The Yellow Brick Road

All the last two years I’m writing about Kondratieff wave on the regular basis, and as a former scientist I’m trying to abstract from any particular economy as if K-wave just happens every time and everywhere with equal force. But it simply doesn’t work that way and again, as a former scientist I want to recognize that and introduce some international layer that makes US economy very special and it will make it all simple and dandy again.

There are many bubbles that inflated and popped all around the globe, but there is one bubble that rules them all, the dollar bubble.

The world trade

How the world trade works, just in a simplest form? Suppose there is a big cargo ship moving from China to Brazil. It has maybe $2 bln of goods onboard. The resources to produce those goods were paid a while ago, the labor is paid, almost all of the other expenses are paid too. So far Brazil paid nothing. All the required capital was provided by the banking system and it’s probably over a billion. Some of this credit is nominated in yuan, some in dollars.

How Brazil will pay for those goods? They will be sold for reals, can Brazil pay in reals? I guess not. Brazil can pay in yuans or dollars or both. But it’s very unlikely that Brazil can pay in yuans – where it’s gonna get them? Brazil certainly can pay in dollars, because they sell plenty of coffee to Starbucks and got paid in dollars, even for those Starbucks that are located in China.

Would China prefer Brazil to pay in yuans? Yes. They are definitely unhappy that there is a third party involved, US economy, doing absolutely nothing except providing money. US is not even directly providing the capital, because at the micro level the capital is provided by Chinese banks. The US banking system is providing capital at macro level, with large multi-billion chunks. As the largest holder of dollar reserves out there China can essentially mediate the whole flow of the world trade but still use foreign currency to do that.

The call for dollars

The communism (centralized non-market economy) crashed in 1991 and that triggered the growth of the world trade at the unprecedented pace. If you recall, 1000 years ago 50% of the world economy was India and China, while Europe was ruled by barbarian warlords. Now they are simply taking that back. But as in 1950 50% of the world economy was United States it was only natural to extend the dollar into universal currency that is providing a fast and convenient way to nominate the global transactions.

Essentially the world was pulling $800 bln per year of new dollars just to run its normal trade operations. As any fiat currency is backed by debt essentially new dollars were printed by US by expanding its debt.

In late 1990s the world was shaken by the financial crisis and the world, just for safety, was demanding that all the new dollars are AAA, i.e. they must be backed by AAA rated debt. But US was simply not borrowing at AAA level at the desired pace. No matter how big was the budget deficit it was simply not enough.

The Wall Street came at rescue. It invented a way to use credit default swaps to package the low-rated debt, slice it into tranches and use multi-layer protection to produce AAA paper from junk. At that point the mortgage industry was chasing anyone willing to borrow, the world trade would suffocate without that new debt. The housing bubble was one of the mechanisms to create private money for export.

We all recall those strange calls that China is manipulating its currency preventing US to export its goods. This is all baloney, the strength of yuan doesn’t matter in the big picture of things.

Essentially US trade fell into very unfavorable position. US exporters were asking – take our cars, take our computers. But the world’s answer was firm – we don’t need your exports, we need your money, we need you to borrow more. That famous old unemployed in Alabama was not simply mortgaging his home. He was providing liquidity for the world trade.

It’s an old story how every strength is fertilizing the soil for the seeds of its own weakness. As the main US export for decades was the export of money, both government and private, the domestic manufacturing was struggling. The trade deficit was enforced by the whole fabric of the complex world trade and the flow of imported goods was essentially impossible to stop. I cannot blame any authority for this bubble. Perhaps the dollar’s world dominance was decided behind some closed doors but obviously those who made that happen did not expect what will happen, those famous unintended consequences.

The patchwork for the global trade

It might be not clear yet, but the world is already calling for China to provide liquidity. China is running a huge stimulus package and will expand it even more. By definition, any stimulus package means printing money, so China is already sharing the monetary responsibilities with US as we speak. Essentially whatever they do at this stage is stimulating its domestic consumption. The China’s trade surplus will decline (or collapse?) and that will finally enable yuan to float around the globe. Any outsourcing from China to cheaper regions will only accelerate the trend.

In that example of trade with Brazil, how can China make Brazil to pay in yuans? I see two ways – run some little trade deficit and do currency swaps. At this stage the currency swaps are already performed and this is just the start of new trend. Of course the currency swap is very risky, so if China is engaging in it that is a sign that important decisions are already made.

The case for W shaped recession

The worldwide recession is the worst time to do any radical changes. The governments are simply enacting the coordinated stimuli packages. Every stimulus package is based on new debt. Essentially the world is simply relieving the US from the burden of doing all the printing by itself. But it will be done in the way that doesn’t change the status of the dollar a bit, hence I would not expect any material decline of the dollar. No changes in the dollar status will happen until the recession is over because everybody knows about the danger of unintended consequences.

Those efforts will probably pull the world from recession by the end of 2009. The world economy will apply all its efforts to force China to float the RMB (yuan) internationally. That will increase the domestic consumption, raise the labor cost and decrease the trade surplus. The explosive Chineese growth will slowdown substantially. At the same USA will close its trade deficit and probably even run the trade surplus.

When the global trade recovers firmly that will be the moment to finally expect the new trend to push the dollar out from some third-party transactions.

At the beginning it will show up in the stats as the rebound of US export and it will produce many optimistic expectations. Economists will say that the American Industrial Superpower is back. The huge trade deficit may even turn into trade surplus.

But a little later those economists will realize that the domestic consumption is not rebounding. At all. And the sharpest minds will explain that borrowing money by selling mortgage bonds to Arabs and actually earning money by selling planes and machinery at the markets that are already stuffed with planes and machinery are two different things.

That is when the second recession will start and it’s not going to be pretty.