December 3, 2006 at 6:31 PM #8005powaysellerParticipant
In all my reading about the economy, I have never come across a good description of the liquidity bubble, until earlier this year when I came across Richard Duncan’s The Dollar Crisis. Since he wrote the book, he went to work for an investment company and doesn’t write anything on the internet. Too too bad.
Richard Duncan explains the process of money creation and recycling:
“There is a wide-spread misconception that the United States relies on the
savings or other countries to finance its current account deficit. This is
During recent years, at least, the US current account deficit is financed
primarily by money newly created by the central banks of other countries.
Newly issued paper money is not the same thing as a county’s savings.
The companies that earned money by exporting to the US keep their savings.
It is only that they keep them in their domestic currencies after having
sold the dollars they earned from exporting to their central bank.
In fact, the banking systems of the export-oriented economies all across
Asia are burdened by too much savings. Excess deposits are increasing more
quickly than viable lending opportunities and, consequently, interest rates
have fallen to historic lows.
Therefore, it is not a matter of the US using up all the rest of the world’s
savings to fund its deficit. It is a matter of that deficit being financed
by the central banks of the United States’ trading partners.
Many countries around the world accumulate large stockpiles of dollars as a
result of their trade surpluses with the United States. The central banks of
most of those countries print their own currency and buy those dollars in
order to prevent their currencies from appreciating when the private sector
companies that earned the dollars exchange them for the domestic currency on
the foreign exchange markets.
The central banks then invest the dollars they have acquired into US
dollar-denominated debt instruments, preferably US treasury bonds or agency
debt, in order to earn a return. If the amount of dollars accumulated by
foreign central banks exceeds the amount of new debt being issued by the US
government and the US agencies during any particular period, then the
central banks will buy existing government and agency debt instead of newly
By acquiring existing debt, they push up the price and push down the yield.
That seems to explain why long bond yields have been falling since mid-2004
even though the Fed has been increasing interest rates at the short end of
the yield curve.
“December 3, 2006 at 6:47 PM #41080powaysellerParticipant
Duncan continues, and explains that reducing our deficit is actually bad, because it wouldn’t allow the FCBs to buy all the Treasuries they need to buy with their dollars, and that would cause even more asset bubbles and push interest rates even lower. The Fed has lost control of the long end of the yield curve, so they are talking down the dollar to regain control and bring up the yield.
“Soon, foreigners will own all US debt. At present, foreign investors own approximately 50% of the $4 trillion in US government debt that is held by the public. Under the circumstances just described, within four years, foreign investors could end up owing all outstanding US government debt.
After that, they would have no choice but to invest their annual surpluses into other dollar-denominated assets, such as agency debt, corporate debt, equities, property, bank loans, etc. Such a scenario would cause extraordinary asset price inflation, directly as foreign investors bought
more and more US assets, and indirectly as their acquisition of bonds drove down interest rates, providing still more unwanted stimulus to the US economy.
Regardless, then, of whether the US government reduces its budget deficit or not, it would appear that the rapidly expanding US current account deficit has begun to undermine the ability of the Fed to determine the level, or even the direction, of interest rates in the United States.
Moreover, if the present trend in the current account deficit is left unchecked, the investment of ever larger amounts of dollar surpluses by foreign central banks into US dollar-denominated assets threatens to produce asset price bubbles and economic overheating in the Untied States over which the Fed would have no power to control.
Seen from this perspective, there is little wonder that the Fed has begun to talk down the dollar. These fears may also explain why the United States has recently launched an aggressive campaign to force China to revalue the Yuan.
Their best hope of regaining control over the situation is for the United States to force a sharp devaluation of the dollar relative to all the Asian currencies in order to reduce the US current account deficit; the European economies are simply too weak for the Euro to bear any more of the burden of adjustment. The United States has now adopted – and begun to enforce – a Weak Dollar Policy. Asia must come to terms with this fact and recognize that this policy shift poses a grave threat to its export-led model of economic growth.
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