Thursday, January 08, 2009

The Economics of the Great Despression by Eric Carbonnel

Most people think that the United States is borrowing most of the world’s savings to fund the deficit. Ben Bernanke, the chairman of the Federal Reserve, who is presiding over ever higher inflation rates, even made a speech in 2005 called “The Global Savings Glut and the U.S. Current Account Deficit.”

The speech makes it sound as if the rest of the world has way too much savings, so much so that they don’t know what to do with it except loan it to the United States.

People think that the excess dollars that go overseas due to the U.S. trade deficit are being loaned back to us. This is not entirely true. To be sure, there is a lot of real foreign investment happening in the United States, but it’s not nearly to the extend reported.

So where does all that extra currency that purchases all those U.S. Treasury Bills to fund a large part of the deficit come from?

The countries that are the U.S.’s major trading partners create it.

China is the best example. When someone in the U.S. buys something in the U.S. that was made in China, that U.S. vendor bought that product from a Chinese businessman and paid in U.S. dollars.

The Chinese businessman then deposits those dollars into his checking account at his local Chinese bank. The bank then converts those dollars to yuan, the official Chinese currency. Now, the local bank has a glut of dollars and a shortage of yuan, so it sells the extra dollars to the People’s Bank of China and buys more yuan.

As long as the trade between the two countries is in equilibrium there is no problem with this. But when one country is running continuous trade deficits and the other continuous surpluses, as the United States and China currently are, a problem arises.

In the case of China, because there is more currency flowing into China than out, the People’s Bank of China ends up with a huge glut of U.S. dollars. Under the rules of the game of international trade and currency exchange they are supposed to sell those excess dollars on the Forex (foreign exchange market) and buy yuan.

But that would mean that there would be a glut of dollars and a shortage of yuan, which would cause the dollar to fall in value and the yuan to rise.

This means Chinese goods would then become very expensive in the U.S., slowing China’s exports, and that’s the last thing China wants.

So to get around the international trade and currency exchange game, China bends the rules. The People’s Bank of China takes the extra dollars and neutralizes them by buying a dollar-denomenated asset, most often some sort of interest-bearing investment instrument, like U.S. Treasuries.

This keeps the yuan from rising and the dollar from falling.

This is known as “neutralizing” or “sterilizing” excess currency inflows. The funny thing is that the U.S. was doing the same thing by sterilizing excess gold inflows all through the 1920s to keep the dollar artificially low and exports up, and it was one of the major factors that contributed to the Great Depression.

So if the People’s Bank of China used excess dollars to buy U.S. Treasuries, and didn’t buy the yuan on the Forex to sell to the businessman’s local bank, where did the People’s Bank of China get the yuan?

Answer: China creates it!

During recent years, the U.S.’s current account deficit has been financed primarily by money created by the central banks of other countries, in particular China.

Therefore, it is not a matter of the United States using up all the rest of the world’s savings to fund its deficit. It is a matter of the deficit being financed by the central banks of the United States’ trading partners, and, for their part, Asian central banks in particular have consistently demonstrated their ability and willingness to create money in order to finance the U.S.’s current account deficit.

So China is now sterilizing excess currently inflows just like the United States did in the 1920s. But why hasn’t China fallen into a depression like the U.S. did when it played the sterilization game?

Because China has added a little twist.

In the 1920s, Europe paid for U.S. imports with gold, and the Federal Reserve would cheat gold by locking it away instead of expanding the currency supply to match, thereby preventing the commensurate inflation it would have caused, keeping the price of U.S. goods low, and insuring a continuing trade surplus.

This was hugely deflationary.

As the rest of the world bought cheap American goods, gold would just disappear into the black hole of the Federal Reserve and the world money supply would contract.

And when currency contracts, deflation ensues.

When China sterilizes excess currency inflows, however, it’s extremely inflationary. For every excess dollar that China neutralizes by buying U.S. Treasuries, the People’s Bank of China has to conjure up a commensurate amount of yuan out of thin air.


As a result of all the currency games being played by China (and other countries), the total U.S. deficit has grown to over $7 trillion since the dollar was taken off the gold standard by President Nixon in 1971. These deficits are sustained by fiat currency from other central banks around the world.

All the while, these foreign banks are hoarding ever increasing amounts of U.S. debt (in the form of Treasuries) and artificially propping up the value of the dollar.

Much of our debt cannot be repaid, and if our trade partners begin to dump U.S. Treasuries on the world markets, the whole credit bubble will implode, resulting in a worldwide depression.

The longer governments and central banks try to cheat the free markets, the greater the pain will be when the correction occurs. Remember, in the end, fixed markets lose, and free markets always win.

I believe that inflation has slowed in China due to fears about deflation. When those fears fade, inflation picks up again and China will sell dollars to save its currency. This hyperinflation in China combined with the crashing value of the dollar will cause most fiat currencies to lose all value and will spell the end of the world's paper based currency system.

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