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Andy Xie: Fed would fool both bond vigilantes and liquidity junkies

Section: Daily Dispatches

Taming the Beast

By Andy Xie
China International Business magazine, Beijing
Thursday, July 2, 2009

A tide of fear is sweeping financial markets: fear of inflation. Oil prices have doubled over the past three months, the US Treasury yield has surged by a third in one month, gold is nearing its record high again, and agricultural commodities are all soaring. The rising prices are taking place amid weak demand. Inflation fears are driving the surge.

The market is getting it right this time. The US is targeting a 5-percent-plus inflation rate for the foreseeable future. It's the only way to speed up relief for indebted American households. Inflation works well when debts are locked into long-term fixed rates and don't need new financing. The recent wave of mortgage refinancing, for example, has put many American households in an excellent position to benefit from inflation. If inflation surges, American household income will rise with it but the debt will remain locked into the previous low rates. Of course the people who lent to American households will be robbed.

However, the US government isn't quite ready for high inflation. It has $11.4 trillion in outstanding debt, and this is growing by over $6 billion per day. The average maturity of the federal debt is only four years and, hence, a quarter needs refinancing every year. With $2 trillion net financing for 2009, the federal government needs to raise about $10 billion per day. If Treasury yields continue to surge, the expected interest burden for the federal government may spiral out of control. At some point the market may stop lending to the US government if it expects it to go bankrupt.

The government bond market is usually a Ponzi scheme. Governments rarely run budget surpluses to pay off old debts. They almost always borrow new money to pay off the old and spend the difference. A check of modern history shows that most countries have experienced a government debt crisis. These were related to defaulting government debts accumulated over decades. Government bonds are usually viewed as safe as they rarely default. But this is the case only as long as investors are willing to lend. When the bonds do default, they do so on all the debt they have borrowed. The safety of government debt is a self-fulfilling market expectation. Hence, when interest rates are high and government financing need is great, the expectation bubble can burst.

When the market stops giving money to the federal government, the Fed can step in and print it, to monetise national debt. However, this will almost certainly lead to a dollar crash and hyperinflation. Russia wiped away national debt in 1998 only for investors to shun the country afterwards, with Russia remaining poor for many years. Only surging oil prices have brought prosperity back. Is the US ready to "do a Russia"? I think not. America still has enough credibility to charter a more profitable path that would impoverish its creditors slowly.

The Fed will probably talk tough on inflation soon and may raise interest rates before the end of the year. Though its action may calm bond vigilantes, it could spark a liquidity panic among commodity and stock market speculators. A market crash is likely. The Fed may need to respond to the liquidity panic with soothing words and more purchases of Treasuries. It will have to skillfully navigate between bond vigilantes and liquidity junkies. The idea is to fool both: They should be made to believe in the Fed's determination to fight inflation and, later, to support growth. The reality will actually be stagflation.

The ideal path for the Fed is for interest rates to stay well below inflation -- keeping the real interest rate negative -- and for the US dollar to decline gradually. The former minimizes the US debt burden and transfers it to foreigners. The latter draws manufacturing back to the US. It won't be easy to pull off such a feat.

The liquidity junkies are easy to manage. They speculate with other people's money and desperately want to be fooled. It takes little to make them jump.

Bond vigilantes, however, are not easy to pacify. They are ardent wealth preservers and will run at the first sign of inflation. However, they may not be as tough as before. Everything else is inflated already. When the consumer price index inflates to devalue money, there is nowhere to hide. If the Fed performs well, the bond vigilantes could become pussycats too.

"Feeling lucky" must be hard-wired into the human psyche. When homo sapiens evolved on the African savannah, the ones with a penchant for trying new horizons prospered. It was the right strategy in an underpopulated world. One group that felt lucky left Africa for Eurasia and got really lucky; they got the ultimate free lunch -- the rest of the world for nothing. We are all their descendants. We are all born with the "lucky" gene.

Today, however, the world has 6.6 billion people. Everything is taken. So we have created financial markets to satisfy our "lucky" urge. In this virtual world, central bankers play God and print pieces of paper for us to fight over.

Over the next five years governments and central banks will suck investors into subsidizing economic growth through volatility. We have seen this in the tech world before -- the Nasdaq attracts people with its ups and downs, volatility creating the illusion that one can get lucky and become rich.

Over the past 20 years hundreds of billions of dollars have been poured into tech companies. The money has spawned many technologies to benefit mankind. But investors as a whole have not made money.

The same will happen to the stock market in general. A weak economy needs low-cost capital, preferably negative, to maximize employment. No one will put money into a sure loser. Volatility creates the possibility of winning. Nothing turns homo sapiens into willing losers like chance.


Andy Xie is an independent economist based in Shanghai.

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