Another good article by the New York Times today (in addition to the article on torture in Afghanistan eloquently covered in Welshman’s story below): Krugman has a column which touches a topic I have written about here – the noxious and unsustainable trade and financial relationship between the US and China, and he covers it with his usual talent:

The Chinese Connection

Here’s what I think will happen if and when China changes its currency policy, and those cheap loans are no longer available. U.S. interest rates will rise; the housing bubble will probably burst; construction employment and consumer spending will both fall; falling home prices may lead to a wave of bankruptcies. And we’ll suddenly wonder why anyone thought financing the budget deficit was easy.

In other words, we’ve developed an addiction to Chinese dollar purchases, and will suffer painful withdrawal symptoms when they come to an end.

And it’s actually even worse than that, because it appears the the US Treasury is lying about the scale of the problem.

The coming crash

Here’s how the U.S.-China economic relationship currently works:

Money is pouring into China, both because of its rapidly rising trade surplus and because of investments by Western and Japanese companies. Normally, this inflow of funds would be self-correcting: both China’s trade surplus and the foreign investment pouring in would push up the value of the yuan, China’s currency, making China’s exports less competitive and shrinking its trade surplus.

But the Chinese government, unwilling to let that happen, has kept the yuan down by shipping the incoming funds right back out again, buying huge quantities of dollar assets – about $200 billion worth in 2004, and possibly as much as $300 billion worth this year. This is economically perverse: China, a poor country where capital is still scarce by Western standards, is lending vast sums at low interest rates to the United States.

Yet the U.S. has become dependent on this perverse behavior. Dollar purchases by China and other foreign governments have temporarily insulated the U.S. economy from the effects of huge budget deficits. This money flowing in from abroad has kept U.S. interest rates low despite the enormous government borrowing required to cover the budget deficit.

Low interest rates, in turn, have been crucial to America’s housing boom. And soaring house prices don’t just create construction jobs; they also support consumer spending because many homeowners have converted rising house values into cash by refinancing their mortgages.

Borrow and binge, courtesy of “Bubbles” Greenspan and the complicity of the Chinese. If you don’t believe it is a binge, take a look at that graph:

(From Financial Sense)

Back to Krugman (I skip the parts where he explains how domestic US politics are feeding the calls to revalue the yuan) and what should be done:

I’m not saying we should try to maintain the status quo. Addictions must be broken, and the sooner the better. After all, one of these days China will stop buying dollars of its own accord. And the housing bubble will eventually burst whatever we do. Besides, in the long run, ending our dependence on foreign dollar purchases will give us a healthier economy. In particular, a rise in the yuan and other Asian currencies will eventually make U.S. manufacturing, which has lost three million jobs since 2000, more competitive.

But the negative effects of a change in Chinese currency policy will probably be immediate, while the positive effects may take years to materialize. And as far as I can tell, nobody in a position of power is thinking about how we’ll deal with the consequences if China actually gives in to U.S. demands, and lets the yuan rise.

Doesn’t this sound like Iraq all over again? No planning for the future? Except that this time, it’s not just a couple hundred billion at stake, it’s about ten trillion (yep, ten thousand billion) dollars worth of assets whose value may drop significantly. You’d expect them to care about that, maybe?

How it is actually worse than that

But they are actually doing something worse than nothing – they are apparently actively hiding the real numbers, as flagged by Rob Kirby over at Financial Sense, in two installments:

Two months ago he pointed out that the statistics on holdings of US treasuries by international investors had “gained” a new player, whose numbers seemes to move in strange ways:

PIRATES OF THE CARIBBEAN,

Upon further examination of the red line in the table above depicting the Caribbean banking centre and their holdings of US securities; what stands out above all else is that this line, unlike any other jurisdiction in the world, looks contrived, lacks continuity and its erratic fluctuations give the appearance that this line is being used as a “plug”. Actually, the term `skullduggery’ comes to mind. It should be remembered that other jurisdictions in the world are home to hedge funds also, yet none of them exhibit such wild fluctuations in their monthly reporting. Strange, ehh?

You see folks, it’s officialdom and their Wall Street shills themselves that would have us believe that Caribbean based hedge funds have actually `picked up the slack’ so to speak [if you want to call 23 billion slack], and anted up this enormous amount of investment capital to float the American government’s profligacy pontoon boat.

(…)

The foregoing suggests that hedge funds categorically did not buy these securities. The explanations being offered up as plausible by officialdom and fed to us by the main steam financial press are not consistent with empirical facts or market observations. There are no wide spread or significant losses being reported by the hedge fund community from ill gotten losses in the Treasury market.

The answer to the question posed above, dear reader, rests with one determining who else in the world has pockets that deep, to buy 23 billion bucks worth of securities in a single month? One might surmise that a printing press would be required to come up with that kind of cash on such short notice, ehhh? Observing my surroundings, I can see rapidly rising prices for virtually everything. Look at the CRB index. Look at the price of oil. Look at the price of houses. Look at the sorry state of the dollar and listen to its biggest holders complain that they are holding too many of them?

Basically, he was saying that:

  • the “Caribean” statistics behave very differently from others, including from other hedge fund centers
  • these statistics for January imply that hedge funds lost a lot of money that month, which is not compatible with what happened in the market that month
  • the only explanation left (he discounts others in his article) is that the US government is starting to print money.

Devaluation by inflation. Soth America in the 80s anyone?

But wait, it gets even worse. This week, he came up with a new twist in the data:

PIRATES REPRISE

Economic history has apparently been rewritten folks. The inconsistencies and conflicting data being fed to us by officialdom are brazenly astonishing. In the month of Jan. 05 alone, Japan’s holdings of US securities have been retro altered to the tune of over 20 billion, China’s by close to 30 billion and the United Kingdom’s by more than 60 billion. Can any of us really believe anything these folks have to say? Imagine, a restatement of this magnitude without as much as an explanatory footnote or a press release? Somehow, none of this is even deemed to be newsworthy? What’s beginning to scare me; if the US Treasury tells us the world is flat – what happens to the South Pole?

Basically, he has looked at the data provided by the Treasury in May and in March about January numbers, and he has found wild differences, which cannot be explained away as simple corrections (you can see the full tables in his article).

Put simply, he says that the Treasury Dept. has cooked the books to the tune of at least 60 billion dollars, and that such manipulation puts in doubt all the slightly reassuring numbers that have come in recent months on the foreing debt holdings front – i.e. the apparent willingness of foreign central banks and investors to keep on buying US Treasuries and fund the US current account deficit and consumer binge.

This is really worrying, because if foreigners will not foot that bill anymore, the only two options (which ultimately amount to the same thing) are to print money (thus leading to inflation, and by reaction, to increasing interest rates) or to offer much higher interest rates to outside investors.

Either way, consumption will fall and house prices will not be sustainable.
Basically, what Krugman says could come even quicker than expected if the underlying number have been cooked by the Treasury.

Frankly, with this administration, this sounds all too credible. Hang in tight.