Monday, 9 May 2011


Does monetary inflation linked to reserve currencies help debtor countries and hurt creditors, or does it make any difference because of price adjustments? While the US benefits by printing money and devaluing its debt obligations amid a very low interest rate environment, the EU maintains very high reserve currency that helps Germany and France as creditors for debtor member nations, especially Greece, Portugal, and Ireland.

The highly valued reserve currency makes it very difficult for the EU debtor nations to recover amid austerity programs, because unlike the US that has cheapened its currency, the EU maintains a strong monetary regime. In short, Germany and France are refusing to devalue the euro in the same manner that the US has devalued the dollar, because the former are lender nations while the latter is a debtor nation that is using cheap currency to stimulate its export trade.

Bankrolling America's debt, China is allowing for a cheap dollar because it too has a cheap yuan, an issue that infuriates the US, which wants Beijing to raise the yuan's value thereby affording the US a real discount for its public debt.  Currently, China has a surplus of roughly $3 trillion, allowing it the luxury to plan a global economic strategy that would catapult it into the preeminent position as the number one economy and keep it there for the duration. China's surplus reserves (on paper) are just slightly more than the entire reserves of the European Central Bank (ECB). Unlike China waiting for a more stable global monetary and trade climate, the ECB has prospects of real problems ahead.

Greece is a real prospect for more bailout loans and better terms, as are Portugal and Ireland. As insignificant as Greece is to the EU economy, representing a mere 2.5%, while German and France repent 48% of the Eurozone GDP, the domino effect combined with the inevitable negative psychology would derail not just the euro, but the entire world economy. Anxious German economists and officials are worried that Greece has few choices because a strong euro entails continued deep cuts in living standards that would invite sociopolitical instability. Without a stable Greece, Europe will pay a price of instability as well. And an unstable EU means that the US cannot move forward with its economy, and along with the US, Canada, Australia, Japan and China are impacted as well.

Greece will limp along the downward path to greater poverty for the rest of the decade, and there is a very remote chance it may declare  bankruptcy temporarily is there is government change and/or sociopolitical instability. There is also a chance of social uprising and government change. The larger issue for the EU is how to restore confidence in the union now that the facade has been stripped and it is obvious that the Franco-German hegemony is in the driver seat, thus making a mockery of national sovereignty for the other members. Another issue for the EU is how strong should the euro be, considering that other reserve currencies are cheap?

On 9 and 10 May 2011,  China's top economic policymaker Wang Qishan and diplomat Dai Bingguo will be meeting with Treasury Secretary Timothy Geithner, Secretary of State Hillary Clinton and Federal Reserve Chairman Ben Bernanke. Topics will include not just monetary, trade and political issues, but military as well.
American companies are complaining about unfair trade practices, currency manipulation, and unfair competition; all issues that many countries around the world have been accusing the US for decades.

Holding more than $1.2 trillion in U.S. Treasuries, the Chinese are worried. The US congress is currently considering raising the borrowing limit to $14.3 trillion, thus further diluting the currency. Beijing realizes that IMF and private investment firms are warning about a possible US downgrade of US bonds to the degree of a default if nothing serous is done. That the US has come to the point that it is borrowing 40 cents on the dollar is alarming; not as alarming as Greece that is a semi-developed country - in essence bankrupt - with very limited productivity prospects, but alarming nevertheless for creditors.

The US has been demanding that China revalue the yuan, while the US keeps devaluing the dollar - in short, have the Chinese eat the loss of the paper they are holding. The yuan has risen 5% in value, but it has a long way to go to absorb the kind of huge discount the US wants from China. Many in the US, especially manufacturers and some US officials, demand a 40% yuan over-valuation. In essence, Americans want China to pay for the US economic recovery. Why? Because the U.S. has helped to make China the giant that it is today! Because US trade deficit with China hit $273 billion in 2010, or 20% higher than 2009, despite a drop in China's surplus from 10.6% of GDP before the global recession of 2008 to 5.2% in 2010.

The question is whether it is in China's interest to have a surplus in the double digits as % of it GDP, or if long term it is in its interest to achieve slower steady growth by subsidizing the US and other major economies exxactly in the manner that the US is suggesting. Why not allow the US Federal reserve to continue to print dollars to pay debt until the US economy is stronger in a couple of years? Those holding dollars lose their purchasing power, and investment tends to gravitate toward precious metals, commodities and stronger currencies like the euro.

What is so wrong with that scenario? The answer is the Japanese example in the last couple of decades should be a lesson. Zero interest rates have entailed flight of investment, just as currently US corporations are holding more than one trillion dollars outside the US and will not bring it back unless they are assured of no taxes or very low rate, as well as a more stable monetary policy.

Now that Japan needs hundreds of billions to rebuild the country after the earth quake, tsunami and nuclear plant disasters, all it can do is resort to the same monetary policy as the US, namely print money and accept higher debt levels, hoping that higher productivity and inflation will take care of the problem in the future. The US and Japanese monetary policy can work as long as there is cooperation with trading partners and bondholders, and national corporations. Otherwise, an out of control monetary policy could lead to hyperinflation that some European countries were facing in the interwar years when international cooperation broke down and the Great Depression ensued.

The key to keeping the credit economy together is close cooperation between creditors and debtors. Credit economy is based on nothing but FAITH between creditor and debtor. The kind of cooperation that exists between US and China out of sheer necessity and self interest, although through very tough negotiations and multiple deals that have resulted in an interdependent relationship are absent between creditor and debtor among EU members. The antagonistic relationship that exists within the EU between the strong creditor nations and weak debtor members could explode into a major crisis unless there is political leadership on the part of Germany and France to prevent an inevitable crisis.

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