Monday 1 December 2008
As Inflation Passes Away, China Becomes a Big Winner
And how does China fit into this scenario? As China chooses the US Dollar as its reserve currency, the passing away of inflation is a major benefit to China. Long criticized by dollar critics, China is now looking like a real winner as its US bond investments increase in value and purchasing power. Yes, the passing away of inflation is a big boost to China!
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As Inflation Passes Away, China Becomes a Big Winner
Thomas Wilkins
30 November 2008
This is a big surprise to generations of Americans who were schooled in believing that prices always increased and monetary policy should always aimed for “full employment.” Hence, a little inflation was not so bad or worrisome. But as economist George Selgin wrote, “Today most of us know better: both theory and experience have taught us that trying to hold unemployment below its ‘natural rate’ through monetary expansion is like trying to relieve a hangover by having another drink: in both cases, the prescribed cure eventually makes the patient worse off.”
In order to stimulate its weakening economy, the U.S. government must either print or borrow more money than we can dream of. The government’s mission will be to re-inflate the economy.
But can we expect inflation to return quickly as many monetarists expect due to the increase in the US money supply? The old argument was that extraordinary borrowings by the government “squeezed out” private borrowing and drove interest rates go up and bonds down. This leads to the opinion that the U.S. Dollar should be ditched as a reserve currency just as Britain lost its standing in the early 20th century.
But are these arguments reasonable this time?
If inflation is just waiting to raise its head, why are U.S.Treasuries performing so well in the capital markets?
The reasons are (1) Flight to safety as bankruptcies increase due to the economic slowdown, (2) A lower rate of inflation takes out the inflation factor in the pricing of bond yields. (3) The slowing economy creates less worry that the government will be “squeezing out” the private sector in the bond market, (4) As major price indices decline, the purchasing power of money increases and the real rate of return for fixed income securities increases.
Even if Obama pumps in a lot of money, he cannot automatically cause lots of inflation because of the slack in employment and production. In other words, there is in GDP accounting more supply than demand and it will take a lot of stimulus just to get back to where we start and then even more to reignite inflation.
When we had high interest rates under Fed Chairman Paul Volcker in the early 1980’s, the Fed was operating on a monetary model which wanted to control money supply. Today, money supply is going through the roof. Paul Volcker may surprise us due to different circumstances.
And how does China fit into this scenario? As China chooses the US Dollar as its reserve currency, the passing away of inflation is a major benefit to China. Long criticized by dollar critics, China is now looking like a real winner as its US bond investments increase in value and purchasing power. Yes, the passing away of inflation is a big boost to China!
(Thomas Wilkins, CFA is the Chief Executive Manager of Joseph Jekyll Advisers LLC at thomaswilkins5@charter.net.)
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