Reply #21: Too much like 1929

[54anickel]

http://www.prudentbear.com/articles/show/2001

The following commentary will describe the final sequence of events that will lead to the implosion of the global economy.

As US real estate prices fall and depress US economic growth, private foreign investors begin to withdraw their capital from the US financial markets. This capital flow would by itself act to elevate the currency value of the country that it is returning to. However, the governments of developing foreign countries have policies in place to fix the exchange rate of their currencies. In order to maintain this fixed exchange rate, foreign central banks will print their own currency and exchange it for US dollars (which are then invested into US government debt). The amount of money printed and exchanged into US dollars by the foreign central bank will necessarily equate to the amount of private capital returning to the country. These central bank policies will act to artificially keep the value of the US dollar elevated and artificially keep US interest rates low.

The fixed exchange rate regime is put under great stress when private investment capital begins to leave the US, because it necessitates that the foreign central bank print much greater amounts of their own currency. This will act to boost their domestic money supply and cause their own economy and stock market to “overheat”. Additionally, in the process of exchanging increasing amounts of their own currency for US dollars, the foreign central bank rapidly builds up the amount of foreign exchange reserves that they own. The increasingly large holdings of foreign exchange reserves represent a corresponding increasingly large risk of foreign exchange losses to the central bank (should the US dollar fall in value in the future).

When the central bank fixes the exchange rate, it effectively cedes control over the domestic money supply, as they are obligated to print whatever amount of currency is required in order to offset the amount of foreign currency being brought back to the country. The only tool that the central bank has left at its disposal is to change the level of the domestic short term interest rate. However, even there its’ hands are tied, because if they decide to increase the interest rate (should the economy “overheat”), then this will only serve to worsen the situation. This will cause even more investment capital to return to the country from the US because the interest rate differential between the two countries is made more favourable, drawing in capital in search of higher interest yield.

In the face of increasing private investment inflows (caused by a deteriorating US economy), the foreign central bank is faced with a tremendous dilemma. Its economy begins to overheat and yet increasing interest rates will only serve to worsen the situation. The only way to stop the rapid acceleration in domestic money supply growth is to finally abandon the fixed exchange rate regime altogether. This will negate the necessity of printing new currency with no control.

When the fixed exchange rate regime is terminated, then newly minted funds from the foreign central bank no longer act to support the value of the US dollar and maintain low US interest rates. In effect, there is nothing left to support the US consumer anymore. The value of the US dollar collapses and US interest rates skyrocket. The skyrocketing interest rates cause a real estate crash. The collapsing value of the US dollar causes the price of gold to skyrocket. And needless to say, the stock market collapses.

At this time, the key foreign central bank that is artificially supporting the US economy at present is the central bank of China. Their current foreign exchange reserves now stand at $1.2 trillion. The latest statistics indicate that their foreign exchange reserves grew by about $135 billion in the first quarter of 2007, which equates to an annualized growth rate of $540 billion. They are not alone in propping up the US economy, as total worldwide central bank reserve growth is running at an annualized rate of $1 trillion (with current total reserves of $5 trillion). Some people look at the data with puzzlement, but what it clearly reveals is that a great deal of private investment capital is being repatriated from the US. Economic growth in the US began to decelerate significantly in the fourth quarter of 2006. I don’t see that as a coincidence.

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