ECONOMIC WARFARE (PART 1) - INFLATION BOMBS

We've all heard that players in the global economy "export inflation" or "export deflation". In fact I saw an opinion piece on Bloomberg last week where the author stated quite clearly that China is complicit in allowing the US to act AND therefore is bringing inflation on themselves. - Find the opinion piece here - http://www.bloomberg.com/news/2011-01-21/china-can-just-say-no-to-one-u-s-export-commentary-by-caroline-baum.html -  Essentially how this works is the following;


STATED FED POLICY -
If the US is trying to create inflation (they are) they will print more of their money supply and flood the world with liquidity and excess credit. As banks have excess liquidity through any of the mechanisms that Bernanke has employed the money finds its way to other things. US Central Bankers state that they hope that the liquidity moves from the banks in the form of loans to consumers and businesses. CLEARLY WE KNOW THIS HAS NOT HAPPENED, BUT STAY WITH ME.  In theory the consumption of these loans for business investments creates new opportunities and projects that will create jobs, stimulate income growth, get consumers buying, and voila, all is better!  Further, while the Fed hopes this is the longer term outcome, they want a quick fix.  Alan Greenspan and Ben Bernanke have directly commented that the best way to get a faster recovery is to give the appearance of a healthy economy by lifting stock market index levels.  Another way to say this is that they know that if they can pump up stock market valuations they can make consumers feel better (even if things really aren't) and that is about 80% of the battle.  Once the economy feels better through "asset price lift" the real economy is sort of dragged along and activity improves.  Now don't get all focused on the fact that structural issues haven't changed, remember they are only talking about perception and how appearance becomes real.  All of these actions by the Fed are based on the notion that is that "inflation is good" and "deflation is bad".  The moves of Bernanke are being made to avoid deflation at all costs.  We'll discuss what deflation looks like and why it is bad for the government, the Fed, the banks, and citizens in a future post.

ACTUAL OUTCOMES
Rather than the "expected outcome" we have seen some other results that impact the US and other countries. In a real life scenario we see the pumping of dollars to banks who then have not loaned out their capital. This "unexpected" event has occurred for several reasons including that small businesses just don't want loans because their business outlook is poor, consumers can't qualify for new mortgage loans due to impairments in their properties or lack of income and destroyed personal balance sheets, or frankly banks just don't want to take credit risk and would rather stuff that money in other investments.

Notice the last item there.  As Ben Bernanke and his FED have printed lots of liquidity and provided it to banks that have nowhere to lend it, they simply have found other assets to buy.  As a result of the magical deployment of excess greenbacks we've seen a historic rise in treasuries recently and now we see an amazing run in stock markets and other commodity markets.  As we've discussed many times though, the flooding of the markets with dollars does come at a price.  The price is that other countries perceive the underlying value of the dollar to be poorer and therefore we see declines in the value of the dollar.  To combat this action, banks, hedgefunds, and investors have looked to deploy their investment dollars in assets outside of the US or into assets that are hard in nature such as commodities.  As typical with all herds, they tend to over do it.  Remember way back in 2008 when oil rocketed to $147? What did we call that despite all of the commodity trading regulators denials? WE CALLED IT SPECULATION!  At that time we heard of banks storing oil in barges and tankers off shore and we saw $4 gasoline too.  While I have not heard of banks store oil now, they seem to be buying great stuff like cotton, wheat, sugar, and coffee. You know, stuff that is needed for absolutely every other product!  We're almost at the point, stay with me.

There are two reasons that other countries get really upset about the Fed's master plan to engineer the "recovery" of the US economy through printing and devaluing and making the appearance that all things are better through targeted asset price increases. 

PROBLEM #1 - DEMAND FOR FOREIGN CURRENCY HURTS EXPORTING NATIONS
First, when investors believe that their home currency is going to be devalued they look for other places to send that money to protect their wealth.  They do exactly like we suggested over the last year which was to "Go Emerging".  I liked this strategy because those countries were growing much faster than the US AND they had a currency that was not the USD.  While I'd like to think that many other investors we're as quick to recognize this as I was, it is clear that many came around and flooded those emerging countries with excess capital.  These remarkable inflows cause the currency of the emerging country to rocket higher compared to the dollar because there is excess demand.    This is a problem because all of these countries are typically big exporters.  When their currency goes higher they have to pay wages in their home currency and yet they receive less valuable payment (dollars) or the buyer in a foreign country sees their costs go much higher because it costs more dollars to buy that Brazilian iron ore, Korean television set, or Chinese plastic thingy.  So, the increasing value of the currency hurts the emerging countries exporters (which is a huge portion of their economy since they have been built on foreign demand rather than domestic consumption).

PROBLEM #2 - FLEEING SPECULATIVE DOLLARS DRIVE ASSET PRICES BEYOND THE EQUILIBRIUM STATE OF THE CURRENCY DECLINE/GAIN.
That is a long sub-title there but where I'm getting to is that as more of the herd recognizes that US dollars are being devalued and there is a need to diversify into other assets there is a rush to buy those "hard things".  Remember that many commodities are actually priced in US dollars (oil).  As we've covered, as the dollar drops there is an adjustment in the price of oil or other goods to compensate for that drop in another currency.  The problem with these investors though is that they tend to move the price much more than a 1:1 move to offset the decline in the dollar.  The herd of investors may drive oil, cotton, sugar, wheat, corn, etc much farther than what could be expected.  The extraordinary moves in commodities, especially foods really hurts those emerging economies where laborers make just a few dollars a day.  Think about it, sugar is up from its low in May of 2010 more than 100%.  Grains too are up 70% or more.  If 50% or more of your income goes toward the cost of feeding your family, what is the impact if food costs go up 100% during the year?  We are very fortunate in the US because food costs so little relative to our total income.    Is it any wonder why I mentioned in the 2011 perspective that inflation concerns, government reaction, and political turmoil would be big issues?  When food costs rise dramatically people in those countries riot and seek to overthrow their governments.  We don't need to look too hard to find examples such as Tunisia and even Egypt (over the last couple of days).  These countries have other issues like high unemployment, but the price of food is often the straw that breaks the proverbial camel's back. 

ECONOMIC WARFARE - WHAT TO DO WHEN YOU ARE HIT WITH AN INFLATION BOMB?
Brazil has described Bernanke's actions as economic war.  The overt devaluations of the dollar are hurting their economy and are essentially attacks on their prosperity.  What is a country to do in response to these attacks?  In response to these attacks, a country can do a few things to attempt to stem the pain associated with the "imported" inflation.  Unfortunately, the responses also have consequences.

TACTICAL SOLUTIONS WHEN ATTACKED -A country can slap on currency controls that attempt to limit inflows of foreign investment money.  In this case non-domestic investors may need to pay a 15% tax on all money that is coming into the country.  Countries also may be forced to put taxes or levies on all imported goods to their country because suddenly imports to the country are much cheaper.  Emerging governments also try to reduce domestic lending by banks to reign in access to cash that goes toward investments.  We've also seen governments in emerging countries attempt to crack down on purchase of commodities as people attempt to trade out of currency and into hard assets, creating shortages.  Last, the "responsible" government can increase interest rates in their countries to attempt to head off inflation and crush the "domestic speculation" there.

The Bloomberg opinion piece I mentioned above stated that the move to increase interest rates and essentially drive the value of the yuan higher was the prescription for China to head off inflation and justify the imbalance of a currency that is valued too low.  But think about it, that move does not happen without serious consequences.  Yes, it may stem food inflation costs in local terms, but it most certainly harms their export driven economy by making their manufacturers less competitive and may even drive them out of business.  Leaders in these countries are faced with tough choices.  Do they endure domestic strife due to rampant inflation for food, or do they crush their exporters making many lose their livelihood?  Further, these choices are being thrust upon them by our central bank and the "devalue the dollar" strategy.  At some level I'm sure these leaders see this as a death by firing squad or death by electrocution choice.  Further, China is facing competition from countries like Vietnam, Malaysia, and Thialand now.  No longer is China the cheapest manufacturing country out there.  Wage pressures have forced Chinese producers to pay higher wages so industries have searched for even cheaper labor in other places.  If China takes the prescription and raises rates and the value of their currency do you think they will lose business to these competing countries?  Of course!  If you had 100 million or 400 million workers in the exporting industries do you think you'd be quick to make them less competitive?  Not a chance.

BEWARE OF CHINESE PRESIDENTS VISITING BEFORE THE STATE OF THE UNION ADDRESS
Isn't it interesting that President Hu Jintao of China visited last week?  Isn't it odd that he remarked that the US dollar's place of significance in the world is past its time?  While the US has the ability to inflict serious pain on the Chinese by pursuing our strategy of a lower dollar and inflating away our debt, the Chinese have significant leverage with us because they own more than 1 Trillion dollars worth of US treasuries and other assets.  The timing of President Jintao's visit was not a mistake.  At some point our friends and lenders will try to get our attention in a more overt way by shaking up our bond markets and driving interest rates much higher.  As our Congressional leadership and our President continue to spend money without restraint and produce huge deficits world investors will shun our treasuries.  This action will drive up rates and will also serve to further drive down the value of the dollar.  A move like that would create considerable pain for the Chinese, but since the Fed has dethroned them as the largest holder of US Treasury debt, we would hurt even more.

(EDIT) - The point I just raised has actually made me think more about what really is going on.  We are beholden to our Chinese friends who don't necessarily like holding our debt because the compensation for holding our bonds is mispriced.  Here we go again, this is and has been the problem with markets for the last 8 to 10 years in that the reward paid for holding debt is too low for the risk that investors (lenders) are assuming.  I'll write more on this, but I couldn't contain my excitement here as I've re-emphasized a common theme I've raised often.

INFLATION BOMBS ARE MESSY - UNINTENDED CONSEQUENCES
A smaller nation doesn't have much leverage against the US right now, but this monetary policy may have greater impact in fostering a much more violent response than we think.  Consider that the Fed policy of exporting inflation may drive food prices higher, unemployment rates up, and may even lead to an overthrow of a government in an emerging area.  Is it possible that a terrorist faction or a new government blames the US for its problems (that never happens does it?)?  Do you think that masses of poor disenfranchised young men might want to lash out as the US for harming their family and their country?  Is it as big leap to think that they might act violently and attack in some manner?  Of course this is ridiculous, something like this would never happen! 

While the chance is probably remote and could never, ever happen, the Fed would be wise to review it's Inflation Bomb strategy.  We know that the approach taken by Bernanke here is about creating the "quick fix" rather than creating a solid foundation for recovery where structural issues are addressed and cured.  We know that Congress (both Dems and Repubs) really has no appetite for cutting spending or fixing our fiscal madness.  It is time we recognize the out of control mess that is going on and take action.  Cutting $100 million or even $100 billion from our budet is like peeing in the wind.  Dramatic cuts in entitlements must be made starting with Social Security, Medicare, and Obamacare and also cutting defense spending.  The Fed's monetization is a mirage and farce and is designed to hide the true cost of these programs and is a strategy of extend and pretend that all is ok and recovering.  It is time for action and the leadership in Washington (all of them) continue to fail miserably.  Unfortunately the policies are failing domestically and also abroad, it is only a matter of time before an Inflation Bomb goes off.

BE CAREFUL!

GOATMUG