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THE
ROCKET SCHOOL OF ECONOMICS


Unintended Consequences! Part 1
by Professor von Braun

June 25th, 2005

In a recent article by Richard Duncan entitled "What's worrying the chairman?" the author raises the question as to whether the Fed has lost control over interest rates. Within the last two years a buying binge by the Bank of Japan has seen their holdings of US Treasuries rise by nearly 80% to a record level. In another article by the same author, entitled "How Japan financed global reflation", he discusses Japan's actual buying binge of US Treasuries.

Now Mr. Greenspan talks of a conundrum when it comes to the fact that as he is raising interest rates, albeit gradually, the interest rate of the 10 year bond continues to decline, recently falling below 4%.

It seems that the Fed's fear of deflation, resulting in a loosening of the money supply over the last few years, may be having several unintended consequences. Japan is of course the largest holder of T-bills, followed by the 'collective' Caribbean tax havens, then of course China.

As the trade deficit continues to rise both Japan and China, along with other Asian countries, continue to accumulate US dollars; and as US dollars have the greatest utility in international trade they therefore buy more and more of the interest-paying T-bills, pushing down the yield. Mortgage rates are a reflection of these yields and as such could drop even further. Easy Al can not raise these yields at all, they are market dictated, hence his dilemma.

Japan's decision to accumulate large amounts of T-bills obviously was not solely intended to prop up the dollar, but may reflect a growing concern about China and its role as a major trading partner with the US, threatening the role Japan has enjoyed for many years. Both Japan and China have an 'internal' economy which has a separate currency issued by the respective central banks and both CB's hold large amounts of US dollars.

Needless to say, doing business with the US is a very much one sided affair, since the US is the only country on the planet that can pay for it's imports with paper that only it can print and there is no shortage of printing presses apparently. They might have even been made in Japan, who knows? Most of the world's central banks hold these dollars as recognized reserves and now, midway through 2005, Easy Al has a conundrum.

As long as the trade deficit stays there will continue to be a surplus of US dollars looking for a home.That home is US Government and Agency debt. The amount of new US treasury debt coming into the market is less than the trade deficit and that, given rising commodity prices looks likely to continue which suggests that a surplus of dollars in favor of trading partner's, is going to be the norm for some time to come. (The alternative -- buying US assets -- has recently shaken US markets and in fact may prove to have even more unintended consequences for the US economy.)

What can Greenspan do about interest rates? Well, not a lot it seems, since he is not in charge, not that he ever was, as it was more a result of what the market would pay. Now with Japan holding over $800 billion in US securities, all of a sudden you have an 800lb gorilla in your living room and you have it's baby brother (China -- the two pandas were a decoy) sitting on the lawn looking for more bananas. This $800 billion figure will rise, as will China's, as will any other country's that deal with the US and 'enjoy' a trade surplus.

This surplus, the consequence of which is lower interest rates, has been the driving force behind the rising US real estate market. And while there are calls for this bubble to end, it won't, as a consequence of rising interest rates, as long as this rather unique situation remains. It's not just the average American that's buying US real estate, but money is flowing in from offshore as well. Can the average consumer, the key to the trade deficit keep it going by consuming more and more? Who knows?

It's safe to assume that there are still more 'tricks' up the sleeves of the writers of ever more and more loose mortgage packages, ones that continue to put some cash in peoples pockets. Don't be surprised if some don't start offering free trips to Japan, a year's supply of sushi and a new Sony laptop, if you take out a 125% mortgage. There remains, and most likely will remain, the potential to refinance at ever lower rates as well, returning even more cash to the consumer's pocket.

The world is awash with paper currencies and the main players all have a vested interest in keeping the game going and going and going. We, the participants, are now in uncharted waters, since never before has the economic activity on this planet been so dependent upon one currency, backed by nothing other than a willingness of the participants to hold it, forsaking redemption.

Perhaps Easy Al's conundrum might be that he, the wizard, can't quite figure out how it's going to end, but end it will. Taking potshots at Freddie Mac and Fannie Mae suggests that it won't be them; making noises against any trade protection measures strongly suggests that the wizard is aware of the fact that it would not be a smart idea to annoy your largest creditors, but is he aware of how far down the debtors road the US has gone? Does the point of no return, mean anything to him?

With a rising inflation rate and a low return on cash deposits, money as such is not showing an attractive return. On the contrary, it's losing purchasing power, what little it has left, and as such will soon be seen for the very real problem that it is.

One should not forget the Euro 'NO' vote either, since this has effectively diminished the chances of the Euro being a viable alternative to the dollar, more reason for the other CB's to hold even more US securities. A look at the Euro/dollar exchange rate indicates that conundrums are appearing elsewhere (becoming perhaps as visible as new condominiums in Florida) since holders of Euros are already thinking seriously about the quality of that asset as well.

The majority of paper currencies are starting to look like they are at best, an instrument that may be nearing the user date. The interconnectedness of Central Banks -- by virtue of the reserves they hold and need to continue to accumulate more and more of these irredeemable reserves, while providing the US consumer with a vast selection of widgets, gadgets and gizmo's, as well as providing them with the money to buy them -- is astounding. Free money it may not be but it is as close as it gets!

If the 'raise-or-lower-interest-rate department' is now in the hands of both the Bank of Japan and the Bank of China, both of which have (along with others) a vested, albeit not necessarily benevolent, interest in the American consumer, then, yes, Easy Al has a conundrum. In fact he might even have three or four of them.

In the unintended consequence department, located somewhere other than Washington, Tokyo or Beijing, the main argument against owning gold -- which is that it does not earn interest -- has just been completely demolished!

Now it's a case of neither does anything else earn enough interest to offset the risk of owning it -- unless of course you are a central bank that plays a critical role in this system of wealth destruction, in which case you have to buy more 'reserves'. The smart money will eventually figure this out, Demand for gold in the form of actual metal, as opposed to paper contracts, will increase as the Greenspan conundrum becomes more clearly understood by market participants.

The Bank of Japan may have inadvertently attached its own longstanding monetary woes to the Federal Reserve and Easy Al is beginning to realize that he too is now in a corner. Perhaps the dunce hat is not far away!


The Prof can be contacted by email at profvonb2@aol.com

Copyright by Professor von Braun. All Rights Reserved. Reprinted at USAGOLD by permission.

Return to the The Gilded Opinion Index Page

The Rocket School of Economics -- The Lecture Series Index

  • 22 May 2009 -- An Often Overlooked Issue!
  • 28 Mar 2009 -- Problematic Banking Systems!
  • 14 Nov 2008 -- What Exactly is an Asset?
  • 23 Aug 2008 -- Through the Looking Glass?
  • 02 Aug 2008 -- Compounding to the Downside!
  • 26 May 2008 -- Back to Basics Again!
  • 31 Mar 2008 -- The Broken Watch -- Part 2.
  • 27 Mar 2008 -- The Broken Watch -- Part 1.
  • 06 Feb 2008 -- The Financial Equivalent of Faulty Towers.
  • 10 Dec 2007 -- Monetary Systems & Productive Assets.
  • 14 Feb 2007 -- Divorced from Reality
  • 06 Sep 2006 -- Gold, Bankers, the Trade Deficit and Unsettled Transactions
  • 19 Jun 2006 -- When is a Reserve Not a Reserve?
  • 31 May 2006 -- The significance of August 15, 1971.
  • 08 Apr 2006 -- Keep Your Eye on the Ball!
  • 30 Mar 2006 -- What came first?
  • 11 Mar 2006 -- An Unanswered Question.
  • 08 Jan 2006 -- Where have all the projects gone!
  • 11 Dec 2005 -- Gorillas, Rising Gold Prices and Depreciating Paper Currencies!
  • 23 Oct 2005 -- Custodial Risk.
  • 16 Sep 2005 -- An Inherent Flaw.
  • 08 Aug 2005 -- Central Banks and 'Reserves'.
  • 31 Jul 2005 -- Central Bankers, Actors and 'We'.
  • 17 Jul 2005 -- Unintended Consequences! -- Part 3.
  • 07 Jul 2005 -- Unintended Consequences! -- Part 2.
  • 25 Jun 2005 -- Unintended Consequences! -- Part 1.
  • 14 Jun 2005 -- The Two Greater Fools Theory.
  • 03 Jun 2005 -- Real Money, Funny Money and YOU -- Part 4.
  • 30 May 2005 -- Real Money, Funny Money and YOU -- Part 3.
  • 26 May 2005 -- Real Money, Funny Money and YOU -- Part 2.
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  • 09 Nov 2002 -- Carrying a Big Stick.
  • 17 Sep 2002 -- Wishful Thinking!
  • 27 Jul 2002 -- Gold Bugs Beware -- part 2.
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  • 06 Apr 2002 -- Currencies versus Gold.
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  • 01 Jan 2002 -- 2002 -- A Perspective.
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  • 22 Jan 2001 -- US Dollar Admits Identity Crisis!
  • 16 Jan 2001 -- Dear George W.
  • 24 Nov 2000 -- The Bubble Has Burst
  • 11 Nov 2000 -- The Media, Bull Markets & the Gold Price
  • 02 Nov 2000 -- Gold Stocks
  • 29 Oct 2000 -- Oh The Tangled Web We Weave ...When We Set Out to Deceive
  • 24 Oct 2000 -- A Mystery!
  • 16 Oct 2000 -- A Peso Here ...and a Few Thousand Pesos There
  • 10 Oct 2000 -- The Unfolding
  • 30 Sep 2000 -- What's Wrong with THIS Picture?
  • 25 Sep 2000 -- Buy Gold Now!!
  • 23 Sep 2000 -- The Times, They Are a' Changing
  • 15 Sep 2000 -- Time WILL Tell!
  • 27 Aug 2000 -- SS "Paper Assets" Begins to Take on Water
  • 06 Aug 2000 -- The Indian Summer
  • 26 Jun 2000 -- A Yellow Brick Wall
  • 22 May 2000 -- The King IS Naked
  • 30 Apr 2000 -- Goodbye Yellow Brick Road
  • 18 Apr 2000 -- Beware the Ides of March, April and May
  • 08 Apr 2000 -- Really, Sir Aldot!
  • 25 Mar 2000 -- Where To From Here?
  • 18 Mar 2000 -- The Gnomes of Zurich
  • 12 Mar 2000 -- The "New" Economy??
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  • 28 Feb 2000 -- The Wizard of Oz
  • 06 Feb 2000 -- Here We Go Again!!
  • 15 Jan 2000 -- Comments on the Gold Market
  • 29 Dec 1999 -- No Raw Ingredients Required
  • 28 Dec 1999 -- No Way Out
  • 14 Dec 1999 -- Ho, Ho, Ho!
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  • 03 Dec 1999 -- Early Warning Signs


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