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starbucks4ever (89.25)

Bad loans to the US government



July 21, 2008 – Comments (8)

Here is the situation. You're an export-oriented country (let's say, China), and you sell tons of consumer goods to America. As a result, you run trade surpluses and your exporters bring in tons of dollars. You want to keep your domestic currency weak, so you print billions of renmimbi with which you buy the dollars, and then you deposit the dollars into US T-bills or the FNM / FRE bonds. You think you've become rich because you own some two trillion dollars worth of bonds. You think you must sell your consumer goods to America because that where your largest market is. You think you cannot sell your consumer goods to the locals because the locals are too poor to buy them. As long as you believe in the intrinsic value of the dollars you hold, things look fine.

But then suppose you begin to ask yourself this question: we produce manufactured goods and ship them to America. What exactly do we get in return? One answer to that question is that you get lots of dollar bills. But since you can't eat dollar bills, it would be helpful if you could exchange them for various life's necessities. The alternative is to let enough people convince themselves that these pieces of paper have intrinsic value. If this trick works, then dollars will have intrinsic value because of the sheer power of mass psychosis. The trouble is, mass psychosis can end very abruptly, as Dutch tulip investors can testify. So perhaps it's not such a bad idea to ask yourself if you can in fact spend your two trillion dollars to buy something that you may want. So let's run the stress test of your two-trillion-dollar bond portfolio. Suppose you decide to pull your dollars from the bond market and go shopping. Wait a minute. You can't pull two trillion dollars from the bond market. As soon as you pull the first half-trillion, the bond market collapses, and the Federal reserve tries to avert the financial catastrophe by injecting the equal amount of liquidity into the economy. That's unfortunate. You were hoping to get paid in real, not inflated dollars. Now, instead of two trillion real dollars you salvage some one and a half trillion from the collapsing bond market, and to add insult to injury, the Fed has inflated the hell out of them. Ouch. That's less purchasing power than you hoped for.

But anyway, the things done cannot be undone, and now you find yourself on the global marketplace with some 1.5 trillion dollars much worse for the wear and tear, and try to buy commodities, consumer goods or services with them. From the first glance, things don't look too bad. You can buy oil from Saudi Arabia, metals from Russia, software from India, sugar cane from Brazil and consumer goods, well, from China. This, however, involves the assumption that Saudi Arabia, Russia, etc. will be willing to accept your dollars as means of exchange. They may well accept it if you get so lucky. But suppose the bursting of the bubble of exaggerated expectations and the reappraisal of risks of investing in treasury bonds is taking place at the same time in all parts of the world. Now things suddenly look very different because you are not alone in your desire to get rid of dollars. Every other exporter is taking their dollars out of US debt instruments and is trying to spend them. That includes the currency reserves of China, Japan, Russia, OPEC states, Europe and, last but not least, the holdings of American investors who realize that they sit on a rapidly depreciating asset. There is a global rush to convert pieces of paper into something tangible. It turns out that all your foreign shopping malls are closed. Can you spend your dollars in Saudi Arabia? No, because the Saudis don't know what to do with their own dollars. Can the Saudis get rid of their dollars in your country? No, because you're now in a similar situation. 

So all roads lead to America, this is the only supermarket still open at this time of the day. Again, from the first glance, store shelves look full of products. The US economy produces 14 trillion dollars' worth of products every year, surely you will find something valuable to you. Wait a minute. One trillion of those 14 is imputed rent. A useful product to a statistician from the Ministry of Truth, but it's not very clear how you can purchase this product or why anybody would want to. That leaves us with 13 trillion dollars' worth of inventory. Again, wait a minute. This also includes some 300 billion dollars of imputed interest income. Ouch. Not very useful either. 12.7 trillion seems to be the actual figure of economic activity that is not ficticious. So let's begin our shopping tour. The first shelf in our supermarket displays American-made cars, trucks and SUVs. A nice thing to have, but...but our domestic industry can produce very similar cars. The technology is the same, we just got it from America, the factories were built by the same American companies, the materials, labor and spare parts are local, corporate taxes are lower, shipping expenses are lower, and the price point is just right for the local market.  American cars have a place on our market, but they should first become much cheaper. How much cheaper? Take a hint from Tata Nano. What's on the second shelf? Yes, consumer electronics. Gee, these gadgets look cool...Wait a minute. The label says "Made in China". Hmm, no point to travel to Nashville to buy a CD player that came from Guangzhou. What's on the third shelf? Education services. There was a time we used to go nuts about this product. But we are smarter now. We know which textbooks they use, we have same the same textbooks translated into our language, and our professors can learn a page from the textbook and recite it in class almost as well as their American colleagues. And the prices? 40,000 dollars per year does not look too inspiring. Take a pass on that one. What's on the next shelf? Yes, legal services. Americans produce plenty of those, so much in fact that they have to sue each other for years because both lawyers have some article of law on their side. What kind of system is that? Our system is so much better, the amount of the bribe you pay is an objective criterion that anyone can understand. Anyway, we can't use these services outside of America. What's next? Restaurants, laundromats, transportation, auto repair, wholesalers, retailers and other such economic activities? Kind of hard to consume these services if you live in Guangzhou. What else? Machinery and equipment? Yup. That's warmer. We always need equipment. The thing is, though, we are already buying equipment from them, we buy it faster than our people are able to install it, and yet we still have a huge trade surplus, and they can't raise the prices of equipement because then somebody in Japan will offer it cheaper. The more equipment we buy, the larger the trade surplus. Investment services? Sure, in America everybody wants to sell you investment advice, but that's putting the cart before the horse. The question was what to buy with these dollars that they are so eager to manage for us, and besides, we don't have any lack of investment gurus back in Guangzhou. Health care services? Sure, we could buy those, but we'd have to undergo lobotomy first to buy them from American HMOs. Somehow, these HMOs made sure that a simple operation that costs us $1000 to perform carries a $20,000 price tag.  If Americans want to pay that kind of money to their insurance companies, that's fine with us, but  let our dollars stay on the sidelines. Financial products like CDs and annuities? Again, most of them is money-insinerating crap and besides, we can buy those back at home. The last shelf offers consumer goods that America is not producing now but could produce on demand. That's an impressive display of products. Look, these yankees can even produce clothes and shoes, who would have thought? The problem is, this production is not competitive. Labor costs may be rising in China, but American labor is still several times more expensive. They cannot produce things at competitive prices because they want to keep their housing bubble and health care bubble, so their workers willy-nilly have to demand salaries that would allow them to overpay 4-5 times for housing and health care, and then, after they finish working, they go to McDonalds, where they buy an overpriced BigMac from a guy who demands an excessively high salary to pay for his own housing and health costs. That's why their labor is grossly overpaid. They know the correct solution to their predicament is to pop their bubbles so that wages could reset, but they will never do this because their own savings are fully invested in these bubbles. The second alternative is to devalue the dollar by another 60%-70%, which would help them restore competitiveness. But in this case we must sell every dollar-denominated asset we might own, including housing and stocks, because if the dollar drops 70%, then we'll need to earn a 200% nominal return just to keep our head above water. Besides, there is a good chance American investors will also think the same way, so it should be a good idea for us to hurry before they wake up. At some point in the future, devaluation should bring its fruit, but for now, American assets are not worthy of our attention. Even if they are not rendered nearly worthless by the shortage of American-manufactured goods, then currency exchange rate will finish them off.

Summarizing, we come to a sad conclusion that there is nothing to buy in this supermarket for the time being. After weeding out statistical lies, impractical or impossible propositions, scary rip-offs and super-duper deals, we see nothing but empty shelves. Everything canceled out. 

When a bank lends money to a suprime borrower, bank shareholders think that they should be working with this this type of customers because that's where the money is. Upon a closer inspection, the customer's wealth turns out to be an illusion based on the customer's statements on the liar loan application. Our trade relationship with America falls into this category. Looks like we made a serious mistake lending consumer goods to people who cannot pay us back.

8 Comments – Post Your Own

#1) On July 21, 2008 at 1:02 PM, FreundInvesting (28.85) wrote:

Wow, fantastic article. You're a great writer.

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#2) On July 21, 2008 at 1:03 PM, Nainara (< 20) wrote:

I agree with your basic thesis that the China/Japan/Arab holders of US debt will have difficulty diversifying their holdings on any meaningful scale. However, although I dont necessarily agree that the US is without worthwhile assets to buy. Quite the contrary, at this point the US still represents the largest accumulation of assets in the world.

In the coming years, expect to see a major shift in wealth of the major dollar-denominated asset holders into sovreign wealth funds like the ADIA, CIC, GIC, etc. as well as government-championed international corporations. These funds will quietly exchange their massive dollar foreign exchange reserves for real assets - ie. real estate, commodities and especially businesses. They will do so with maximum discretion so as not to trigger a premature stampede for the exit or a protectionist reaction from the debter nations. All countries involved have made an implicit decision (rightly or not) that rocking the boat is a bad idea at this point.

Friendly suggestion though, make gigantic wall of text more manageable by breaking it up into separate thoughts.

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#3) On July 28, 2008 at 8:07 PM, Donnernv (< 20) wrote:

Nice article.  Let me second and third the last suggestion.  Force yourself to hit a carriage return after every third sentence or, at the very least, after every fourth.

This makes it so much less forbidding for your reader.

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#4) On September 13, 2010 at 8:13 PM, truthisntstupid (91.09) wrote:


This is over two years old and someone is bound to bust me and call me stupid again for commenting on old blogs.

What makes people think the passing of time alone makes means a blog like this doesn't STILL deserve readers?

zloj, this is awesome.  It should have gotten more attention when you wrote it.  I feel like I learned something,,,and that's anything but stupid.

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#5) On September 13, 2010 at 8:17 PM, truthisntstupid (91.09) wrote:

"What makes people think the passing of time alone makes means a blog like this doesn't STILL deserve readers?"

ahh..strike out  "makes",  please.

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#6) On September 13, 2010 at 9:10 PM, starbucks4ever (89.25) wrote:


Thanks for the kind words. But looking back now, being 2 years older and hopefully wiser, I owe you this confession.

When I joined Caps, I was bearish on the US. I thought this trend of declining dollar (everybody was talking about it back then) was for real. In my mind, the anticipated crisis would follow this simple logical scenario: Fed prints money, the foreigners holding dollars behave like rational economic agents, investors dump bonds, we hyperinflate the dollar and lose our reserve currency status, and foreigners come in and buy our real assets on the cheap, and we emerge from the crisis with a weaker America and stronger Asia. Naive, of course, but then everybody was thinking along these lines.

We all know what happened instead. Instead of dumping bonds, the Asians took part in the greatest bubble in history, for that's what we should it - a bond bubble. And so it turned out that Bernanke could print an unlimited amount of dollars without any bad consequences. Instead of punishing him for that robbery attempt, foreign investors smiled happily and said, "thank you, Ben, would you please help us some more, we have another trillion dollars that we want you to devalue". It all seemed unreal. It was clear that somebody will be left holding the bag. So I had to admit that I was totally wrong about the crisis. My old naive model was not working. It was now clear to me that America would emerge stronger from the crisis, and both Europe and Asia would pay the bill. That was about a year ago. 

From that moment I became a US supremacist (as AndreyLikesMTL put it), bullish on America and bearish on emerging markets. And ever since then it felt like I had a crystal ball, capable of predicting all trends abroad, and even the temporary tops and bottoms in S&P 500. Yes, my US-centric model was working almost flawlessly for this whole year, and I'm not about to abandon it any time soon.

My old prediction of a bond apocalypse is no longer active. Instead, I am predicting a strong recovery of all American assets, and a dramatic crash of emerging markets. Emerging markets have been performing well in the recent months, but that's natural. The bond bubble is still growing, and for a while, Chinese central bankers can look clever. The chickens will come home to roost when we get a real inflation and the bond bubble bursts. A bad loan to the US government in the amount of $2 Trillion, and now it's already something like $2.5 Trillion dollars? That's enough to sink China's economy. It's bigger than our own housing crisis, in relative terms! But so far, nobody is talking about it.

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#7) On September 14, 2010 at 6:31 AM, truthisntstupid (91.09) wrote:

But,zloj, it seems to me like what you've offered here is a pretty convincing (and funny)  reason as to why they're stuck with our debt!  It's hilarious...and there probably is some truth to it...isn't there?

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#8) On September 14, 2010 at 9:04 AM, starbucks4ever (89.25) wrote:

" is a pretty convincing (and funny)  reason as to why they're stuck with our debt"

They are not stuck with anything except their own stupidity. And I see no way this can be helped because we don't know how to treat stupidity. 

Another flashback: 

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