The liquidity crisis and the stagnating US trade deficit(excerpts)
Globalliquidity is pumped up by the global trade imbalance, not by the totalamount of global trades. The majority of the global trade imbalance isdue to the runaway US trade deficits.
As the US runs tradedeficits, US dollars are handed over to foreigners. Since US dollarsare not legal tenders in foreign countries, those dollars related tothe trade deficit (we will call them trade-deficit-dollars from hereon) must flow back to the US markets, mainly via the Wall Street.
Aportion of those returned trade-deficit-dollars will purchase US basedassets like stocks and real estates, but the majority of thetrade-deficit-dollars will be lent out in the form of purchasing dollardenominated debt instruments, ranging from US treasury issues, mortgagebacked instruments, corporate bonds and so on.
As lending generates more lending, the trade-deficit-dollars balloons to a large amount of liquidity.
In 2005, the US current account deficit, the broadest measure to gauge the trade situation, has topped 600 billion dollars.
Thuswe may expect that the total liquidity originated fromtrade-deficit-dollars has already reached tens of trillions of dollars.It is this liquidity glut that is supporting the US governmentspending, the local government spending, the consumer spending, themortgage lending, the borrowing by private equity firms to financetheir buyout frenzy, and the borrowing by hedge funds to engage inspeculative activities.
However, the US trade deficit has stagnated for more than a year, and thus the liquidity squeeze.
We will look into the actual data to give supports to this argument in the following paragraphs (see link). IfFED lowers short-term interest rates substantially to replenish thelost liquidity and to prevent the deflation of the debt bubble,Japanese Government probably needs to buy up nearly one trilliondollars this time to prevent a whole sale collapse of US dollar. Evenif Japanese Government is able to perform such a feast again, FED willbe forced to raise interest rate again after Japan's dollar buyingspree ends in order to defend the dollar and to fight off theinevitable inflation in such a scenario, and thus the financial crisiswill reemerge in a few years.
DerivativesIt isreported that the total amount of the exiting derivatives alreadyexceeds 50 trillion dollars globally. The values of a substantialportion of those derivatives depend on the value of US dollar.
Whenthe US dollar collapses, a sizable loss, like 10 trillion dollars willbe incurred in a sector of the participants of the game of derivatives.Many losers in the game naturally have no means to sustain such anoutsize loss and will inevitably go under.
Derivatives are a zero sum game. If there are losers, there will always be the matching winners.
However, as losers go bankrupt, the paper wins of the winners also disappear. Mostof those winners are probably using the derivatives to hedge theirhighly leveraged holdings that will lose value as dollar plunges. Thusthose so called winners must realize the full amount of loss in theirover-extended holdings once their insurance derivatives evaporates, andwill go under along side with the losers.
The bankruptedlosers and winners of the derivatives tied to the value of dollarprobably are also playing the game of derivatives tied to interestrates. As they go down, interest rate related derivativeswill also evaporate, and expose the holders of outsize interest rateinstruments directly to the rapidly gyrating market force. In a veryshort time span the shock wave of collapsing dollar will spread andwill bring down the whole derivative house of cards, along with thewhole global financial system.
If that kind of scenariounfolds, due to the sheer size of losses involved, the whole world'scentral banks, IMF and the world bank combined will be utterlypowerless to combat such a wholesale disaster. The best wecan hope is that FED will not succumb to the temptation of loweringinterest rates in a haste, and not to test the jinni of Dollar andderivatives.
The claim of soothsayers that the US has nothing to fear since the global economy is strong is simply dubious at best. Thesafest course for FED to take is to adhere to its current interest ratetarget, and steadfastly defend this target. If needs arise, FED cancontinuously inject sufficient amount of liquidity into the financialmarket to prevent the Federal Funds rate to go above 5.25%.
Aftera while the financial market will get used to the gradually shrinkingliquidity bubble, and the panic stage will be over. As the liquiditybubble withers away, the US economic growth rate will come down furtherand the job market will become worse, but the ratio oftrade-deficit-to-GDP will keep declining.
As the ratio dropsto a certain level, US Dollar will regain the power to bounce upwithout the artificial stimulus like yen carry trades.
It isat that juncture FED will be able to lower interest rate gradually andjump start the economic growth again. Only after such a soft landing isaccomplished, policy makers should seriously consider ways to addressthe means to prevent the reemergence of global trade imbalance and torein in the run away leverage and the explosion of derivatives even atthe cost of scaling back the irresponsible and ill-thought-ofglobalization process.
Otherwise the financial crises willreoccur again and again until the big bang that destroys the globalfinancial system as well as the global economy.
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