2012: The Other Prediction

On 21 December 2012, the “world as we know it will end.” The Maya seem to have made a similar prediction, but they were referring to physical things happening e.g. a polar reversal, or a rapid change in sea level, or something like that. (Remember the movie ‘2012’?). My prediction, on the other hand, refers to the world financial system. More specifically, I predict that on 21 December 2012, the postwar Bretton Woods financial system – which has the US dollar as the world’s reserve currency – will collapse.

The dollar-based world financial system is set to collapse. This we saw during the 2008 world financial crisis.  The main reason that it didn’t collapse then was that the whole world’s economy would have crashed, as in deep depression worldwide. Thus, all countries chipped in to prevent the system from collapsing.  In the years since then, many countries have de-coupled from the US economy to the extent that if the US economy were to collapse, they will get ‘only’ a recession, instead of a depression. Other countries will be less willing, the next time around, to go into deep into debt to save the US; and causing them to suffer from secondary crises e.g. Eurozone sovereign debt crisis.

The US dollar is the cornerstone of the world’s economy, and it is under pressure. This is because of the dire state of the US economy, with its very high sovereign debt, negative trade and exchange balances, high unemployment, falling housing prices, etc. The US economy has been kept running mainly because of extremely low interest rates for US Treasuries, which have to go up sooner or later.

Why 21 December 2012? Well, why not?, why not on that date? But I have more going for this date than any other, as I will now explain. There are enough reasons to think that A CRASH WOULD HAPPEN on or around this date.

Triple Witching
21 December will be the ‘triple witching’ date for world markets in 2012. Every third friday of a month, option contracts (as well as warrants and futures) for stocks, bonds, currencies, and commodities expire. That is the month’s ‘witching’ date. Every three months (March, June, September and December), quarter options also expire. And on the 3rd friday of December (which is 21 December in 2012), the year options, quarter options and month options all expire at the same time.

Trading on a witching day is a lot more volatile than in ordinary days, since holders of contracts need to settle their accounts at the end of the trading day. Depending on how widely options had been bought and sold for a category, the fluctuations in the price of the underlying asset can vary by several percentage points. With triple witching, it could vary enormously.

Lame Duck, Debt Ceiling
The US will be having elections in early November 2012, but the winners will be installed only in late January 2013.  There will be almost 3 months when the outgoing congressmen and senators (and perhaps even president) will still be in office. This is known as the ‘lame duck’ period.

If, for example, the tea party congressmen and senators lose big in November, they will try to maximize the 3 month lame duck period to pass all kinds of laws they like. They will also block everything they don’t want with even more energy. It so happens that there is an important piece of legislation that is practically scheduled to be passed during the lame duck period, and this is a law that would (again) increase the debt ceiling for the US government. The recently approved higher debt ceiling is expected to be reached around December 2012, meaning that the debt ceiling would need to be raised at that time. The Democrats had demanded this, so that the decision won’t be influenced by the election’s dynamics.

Thus, the US debt ceiling legislation will have to be passed by the lame duck congress in December 2012. The fight over this promises to be even more intense than the last time, which was then quite destructive (as a result, the US Treasuries’ credit rating was downgraded).

Window Dressing
During the course of the year, traders buy shares of small-cap companies, emerging market stocks and bonds, etc, and before the year ends they sell most  of these and buy prime stocks, mostly from the Dow Jones Index. This is called ‘window dressing’. Traders everywhere do something similar, because they want to report holding ‘stable’ stocks at the end of the year. The only difference is that in each country, they would have some local stocks which are a ‘must hold’.

Now, imagine what traders will do when presented with the prospect of buying Dow Jones stocks, which are almost sure to lose value come 1 January. What will they do in terms of ‘window dressing’? Well, the prudent trader would buy up Euro, Yen and Swiss Franc denominated stocks (e.g. Nestle, Toyota, Shell, or Siemens)  and bonds; in the process selling a corresponding amount of US stocks and bonds. This may be prudent for the individual trader seeking to protect the capital of their investor-clients, but if they all do this at the same time it will mean a massive sell-off of dollars.

Christmas and New Year
21 December 2012 will be the last full trading day before Christmas. On Monday, 24 December, markets will only be open for a half day, at most.

But Christmas 2012 will be a bit different from most others. For one thing, it will be end of a year of depressing economic performance, particularly with regards to employment.  By mid-December, there will be initial figures for Christmas sales and Christmas hiring; and both are sure to be disappointing (i.e. significantly lower than 2011).

To make matter worse, foreign Central Banks usually decide to reduce the percentage of dollars in their currency reserves at the beginning of the year (i.e. on 1 January). They’ve been doing this for the last few years already, reducing the percentage of dollars held in reserve by one or two percent every time. It usually leads to a slight deterioration in the value of the dollar in January, and then the effect usually dwindles. But at the end of 2012, with so many things going on, the prospect of yet another factor causing the dollar value to dip could really worry traders. They may take from the experience of 2006, when the dollar lost value starting early December in anticipation of the January dip.

External Factors
So far, I have mentioned America-specific (and date specific) reasons for the US economic collapse on 21 December 2012. Now, let’s look at the external factors.

The Euro will be stable. It may be hard to imagine now, but by the middle of 2012, the so-called Euro crisis will be over.  The Eurozone countries would have settled the Greek problem with a programmed partial default, and have saved the banks from bankruptcy. They would have strengthened the EFSF, and made sufficient funding arrangements to help countries in trouble.  They would have even amended the relevant treaties to strengthen the Eurozone’s financial health. Financial market speculators will avoid betting against the Euro, knowing that it has enough ammunition to defend itself.

With the Euro stable, it will only take a few months before US investors would realize that they stand to earn more if they invested in Euro-denominated assets. The dollar is sure to lose value as a result. A stable Euro will make the dollar a lot less attractive as a place to put money. Why invest in dollar denominated assets when the dollar will devalue 10% to 15% per year? Dollar devaluation will be a self-perpetuating process.

High Oil Price. When winter comes, the price of oil usually goes up, as demand for heating oil rises. During the whole of 2012, the oil price would have inched itself higher and higher, reaching from $130 to $150/barrel (if not even higher) by December 2012. The price of oil has an inverse correlation with the value of the dollar.

Political Events. Foreign countries know that America’s political ‘wiggle room’ during the lame duck period is limited. If a country wanted to declare war with its neighbor, or if people plan to rise in revolution against a state that is supported by the US, the lame duck period would also be a great time to do it.

China Sanctions? I expect that the Democrats will seize control of both Houses of Congress in the November 2012 elections. With this, the Democrats would push for legislation accusing China of currency manipulation, and compelling the government to impose extra taxes on chinese imports. The Chinese would be extremely worried about this, and may start reacting as early as December 2012.

All in all, there is every reason to expect a very significant fall in the value of the US dollar and a huge stock market decline on 21 December 2012.  The US financial system is so shaky that it won’t be limited to a mere ‘dip’, but will become a crash that will signal the end of the US dollar’s financial dominance.

All this is assuming that nothing apocalyptic of the type the Maya predict will happen.

You have been warned.

Beyond the Debt Ceiling

The US is in the grip of the political drama around the raising of the debt ceiling. Economists are worried that if politicians fail to come up with a satisfactory solution, the US will go back into recession even if they finally agree on raising the debt ceiling.

Most Americans do not realize that solving the debt ceiling problem isn’t really the main issue. The main issue that they have to face is that the US economy is designed for the wrong century, and that it is long due for a transition to a more ‘modern’  design. Officials try to avoid the inevitable by artificially propping up the economy, but it won’t work. The transition will come. And it will be much more painful than a mere ‘double dip recession’ – it will make the recession of 2008 look like ‘foreplay’.

Transitions are alright in economics – the market will be able to recover and adjust the distribution of goods and services to adapt to any changes in the patterns of use. However, some transitions take long, and this means that the economy will suffer till the transition is over and the market has made the necessary adjustments.

The US is in the midst of three transitions: that of its housing patterns, the use of resources, and the US dollar. And since the nature of all these transitions is that they take a long time, I believe the US “crisis” will last for some time.

The government will naturally act as if it is only a matter of pushing through certain programs, and then the economy will recover. Perhaps certain programs may result in short term growth or increased employment. But this will ultimately be quite futile, and the longer term trends will overpower these gains.

 Housing
The economic crisis was caused by the housing bubble – specifically, the market for ‘sub-prime’ mortgages was oversold.  And this problem continues to this day, with homeowners continuing to default on mortgages. However, this is only part of the problem.  There is a creeping re-concentration of housing patterns in the US. People are not as willing as before to commute two hours or longer to work every day. This is partly due to the economic crisis – if you’re looking for a job, it is better to do so close to home. And, if your house is foreclosed, you would most likely move closer to the city for new and cheaper housing.

But the crisis only aggravates the problem, it did not cause it. Things like demographics (people getting older – and thus wanting to be nearer health care facilities) and the rising price of gasoline/diesel have a longer term effect on housing choices.

The movement of people from sprawling suburbs to smaller urban hubs means that many houses built in the suburbs will go unsold (or not rented) for a long time, and sometimes will only get sold at a very big discount. And the bad effect of this is that people won’t be that eager to buy houses in an area where house prices continue to go down. So, home building companies will lose money or even go bankrupt, until they completely shift their activities nearer urban hubs.

Expensive Resources
With the development of countries such as China and India (and of course, the rest of the world), there will be a squeeze to divide up all the resources needed. The days when Europe and America  could get away with using 80% of the world’s resources are over; and this means that the resources of the world should be shared more equally. And, this means that the price of most resources will go up significantly.

The resource that Americans  will really FEEL going up in price will be that of oil. From the crisis-level price of around $95/barrel, oil will surely go to $150/barrel by 2012. This is on the logic that if the world’s GDP returns to the pre-crisis level, so will the scarcity of oil, and this means that prices will return to pre-crisis levels. And that is only the beginning: beyond 2012, prices will rise even higher. Oil supply volatility may cause temporary peaks or dips in the price, but the overall trend is still for the price to rise.

For the American automobilist, this means that oil will return to highs of $5/gallon, or higher. This will need a permanent adjustment of living patterns. People will need to either commute less, ride trains or buses to work, or use smaller cars or hybrids.  And since oil is used for making things like plastics and fertilizers, the prices for these will also rise, forcing people to change their consumption patterns.

The rise in the price of grain, particularly that of corn, will eventually spell the end of feeding grain to cows.  At a certain point, the number of cows will be limited by the grass that they can eat. See High Corn Price Will Lead to Lower Beef Production Cheap meat will become a thing of the past.

Increased commodity prices will cause a move away from the throw-away economy. There will be a new emphasis on goods that last longer, and use less energy and other inputs.

The “Fall” of the US Dollar
The days of the US dollar as the international reserve currency are soon over. I would say that it would “fall” from this position sometime in this decade. And that the US economy will feel this change quite deeply. (see Two Years After the Fall )

The fall of the dollar finds its roots in the massive debts that the US has – almost 14.3 trillion dollars, to date. The Fed is even tried to stir up US inflation by ‘printing money’, or Quantitative Easing. And to make the problem worse, total US currency abroad totals $75 trillion.  The resulting inflation and the high amount of debt will be the dollar’s undoing; at a certain point, countries will decide NOT to keep dollars as reserve anymore, and NOT to buy up US treasuries, and this will drive up the interest rates on these treasuries.

Already, the rating agencies are threatening to downgrade the rating for US Treasuries from AAA to AA. While this seems like a small step, it will be the first push down the hill for the dollar.

The strength of the US Dollar rests on the willingness of other countries to keep dollars in their foreign currency reserves. Dollars make up to 80% of Central Bank reserves of many countries. Historically, this has meant that the US could buy more from other countries than it sells to them. If Central Banks’ change their mind regarding the desirability of the US dollar as a reserve currency (especially as a result of a change in Treasuries’ ratings), this will result in a sharp drop in the value of the US dollar. And  this point will happen sometime very soon.

After the Transition
After the decade of transition, the US will face a new period of sustained economic growth. The American people’s  flexibility and the country’s huge resources are sure bases for it to build a new prosperity.  Politicians should hurry the transition instead of trying to deny that it will happen.  They should not be distracted by the call to ‘preserve jobs’ or to ‘preserve our way of life’.

Is US Dollar About to Fall?

The US Congress will have to raise the Debt Ceiling from the present $14.3 trillion by August 2, or else the country would face technical default. But the Republicans are demanding budget cuts be done first; and Democrats are demanding that measures should include increased taxes for corporations and the rich. Both sides are standing their ground, and there is a real danger that the country will indeed default by August 2.

Most probably, a deal will be made at the last minute, and the US can go on merrily increasing its national debt for a few more years. But the question remains: can the US dollar’s credibility withstand such a strain? Will the US dollar fall while Congress debates over raising the Debt Ceiling?

I think that sooner or later, within the next 5 years or so, the US dollar is going to “fall”.  The national debt limit is only part of the problem; the main problem is that the US has a triple deficit – of the budget, trade balance, and payments. And that it has accumulated a huge amount of “unbacked liabilities” in the world – to the staggering amount of $75 trillion.

All proposals on the table will help to reduce the budget deficit, but it will even not be enough to get a balanced budget.  Since there will continue to be a deficit in the coming years, the national debt will continue to grow. And then, there is the trade deficit which also grows from year to year. Thus, all plans now being considered will not improve the US’ capacity to repay its debt.

The world is getting impatient with the dollar, and it seems that US politicians are taking their time at solving it, not realizing that the problem is really urgent.

Signs of Trouble
The problems in the Middle East are all in the news. But the biggest problem with it lies not in Libya or even Yemen – but in the fact that the US dollar has not strengthened in the face of all these problems. Almost always before, when there is political turmoil somewhere, the US dollar gains in value, as money exits that country and goes to the safety of the US dollar. Now, the whole Middle East is ablaze, and the dollar, instead of strengthening, has weakened considerably.

Another sign of impending trouble is that the US, even with “QE2” (the program of the Fed for creating $ 600 B by buying government treasuries) and the extremely low Fed interest rate, faces rising commercial interest rates. QE2 was instituted in the first place to REDUCE interest rates. What will happen after June, when the QE2 program is over? Will interest rates rise substantially, resulting in a rise in unemployment? Will there be a double dip recession? If the Fed makes a “QE3” program instead, will this be enough to hold interest rates down? or will foreign fund managers dump US treasuries instead?

A third sign of trouble is the news that PIMCO, the world’s biggest holder of bonds, has entirely stepped out of US Treasuries. Even worse, PIMCO has resorted to selling US Treasuries short – which means that it even has negative ownership of Treasuries. This shows that US Treasuries are no longer attractive to the wiser international investors. I doubt that many hedge funds keep Treasuries in their portfolios either.

A fourth sign is that when Osama bin Laden was killed, he had with him 500 Euros. He had Euros, not US Dollars, which means that he considered Euros more useful in case he had to escape capture in Pakistan – Euros seem to be more useful in bribes etc. in Pakistan. This shows that even in the underworld, the US dollar is not considered a good currency anymore.

Roots of Crisis
The present crisis has its roots way back in the Bretton Woods agreement, made after the Second World War, to have the US dollar as the world’s reserve currency. Until 1971 the dollar’s value was pegged to the US supply of gold, keeping the US currency in “control”. In 1971 President Nixon let loose the gold peg, making the dollar itself as the only thing in reserve.

The US dollar as reserve currency meant that countries were willing to run a trade and exchange imbalance with the US, since this would mean that they would accumulate US dollars in their reserves. This meant that the US tended to have a structural trade and payments deficit with the rest of the world. This  effectively overvalued the dollar, making its imports cheaper than they otherwise should be. And this contributed to the very high standard of living in the US.

Over the decades, the US steadily accumulated a big debt burden. It is now at $14 trillion, or more than 90% of the US’ annual GDP. Among developed countries, it is only Greece and Japan which have higher debt/GDP ratios. Greece has had its debt crisis, and is now forced to undergo a strict program to get rid of its deficit. As for Japan, most of its debt is to Japanese citizens – and thus the impact of the debt is less than if it was held by foreigners.

The US debt is only part of the “US dollar overhang” in the world economic system; because the bigger part (approximately $60 trillion)  is simply the dollar reserves that countries have accumulated, due to the US trade deficit.  The national debt, in the form of US Treasury Bills, is the smaller part of the problem; but it is the more worrisome part of it, since the US has to pay interest on this.

Stumbling into Dollar Fall
The danger is always present that a country would decide to dump their US treasuries, leading to a chain reaction that sees other countries dumping treasuries, a spectacular rise in interest rates, and the dumping of US dollars from national reserves, and the fall of the dollar. This has not happened so far, since no country will do that consciously and devalue their own reserves. But we cannot depend on this not happening in the future. In fact, I think that the chance of this happening is getting bigger with time.

As more and more dollars are sent abroad, in the form of  US Treasury bills or simply “cash”, the danger that they will no longer be accepted by other countries increases. Already, many countries are calling for an overhaul of the international currency system. Countries have to continuously weigh the advantages of holding dollars against the cost due to the continued watering down of the dollar’s value.

Even if no country would willingly cause the dollar to fall by dumping it, a series of smaller events could push things so that even  minor players could accidentally cause such a fall.  The recent intervention against the Japanese Yen had the inadvertent effect of increasing Central Banks’ reserves of dollars. Central Banks all over the world had to subsequently find ways of restoring their dollar reserves to normal levels. The BRICS agreement to use their own currencies when trading with each other means that less dollars need to be kept as reserves. Eurozone countries intervention to support weaker Euro countries’ finances is another measure that strengthens the euro against a potential fall of the dollar. All these make the dollar weaker. A disruption of the scale of the 2007 sub-prime crisis happening now would surely topple the dollar.

Perhaps it won’t even be a single country or investor which would precipitate the dollar’s fall. It could be simply an accumulation of small steps that would push it over the edge. The US high unemployment rate has “forced” the Fed to keep the Fed Funds rate low, but this at the same time increases consumption and imports, and to further trade deficits.

The US dollar is undergoing something like a game of international “musical chairs”. US-based investors buy securities in other countries, effectively moving dollars abroad; Central Banks sell dollars to prevent their currencies from appreciating; the continuing US budget deficit means that the government has to issue more Treasuries;  foreigners buying US equities or Treasuries effectively returns dollars to the US;  too much incoming dollars could cause inflation, and increase unemployment. The cycle continues, and dollars are passed back and forth from the US and abroad.  A growing number of Central Banks are wary of keeping too much dollars, and this cycle would eventually break down at some point.

Tipping Points
There are a number of occasions or events which could push the dollar over the edge. The Debt Ceiling of the US has been reached, and by August 2 the US Congress has to agree to raise the limit. Not to do so will surely bring about a loss of trust in the dollar, and its subsequent fall.

And then will come the budget discussions later in the year. This is another occasion when confidence in the dollar may be critically damaged.  This will be followed by the Presidential election campaign and possibly a new administration.

At any time, Congress may pass a law imposing a tax on Chinese imports. This will cause Chinese countermeasures, including a stop to buying US Treasuries. And this will be enough to precipitate a chain reaction that will cause the fall of the US dollar.

The US dollar will fall within the next 5 years. While it will cause a deep crisis, it won’t be that bad, in the long run. I wrote a blog post about how it will be Two Years After the Dollar Fall

Two Years After the Fall

It is now March 13, 2014. America has undergone a huge shift in its economy in the last two years. On this day, in 2012, the dollar “fell” in value, by about 100%; and more importantly, it “fell” from its position as the world’s reserve economy.

The Dollar Falls
It all started in November 2011. Riots had broken out in Saudi Arabia, and the government was frantically trying to restore order. The Saudi government had bungled in its handling of a relatively small disturbance among Saudi Shiites in Qatif, in the Eastern province. In November 2011, the disturbance had escalated into a nationwide protest movement. By December, workers in the vital oil industry and in the ports had gone on strike. And the demands had hardened – where before they had merely asked for the release of arrested Shiite leaders, protesters had now gone on to demanding a Constitutional Monarchy, some even wanted a republic, while others were calling for the independence of the Eastern province. All of this caused the price of oil to go through the roof. By the end of December,  oil had reached $200/barrel.

To make matters worse, the US response to it was also wrong. Congress passed a new Stimulus Bill of $500 billion, and the Fed proclaimed QE4 – a program to pump $1 trillion into the economy, as a response to the new recession. Unlike what happened during the 2008 recession, however, the US was now alone in pursuing an expansionary policy. This caused a lot of misgivings in other countries regarding the value of the US dollar.

Oil producing countries responded by demanding that they be paid in “hard” currencies – e.g. Euro, Yen, even the Chinese Yuan – and NOT in US Dollars. By January 2012, Central Banks all over the world decided to cut the US dollar component of their reserves, by a modest 1/4. Thus, from an average of 80% of reserves in US dollars, to 60%. This seems to be a modest change in policy; but when it is done by ALL Central Banks at the same time, it had a devastating effect. This policy meant that the Central Banks would gradually replace their dollars with other currencies in the course of a number of months, eventually ending with the target percentage of US dollars in reserve. By the end of February, however, the value of the US Dollar had gone down to the point where Central Banks holding lots of dollars (mostly in the form of US Treasury Notes) became nervous. They stood to lose a lot, if the dollar lost value.

So, it finally came on Tuesday, March 13, 2012. The Saudis were the first to dump their US dollar holdings. This was followed by Russia, Japan, and then China. After this, everybody else dumped their dollar holdings. You could probably speak of an “oversold” situation with the dollar then, but Central Bankers didn’t care anymore – they just wanted out, as quickly as possible.  As a result of all this, the dollar sunk to $4: 1 Euro on March 16, 2012. In the months following, the dollar regained some strength, finally stabilizing at $3:1Euro by December 2012.

Picking up the Pieces
The US was left to pick up the pieces. It still had a big budget deficit, and a huge payments deficit, and a 16 trillion national debt. The only good news in all this was that the national debt remained at 16 trillion dollars, even though the dollar was half its former value (thus, effectively the national debt was reduced by half).

The US had to go to the IMF to borrow money to finance its budget deficit. Nobody else was willing to lend the US money at that time. The US got a 500 billion SDR loan from the IMF (roughly equivalent to $500 billion at the old exchange rate). But the IMF loan came at a price: the US government had to cut spending, and increase taxes, and it had to have a concrete program to balance the budget by 2015. The US also had to open up its economy to foreign investments (thus, the airline, oil, banking etc. industries were opened to 100% foreign ownership).

Recovery
The IMF conditions were tough, but now, 2 years after the fall, the economy is on its way to recovery. US labor costs had dropped in relation to the rest of the world (while the US dollar’s value was halved, prices rose 30% and wages rose only 10%). This has led to a huge expansion in US-based manufacturing of products which used to be imported from China. (Another large chunk of the production had gone to Mexico, from which it is cheaper to ship to the US.) Automobile production has greatly expanded, with so many people buying smaller cars, hybrids and EVs (Electric Vehicles). And there is now a huge demand for buses, as local governments expand their public transportation services.

Tourism is now booming, with Asians and Europeans making the most of  “cheap” US vacations – tourism revenues have quadrupled since 2012. There is also a surge of “medical tourism”, with Europeans and Asians coming for elective surgery (which are not covered by their country’s health insurance).

American university enrollment has surged; while the number of American students has lessened, foreign students have more than made up the loss. Foreigners find that the US is offering quality education at bargain prices. And while foreign graduates are now in demand in the US, a bigger percentage of them opt to work in their home countries about graduation.

The stock market is enjoying a bull market of sorts – the Dow Jones just topped 20,000 points last January. Some companies are having a hard time: Walmart’s sales suffered as a result both of the lower purchasing capacity of people and the higher prices of goods. It is now repositioning stores to city centers, since people now find their suburban locations “too far away” (due to high gasoline costs). Starbucks has suffered because people have decided en masse that Starbuck’s coffee is a “luxury that they could live without”. Airlines are suffering from people cutting back on air travel.

But more companies are thriving: McDonalds has noted an increase in sales, even in the face of 30% higher prices; Amazon has seen a boom in the sale of Kindles and e-books (paper prices have also spiked); IT companies are profiting from people spending more time at home (people are also working more from home).

People have developed new habits. The magnetron is still all important; what’s new is that companies are now selling magnetron meals in reusable containers. Children often go to school now on bikes (leading to a reduction in child obesity). People are consuming more (local) vegetables, and eating less meat.

Many more people are employed than at any time in the past few decades. The unemployment rate is now at 5%, and is still dropping. There are less illegal Latinos now, since many Mexicans now prefer to work in the new Mexican factories. Americans are now more willing to take on farm jobs that were formerly done by Latino migrants. There is a marked reduction in the drug trade, with lower US buying power and prosperous Mexican workers.

There are now plans to build a nationwide rapid rail network. Ordinary rail lines are more intensively used for carrying products (replacing trucks), and a lot more products are transported by water. Solar farms are being set up in the Southwest; in Hawaii, the government is feverishly building solar and wind power plants (Hawaii was the worst hit by the oil price rise).

The “fall” of the dollar has caused a lot of suffering in America. But the American people are not only adapting well to the change, they are actually thriving. The resilience and hard work of the American people is now showing that a new economy could be fairer, greener, more equal, and eventually, more prosperous.

Some people say that the “fall” may have been the best thing to happen to America. They’re probably right. The future indeed looks quite bright.

QE2: A Formula for Disaster

The US Fed will soon decide whether to embark on a program of quantitative easing (QE2), which will mean that it will pump from $500 billion to $2 trillion dollars into the US economy, in the hope of stimulating it. This will be the second time in the recent past that it will do so.  In 2008, the Fed “created” $1.7 trillion, and used this to buy mortgage-bound securities, which nobody wanted to buy, and get the economy moving again. Now, with the economy growing at 2% and with 10% unemployment; the Fed wants to use quantitative easing again, in order to induce the economy to grow faster, and to lower the unemployment rate.

I think this is simply a recipe for disaster. In the first place, the “bubble” which burst in 2007 was caused by excessive spending, especially in the housing market. Now, the Fed wants to address the ensuing low growth by pouring money into the system. It sounds like the saying: “avoid hangover, stay drunk.”

US Centered
The Fed is playing with the idea of quantitative easing (QE2) because, for them, QE2 will stimulate the economy, and there would be minimal bad effects.  But this is because they only look at the short-term situation of the American economy. They do not realize, for one, that QE2 will have a detrimental effect on the US Dollar’s reputation the world over. They assume that the dollar’s prestige and acceptability all over the world will be the same even after QE2.

I think that this all depends. If QE2 is limited to say $500 billion, perhaps it may not have that much of a detrimental effect on the dollar’s prestige (though it is really going to be at the edge, I think). But if QE2 will be $2 trillion, then I am almost sure that there will be a chain reaction in the world that will turn around to bite the US back.

The US Dollar’s prestige throughout the world is declining, and since it is not an “ordinary” currency (but rather the world’s reserve currency) it needs to maintain a minimum of prestige and value for it to continue in its present role. That the dollar will remain as the world’s reserve currency is not a given; and I think that printing too much additional dollars will severely damage the image of the dollar.  And if this image is severely damaged, think of the consequences: what if the Saudi’s suddenly decide to take their currency off its US Dollar peg? What if this would lead to a substantial increase in the dollar price of oil? And what if the Chinese decide to get rid of their own US Dollar peg? These events are not theoretical; I’m sure the concerned governments are seriously thinking about it.

Money created through quantitative easing does not remain in the US. Hedge funds use this to buy fixed-interest assets in other countries, causing those countries’ currencies to rise in relation to the US dollar. And this will force these countries, sooner or later, to raise the dollar price of their exports, just to be able to maintain their profits. This will in turn mean that imported products in the US will cost more.

Even for the US
But even for the US, QE2 at this moment will be quite ineffective to stir the economy, and at worst will even cause more trouble. QE2 will increase the supply of money, but this will not do too much in the way of solving the problems with the housing sector. Increasing the money supply will not save people’s homes from foreclosure; and thus could not solve the problem of low consumer demand. People don’t spend as much because they fear they may lose their jobs or the houses, and I don’t see how pumping money into the economy will help this.

Sure, economic theory says that additional money supply could stimulate the economy, even the housing market. But this is true in a “normal” situation. Additional money, when provided at a time when banks are willing to lend, and when there is sufficient consumer demand (or industries are busy investing and hiring), will mean that the economy will grow faster than it otherwise will. But consumer demand and industrial investment will not happen just because there is money available; consumers and businesses should have at least a minimal level of confidence before they increase their expenses. This is like pulling a horse so that it is next to the river; nothing you could do could compel that horse to drink. If it is thirsty, it will drink. If not, there is no way that you can force it to drink.

But worse than being ineffective, QE2 could also do harm. For one, it creates an oversupply of bonds, which are fixed-interest instruments. This translates to low interest rates, which has a detrimental effect on pension funds and insurance companies. It also creates an artificial boom in the prices of stocks and even commodities.  The artificial boom in stocks will lead eventually to another stock market crash. And the rise in the price of commodities will mean higher consumer prices for the people.

QE2, by increasing the money supply, and through the mechanism of “carry on” trade (where people borrow cheaply in the US, and invest the money in fixed-interest instruments in other countries, taking advantage of the interest deferential, and possible foreign exchange gains) will devalue the US dollar. And this devaluation, some economic theorists say, will increase exports and decrease imports. True, it will. But it takes 18 months for exporters to gear up, and importers to adjust their purchases downwards. In the meantime, the balance of trade will worsen because exports remain the same, while the price of imports rise. And, in this world today, an 18-month gap is a long time; long enough to cause a downward spiral in the economy.

The inflation that the Fed wants to induce will come. The problem is that I don’t see how the Fed will be able to stop it when it comes. I don’t think that inflation will simply stop rising where the Fed wants it to. It will continue rising. And, if it is accompanied by low growth, that inflation will not be easy to eradicate. It will have become stagflation.

If the Fed realizes the full implications of quantitative easing on the US and world economy, I think they would think twice about using this instrument. Then, it will be the case of limited positive effect against a very dire possible negative effect.

The Fed would be well advised NOT to use quantitative easing at this time. Let the US economy grow at 2%. While this is low, it is a good basis for the economy to build on to achieve higher growth rates later. The US economy had been on a spending binge; let it recover gradually.