Funny money: the perils of printing T-bills

By selling Treasury bills to the PBOC and other central banks, the US has turned good money into bad. The effect on global currencies and economies has been enormous.
Currencies are seen by ordinary people as being subservient to the real issues of the economy: wage levels, unemployment, productivity increases, income and consumption tax, imports versus exports, investment and so on. This is the stuff that makes eye-catching headlines. Much less so the columns of FX rates at the back of the newspaper.

However, with extraordinary strength in recent months, those same ordinary people must be starting to wonder if there is any such thing as the real economy. Indeed, it increasingly appears to be the financial flows that are the real economy, while many of its tangible manifestations (property, for example, and the wealth that it has created) of the real economy seem set to melt away like ice under the Hong Kong sun.

The explanation for this topsy-turvy world is simple. China has been creating money out of thin air to keep its currency low ($1.3 trillion at last count) û and the US has been pouring this funny money û in the form of Treasury bills û into its own real economy. The consequence is that the US economy has been looking increasingly less real, and increasingly funny, the more the process carries on. This is not just a case of bad money driving out good, but more like bad money driving down a whole economy.

Other central banks (especially in the Middle East) are also implicated of course û in fact, any country that has been piling up foreign currency reserves is implicated. None of them, apart possibly from Japan, are ones you necessarily want to entrust with your pension.

The nexus between finance and factories can be found in interest rates. By accepting Chinese money at face value (quite ironic when you would be met with ridicule if you tried to offer yuan to money changers in Switzerland or France), the US has allowed an unprecedented decrease in the cost of capital to its own economy. That, of course, brings down the hurdle rates these companies need to achieve to exceed the cost of capital (ie, to become profitable). They could lower the hurdle rates as the cost of capital collapsed, and still throw off lots of cash flow. Euphoria (especially in tech stocks) was the by-product.

ôItÆs another rally/right cross the Valley,ö as the band The Richter Scales puts it in their YouTube hit Here comes another bubble. The cash generated by the cheap capital, unfortunately, was generally used for consumption rather than re-investment.

After all, if people are kind enough to lend you very cheap money, why bother working too hard for it, the traditional method of generating wealth.

The two economies have both been huge beneficiaries of this process, giving the lie to all hostile rhetoric emanating from both sides û essentially just political propaganda for the saps on both sides who will be making the real sacrifices when the bill needs to be paid. That will be in the form of the housing collapse in the US and is already being paid in China in the form of the lopsided anti-rural industrial development model the government has championed û which throws off lots of cash for the city elites, but doesnÆt do much to raise the overall standard of living.

People are now waking up to this scam. The collapsing US dollar is becoming increasingly indistinguishable from funny money. A global reserve currency is meant to be, literally, as good as gold. ItÆs meant to be a store of value in troubled times. On that definition, the US dollar has already forfeited the moral aspect of currency supremacy. The result is commodity prices, which have already been on an upward trend for the past few years are sky-rocketing even higher as investors flee cash and put their funds in generators of inflation (rather than victims, such as the corporate and consumption sectors), such as oil; or stores of value, such as gold.

The domestic US economy has naturally not escaped the contamination. All that money gushing through the system, has (as it always does) reduced standards across the board.

Whether you are talking of hurdle rates, credit checks, investors and regulators û performance all went down several notches. Again, thatÆs not surprising. When money seems to have become more plentiful, it encourages the perception that mistakes can be easily fixed. In practice, it never works like that.

Funny money rarely has the qualities needed to fix the problem since everybody
stops trusting it. ThatÆs exactly whatÆs happened in the inter-bank markets. And itÆs beginning to happen as foreign central banks start throwing the stuff theyÆve been accumulating for so long out of the window û mainly to buy euros. That has a disastrous knock-on effect for Europe, especially as the European Central Bank seems wedded to the increasingly quaint notion of non-interference.

The US corporate sector is now starting to pay the price û as that other line from The Richter Scales song predicted: ôSuffered through the market crash/lost a load of cash.ö

According to a research report produced by Merrill Lynch in early December, S&P500 earnings for 2007 are likely to hit 3.2%, compared to expectations of 9.3% at the beginning of the year. And according to Thomson Financial, banks will have a disastrous fourth quarter, with a 35% decline in results. What has clearly happened is that as capital gets more expensive (despite the Fed rate cuts, since banks are hoarding cash) it becomes a lot more difficult to make easy profits. Indeed, observers could be forgiven for being cynical about the vaunted US strengths in labour market flexibility, creativity and innovation, and miraculous productivity increases on the back of clever IT systems. It rather looks more like a case of easy profits emanating from easy money.

The dollar standard wonÆt disappear overnight, of course. ôThe US dollar became the world currency because of the proportion of world trade it was, and still is, involved in,ö notes UBS currency strategist Pu Yonghao in Hong Kong. ItÆs also the legacy of the dollar being the most trusted currency in the aftermath of World War II. Most importantly, the US is bound to react like a scalded cat if there are any attempts to push the dollar off its pedestal. The reason is clear. While so many global commodities are denominated in dollars, the US will be able to acquire those assets as fast as its printing presses can churn out the greenback û indeed, thatÆs why the US doesnÆt have anything as vulgar as forex reserves.

So is this the end of the world as we know it? Of course not. AmericaÆs undoubted strengths in technology, manufacturing and services will serve as a buffer for a long time yet.

Even from a technical viewpoint, specialists believe that a rebound is near. SG currency specialist Patrick Bennett reckons that the current dollar weakening cycle started in 2002, and that the downturn is ready to bottom out. ôThe dollar cycle is typically five to seven years,ö he says. Nevertheless, the longer the government tilts the playing field by pretending that money fresh off the printing presses of the PBOC and other mercantilist central banks is actually real money, the weaker those buffers become.

This story first appeared in the foreign exchange supplement that was published with the December 2007/January 2008 issue of FinanceAsia magazine.

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