- Jul 22, 2012
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We're in a rather odd situation right now. An important thing to keep in mind is that inflation and deflation depend on who is buying US debt or holding US dollars. If someone like you or me buys US treasuries, this doesn't cause inflation or deflation because there isn't a net gain or loss of money in circulation within the US. $100 leaves you, it goes the government, then the government spends it on EBT cards or something. Our status of being the world's reserve currency has a deflationary effect. Money leaves the US and is used for international trade. More than 60% of all US dollars are outside of the US. As Peter Schiff would say, our ability to export inflation (or import deflation) is why products are so much cheaper in the US. People in Australia or Canada or the UK need to export things in order to import things. That doesn't really apply to the US because US dollars are the product we export. People want dollars because you need US dollars to buy oil or trade with other nations.
Enter the fed. Real demand for US debt is very low, and the fed is currently the biggest buyer of treasuries. This has a significant inflationary effect because those bonds are purchased with newly created money. The fed prints money, uses that money to buy bonds, then that money goes into circulation through things like EBT cards, medicare, social security, government wages, etc. You might not care too much about this inflation because your wage is in US dollars and you naturally assume that your pay will scale with inflation. People around the world see it differently. The rest of the world is sitting on trillions of US dollars that are worth less every single day. What do you do when a stock or a bond is declining? You sell it as quickly as possible. The same logic applies to money. If you're holding a trillion US dollars and the value is dropping, it would make sense to sell those US dollars in exchange for something else like gold or real estate. That's exactly what is happening. China has been buying lots of gold and real estate. Not just American real estate, but everywhere around the world. This creates a second kind of inflation. While the fed is causing inflation by creating new money, China and other countries are causing inflation by bringing US dollars back to the US. Having more in circulation within the country means each one is worth less. Worst case scenario, the price of everything could double because that's how many US dollars could potentially come back home after the world abandons the petrodollar.
So the solution is to stop inflation by stopping QE, right? Not quite. This is where we've really painted ourselves into a corner with an incredible amount of debt. Our debt is sustainable as long as interest rates stay low. What determines interest rates? Just like your own personal debts, this is controlled by supply and demand. If you're a top quality borrower, lots of people want to lend you money, so you get loans with very low interest rates. When fewer people are willing to lend you money, you need to offer higher interest rates. Another layer of complexity is that bond prices are inversely proportional to bond yields. Think of it like the government holding an auction for a bond that pays $100 in 1 year, and it goes to the highest bidder. If people really want that debt, they'll pay $99 for that $100 bond, so the yield is about 1%. What happens when people don't want that bond and are only willing to pay $50 for it? The price of the bond drops from $99 to $50, and the yield would go from 1% to 100% because it still pays $100 after 1 year. QE is intended to keep the interest rates on US debt low by creating artificial demand. That seems like a good thing, but remember that QE made every bond in circulation more valuable. What happens when QE ends? The value of bonds already in circulation will go down. Just like anything else, people will sell if the think the value of something will go down. That's exactly what happened in June:
http://www.reuters.com/article/2013/08/16/us-usa-economy-capital-idUSBRE97F02T20130816
So now we're in a situation where QE inflation is causing countries to abandon the US dollar, but we can't stop QE because stopping QE would make interest rates go up and make the interest on our national debt consume the entire federal budget. How the hell do we get out of this?
Enter the fed. Real demand for US debt is very low, and the fed is currently the biggest buyer of treasuries. This has a significant inflationary effect because those bonds are purchased with newly created money. The fed prints money, uses that money to buy bonds, then that money goes into circulation through things like EBT cards, medicare, social security, government wages, etc. You might not care too much about this inflation because your wage is in US dollars and you naturally assume that your pay will scale with inflation. People around the world see it differently. The rest of the world is sitting on trillions of US dollars that are worth less every single day. What do you do when a stock or a bond is declining? You sell it as quickly as possible. The same logic applies to money. If you're holding a trillion US dollars and the value is dropping, it would make sense to sell those US dollars in exchange for something else like gold or real estate. That's exactly what is happening. China has been buying lots of gold and real estate. Not just American real estate, but everywhere around the world. This creates a second kind of inflation. While the fed is causing inflation by creating new money, China and other countries are causing inflation by bringing US dollars back to the US. Having more in circulation within the country means each one is worth less. Worst case scenario, the price of everything could double because that's how many US dollars could potentially come back home after the world abandons the petrodollar.
So the solution is to stop inflation by stopping QE, right? Not quite. This is where we've really painted ourselves into a corner with an incredible amount of debt. Our debt is sustainable as long as interest rates stay low. What determines interest rates? Just like your own personal debts, this is controlled by supply and demand. If you're a top quality borrower, lots of people want to lend you money, so you get loans with very low interest rates. When fewer people are willing to lend you money, you need to offer higher interest rates. Another layer of complexity is that bond prices are inversely proportional to bond yields. Think of it like the government holding an auction for a bond that pays $100 in 1 year, and it goes to the highest bidder. If people really want that debt, they'll pay $99 for that $100 bond, so the yield is about 1%. What happens when people don't want that bond and are only willing to pay $50 for it? The price of the bond drops from $99 to $50, and the yield would go from 1% to 100% because it still pays $100 after 1 year. QE is intended to keep the interest rates on US debt low by creating artificial demand. That seems like a good thing, but remember that QE made every bond in circulation more valuable. What happens when QE ends? The value of bonds already in circulation will go down. Just like anything else, people will sell if the think the value of something will go down. That's exactly what happened in June:
http://www.reuters.com/article/2013/08/16/us-usa-economy-capital-idUSBRE97F02T20130816
.China and Japan led an exodus from U.S. Treasuries in June after the first signals the U.S. central bank was preparing to wind back its stimulus, with data showing they accounted for almost all of a record $40.8 billion of net foreign selling of Treasuries.
So now we're in a situation where QE inflation is causing countries to abandon the US dollar, but we can't stop QE because stopping QE would make interest rates go up and make the interest on our national debt consume the entire federal budget. How the hell do we get out of this?