Inflation or deflation? ‘Yes,’ is our answer
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Today, we give you not one, but two, apparently contradictory views. One is bound to be right. We think they both will be.
First, the basics: China is a big country in Asia with a big pile of cash – $1.4trn of it. Most of this currency features pictures of dead US presidents.
The USA is a big country in North America that emits these dollars, using them to buy things it cannot afford and doesn’t really need.
Meanwhile, Americans owe more dollars than ever before. Until 1980, debt as compared to GDP never surpassed 150%. Now it is 330%. Many people are finding it hard to pay their debts. And many leveraged bets made on this debt are now going bad, reducing the availability of cash and credit generally.
So, back to our views. On the one hand, the world is awash in paper money. So much is gushing into the world economy that prices – notably of oil and gold – can only float higher. The dollar, of course, is doomed. It will be dragged down by the weight of its own numbers. On the other hand, the world is caught in a credit crunch. The days of reckless lending are over. Assets – real and imagined – will fall in value, prefiguring a major drop in prices across the board. The housing industry got nailed first. Then property prices headed down. Finance was next. And then technology. And now stocks, generally, are in retreat… with much further to go.
How the dollar came to have no economic value
Take your pick. The right hand is clearly working the pumps. For clarity, we turn to no less an authority – and we can’t think of any – than Mr. Mahmoud Ahmadinejad. You may recognise the name – he’s the desperado in charge of Iran. He was in Monday’s Financial Times this week. A photo showed him looking rather glum. Of course, you’d probably look gloomy too if Hugo Chavez had his arm around you. Still, Ahmadinejad managed to summarise the entire post-1971 world monetary system so clearly and so precisely; it was almost poetry. A haiku: 
“They get our oil
and give us
a worthless piece of paper.”
Nobel Prize committee, take note. Mr. Ahmadinejad is not known as a poet nor as an economist. Still, he went on to give graduate level instruction in central banking: “We all know that the US dollar has no economic value”.
How the dollar came to have no economic value is a long story. How there came to be so many of them is shorter; the dollar is the USA’s most successful export. Americans are world champion spenders. They may make up only 5% of the world’s people, but they do 20% of its consuming – in dollars. Central banks, fearing that an oversupply of dollars will drive their own currencies up, print local currencies, use the money to buy dollars, and add the dollars to their reserves.
This year alone China has accumulated nearly $400bn of foreign reserves, mostly dollars. It has so many dollars that the Chinese are getting nervous. Wen Jiabao, China’s premier, told an audience in Singapore: “We have never been experiencing such big pressure. We are worried about how to preserve the value of our reserves”. Meanwhile, another headline from the FT told us that the greenback is under attack in other parts of the world: “Dollar loses grip on Asian debt sector”.
“The US dollar has lost is status as the pre-eminent currency for fixed-income products, such as corporate bonds in Asia, a sector it used to dominate,” said the story. The dollar itself fell to record lows against practically everything – notably, the pound, the euro, and oil. And if the Fed cuts rates again in December – a 90% probability, says the futures market – the dollar will fall further and prices will continue to go up.
Credit contraction
But, while the right hand pumps, the left knocks a hole in the bucket. Week after week, more losses are announced. The latest tally by Goldman Sachs estimates total losses at $400bn from the subprime debacle, with a total of $2trn of cash and credit sucked out of the financial system.
Leverage works both ways, it turns out. When credit is expanding, a deposit of $10m can be levered into a $100m gamble. When it is contracting, a $10m loss reduces the supply of credit by as much as $100m.
The drop in the dollar and the drop in housing prices have already cost Americans about $2trn in implied wealth. A trillion here. A trillion there. Pretty soon you’re talking real money. And it’s money that is going, not coming.
Says the Economist Intelligence Unit: “The main risk to the world economy is a deflationary spiral in asset prices.” Which hand will do the most damage? We don’t know. But we suspect both of them will smack us sooner or later.
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