US Economy and its debt 2

By pursuing the path of devaluation, the administration is invoking the mind-numbing logic of solving debt problems by issuing more debt.

With the government taking on more than one trillion(that is one million million) dollars of liabilities in this crisis, it appears that the government does not intend to let debt destruction take its natural course. With the bailouts, debt in the system is preserved, not destroyed.

A weakening dollar does make sense. First, it allows both domestic and export industries to become more competitive with foreign-made goods. Second, perhaps just as important, the government can slowly inflate away its debt.

However, one interesting point to take note is to ask yourself how long can the US keep up inflation to wipe away its debt. Who has the most to lose from the US inflation? A breakdown of the debt holdings might shed light on this issue.

It is one thing if “America owes her debt to herself”. However, recent times have proved that America increasingly relies on foreign countries to lend her money. An increasing amount of US debt is being held by foreign powers.

Together, China, Japan and Oil Exporters made up more than half of total foreign ownership. With so much debt being held by foreign powers, the US seems to be nervously whistling past a huge potential landmine by inflating away its debt. Will foreign debt holders really let the US dollar slide with nary a complain? Already, the rumblings of dissatisfaction from China is becoming louder. (By the way, OPEC has, through past history, shown itself to be quite capable of drastic action if their demands are not met eg. oil embargo).

Turning to other issues, one side effect of the weakening dollar and low interest rates is that it becomes relatively cheap to borrow US dollars and invest them elsewhere is risky, higher-yielding assets. This is termed as a carry trade, and it pushes asset/commodity prices higher, as long as the dollar remains weak and interest rate remains low. According to Nouriel Roubini, this is now helping to fuel another asset bubble. To quote him,

“We have the mother of all carry trades…Everybody’s playing the same game and this game is becoming dangerous.”

Once the dollar stabilizes and interest rates rise, it no longer becomes profitable to borrow in US dollars. To cover their short positions, there will be a massive flow of money back into the US, which might spark off another large decline in asset prices. With equities worldwide soaring, it might be good to ask yourself if the economic fundamentals are there before investing. Once the liquidity is drained away, can share prices remain at their current level?

How long can the weak dollar persist? While everything seems fine and dandy now with share prices rocketing, closer examination reveals plenty of hidden risks and uncertainty about the future. While the Fed has kept interest rates low in order to spur business, much of the easy credit seems to have been directed into asset/commodities market, fueling another asset bubble, instead of into the real economy and creating new jobs.

When a government owes a lot of debt, how it decides to pay off its debt is equivalent to how the debt burden is shared. Through deflation, the debt burden is shifted to the taxpayer. Unemployment will be higher, credit is tightened, and the economy will contract. Through inflation, the debt burden is shifted to the savers, where the real value of their savings will plunge in step with the declining dollar. Sad to say, history has shown that typically, the government will choose the path of inflation. While deflation might bring about a swifter and stronger economic recovery, the future is never certain and there is no guarantee the economy will rebound. Meanwhile, the pain is certain to be a lot sharper (Eg. Britain after World War I). Inflation, on the other hand, as long as it is not too drastic, typically reduces the pain of restructuring the economy. Of course, the trade-off is that the pain will persist for much longer as inefficiencies are slowly worked out of the system. As for the savers, about all they can do is to blame their luck and hop around in impotent fury. Life is unfair after all.

结论呢？就是我们一起去吃大便吧。

US Economy and Debt

One of the main causes of the current financial crisis is the fact that too many Americans have become addicted to the debt-fuelled lifestyle. By buying things they cannot afford, putting everything on credit and getting into debt that they are unable to pay off, the financial crisis is exacerbated. Let us take a look at this illuminating graph.

While national income only grows modestly, debt has exploded upwards. How did the US accumulate all this debt? It is due to the easy credit that has become the cornerstone of the relationship between developing China and America. Niall Ferguson, author of The Ascent of Money, termed this relationship Chimerica. China did the saving, America did the spending. China exported, America imported. China lend, and America borrowed. By pursuing an export-oriented economy, China was helping to finance the debt-fuelled American economy. As China poured its surplus back into buying Treasury securities, thus keeping its currency pegged to the dollar, interest rate in the US is artificially lowered. With the economy awash with easy money, America is thus able to pursue a debt-fuelled economy, where banks tend to lend recklessly to individuals and individuals cand spend in excess of their earned income.

Obviously, a debt-fuelled economy is unsustainable and cannot last forever. Debt has to be repaid, one way or the other. How it is going to be repaid will depend very much on what the US intends to do to the dollar.

Typically, when you owe a lot of debt, you will have two routes available to pay off the debt—deflation or devaluation.

Let us first focus on deflation. As was mentioned above, because of Chimerica, America has been awash with easy credit for a long time. This led to asset price inflation(eg. housing market, stocks, etc).

Meanwhile, income does not seem to enjoy the same surge upwards.

Ultimately, debt must be paid off using earned income. A look at the above graphs tells you that this is well nigh impossible unless one of the following happens—income has to rise significantly, or significant debt destruction has to occur. To quote Andrew Mellon, “Liquidate labor, liquidate stocks, liquidate farmers.” After so many years of asset price inflation, we are now due for asset price deflation. Debt destruction will have to occur, hopefully in as orderly a fashion as possible, to bring asset prices down where people can realistically pay them off using earned income.

Unfortunately, such an approach is likely to be a political hot potato. It is almost certainly to involve a lot more pain in the short term, setting off a chain of debt defaults and bankruptcies and increasing unemployment. Certainly, it will face opposition from powerful lobby groups in Congress. Going down this path, the pain will be sharp. However, once the economy has recovered, at least, the rottenness will have been purged out of the system.

Risk and Uncertainty

Not too long ago, I had an argument (discussion?) with two other people, on an issue regarding risk management. I maintained that despite all the actuarial science that insurance companies utilize, they still tend to underestimate risks due to the uncertainty factor. By uncertainty, I refer to events that are unpredictable, events that are not covered by past history, and hence left out in the calculations so integral to the decision-making process. As a result, with the underestimation of risks, insurance premiums are lower than they should be, and companies can go bust quite easily. I cited the example of 9/11 to illustrate my point, where several insurance companies posted enormous losses because they did not factor in the possibility of 9/11 occurring.


Meanwhile, my two contemporaries dispute my point, claiming that insurance companies do know the risks involved, that their actuarial science is impeccable, and their models solid. The fact that so many insurance companies went bust because of 9/11 is not because of a flaw in their calculations or because they failed to factor in uncertainty, but because they are “suay”.


Apparently, according to them, if your model states that there is a one-in-a-trillion chance of this event occurring and this particular event still happens, you are just “suay”. The model is correct. The chance is still one-in-a-trillion. The fact that it happens simply means that you are unlucky.


I disagree. For me, when it is a one-in-a-trillion chance (statistically insignificant) and the event still happens, obviously something is wrong with the model and it needs more work. Risk premiums need to be adjusted upwards. More factors need to be considered.


In the end, none of us succeeded in convincing the other party.


To further substantiate my argument, I would like to borrow an example from The Black Swan by Nassim Nicholas Taleb. Imagine yourself as a turkey on a farm, well-fed and well-cared for all throughout your life. Nothing negative has ever happened to you, and using past history, you extrapolate and think that nothing bad is ever going to happen. Meanwhile, Thanksgiving Day draws nearer and nearer. What is the probability that you are going to get hauled off to the slaughterhouse in the next few days? By using past history, the probability is zero. Nothing bad has ever happened, so why should it happen now? But in actual reality, with each day that passes, the probability jumps exponentially, until eventually, Thanksgiving Day arrives and the unsuspecting turkey is in for a nasty surprise.


Risks are quantifiable. Uncertainty is not. Life is about uncertainty. Please don’t torture reality to fit your “models”.



Or maybe, I’m just a cynical skeptic who doubts everyone and everything.

Part 1--The US Economy

1 year 10 months is finally over.

To get rid of the rust in my mind, I have decided to embark on a quest that would hopefully show me the path to riches. While school has taught me lots of things, it has not taught me the most important thing of all—money.

Therefore, I will now seek to understand the global economy, the results of which may hopefully enable me to make better investments in the future. At the same time, a record of my thoughts is probably good as I can look back in the future and deduce where I have gone wrong. Without further ado, let us begin.

Is the recession over?

Recently, the press is inundated with reports on the “recovering economy”. Manufacturing data is up, forecasted GDP is constantly being revised upwards, and stock markets worldwide are soaring. In light of all this optimism, it is indeed tempting for the unwary investor to start buying equities in the market. After all, what better way to see one’s beliefs justified in an expanding economy as asset values explode in price?

Yet, a few indicators cast a worrying shadow over all this positive data. One particular indicator would be the stubbornly high unemployment rate. While most would decry the unemployment rate as a lagging indicator, nonetheless, I feel that unemployment rate is quite critical as it gives a clearer picture of the real economy in the country. Unemployment rate has hit 10.2% in the United States. For the uninitiated, consumption makes up for 70% of the US economy. With unemployment remaining stubbornly high, consumption is likely to be curtailed, and any recovery is likely to be subdued. Despite all the rosy figures in the press, the real economy is not doing well. Delving deeper into the unemployment situation, we can discover further sobering facts that serve to highlight this dismal situation.

1) U-6 rate now stands at a record 17.5%, a discrepancy of a staggering 7.3 percentage points from the official U-3 rate. (http://www.bls.gov/news.release/empsit.t12.htm) Looking at the chart below, 7.3 percentage points is statistically significant. Never before has the gap between U-3 and U-6 rate been so wide. Approximately 1 in 5 Americans are now out of work.

2) Number of persons eligible for food stamps now stands at a record high of 36 million, which is around 12% of the US population. ( http://www.fns.usda.gov/pd/34SNAPmonthly.htm)

With chronically high unemployment, consumption by households is likely to decrease over time. With reduced consumption and reduced demand for goods, how likely is it that firms will continue to commit further funds in investment? Firms will only invest more (read: employ more people) when there is increased demand for their goods.

One might argue that the trillions of bailout money supplied by governments can help us tide over this crisis. Shouldn’t the trillions of money have an effect in creating new jobs? My response would be yes, but the number of jobs created would probably be limited in scope. Most of the money is given out to too-big-to-fail institutions. TARP alone accounts for 1/3 of the stimulus funds.

Instead of focusing on the real economy and creating jobs, the money is used to support inefficient institutions, which then have no qualms in paying their employees record bonuses using taxpayer money. When institutions are deemed too-big-to-fail, the process of creative destruction, so vital in a free market, is halted, and inefficiencies in the system remain. The situation is eerily reminiscent of Japan in the 1990s, where inefficient companies were bailed out by the government, leading to a zombie economy and a “lost decade”. Furthermore, too-big-to-fail increases systemic risk as it introduces a “moral hazard”, where banks take on excessive risks because they know that the government will be there to bail them out if crisis strikes.

So, looking at the general economy, I must say that I do not have great confidence in a strong recovery. Reported “profits” seem to be more of cost-cutting measures, than due to increased revenue from a recovering economy.

For all the talk about a recovering economy, Bernanke and Co. do not seem to employ the measures in a recovering economy. Take away all the talk, and just look at their actions alone (keeping interest rates low, etc.). It would seem that we are still in a recession.

Of course, there are still several factors that are unknown, for example, whether the toxic debts of big banks are already resolved or just covered up and hidden from view, whether domestic consumption in China alone can power the world economy out of the recession, whether the soaring stock markets are able to affect the real economy to a significant degree, what is the effect when governments begin to exit emergency stimulus, etc.

George Soros once said "The stock market predicted 10 of the last 6 recoveries." It might do well to keep that in mind.

PS: This is not a recommendation to buy or sell stocks. As of now, I myself had no money in the stock markets. I might very well turn out to be wrong in my analysis…and it won’t be surprising.
Comments welcome!