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The Gong of Doom

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We’ve seen a couple of weeks of rising stock market indexes. Today the DJIA  was up over six percent. The President, the media, and many pundits are talking about having reached a market bottom. They all forget that this recent rise has only brought the indices back to the lows reached before Timmy and Barry made their first set of fumbles. We’ve made it back up to an ordinary recession. Woo hoo.

I suggest the rise is significantly attributable to the continuing value created in the US economy. As I have documented, 142 million people are still at work. No factories have been destroyed, and no skills have been wiped from workers’ memory. The sky was not falling. A dynamic economy was realigning itself, finding its new best allocations of resources.

Meanwhile the Federal Reserve has created a few trillion more dollars to chase the essentially unchanged US capital base. Inflation is coming. Neither the Federal Reserve nor the Treasury create any wealth or value. They only print the money used to keep track of wealth and value. More dollars for the same stuff leads to higher prices.

But that’s not necessarily the end of the world. It’s important to consider how fast inflation might rise. I mean not just the rate of inflation, but also how fast that rate goes up. A relatively stable rate of high inflation is undesirable, but predictable. Think of 15% annual inflation. That’s high, and will make the interest rate on borrowing high, which makes it harder for a dynamic economy to reallocate its resources. But if it stays near a steady fifteen percent for as many years as it takes to absorb all the phoney dollars the Fed has unleashed, we can plan and grow. And, as an old sketch from the 70s Saturday Night Live joked, we’ll all be millionaires.

Unpredictable and high inflation would be cause for the sky to fall. Imagine now instead of a steady 15%, we faced annual rates of 15%, 25%, 22%, 30%, and maybe 15% again. At those high rates and high variations, it becomes harder to plan and almost impossible to borrow using the current system of fiat money. (Fiat money is paper with nothing but a government command to back it)

Borrowing becomes impossible because high rates of inflation hurt lenders. If I loan you a hundred bucks, and inflation makes the price of everything go up 20% by the time the loan is due, I would need $120 to break even—leaving interest aside. But you only need to pay me what the contract said, the original hundred bucks. I'm out the rate of inflation.

Imagine this in the high-and-unpredictably-high environment. I wouldn’t really want to lend you anything. Or, I would write the contract in terms other than those inflating dollars. I might write it in grams of gold, or gallons of oil, or even hours of labor. Then, I don’t care what the Fed and Treasury do with the dollar. The dollar would effectively lose all three functions of money; it would no longer serve as a store of value, it would not be a unit of account, and it wouldn’t even be our means of exchange.

Now imagine you have a few trillion dollars worth of loans contracted in terms of that fiat currency. You probably would be looking for a way to get away from writing all your investment lending in dollars. You might be Chinese:

China’s central bank on Monday proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund.

In an essay posted on the People’s Bank of China’s website, Zhou Xiaochuan, the central bank’s governor, said the goal would be to create a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies”.

Analysts said the proposal was an indication of Beijing’s fears that actions being taken to save the domestic US economy would have a negative impact on China.

“This is a clear sign that China, as the largest holder of US dollar financial assets, is concerned about the potential inflationary risk of the US Federal Reserve printing money,” said Qu Hongbin, chief China economist for HSBC.

In the same way that inflation hurts lenders, it also hurts those who produce commodities. When Cesar or Mahmoud agree to deliver a barrel of oil next month, they’re essentially lending the price of that oil in today’s dollars. On delivery they get paid the agreed number of dollars, but inflation has made those dollars worth less than when the contract was made. They lose the month’s inflation. Thus, nations have tried to break the hold of the dollar on the world’s contracts. Iran is operating an exchange which trades oil in contracts that aren’t tied to the value of the dollar.

That exchange is functioning, but is not significant. Pretty much all the rest of the world s still using dollars, and Iran presents its own set of risks.

China, on the other hand, is a big enough player to make it work. Our own American pride overestimates the importance of the US market to the Chinese. They not only produce much of the stuff we buy, but they buy huge amounts of stuff around the world. Oil, steel, concrete, copper, and food are all brought in to by China to sustain its domestic growth. The Chinese market is enormous and comprehensive. They could crack the sky above the US economy.

The gong of doom is ringing. Get a helmet.