of a Bad Bank, which is why the Spanish initiative will fail:

1. The banks' equity exposure to the transferred assets continue to exist, just now in the form of an equity stake in the Bad Bank, so it does not completely de-risk the banking sector.

2. Investor's capital outlay's into the Bad Bank cannot be recovered by a future sale of equity of the restructured banks.

3. Transfer of assets will most likely NOT happen at market prices, as doing this will erode capital adequacy ratios for the banks, trigger re-financing.

The currently proposed structure is a political compromise (or a result of the bank's bribing the policy makers?) designed to protect the interest of the country's wealthy, with (again!) Northern European tax-payers paying the price in the form of higher inflation (only financing available is printed money from ECB).

Bernanke is creating inflation....in China (part 2)

This is the real chart I should have used in the previous post, it illustrates my point. It is taken from the blog of someone who thinks that the "money multiplier is dead" (Cullen Roche at PragCap.com).

His observation does not account for how the US Current Account deficit (and the Chinese dollar peg) impacts the relationship between the policies of the Fed, US monetary supply and inflation.

Bernanke is creating inflation... in China

This chart says it all (or if not all, at least quite a lot):

It is showing the US M1 money supply versus the price of gold. Interestingly, the oil price is showing a similar relationship, however less succinct in the very recent years, as oil has been substituted for alternative energy sources in developed economies. Since year 2000, the correlation has become much more distinct. It is worth noting, that in the decade before year 2000, the US Current Account deficit was about 1% of GDP on average. In the decade following year 2000 (and to date), the US Current Account deficit has averaged around 5% of GDP.

As shown in my post "the inflation storm", a high Current Account deficit means that the money is Fed printing is going out of the domestic economy, and in the first instance creates inflation elsewhere. Particularly in trade-able global commodities (such as oil, gold, wheat etc), but also to general wage inflation in countries that have massive trade with the US and dollar based currencies though the maintenance of some kind of USD peg (about 80% of global money stock is somehow dollar based, as discussed in "the inflation storm"). The inflation is then imported back to the US in the form of higher energy prices, higher production prices and higher food prices.

QE 3 will continue creating inflation in China, India, Gulf states etc, until these countries break their USD peg (when that happens, the US may experience hyperinflation almost overnight), or become less competitive due to increasing domestic wages, thus reducing the Current Account deficit due to exporting less. However, wages are still so low, and there is considerable room for labor productivity improvements in these economies (as the economies become richer, their population becomes more educated, thus more productive), that it will take at least 30 years before this happens. Due to election cycles on average being only 4 years, politicians' interests diverge from the long-term interest of the public (whose understanding of economics is nil anyway), and nothing will be done to prevent what eventually will be an economic disaster unlike anything the world has ever seen. As the response of global policy makers will be to continue the use of monetary stimuli, the value of fiat money will continue to diminish. The world will not reach stability again until global trade can be re-established through a re-introduction of the gold standard. This will be done at a purchasing power value of gold that will be much much higher than today. Before it happens, we will see all kind of policy measures being tested, such as price controls, trade restrictions etc which will do nothing but reducing economic efficiency, leading to more monetary stimuli to combat unemployment etc.

We are only seeing the beginning of the end. Meanwhile, one should question the intelligence and foresight of investors taking long-term hold positions in US fixed income. Mad or stupid, they have no excuse.

It is called convergence....

It is September 2012:

One in seven Americans is depending on food stamps for survival.

Real US unemployment has hit about 16% (work-force participation is just 64%), in spite of official statistics showing unemployment have come down to about 8.1%

Median US household income has dropped from $55,470 in January 2000 to $50,964 in August 2012.
Simultaneously, according to official statistics, prices have increased 34% over the same period.

Apple's market capitalization is hoovering around $ 650 billion, making it the largest company by market value in the world.

Gold is trading around $ 1,770 per ounce, oil is at $99 a barrel.

Just 10 years ago, very few would think the above possible. What is going on?

In one word: "Convergence".

Or more precisely: Economic convergence between trading economies. Shortly put; because wages are lower in China, manufacturing continues to move to China, and will do so until Chinese labor becomes so expensive that it is more profitable to produce elsewhere. The prime catalyst of convergence has been the wide-spread roll-out of efficient information infrastructure.

In plain language - internet access and electronic data interfaces are enabling global supply chains and disrupting traditional economic patterns as producers and consumers find new, efficient ways of transacting. The lessons learned for developing nations still struggling with growth should be obvious: Focus on supplying the enablers - electricity (particularly for Africa) and access to the internet (Africa, Cuba, Burma etc). If you on top of that can maintain political and monetary stability, just lean back and wait for growth to follow.

Convergence benefits investors and foreign labor (e.g. consumers) in the country of production, and hurts local labor (e.g. consumers) that have skills that can easily be substituted. Apple would not be able to sustain a 50% profit margin on every iPhone and iPad sold, had it not been for cheap Chinese labor and cheap Chinese components. Foxconn, the assembler of Apple devices, employs 1.2 million people. If considering component manufacturing and subsequent value chain activities, Apple probably contributes to somewhere in the range of 3-5 million Chinese jobs.

And this is just Apple. HP, Dell,GE AT&T, etc are all American companies with substantial impact on Chinese employment. As they have shifted production to China, jobless Americans have found lower paying jobs at McDonald's, maintaining their ability to spend with borrowed money, leading to today's over-leveraged consumer

However, consumers (also US consumers) all want affordable products. So as outsourcing and trade leads to efficiency gains, it is for the greater good, right? 

Not quite...

There are at least three main challenges with this development:

1. Though trade generally leads to efficiency gains, the current trade balance is unsustainable, as US consumers ability to consume is enabled by China (and others) continuing to finance the US consumer (and government) with debt. As the Fed is effectively printing money to support government finances, it will erode the value of the dollar, and China and others will eventually shift their holdings to other assets, such as gold (they already have).

2. The large part of the work-force that is without a job does not contribute to economic development (this is called an "output gap" in economic terms), and their human capital is deteriorating, as they are unable to find jobs even at lower wages. As it will still take decades before Chinese and US wages have converged, future Chinese wage catch up may still leave little hope, as the US will then have a large pool of labor that has been out of the workforce for so long that they may never regain their past productivity.

3. The collective feeling of becoming poorer will widen feelings of dissatisfaction among the general public and eventually lead to social unrest, crime and instability. The US will move onto the path followed by several Latin American countries, where slums are existing next to middle class neighborhoods, crime and kidnappings are prevalent, and barb wire and guns are key to separate those who have from the have-nots.

For the record, this is not just a US problem. The Euro has also been kept artificially high by Asian central banks' currency purchases, painfully contributing to the economic difficulties experienced in the periphery of the Euro zone, where wages are relatively low in absolute terms, but still way too high to attract capital for investments when considering the full cost of doing business; corruption, inefficient and obstructive government, rigid labor laws and high taxes. Unlike in the US, real wages have so far not declined notably during the recession. What we are experiencing is not just a temporary recession that can be influenced by fiscal and monetary stimuli, it is the beginning of a paradigm shift that will influence the world for the next 50 years. 

So, if this is the general direction, how-come the US Congress cannot decide on actions to prevent it?

US Congress are mainly capital holders with significant assets under management (an average net worth of USD 6 and 13 million for members of the House of Representatives and Senate, respectively). Most of them own businesses and/or (for example) Apple stock. As US labor cost come down, capital returns increase, and US companies with outsourced production also become more profitable. And since they consume the same amount of basic goods as every other American, they do not feel the pain of food and gas inflation. They are likely to allow for the trend to continue until it becomes unsustainable, and the society collapses as a whole, threatening property rights, and the value of their cash holdings disappear as it is inflated away.

There is anyway not much they can do, without going back to a gold based currency (preventing the Fed from printing money in response to Asian demand for their currency) they cannot change the fundamental flaw which has allowed for these imbalances to occur. And the economy is still far from reaching the point where this can be done yet - a major collapse must (and will) happen first.

Trust me. I am a Central Banker.

Many people seem to believe that the Eurozone’s monetary problems, caused by economic over-regulation and intervention (e.g. the common currency), can be solved by imposing even more regulation and intervention (e.g. fiscal integration).

But what kind of track record do governments really have when it comes to manipulating the fundamentals of the real economy?

It Is Not Just the Euro…

Whilst the impact of fiscal policy is rather contemporary, the use of monetary policy as medicine to improve economic health has long-term implications, comparable to the side-effects of substance abuse. There are numerous examples of how government’s manipulation of money flows and exchange rates has lead to short-term economic euphoria (usually correlated with election cycles), but at the cost of creating long-term imbalances that end up being reversed with a significant element of social stress.

For example:

- The credit bubble leading up to the Great Depression of the 1930s was created by the US trying to help the UK keep the gold standard after World-War 1. The Fed bought British pounds with freshly issued US dollars, which increased the US money supply (creating a lending driven economic boom, leading to debt levels which, though large in size, were still smaller than what can be observed in the global economy today before the economy reversed)

- The crisis in Latin America in the early 1980s was similarly the result of currencies initially being pegged to the USD, driving up domestic money supply, creating negative real interest rates leading to huge debt imbalances (in USD)

- The Japanese real estate bubble between 1986-1991 (which Japan still has not recovered from) was the result of a lending spree occurring because the Japanese pegged their currency to the USD to stimulate their export industry (the central bank had to print Yen to buy USDs, which increased the domestic money supply and kept real interest rates in negative range)

- The Asian Crisis (1997) was also the result of an initial USD peg among a select group of Asian economies, which lead to unsustainable inflation, asset bubbles and debt levels

- The pegging of the Dirham to the USD lead to too lax monetary policies which gave fuel to a massive real estate bubble in the United Arab Emirates that pricked in 2009 (prior to that, real interest rates where in negative range for about 7 years). The UAE was able to keep its peg due to significant oil revenues, however is still struggling with the aftermath of high inflation

- Now China is overheating with inflation because it cannot control its money supply as the result of the USD peg. Inflation is at 6.5% and real interest rates have been negative for a long time. China may need to de-peg sooner rather than later, if it does not do so, it is risking further build up of an asset bubble that threatens economic stability. A de-peg will inevitably lead to a USD collapse, potentially creating double digit US inflation almost overnight and putting further strains on the Eurozone as exports will become massively uncompetitive – to come on top of the zone’s already huge structural problems.

And the list can go on and on….

A Change of Paradigm

A crisis yet to come is founded in the widely celebrated central bank interventions from Greenspan and the Fed. They have succeeded only in postponing major economic re-adjustments which have been overdue since the 1990s.

Through counter cyclical monetary policies during what initially must have been smaller recessions (which technically are nothing but temporary periods of lower economic growth due to businesses and consumers re-paying debt instead of consuming and investing), the Fed decided to cure the symptoms experienced by having too much debt (e.g. low growth) by lowering interest rates, which stimulated even more debt.

With progressively lower interest rates, consumers kept the economy growing by consuming with borrowed funds, and debt has increased to levels never before seen in history (US public and private sector is debt is now close to an astonishing 260% of GDP, roughly quadrupled since 1982, and around 50% higher than before the Great Depression).

And when the private sector in 2008 eventually was unwilling to continue their loan financed consumption spree (even with interest rates close to 0%!), borrowing (and spending) was instead taken over by the US government, sold to the public as “Keynesian counter cyclical fiscal expansion”.

The Fed’s overly expansive monetary policy of the late 1980s, 1990s and throughout the 2000s, has not only created a massive debt overhang, but have also sustained artificially high domestic GDP growth rates (driven by the debt fueled consumption) and supported global confidence in the USD as a reserve currency. The rest of the world believing in the “almost supernatural” powers of the Fed (remember the t-shirts saying “in Greenspan we Trust”?) has contributed to overvaluing the USD vs the currencies of trading partners. This has in turn driven the US from being a manufacturing driven economy focused on production to a service driven economy focused on consumption (to put it simply, US cars became too expensive to produce, so people found work at Burger King instead).

Throughout all this time, the US public accepted the structural economic shift towards low-earning service sector jobs, as they were still able to keep consuming, financed by the progressively cheaper credit.

Back in the really old days “bread and circus” used to do the trick. Today it is all about “iPhones and Playstations”.

Greenspan was by some declared genius, but truth is that the policies undertaken by the Fed under his management have probably damaged the US economy more than ten nuclear disasters or a hundred terrorist attacks.

The Fed has acted similar to a doctor prescribing more heroin to cure abstinence symptoms stemming from heroin abuse. As time goes, the patient develops increased tolerance and needs higher and higher dosages to feel good. The last dosages administered are so extreme that they impose a threat to his life, and though no-one expects them to cure him, at least he may have a final hell-of-a-party before he must face the real underlying sources to his pain (that is, if he is lucky enough to survive. More about that in a previous article, “The Inflation Storm”).

Convergence to Normality

Today’s 40-year old fiat currency regime is only a blip in economic monetary history (spanning back thousand of years) and will soon make way for the next paradigm shift, which may well be a return to the gold standard and the abolishing of how central banks work today.

Central banks started out as simple reserve banks to ensure stability of commercial banks (which issued gold certificates, at the time the equivalent of money).

Somehow, potentially deluded by perceived progress of economic theory (or simply a case of bad memory following 30 years of post WW2 stability), their mandates grew to encompass tasks requiring superhuman wisdom, divine integrity and foresight…

Before we return to sanity, the next economic paradigm will be a bearparadigm.

The Inflation Storm (October 2011)

The Inflation Storm (October 2011)


The US has had the Great Depression (1930s) and the "Great Recession" (as some people like to call the period from 2008-2010). Some people have dubbed the moderately inflationary period between 1971-1981 the “Great Inflation”. However, others (like Peter Schiff, Warren Buffet, Jim Rodgers and Yours Truly) think real inflation is yet to come. And that it will be uncontrolled and manifest itself more rapidly than anything experienced since the latter days of the Weimar Republic. I have dubbed it “the Inflation Storm" (though maybe “Inflation Tsunami” would a better description of the dynamics of what is yet to come).


The Inflation Storm will manifest itself as the result of the policies which have been undertaken by the Federal Reserve. The Fed has since 2009 deliberately been trying to create inflation, with two objectives in mind:

1. To prevent asset deflation in the housing market, which has the potential of destabilizing the entire banking system, as falling real estate prices are a threat to the solidity of banks and induce a significant risk to the entire financial system, and;
2. To reduce the real burden of the debt held by the US Government and consumers, as inflation will increase their nominal incomes, while the nominal value of the debt stays the same.

Learnings from the Great Depression

One of the architects behind the coming Inflation Storm (but far from the only culprit, as events to come are a consequence of failed monetary policies since the abandonment of Bretton Woods in 1971) is Chairman of the Federal Reserve Bank, Ben Bernanke. Bernanke is known to have been a devoted student of the "Great Depression", a severe economic contraction that occurred between 1928-1931 following an extended economic boom financed by large increases in debt by US consumers and businesses (1923-1928).

The economic contraction and corresponding deflationary spiral that occurred during the Great Depression was particularly severe because the Fed did nothing to expand the money supply (by the way, similar deflationary dynamics are now observable in Greece, see my article "It's the end of the Euro"). On the contrary, the Fed was even forced to raise interest rates to preserve the USD against speculative attacks and maintain its pegged value to gold.

Furthermore, back then the Fed allowed bank collapses to happen on a massive scale, and the prospects of losing their deposits lead to large parts of the public “keeping their money in their mattresses” instead of in banks, were it could be lent on to healthy businesses. This pushed the cost of financing for individuals and businesses to extreme levels, choking the economy.


Helicopter Ben

Ben Bernanke has stated that he will "let money reign out of helicopters" before he allows the deflationary dynamics of the Great Depression to re-occur. For this statement, someone has nick-named him "Helicopter Ben". With this level of determination (also not forgetting the 2 trillion dollars that the Federal Reserve has injected into the US economy since 2009), it is highly likely that he will succeed. It will then not be the first time in modern history the US government is running high inflation to reduce the US public debt burden; in the 1960s and 1970s the Nixon administration borrowed heavily to finance the Vietnam war, in order not to lose elections and fuel public disapproval for the war by raising taxes. As the costs of the war increased beyond expectations, with US defense spending peaking at close to 10% of GDP (1968), the government took the USD off the gold standard (1971) enabling the unrestricted printing of money by the Federal Reserve. The resulting increase in the money supply brought inflation up to a peak of close to 15% year on year in March 1980, averaging around 8% between 1971 and 1981.


Take From the Rich and Give to the Poor

High inflation essentially implies a re-distribution of wealth (measured by its purchasing power) from savers to debtors. The dynamics of this are slightly technical and involves a basic understanding of the time value of money, so feel free to skip this section is you are looking for an easy read. If you are still reading, imagine that you are keeping your savings in 10-year US government bonds, which have an annual yield that equals inflation, initially about 2% p.a.. If inflation suddenly increases from 2% to 20% year on year, your bond holdings will have a required return (“discount rate”) of 20% instead of the initial 2%. Discounting the same cash flows from the bonds with the new discount rate implies they will lose more than 75% of their value. The government can then refinance the bonds (e.g. buy them back in the market with funds from newly issued bonds) at 25% of their initial value, immediately reducing the value of the debt on their books by 75%.

Simultaneously, in this scenario one will expect nominal GDP and government tax income to grow at minimally the rate of inflation. In our example above, with 20% annual inflation, the nominal value of GDP will therefore growth to 250% of its initial value over five years. A debt burden which then initially equalled 100% of GDP when inflation and interest rate were 2% will therefore amount to less than 10% of GDP five years later (remember that the debt will have a nominal value which is only 25% of what it was initially, whilst GDP now will be at 250% of its initial value). And "puff" - it’s like magic; government indebtedness is (almost) no more!

The losers in this game are those who are holding large amounts of USD denominated t-bonds, t-bills and cash. They include pension funds, foreign central banks, sovereign wealth funds and similar. In the simplified example above, the purchasing power of their holdings will be reduced with 90%.

What creates inflation

The dynamics of inflation can be observed in a game of Monopoly. When players start playing, the amount of monopoly money in circulation is low, leaving little cash for the players to buy property (“invest”). As the game progresses, each player receives monopoly money when passing “Start”, adding to the supply of currency circulating in the game. As the monopoly money stock increases, so does the players’ ability to pay for properties, leading to price increases on properties traded between players during the game (if you haven’t seen it, order the game and try it for yourself :-)).  

As illustrated in the above example, price inflation is essentially determined by how much money is chasing how many goods and services.

It can therefore be triggered by either one of two events: 1) A reduction in the supply of a good or service (“supply shock”) or 2) a dramatic increase in the spending on goods and services. Simply put; if Apple reduces the production of computers (e.g. a supply shock), the price of an apple computer will increase. And if Apple should suddenly decide to buy apples instead of keeping its massive cash pile in the bank (God forbid), it will inflate the prices of apples (also considering that a newly planted apple tree needs about four years before it can bear fruit and add to supply).

It is meaningful to classify the players in the global inflation monopoly game into two groups, based on their objectives and how they collectively may behave.

1. Domestic players. These include everything from pensioners and other individuals, to pension funds, to corporates (for example, Apple’s cash holdings were recently reported to be about USD 76 billion)
2. Foreign entities, reflecting that the US have been running a negative trade balance against the rest of the world for several decades (e.g. the US economy has borrowed from the rest of the world to keep consuming)

When the Federal reserve is supplying new money to the economy (the increase in M1 money stock since November 2010 has been close to an astonishing 50%), it only means increased inflation if this money results in increased demand for goods and services (and does not just end up in savings accounts). In today’s global Monopoly game, most players have been saving rather than spending the extra currency the Fed has issued. The key questions are why, and how long one can expect this to continue. To understand how they will behave, one needs to examine them in greater detail.

Domestic players will start spending when the US real estate market has hit the bottom

Domestic players (e.g. the general public in the US) are motivated by maintaining the purchasing power of their savings. They face the choice between spending their money now (consume/invest) or saving their money in order to be able to spend them later. Excluding the share of the population which is saving for retirement (which is low in the US compared to for example Japan) the public will only chose to spend now, if it thinks that its savings will allow it to buy less things later (e.g. price increases are expected).

Currently, the expectation/ consensus view of the US general public is that spending later will buy them more things than spending now. Real estate prices have been declining since 2006, and are expected to decline further in 2012 by “everyone”. Just like a series of rapidly increasing prices in the beginning of 2000 lead to continued expectations of price increases, a series of decreasing prices since 2006 are now leading the public to expect continued price decreases.

It is noticeable that the Fed’s attempts to drive inflation with money supply increases are futile, as long as consumers and corporates expect decreasing prices. When consumer expectations change, all the cash that has been piled up will come into the economy as demand very fast and in great quantities (because it will become clear to “everyone” that one dollar spent today will buy more than one dollar spent tomorrow, and the public will rush to spend their money not to be left out). US inflation increases will be driven by a bottoming-out of the US housing market, likely to occur some time during 2012 (at current price decline rates, real estate values vs. rents and disposable income should then become about 10% undervalued compared to its long term average, which has signaled the turning point in previous real estate price declines).

Foreign players will start spending when...???

The foreign players are much more interesting, in the sense that it is very hard to predict how they will behave. Contrary to domestic players, the primary objective of foreign central banks of holding USD denominated asset is not to save money for future consumption. The holders of US currency are for a large part institutional players in economies that have pegged their currencies to the USD, have been running massive trade surpluses vs. the US over several years, and are reliant on a export oriented manufacturing strategy to drive domestic growth and maintain social stability. 


China is leading the pack, with the Chinese central bank alone holding around USD 3.2 trillion in currency reserves (e.g. 3,200 billions!). Most of this is invested into USD denominated t-bills and bonds. China has been de-facto pegging its currency to the USD since the 1970s, (though after 2005 officially to a “basket of currencies”). The overarching priority of the Chinese policy is domestic stability and economic growth for their largely export based economy, achieved by keeping their currency low in spite of running a massive trade surplus against the US. China is struggling with increasing inflation.


Gulf Council states (Saudi Arabia, the UAE, Kuwait, Qatar, Oman and Bahrain) together hold around 2 trillion in foreign assets, of which roughly half are central bank holdings (the number is difficult to judge as sovereign wealth fund holdings are intransparent). Their currencies are without exception pegged to the USD. These countries have mixed economic states. The UAE is struggling with de-flation in the aftermath of a recent real estate bubble, whilst Qatar and Saudi Arabia are experiencing too high inflation.

Bank of Japan has foreign currency reserves of USD 1.1 trillion, most of it in USD. Their main objective is to keep their currency low against the USD not to hurt their largely export oriented economy. Japan has been trying to create inflation for almost two decades, but its population is dominated by old individuals that are saving for retirement - they simply will not spend more even if they have more money.

The central bank of Russia has foreign exchange reserves of around USD 530 billion. Their objective is to manage currency fluctuations of the Rubel as their banks are largely financed in USD. 


Interestingly, relatively small currency areas like Taiwan and Hong-Kong (population of 23 and 7 million, respectively) have currency reserves of USD 400 and 280 billion, respectively. They have been keeping their currencies low in export oriented economic growth strategies, similar to those undertaken by China and Japan, but started much earlier. Hong-Kong is struggling with high inflation (close to 8% y/y), whilst Taiwan seems to have inflation under control.


These are some of the main examples, though there are many more. It is notable that a minor part of the currency reserves mentioned above is not USD denominated (they also hold EUR, JPY, GBP and other currencies), however the bottom line is that foreign savers (conservatively estimated) hold between 10-15 trillion in USD denominated financial assets! If these should choose to liquidate their holdings (by for example not rolling over t-bills and not re-investing bond principal repayments) and exchange their cash for durable physical assets (e.g. real estate, gold, stocks, farmland, whatever there is) the resulting demand will have a massive inflationary impact, completely dwarfing that of the US general public!

Additionally, not counted in the above are dollars used in the European interbank market (the bulk of bank funding is in USD, as the EUR interbank market is smaller and less liquid), USD on the books of foreign corporates (as a trading currency) as well as cash in circulation among the general public in developing countries (for example, one can pay with USD is most African and Latin American countries, also many individuals have USD accounts). Though the US only has a 27% share of global GDP, the dollar is the global exchange and savings currency and probably the basis for 70-80% of global money stock (including currencies that are pegged to the USD, such as the Chinese Yuan, or that are sought kept low against the USD, such as the Japanese Yen).

The status of the USD as the World’s currency following the end of World War 2 has given the US economy substantial benefits, as it has enabled the US general public to receive foreign goods and services without having to exchange US produced goods and services in return (e.g. a USD in circulation in Zimbabwe was once received by a Zimbabwean as payment for something with originated in a supply of a good or service to the US public - as long as that USD stays in Zimbabwe and is preferred as a mean of payment, it will not result in demand for a US produced service - it's an IOU that will never be called!). Collectively as a Nation, paying with IOUs that will never be called, has contributed to increased standards of living for Americans, and enabled them to consume more goods per capita than most other nations on the planet.

So, being the object of a currency peg has enabled America to consume much more than it produces. And US national debt has been increasing with 0.5 trillion USD a year.

When Helikopter Ben is increasing the US monetary supply, he is also increasing the monetary supply in currencies that are pegged to the USD.

The problem with this policy is that it can only be sustained for longer periods if the currency is undervalued against the USD, e.g. if the economy is running a current account surplus (is exporting more than it is importing). The central bank can then sell its local currency in infinite supply, in the case of China being the Yuan, to counter the demand for Yuan coming from the exports. This essentially implies that the central bank is issuing new money it is changing into USD. It has the effect of creating domestic inflation (as its efforts are increasing the domestic money supply), but also acts to decrease US inflation, as money that otherwise would be circulating in the US are taken "off the market" and placed into t-bills and bonds. This has helped keeping US interest rates close to 0 for long periods of time in spite of excessive borrowing, and without any dramatic domestic inflation observed so far, by some dubbed an "economic miracle".


When the Federal Reserve prints more money domestically in an effort to drive up US inflation, it also means that China and the other nations in the pack of peggers need to buy more USD in order to maintain their currency pegs. Which for China means an increase in Chinese money supply, which means more fuel added to the fire on Chinese inflation. Current measures undertaken in China to contain inflation are related to price controls and control of the lending requirements of banks, however it is without a doubt that these measures have failed to contain inflation, especially when prices of real estate are taken into account. The Chinese have allowed for a re-valuation of the Yuan (it has increased 7% since June 2010), however it has not been enough to counter the currency flows and the continued increase in Chinese money supply. Offcially, China is experiencing a 6.5% year on year inflation, nevertheless if adjusting for increases in the prices of real estate, as well as considering the extensiveness of Chinese measures to curb inflation (even letting their currency appreciate!) true Chinese inflation is likely in the double digit range.