Cheap Dollars Meets Debt – Result Stagflation

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Global Trade, Macroeconomics

Two separate articles in the Telegraph newspaper, when combined, underline a major medium term risk to the US economy. Traditionally, inflation is caused by an excess of demand over capacity pushing up the cost of products and services in a tight market. These two articles suggest an alternative much less pleasant set of circumstances.

The first is an article by Liam Halligan, chief economist at Prosperity Capital Management in which he explores the well covered concerns of the Chinese about quantitative easing in the US, pumping billions into providing liquidity to the US economy by way of buying treasury bills. The Chinese fear is it will undermine the dollar and devalue their estimated $2bn held in US denominated assets. Halligan goes on to describe how the US dollar is being used as a carry currency. Traders are using low Fed rates to take out cheap dollar loans then converting the money into other currencies generating higher yields. When this practice last built to a peak and unwound, (the Yen carry trade in the 1990’s) it lead to the collapse of Long Term Capital Management in 1998 and a global meltdown. So the dollar is vulnerable to a sell off from a number of sources; foreign holders selling the currency as a risk appetite returns, a dumping of dollars if Halligan’s dollar carry trade unwinds, but mostly a gradual diversification from dollar assets to Euro, Yen and other currencies by those outside the US, China in particular. If the dollar were to be sold and lose value, the cost of imports and all commodities would rise, fueling inflation.

The other article is by Ambrose Evans-Pritchard in which he catalogs the statistics for the US economy and by implication much of the western world. The housing crash has tipped 15m US home owners into negative equity. A third of sub-prime mortgages are in default. Foreclosures reached 358,000 in August alone. More Americans are being evicted each month than during the entire Depression year of 1932. This is not to pick on America. Variants of the bubble occurred across the Anglo sphere, Scandinavia, Holland, Club Med, and Eastern Europe. Defaults will hit with a lag in Europe, but hit they will. The IMF expects global banks to lose $2.5 trillion by next year. So far they have confessed to $1 trillion. The west is building massive deficits which will have to be paid down one day by higher taxes, lower spending and slower growth – US (-628bn), Spain (-$109bn), Italy (-$62bn), France (-$58bn), Britain (-$53bn), Greece (-$42bn). America’s baby boomers have lost 45 percent of their net worth. US consumer credit has contracted for six months in a row, falling by a record $21.6bn in July. The US savings rate has risen from near zero to around 5%. According to Evans-Pritchard, the commodities and stock markets may be sizzling but industrial production is still down 23% in Japan, 17% in the Euro zone, 13% in the US and 11% in Russia. We have a global glut of manufacturing plants. This is why companies will have to slash staff this year and next.

So here is the potential double whammy of rising inflation as the currency slides, pushing up the cost of  imports and sparking commodity rises. At the same time, the country faces an excess of capacity and lack of demand as consumers remain retrenched rebuilding their personal balance sheets. This is called stagflation, leading to rising prices but ever falling demand. And if we think the two authors are being far fetched let’s not forget they were two of very few voices calling out about the dangers of CDO’s, leveraging and cheap money back in 2006/7 when the rest of us were busy borrowing on credit cards to buy a second, or third, flat screen TV or car we didn’t really need.

–Stuart Burns

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