Thursday, June 25, 2009

The Great Inflation Debate (Part 2)

Continuing from yesterday...

The Chinese, the Japanese and the Russians have three of the biggest piles of US bonds in the world.

What would you say if you owned $800 billion worth of bonds? Wouldn't you tell the world what a great investment they were?

...and then sell them quietly, when no one was looking?

Most observers fear this exact scenario. And if it starts to happen the US Federal Reserve will be forced to do what they don't want to do. They'll have to buy their own bonds in great quantities to keep rates down. Then, they'll have to buy more...because others will be selling them. Finally, they'll have to monetize a huge percentage of them...ultimately causing inflation rates to soar.

That's the scenario you don't ever hear the US Federal Treasury talking about. Sure they say they can yank the stimulus money quickly if the economy turns around. But that is only one scenario that scares inflationists. There are many others.

And last week Peter Schiff outlined some of those other concerns in an article in Canada's MacLeans Magazine. You can read the full article here. I highly encourage you to take the time to read it.

From the article:

  • Many scoff at the idea that China will suddenly say “no more” to buying U.S. debt. After all, the two countries have had a mutually beneficial relationship for years. China lends money to the U.S. and the U.S. buys masses of consumer goods from China. What’s more, it’s a long-standing relationship and many doubt that China would want to upset the status quo. Schiff sees no logic in that argument. “That they’ll keep lending indefinitely makes about as much sense as the argument that real estate prices have been rising, so they’ll rise forever,” Schiff says. “Nothing that is unsustainable will go on forever.”

    But the thing is, China doesn’t have to entirely cut off the U.S. to cause problems. Even if China decided to pull back slightly there would be consequences. The U.S. would still find itself short of the cash it needs to pay its bills, and like a homeowner who misses a mortgage payment, it would have to find that money somehow.

    Regardless of precisely how and when this all unfolds, the dollar will inevitably become less valuable and interest rates will rise as the U.S. scrambles to attract new lenders. That will translate into inflation and higher interest rates for the average person, too. The cost of living will go up and the value of people’s savings will decline. Canada would likely get dragged into the mess too, just as it was affected by the current downturn in the U.S. The question is how severely this will all hit.

Finally there is the law of unintented consquences.

That's the wild card element that scares inflationists the most.

We'll look at that tomorrow.


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