A Glimpse of the Apocalypse

Today’s New York Times has a front page story that features the concerns of the Chinese premier over the US’s ability to pay the trillion US dollars it owes Beijing. They seek assurances that the money won’t go up in smoke. As a friend of mine much smarter than me once said, “They’ll get their dollars back. Can’t promise what those dollars will be worth.” The point is (obviously to economists) that the best way for a nation (from its’ point of view) to pay off deft is to inflate the currency.

Unfortunately, this is rarely the lenders’ view. Should the Chinese stop loaning us money, the price of our bonds would have to fall so someone would want them. Uncle Sam’s crazy bond blowout! Prices so low, it’s insane!

Brief note here. As the price of a bond falls, the interest rate goes up. The dollar denomination is what you get at the maturity of the bond, either months or years from now. Here’s how it works:

I loan you $90 for your offer to pay me $100 in a year. I earn $10 for my trouble, so I get (10/90=0.11) 11% interest.

Later, I loan you $80 for your offer to pay me $100 in a year. I earn $20 for my trouble, so I get (20/90=0.22) 22% interest.

Much later I loan you $70 for your offer to pay me $100 in a year. I earn $30 for my trouble, so I get (30/90=0.33) 33% interest.

Get it? The cheaper the loan (basically a 1 year $100 bond) the higher the interest. And while the full $100 has to be paid on all three loans, until the end of the year (the maturity), the first guy is screwed if he needs his money sooner, since no one will give him the $90 he loaned, just the $70 the last guy got.

Throw in the higher inflation inevitable with falling bond prices, voila! You see why the Chinese have their knickers in a knot. They can sell (or just stop buying) and the value of their holding will fall in dollar terms immediately, or they can hold on and have the value of the dollar decline, getting back at maturity the right number of dollars, but much less value in what they can buy with these new smaller dollars.

Got it? Good.

Basically, we all know that the US Treasury isn’t like Scrooge McDuck’s basement, with piles of cash and gold lying around. To fight the Iraqi war, bail out the banks and stimulate the economy, we’ll need to borrow the money from guess who?

As noted previously, most Americans never saw this thing coming. Imagine being Chinese! They didn’t have a market economy the last time a nasty spell came around in the early 80’s. Yours truly was moving furniture for $3 an hour with an Economics degree from Trinity College. My friend who cleaned the Slurpee machine at 7/11 wasn’t a Pakistani immigrant. He was a native Californian with a Doctorate in Physical Chemistry.

I’ll be 50 this month, so I remember the hard times and have been cautious about risk, markets and debt. Any American under 50 never saw it first hand. Any Chinese of any age has never been through this. It will become very political, very contentious and very dangerous when 100 million newly middle class Chinese get sent back to the rural villages.

May you live in interesting times.

What just happened?

This was stolen unabashedly from my pal Eric over at iTulip.com.

As Paul Volcker pointed out over the weekend, the global financial system has disintegrated and no one has any idea how to fix it. Lots of good ideas about how to fix the banking system, but as we've explained, even if any of these things are done -- and we are not holding our breath -- it's the endogenous credit system that's the real problem, the one that used to magically allow consumers to lend new money into existence by taking out a car loan or charging dinner on their Visa card, the one that depended on the now defunct securitized debt market.

Most reasonably aware North Americans have, like me, watched this mess develop for over 20 years. Credit was substituted for savings. Two incomes were substituted for one. Other people's savings were substituted for our own.

These past 20 years have been like a long bus ride into the middle of a desert without food or water, with the driver all along telling us that, no, we are not heading into a desert but traveling along a long stretch of beach that leads to an ocean with palm trees and swimming pools, we just can't see the water yet.

All along the way the skeptics look out the window and say, "We're going the wrong way," and, "Shouldn't we turn around or at least stop to pick up drinking water in case you're wrong?"

"Stop being so negative," yells the driver over his shoulder. "You don't understand neo-classical geography."

Meanwhile, the rest of the passengers in the bus sit watching Survivor on portable DVD players or reading about Britney Spears's hairstylist in The National Enquirer.

One day the bus runs out of gas. The driver gets out, looks around and says, "How about that. Here we are in the middle of the desert without food or water. Who could have known?"

He pulls out a cell phone and shortly a helicopter rescues him and his friends, leaving everyone else behind to fend for themselves.

The End