	Generational Dynamics
	Forecasting America's Destiny ... and the World's

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Generational Dynamics Web Log for 18-Jun-07
Congressional xenophobia risking confrontation and retaliation from China

Web Log - June, 2007

Congressional xenophobia risking confrontation and retaliation from China

Senators are promising a tough "veto-proof" law targeting China's alleged currency manipulation.

The bill is supported by both Democrats and Republicans. Republic Senator Lindsey (S.C.) urged the Bush administration to support the bill. Democratic Senator Charles Schumer (NY) predicted overwhelming support from both parties -- enough to override any presidential veto.

The bill is prompted by claims that China has been manipulating its currency, making it undervalued, and using it to pursue unfair trade practices.

Senators are particularly infuriated by a report from the Treasury Department last week did not find that China had practiced currency manipulation.

According to the "Report to Congress on International Economic and Exchange Rate Policies - June 2007":

"Although the renminbi [Chinese currency, also called "yuan"] is undervalued and market sentiment clearly favors appreciation, Treasury concluded that China did not meet the technical requirements for designation under the terms of Section 3004 of the Act during the period under consideration. Treasury was unable to determine that China’s exchange rate policy was carried out for the purpose of preventing effective balance of payments adjustment or gaining unfair competitive advantage in international trade.

The Administration position was expressed by Treasury Secretary Henry Paulson, when he said this week that the best way to get China to move faster on currency reform was "through direct discussions and negotiations, not through legislation."

For many years, the Chinese yuan was pegged to the U.S. dollar, which means that you could always convert dollars to yuans at the same rate, year after year. This was true although the dollar was "falling" internationally, meaning that you would convert dollars to fewer euros or yen.

The fixed conversion rate with the yuan also meant that when the Fed drastically reduced interest rates to near-zero in the early 2000s, the interest rate in China was effectively also near-zero. The Fed policy headed off and postponed a major Wall Street stock market crash in the early 2000s, but it also poured a lot of cheap money into the economy, creating the credit and real estate bubbles. And since the yuan was pegged to the dollar, the Fed policy also poured enormous amounts of cheap yuans into the Chinese economy, creating huge export, commodities and stock market bubbles in China.

I tied all of this together with macroeconomy theory several months ago in an essay that I wrote on "A conundrum: How increases in 'risk aversion' lead to higher stock prices," based on work by Harvard economist named Robert J. Barro. Briefly, the people in the generations that survive the previous crash (in this case, the 1929 crash) become extremely risk-averse, and refuse credit. As those generations disappear (retire or die), the younger generations become risk-seeking, and increasingly use debt and credit abusively. The abusive use of credit actually increases the total amount of money in circulation, so that money is poured into BOTH stocks and bonds, so that they both participate in the bubble. This is what's been happening in both the U.S. and China. At a time like this, there's so much money (liquidity) is available, that people are willing to invest in almost anything.

China has put all its extra liquidity into building manufacturing businesses, and have been manufacturing products that it exports to other countries, especially the US. Americans have used all the extra liquidity to purchase Chinese exports. In a sense, this has been beneficial for both countries, but it's created an enormous trade imbalance.

So the situation is pretty bad, and Congress is going to make it worse. Congress is demanding the People's Bank of China (PBoC) essentially raise interest rates sharply. If the Fed did that in the US, there would be at least a huge recession. In China, the result would be a bursting of all bubbles, and a financial meltdown.

But logic doesn't have anything to do with what Congress does these days.

The level of xenophobia has been increasing steadily in the Congress, as people look for ways to punish both Latinos and Chinese, while the Bush administration pushes for more moderate positions and negotiations.

And this is not Democrats versus Republicans. The Immigration Bill has split both parties, with the xenophobic side favoring deporting illegal Mexican immigrants back to Mexico, and the accomodative side looking for ways to give them a legal status. Which side a particular politician is on probably depends on how many Latinos he has in his district.

But there's NO such split on xenoophobia against Chinese. It seems that almost everyone in Congress hates the Chinese and wants to turn the screws, even if it means hurting Americans as well. It's what my mother used to refer to as "cutting off your nose to spite your face."

When I wrote my book, Generational Dynamics: Forecasting America's Destiny, I never really understood how Congress could have passed the Smoot-Hawley Tariff Act in June 1930. The law was opposed by the Hoover administration and by numerous economists. But it was several months after the 1929 stock market crash, and Americans were blaming high unemployment on foreigners stealing jobs away from Americans. The Smoot-Hawley act didn't didn't help the American economy, but it crippled imports from other countries, especially silk from Japan. Japan was already suffering economically anyway, but this act shut down silk industry. It infuriated the Japanese, who invaded Manchuria and China in subsequent years, and bombed Pearl Harbor a few years after that.

Now, to my amazement, I'm seeing exactly the same thing happen. The Bush Administration opposes this punitive bill, preferring negotiation, and economists are saying that it won't help the US economy at all, and will invite retaliation. But Congress is going ahead with it anyway, and if passes despite President Bush's veto, the Chinese will be humiliated and infuriated.

Plus ça change, plus c'est la même chose.

Treasury Bonds, Mortgage Rates and Greenspan

Alan Greenspan, speaking in Hong Kong last week. <font face=Arial size=-2>(Source: thestandard.com.hk)</font>

Alan Greenspan, speaking in Hong Kong last week. (Source: thestandard.com.hk)

Alan Greenspan got into the act again last week, with regard to the issue of Treasury bills (bonds).

The subject of long-term Treasury bonds is much in the investor news these days, because interest rates have increased dramatically.

In the past several weeks, yields (interest rates) on 10-year Treasury bonds have gone from under 4½% to over 5¼% -- that's a ¾% change, with no interest rate changes by the Fed.

And since mortgage interest rates are pegged to the 10-year treasury bond rate, it means that mortgage interest rates have gone up ¾% as well. It's a very striking development, and could signal that something fundamental is changing.

Let's have a brief review here: Treasury bills are sold by the Treasury to borrow money. They're sold at an auction so that anyone can bid on them. The Treasury hopes to get as much money as possible for them, so they hope that purchases will bid a lot.

No matter how much a bidder pays for a treasury bill, it always pays the same amount back after 10 years. That means that the more you pay for a treasury bill, the lower the effective interest rate (yield) is, and the less you pay, the higher the yield is.

Now, yields have gone up sharply in the last few weeks. That means that prices of Treasury bills have gone down. That means that bidders have been willing to pay less and less to purchase these bonds from the US government. Or, to put it another way, bidders are demanding much higher interest rates to loan money to the US Treasury. Some analysts are predicting 10-year yields may go up as high as 6½%.

This increase in long-term interest rates is a really big deal. The whole global economy in the last few years has been based on easy credit. It's easy credit that caused the real estate bubble, the subprime mortgage debacle, the stock market bubble, the Chinese economy bubble, and all the other bubbles we've been living with. Such a large interest rate increase could affect not only the US economy but also the world economy.

Why would interest rates increase like that? One online blogger blamed it on the mortgage foreclosure surge, but that would be the tail wagging the dog -- the mortgage market is too small to have caused this kind of change.

If 10-year yields are increasing rapidly, then it can only be because very large investors are bidding sharply lower prices on 10-year bonds -- and those very large investors would be countries like Japan or China.

China has been purchasing huge volumes of 10-year US Treasury bills so that we would have enough money to purchase their huge volume of manufactured exports. Other countries with high savings rates, especially Japan, have done the same. The spiking of yields indicates that someone is cutting back on purchases of US Treasury Bills.

This brings us to Alan Greenspan's comment. Greenspan suggested that China and other countries are so that there's less money available to purchase US Treasuries. "What we're now beginning to see is affluence spread throughout what we used to call the `Third World,' and consumption is beginning" to increase, he said.

China has hundreds of billions of dollars in US Treasuries in its central bank, and there's some concern that they might try to sell some of them. This would create an oversupply of bonds, pushing down prices, forcing a further sharp rise in interest rates.

According to Greenspan, there little reason to fear this. "There's no evidence at this stage that China is selling off securities." His reason? China would not have anyone to sell the securities to.

That's a pretty weak reason, and we can see why by returning to the subject of this essay: The anti-China xenophobia in Congress.

The proposed punitive law would humiliate and infuriate the Chinese, and invite retaliation. From their point of view, they've been funding America's buying spree, and is America greatful? Noooo. America is passing hostile protectionist laws. That's how China would look at it.

One step they could take is simply to dump their hundreds of billions of dollars of Treasury bills on the market. Even if there were no buyers, the market would be so depressed that prices would collapse and interest rates would up into the double-digit range. China's intent would be to retaliate and cause a recession in the US. Of course such a move might do a lot more -- trigger an investor panic and a worldwide financial crisis.

At any rate, you may recall that I've advised people to take their money out of stocks, and keep it as cash, or else invest in short-term (6-12 month) Treasury bills, paying roughly 5¼% interest at the present time.

I strongly recommend against investing in long-term Treasury bills. Why? Because of the scenario I just described.

From the point of view of Generational Dynamics, we're now overdue for a generational panic and financial crisis. It could happen next week, next month or next year, but it's coming with certainty. The event triggering such a panic might be anything, but the recent sharp rise in long-term yields and mortgage interest rates certainly raises a lot of possibilities. (18-Jun-07) Permanent Link
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Generational Dynamics Web Log for 18-Jun-07 Congressional xenophobia risking confrontation and retaliation from China

Treasury Bonds, Mortgage Rates and Greenspan

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Generational Dynamics Web Log for 18-Jun-07
Congressional xenophobia risking confrontation and retaliation from China