Thursday, December 4, 2008

Our Greatest Export

I would like to try to explain a concept that I refer to a lot on this site. It is the United States exporting inflation to the rest of the world.

A Chinese boat pulls up to a docking port in New York City to unload its cargo. When the cargo is dropped off the American then pays the Chinese worker with American dollars for the goods.

The Chinese worker then drives the boat back to China and deposits the American dollars into his account and the bank exchanges them for the Chinese Yuan (Chinese currency). The local Chinese bank now has a glut of dollars and a shortage of Yuan, so it exchanges the dollars with the People's Bank of China and buys more yuan.

You can think of the People's Bank of China as their Federal Reserve.

Now the People's Bank of China is sitting there with the dollars, and the dollars keep pouring in month after month. This is called a trade imbalance or deficit, which right now is enormous with American and China. (And the rest of the world)

China then must decide what to do with their dollar reserves. This decision is the most important factor guiding our global economy. One option would be to exchange the dollars on the foreign exchange market for yuan. This would increase the demand for yuan considerably and cause the value of the currency to rise.

When a currency rises in value the American worker at the New York City port now has to pay more dollars to purchase the goods and services. At the same time the Chinese worker on the boat can spend a few hours in New York while he is visiting and purchase American goods real cheap because the value of his yuan is so strong.

The Chinese (right now) do not like this strategy because they do not want to hurt their exports, which is what a strengthened currency will do. They have decided to take the excess dollars received and purchase American assets with the dollars, most notably US Treasuries. This has the effect of "neutralizing" their currency inflows and keeping their currency artificially suppressed.

It has another effect which is the rise in value in US assets such as the bond market because of the increase in demand. Sounds great right? There is one problem. When the Public Bank of China exchanges yuan with the local bank for the dollar, where do they get the yuan? Ah, they print the money or create it with a computer. You remember that trick right?

This money has poured into the local banks creating an explosion in the Chinese money supply. This explosion has caused inflation to rise tremendously. The cost of living is rising at a very rapid rate hurting their developing middle class. They do this (right now) to keep the yuan artificially low and keep the dollar artificially high.

This situation is unsustainable and will come to an end. The rest of the world will not suffer forever to pay for our excess. When the dollar begins to crack, they will send all those accumulated treasuries back to our shores, bursting our current bond bubble, and triggering the collapse of our currency.

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