Some Economics Related Comments

 

Comment 1: About projecting financial markets (original)

        The purpose of this corner is to project economic performances of various economic entities based on the global macroeconomic view as developed in "The Section for Everybody". We have no intention to project financial markets since a financial market is a discounting mechanism and by definition is not publicly projectable. Suppose that we come up with a perfect theory to project the ups and downs of a stock market, and suppose we announce, based on the theory, that the stock market will fall 10% on X-day of Y-month of Z-year. No market participant will wait until XYZ date to sell stocks; they will dump their stocks immediately. Thus the stock market will fall back 10% or more at a date much earlier than XYZ, and render the "perfect" theory incorrect.

Comment 2: "Stock markets dance around the real economy"(original)

        Comment 1 may give an impression that the stock market is disconnected from the real economy since the former is not publicly projectable, but the latter is. Of course, that is not what we claim. The relation between stock markets and the real economy may be summarized best by the phrase, "stock markets dance around the real economy". When stock markets make significantly wrong moves, like stock prices drop by a significant amount whereas the real economy holds up well for a prolonged period, it is always the stock markets that will come back to meet the real economy. Stock markets usually foreshadow the real economy by a certain time span; it may be 6 months, 3 months, 1 months, or 0 month. Sometimes stock markets may even lag behind the real economy by a certain time. It is this time span of foreshadowing that a stock market projection will disturb if made public.

Comment 3: Why is the theory of "buying power parity" wrong?(original)

        The theory of buying power parity claims that the proper level of exchange rate between two currencies should be set at the level where the buying powers of two currencies become more or less equal. The simplest form of this theory is frequently used on financial media to compare the prices of "big mac" hamburgers at two countries. However, when the currency market is left alone without government intervention, the theory of buying power parity is usually completely ignored. Why is so? It is because the price level in a country contains particular factors of that country alone, so comparing the buying powers of two currencies will be comparing an apple with an orange. Let us take Japan as an example. In Japan about 50% of the population are subsidized in some form by another 50% of the population. This gigantic subsidies of Japan are not funded by explicit income taxes, but by deliberately jacking up the prices of consumer goods through invisible import barriers and arcane distribution systems. If Japanese people decides to fund this subsidies honestly through explicit income taxes instead of hidden levies, the consumer prices in Japan will drop by about 50% overnight. Clearly to use the superficial consumer prices in Japan to compare them with US consumer prices, as the practitioners of the theory of buying power parity usually do, is meaningless.

Comment 4: What is "Capital Flow?"(original)

        The concept of capital flow becomes very important in the globalized economic scene. But what is really "capital flow"? Let us take Japan and USA as an example. Suppose a Japanese investor wishes to invest in USA, he must sell his Japanese Yen for US Dollar, and then use the dollar to invest in USA. But this transaction does not constitute to be a capital in-flow to USA, since when the Japanese investor sells his Yen and buys US Dollar, there must be a matching sum of US Dollar been sold and Yen acquired by some other party. Thus this transaction does not cause any real flow of capital, though this action may have converted some parked US capital into more active capital and is positive to US economy. Only when USA runs a trade deficit, US Dollar is handed over to foreigners, and their holding of US Dollar denominated assets increases without the matching increase of Yen denominated assets hold by any US person, and only in that case we say that foreign capital has flown into USA. Therefore, "capital flow" is actually synonymous to "trade balance". For matured economic entities like USA and Japan, when a country runs trade deficit, capital flows in, and when a country runs trade surplus, capital flows out.

Comment 5: What is driving the economy in the era of globalization?(original)

        As analyzed in the two papers in the "Section for Everybody", the driving force to create economic booms and busts in matured economic entities, in the globalization era, is the merchandise trade balance. In the normal situation, economy booms when the merchandise trade balance turns to negative, and the bust befall when the merchandise trade balance turns positive. Only when the matured economic entity is in deep distress, a developing country-like situation develops, that is, with a lot of idled labor and insufficiently utilized capital, then the economy can be boosted by increasing the merchandise trade surplus. In USA, the Reagan era and the Clinton era economic booms are both the results of run away merchandise trade deficits, and the demise of those booms are the result of shrinkage of merchandise trade deficits. In case of Japan, the long lasting economic malaise is due to the mistaken policy of Ministry of Finance to manipulate the currency market, to destroy the value of Yen, and to boost the merchandise trade surplus of Japan. Actually, that long lasting self-destruction of Japan has gone far enough and a third world like economic condition has been created artificially in Japan, the shrinkage of trade surplus in 2001 caused further trouble in Japanese economy and the subsequent recovery of trade surplus in 2002 has boosted the economic growth. However, that kind of third world-like condition is temporary, and Japan will return to the normal pattern that lower Yen and larger trade surplus mean more economic decline. Any attempt to fix long-term economic structural problems in Japan will not spur Japanese economy. Only when Japan stops to manipulate its currency, let Yen rise and its trade surplus shrink to near zero, Japanese economic growth will return to near its maximum potential, like 2 to 3% a year. It is only after Japanese economic growth returns to the normal condition, then Japan can afford to attack its long-term structural problems to boost its maximum growth potential.

Comment 6: What causes ebbs and flows in merchandise trade balance?(original)

        The merchandises traded in the globalization era are just normal manufactured goods and follow the usual constraints of supply and demand. Thus the increase and decline of the exports and imports are sensitive to their prices. In other words the merchandise trade balance is strongly influenced by the exchange rate of the currency. For example, in the second paper titled, "Yen/Dollar, Trade Deficits, and the Boom and Bust Cycles of USA" listed in the "Section for Everybody", it is demonstrated that the movement of Yen/Dollar foreshadows the USA trade balance by a time span of two years. In a free currency market without any government intervention, the free market will regulate the exchange rates to the level such that no country is allowed to run a large trade imbalance, whether it is trade surplus or trade deficit. However, in the present day currency market, the exchange rates of major currencies are almost completely manipulated by various governments, especially by the Ministry of Finance of Japan, resulting in the enormous cross Pacific Ocean trade imbalances.

Comment 7: Why the globalization scheme is at the verge of collapse?(original)

        By reading the preceding comments, the answer should be obvious. It is the exploding cross Pacific Ocean merchandise trade imbalances, which are clearly unsustainable, will eventually torpedo the monstrous currency manipulation scheme of Japan, US Dollar will suffer catastrophic decline, US merchandise trade deficit will be forced to move toward balance by drastically lower imports accompanied by deep financial distress, the proxy exporters in Asia will be thrown into chaos, and the resulting worldwide depression will herald the end of the globalization which has started in 1982.

Comment 8: How China affects global economy(May 26, 2004)

       China has been integrated tightly into the globalization scheme already. Due to the sheer size of population China's tie-in with the global economy is bound to have enormous effects. Since the emergence from the disastrous "The Great Cultural Revolution" of Chairman Mao, China had gradually opened its market for outside capitals on one hand and had steadily devaluated its currency, Yuan, against US Dollar. By 1987 the exchange rate was around 3.7 Yuan per US Dollar; the rate was rigidly maintained at 1 Yuan = 1 US Dollar through Chairman Mao's era. In this early stage only some Hong Kong capitals ventured in and moved some light manufacturing facilities into southern China. It was after 1989's Tieanman square incidents, thanks to the lack of economic sanction from USA and the persistence of the leader Tang to open Chinese market and to devaluate Chinese Yuan further, China has been boosted rapidly by a unique force called "Taiwan Merchants" into the global market and has become an indispensable part of the global economy.

To understand the evolution of Chinese economy, we must look into the evolution of Taiwan first, since Taiwan's developement model, which we call "Taiwan model", is the forerunner of what to come in China. The majority of residents of Taiwan, called "native Taiwanese people" are immigrants from Fujin provice of China; the real natives of Taiwan are aboriginals and are small in numbers. Near the end of the ninteenth century Taiwan was given to Japan by the Imperial China after it lost a war with Japan and Taiwan had stayed as a colony of Japan for nearly half a century. Taiwan has returned to the rule of China only after the defeat of Japan in The World War II. After the return to the rule of China, the native Taiwanese people had an uprising for self-rule and was supressed by force. When the Chinese nationalists was defeated by the communists, the nationalists under the leadership of Chiang Kai Sheik retreated to Taiwan and ruled Taiwan for four decades with martial laws and authoritative governance. During the colonial rule of Japan, Taiwan escaped the turmoil of China,  the revolution, the fall of the Imperial China, the war lords, the invasion of Japan and the World War II, and the civil war between the nationalists and the communists. During that stretch of peaceful period of nearly 50 years the infrastructure of Taiwan has advanced much more than the mainland China, the literacy rate among Taiwanese people is quite high and many of them speak Japanese, but Taiwan mainly remained as an agricultural society producing large amount of rice and abundant varieties of fruits due to its semitropical weather. After the dream of a quick counter attack and the return to mainland China faded, Nationalists Government in Taiwan under the push of Chiang Kai Shek's son, Chiang Ching Kuo, has started to take policies to industrialize Taiwan. By that time the industrialization of Japan after the war has advanced rapidly, the wage level in Japan has risen steadily and the concern abount environment has awaken. Those factors made Japanese industries wanting to outsource their lowest level manufacturing capabilities overseas. Taiwan thus has become the natural candidate, a familiar and friendly place for many Japanese, for that purpose. Japanese capital and know-how, combined with cheap labor and lax environmental control of Taiwan, has created a powerful proxy manufacturing center of Japan in Taiwan. The products from Taiwan have never meant to be reimported to Japan, but are exclusively earmarked to be exported to USA. Serving as the proxy exporter of Japan, the underutilized Taiwan labor resource has awakened and has produced large amounts of goods. This rush of production can be considered as creating a huge amount of consumption power; a large portion of this newly created consumption power has been exported to USA to support the consumption boom there, but a portion of that consumption power has been retained in Taiwan to push it rapidly up the economic ladder. However, as Taiwan industrialized as a proxy exporter of Japan, the wage level and the environmental polution have raisen. With this wage pressure and the gradual tightening of environmental control, manufacturers in Taiwan has wanted to migrate to somewhere with cheaper labor and lax environmental control, now the familiar senario of globalization. After the death of Chiang Ching Kuo,  Lee Tung Huei, a native Taiwanese, became the president. He has pushed democratization of Taiwan, whereas listened to the demand of business circle of Taiwan to open the door for Taiwanese industries to invest in China. The rush of Taiwanese industries to move their manufacturing facilities to China has thus started, creating the phrase, "Taiwan Merchants", to describe those Taiwanese manufacturers of gold-rush mentality. That is why the made-in-Taiwan products dominated USA market were suddenly replaced by made-in-China products (same varieties but with much more in quantity) without any outcry since the manufactures of those made-in-China goods are more or less the same as of those made-in-Taiwan goods. Panicked by the rapid hollowing of Taiwan's manufacturing capabilities, Taiwanese Government has been trying to slow down this hollowing process, whereas Taiwan's focus has shifted from the already lost low tech industries to higher tech sectors like PC mother boards, memory chips, LCD screens and plasma screens. However, as long as the focus of Taiwan's business world is just export, then any industry, whether low tech or high tech, has no reason not to move to China to take advantage of cheap and abundant labor source and comparatively lax environmental control to lower their production costs. Ironically, if China abandons its military threat against Taiwan, the rush for most of merchaints in Taiwan to become "Taiwan Merchants" is irresistable and the complete hollowing of Taiwan's industry is unavoidable. At that point it will be "Taiwan Merchants" banging on Taiwanese Government to abandon Taiwan's western style democracy and to reunite with China. If Taiwanese Government can negotiate cleverly with China and shore up its still shabby financial sector during this reunification process, Taiwan can probably become a tax heaven and a resort for the new riches of eastern China. If that happens,  Taiwan may even see its real estate prices and the stock prices of its shell companies (all their manufacturing facilities will be moved to China by that time) skyrocket.
 
Now returning to the economic evolution of China: With the help of "Taiwan Merchants" China is rapidly advancing to become the factory of the world. As the Chinese fever rises, manufacturers of USA are also joining the bandwagon of "Taiwan Merchants" to outsource their manufacturing facilities to China. As the vast underutilized Chinese labor resource is employed as the trenmendous export engine, enormous amount of goods and thus the consumption power are produced. The major fraction of this consumption power is exported to USA to support an unpreceedent "borrow and spend" consumption boom which is still continuing today. But a significant portion of the newly created consumption power, as was the case for Taiwan, is retained within China and is fueling an emerging consumption boom and prosperity in China. However, China is still a developing country and by definition is resource inefficient when it comes to the economic growth. This means that the boom in China that is based on USA trade deficit requires substantial natural resource to sustain, and this hungry for natural resource from China has fired up the global prices of commodities. The higher natural resource prices is going to intensify inflation rates of the whole world and will damp the consumption boom in USA. Without this natural damping mechanism, relying on the huge
pool of underutilized labor source, USA can run an unlimited "borrow and spend" consumption boom by letting its trade deficit to grow without any bound, and USA will rapidly plunge into the phase of  a jobless "virtual society" as depicted in Article  7 .
With this natural damping mechanism, higher inflation and higher interest rate period will cap the consumption boom in USA and the growth of US trade deficit will stagnate. In such a period China's export engine also will be hit. If China can not compensate the slow down of its export engine by domestic spending, then China's thirst for global natural resource will ease, the global commodity prices will weaken, the world inflation rate will fall, and the ground for another global economic boom based on renewed US trade deficit expansion will be laid. If China succeeds in firing up its domestic consumption during the mean years of its export engine, then Chinese economy can continue its strong growth, China's thirst for global natural resource will continue, the global inflation rate will be sustained at a rather high level, and USA will experience a prolonged period of stagflation. If the export engine of China is suddenly interrupted, for example, if Japan suddenly stops to support US Dollar through its currency market manipulation, if military confrontation erupts across Taiwan strait, or if some unforeseen political turmoil occures within China, USA will be deprived the source to borrow and spend, US economy will sink into a deep recession, and the Pacific Rim economy built around China's export engine will also crash to the ground.
 

Comment 9: Some regularities in the global housing markets(Aug. 20, 2004)

There are some regularities emerging in the global housing markets. For the developed economic entities with high wage levels, the spending happy societies, and especially big borrowers through trade deficit like U.S.A. and UK are seeing  robust housing markets. Resource rich countries like Canada and Australia are also experiencing housing booms thanks to the sharp rise of prices of raw materials. However, for the countries and economic entities woth high labor costs and the insistence to run trade surpluses, consumption have fallen and so are the housing prices; in this category Japan is the most notable, but Hong Kong, Taiwan and Singapore are also experiencing similar housing malaise as Japan exactly due to their misdirected currency policies to artificially supress their own currencies to boost exports, thus exporting away their own consumption power to trade deficit countries. Even Germany can be considered belong to the latter group, since due to the weak Euro Germany has maintained a very high level of trade surplus and a stagnated consumer spending. The situations in developing countries, which enjoy large amount of foreign investments and low labor costs, are quite divergent. In the societies, like China, that has successefully translated foreign investment and strong export into higher economic growth, housing booms ensured. However, for the ones that foreign investments and exports have failed to lift living standards, housing boom is nowhere to be seen, like Mexico and Latin America in general.
 

Comment 10: Why is oil price so high?(Aug. 22, 2004)

Many in the investment and economic circles blame the high oil prices on various factors like the unrest in Iraq, the uncertainty in the Yukos situation, and even on some faceless futures market speculators. However, before relegating the responsibility of higher oil prices to those noneconomic events, we need to look at the situation of supply and demand in the global oil market as the free market economic basics teaches us. Currently the global oil output is about 82 million barrels a day with zero extra capacity to serve as the cushion for some unexpected emergencies, and the global demand of oil is also about 82 million barrels a day. If the normal equilibrium is to have the extra capacity of a few million barrels a day to serve as a cushion, then the price of oil will stay high or go even higher until either the global demand comes down (means the global economic growth rate needs to come down) or some new production capcity emerges to restore the cushion of a  few million barrels a day of idled capacity. Since new production capacities are not so easy to pop up no matter how hard we wish for them, we should expect that the high, or even higher, oil prices will continue until it breaks the back of the too robust global demand; it may take the form of penalizing those Americans who want to drive ever larger and gas guzzling SUVs and military style vehicles until they cry out for pain and give up their gas guzzlers, or it may curtail the desire of many newly rich Chinese middle class to enjoy the freedom of automobile through sticker shocks of gasoline price, or both. Considering the recent drop of gasoline price in USA on the face of steadily rising crude oil price, it seems that the price of oil needs to go substantially higher from todays level in order to have the effect of curtailing the demand for oil and for the oil market to reach a new equilibrium.
 

Comment 11: Why the growth rate of US real personal consumption is slowing down?(Aug. 22, 2004)

In the second quarter of 2004 the economic growth rate of USA has suddenly slowed down to 3.0% in real GDP from four plus percent growth rates of previous two quarters. The drop of GDP growth rate is maily due to the slow down of consumer spending. Many analysts and economists have immediately pointed their finger at the high crude oil price as the cause. Some argue that high oil price acts like an extra tax on consumers and has prevented them to spend. However, this argument is logically fraud. High oil prices will only force consumers to spend less on non-oil related goods but more on oil related products. The total amount of consumer spending should not be affected since the buying of oil related products are also counted in the overall consumer spending. More thoughful analysts argue that high oil prices has affected consumer psychology and thus has retarded the consumer spending. However, consumer confidence surveys through the second quarter and even in July have not picked up any slack in their confidence. The actual data are also not showing any direct correlation between the consumer spending and the crude oild prices. In the following we list quarterly percentage changes in the real personal consumption and the crude oil price, starting from the third quarter of 2003:

                     (3Q2003,  real personal consumption +5.0%, crude oil price +15%)
                     (4Q2003,  real personal consumption +3.6%, crude oil price +7%)
                     (1Q2004,  real personal consumption +4.1%, crude oil price +47%)
                     (2Q2004,  real personal consumption +1.0%, crude oil price +42%).

It is clear that there is no clear direct correlation between the crude oil price changes and the changes in the personal consumption. A more meaningful correlation between the personal consumption and the stock prices can be observed from the data. Monthly close of Dow Jones Industrial Average (DJIA) is used as the monthly indicator of the stock market, and three month average is taken as the stock market valuation of the quarter. The data are listed in the following:

                      (3Q2003, real personal consumption +5.0%,  DJIA +24.5%)
                      (4Q2003, real personal consumption +3.6%,  DJIA +30.2%)
                      (1Q2004, real personal consumption +4.1%,  DJIA +18.6%)
                      (2Q2004, real personal consumption +1.0%,  DJIA -7.4%).
 
DJIA has started to be anti-correlated to the prices of crude oil since the second quarter of 2004, but not before that time. The data show clearly that US consumers rather synchronize their consumption with the stock prices rather than on other indicators like interest rates, crude oil prices and so on. Other indicators can only influence consumer behavior indirectly by first influencing the prices of stocks. If the stock prices continue its downward path in the third quarter of 2004, we can expect another dismal showing of US real personal consumption.
 

Comment 12: The danger of an economic downward spiral when stock markets become the driving force.(Aug. 23, 2004)

In Comment 11, we have discussed the observation that US consumers are synchronizing their spending with the ups and downs of the stock market, and thus have caused the real personal consumption to grow a dismal 1.0% in the second quarter when the stock market, gauged by Dow Industrial Average,  retreated around 7%. In recent decades personal wealth of US consumers is tied to stocks more and more. Though consumers who do active stock trading are the minority, majority have their pension funds tied into stocks. With the bitter experience of the burst of bubble in the early 21st century and seeing their pension savings suffered a noticealbe dent, it is natural for US consumers to be supersensitive to the ups and downs of the stock market. However, this kind of emphasis on the stock prices by US consumers will create the possibility of a dangerous economic down spiral. Stock markets are forward looking instruments, with players constantly trying to gauge the future performance of the economy that will naturally be reflected to the profitability of the underlying corporations. After the June consumer spending report and the personal consumption figure in the second quarter GDP report have confirmed the poor performance of consumer spending, stock market naturally took a further hit. This additional pull back of stocks probably has cooled the spending of US consumers further, and when July consumer spending report comes out at the late August, stock market may stage another drop, cooling consumer spending in September more, and so on into a death spiral. Without this unexpected influence of stock market performance, we have been projecting a gradual slow down of US economic growth rate, like 3.5% in the second half of 2004, 3.0% in the first half of 2005 and 2.0% or below for the second half of 2005. With this new attitude of US consumers to tie their spending to the ups and downs of stock markets, the gradual slow down of economic growth rate may turn into a full scale recession, and thus deserve our close attention.
 

Comment 13: Stock Markets and the Demographic Change(Sept. 4, 2004)

In Sept. 2, 2004 issue of Wall Street Journal an article in "Capital Market" has touched upon the topic of the possible catastrophy for stocks and bonds due to the coming demographic change in USA. The article has presented the counter arguments from optimists who claim that the calamity is just an imagination of alarmists and the selling pressure claimed by the alarmists will not happen. However, the argument of optimists contains a logical flaw, and the whole topic deserves a close examination.

Since baby boomer generation has entered the labor market, US working age population has increased rapidly for many years. The baby boomer generation will retire soon. This will create a situation in USA that the rate of retiring people will be higher than the rate of increase of the working age population. It is well known that younger workers are more apt to hold stocks as their assets, and when people retire, they tend to liquidate their stock holdings and convert them into readily spendable cash. The alarmists claim that the stellar performance of US stock markets during the past half century is mainly the result of the rapidly increasing working age population and their tendency to hold stocks. Now this demographic trend is changing and massive liquidation of stocks and bonds is going to happen when baby boomers retire, and thus the ultimate calamity will hit the markets. The optimists as quoted by the Wall Street Journal article claim that the retirees are not necessarily going to liquidate their portfolios at the time of their retirement, so the calamity is just a fantacy. However, the argument of the optimists contains a logical flaw. Retirees may not liquidate their stock portfolios right away, but they will certainly do so as they approach their death beds. Suppose that the average life span after the retirement is 15 years, then the argument of the optimists only postpone the calamity by at most 15 years. The alrmists are claiming that the calamity will hit in 2023 in a sudden death form, and the optimists' argument is only modifying that prediction and turn it into a slow water torture type agony that can last a decade or more from 2023. Is that kind of calamity really going to happen, and is there anyway to avoid the disaster? It is certainly an interesting question to study.

Let us use Dow Jones Industrial Average (DJIA) as the representation of US stock markets. During the past half century DJIA has risen 30 times. During the first forty years, from 1955 to 1995,  DJIA moved up 10 times, a respectable performance. From 1995 to 2000 DJIA moved up 3 times, a real explosion upward. If  DJIA had moved with the rate as from 1995 to 2000 during the first 40 years, it whould have moved up like 1000 times! This respectable achievement of US stock market is not just due to the increased working age population, but is also due to the trend that US workers invest larger and larger portion of their assets in stocks, either invested actively by workers themselves or passively through their pension funds. There is also an additional factor of foreign money involved indirectly in boosting US stock prices. The foreign money scheme works as follows. As US runs huge trade deficits, US Dollar is handed over to foreigners. Those trade deficit dollars are eventually bought up by foreign governments, especially by Japanese Government, as they manipulate the currency market to keep Dollar strong in order to sustain their trade surplus. Japanese Government uses the acquired dollars to buy US treasuries. This means that some institutions are selling US treasuries to Japanese Government. When those institutions receive cash for their US treasuries, they have little choice but to invest the cash in stocks, thus fanning the stock market boom further. This foreign money phenomena is especially acute after 1995 when Japanese Government has started an all out currency market manipulation to boost Dollar and supress Yen; that is the reason why since 1995 US stock markets have exploded upward, and when US trade deficits have retreated somewhat at the latter half of 2000, the stock market bubble have burst. As the baby boomers retire, massive (in the order of several hundred billion dollars to over five hundred dollars a year) liquidation of stock portfolios is unavoidable. However, this massive selling of stocks can be absorbed by increased holding of stocks by working age population, by the step up indirect foreign government purchase as mentioned above, or both. The current suggestion to partially privatize the social security and let individuals manage their social security retiremnet account and to invest in stocks is a clear ploy to induce working age population to hold more stocks and thus may cancel out a certain portion of the massive selling due to the retiring baby boomers. As for the foreign buying, Japanese Government has already demonstrated that it is willing to pour 400 billion dollars into US treasuries a year. If Japanese Government just increases that amount by a few hundred billion dollars a year, then its indirect buying will be enough to absorb the remaining portion of baby boomer selling. We believe that the calamity mentioned here are avoidable since US Government will do its best to induce individuals to hold more and more stocks and will persuade Japanese Government to continue to do the massive dollar buying in order to cancel out the unavoidable massive selling by retiring baby boomers. If US Government succeeds in those two fronts, then what is going to happen to US stock markets? If the inducement of individuals to hold more stocks come before 2023 and Japanese Government continues to buy Dollar as they are doing presently, US stock markets will stage a strong rally first. When the massive selling by retiring baby boomers become the reality, then the gains will be quickly erased and stock markets will enter a prolonged stagnation period, that is, stock prices will neither rise nor fall, say for ten years or more until either individuals get tired of holding stocks without any capital gains or Japanese Government refuses to buy any more dollars. If either one of the senarios becomes true, then and only then US stocks will suffer a catastrophic fall as alrmists are claiming.
 

Comment 14: Falling Dollar, Economic Myths and Realities(Dec. 1, 2004)

At the time that US Dollar is rapidly falling against Euro and Yen, all kinds of rumors and myths are flooding the financial markets. It is essential that we understand what are the realities and what are just fantacies.

Many think that a sharp fall of Dollar will immediately be translated into higher interest rates and crashing stock prices, because they equate the falling Dollar to the withdraw of foreign capital from US markets. This notion, of course, is false as pointed out in Comment 4, titled "What is capital flow?" Currency market is an auction market. Any Dollar sold must be matched with an equal amount of Dollar bought. Dollar will fall when the sellers are more aggressive than the buyers, but the total amount of Dollar in circulation will not change at all. Let us call the Dollar sold "the old Dollar" and the Dollar bought "the new Dollar". How the falling Dollar will affect stock market depends on where the old Dollar comes out of and where the new Dollar will go into. If the old Dollar is withdrawn from the stock market whereas the new Dollar only goes into the mnoney market funds, then of course stock prices will be adversely affected. However, if the old Dollar comes out of the money market funds but the new Dollar is deployed into the stock markets, then the falling Dollar will be translated into higher stock prices. In average the movement of Dollar will not cause any immediate lasting effect on stock prices. For example, the sharp devaluation of Dollar in early 1985 did not prevent a bubble like upward explosion of US stocks in 1987, and the twin falls of Dollar in 1998 and 1999 did not hinder the formation of the dot com bubble until late 2000 and early 2001.

Reading the previous paragraph, one may ask then what is the worry about the falling Dollar; is it really only US oversea's travellers will be adversely affected and everything else is rosy as many financial spin-doctors on news media try to convince us? As presented in the studies of actual data in various papers posted in this website, the significant movement of Dollar will be translated into the ebbs and flows of US trade deficit with roughly two years of delay. Today's falling Dollar means that in 2007 the expansion of US trade decifit will be slowed. Rapid expansion of trade deficits was the driving force of both the Reagan era and Clinton era prosperities, and the shrinkage of trade decifits had triggered economic recession during the Senior Bush era and again in the manifestation of the burst of the dot com bubble in late 2000. Thus today's falling Dollar implies a substantial economic slowdown in 2007. If Dollar should collapse here, then the 2007 slowdown will turn into a full fledged recession. Stock markets are usually not so far sighted, so the adverse reaction in stocks will come mostly in the latter half of 2006. Until then stock markets may suffer a lasting effect due to other reasons, but not due to the falling Dollar. Stock markets may suffer a temporary set back immediately following a sharp fall of Dollar due to the psychological panick of market players, but the set back will most likely be reversed soon due to the deployment of the new Dollar to pick up the depressed stocks until the time when the trade deficit really shrinks, the inflow of foreign capital actually slows and then stock markets will enter into a lasting bear trend.

There are substantial amount of talks of China reducing its Dollar holdings, and such talks immediately unnerve currency market traders and financial market participants alike. If we study the structure of Chinese economic reality and the intention of Chinese Government with regard to the value of Yuan, then we will know that no way Chinese Government can reduce the amount of its Dollar holdings at all; it rather must increase the amount of its Dollar holdings steadily if it wants to peg Yuan to Dollar or allow Yuan only to appreciate a very modest amount, say like around 10%. The driving force of Chinese economic growth is ironically the Dollar buying operation of Chinese Government. Those Dollars to be sold for Yuan are coming from outside investments to set up factories to product goods to be exported to USA, from multinational companies investing in China aiming at one billion strong Chinese consumers, Hong Kong and Taiwan money intended for real estate speculations, and the repartriate of money by former Chinese emigrants, Hong Kong and Taiwan residents wanting to engage in the currency speculation waiting for Yuan to appreciate. At the stage of falling Dollar it is pointless to distinguish the long term investment money from the so called hot money that is just deposited into domestic Chinese banks and waiting for Yuan to appreciate, since the Chinese banks will not let those hot money deposited in their branches sit idle; they will lend those hot money to Chinese local Government entities to build power plants, steel and aluminium production facilities or just real estate developements. Thus so called hot money is spuring Chinese economic growth just as the long term investments from outside. If Chinese Government wants to trim its Dollar holdings, the most direct way is to scale back its Dollar buying. But then Yuan will appreciate sharply (like 100% to 200%). How about buying Dollar at current rate, but shift Dollar holding to other currencies like Euro and Yen? If Chinese Government does that, Euro and Yen will appreciate vs. Dollar and Yuan sharply. Even if European Central Bank and Japanese Government allow such actions, the pressure on Yuan to revaluate will become untolerable and Chinese Government will discover soon that it needs to buy back much more Dollar than the Dollar it has divested earlier just in order to keep wild gyrations of Yuan under control and Chinese economy not wrecked. Thus we believe that the talks of Chinese Government to reduce its Dollar holdings, are just talks but not practical at all.

As discussed in the previous paragraph the fate of Dollar and the long term effect on the global economy is not in the hands of China. However, the fate of Dollar depends how Japanese Government will react when the line of 100 Yen/Dollar is approached. Japan plays a dominant role in the globalization scheme as the major provider of international capital with its huge trade surplus. This continuously large trade surplus of Japan is sustained by the relentless currency market manipulation of Japanese Government to keep Yen weak and Dollar strong. Japan's zero interest rate policy is just another face of this weak Yen strategy. However, the instigators of this weak Yen policy have totally misjudged the reality of the consumption pattern in Japan. Average Japanese retire early and the social security system of Japan is far from ideal. Thus Japanese public needs to rely on their savings and the interests generated by their savings to suplement the expense of supporting their long life span after their retirement. Under this kind of circumstance zero interest rate is like a poison. It has immediately vanquished Japanese demand of consumption, and ushered in the prolonged period of deflation in spite of the fact that the amount of consumable goods in Japan has also plunged due to the weak imports and strong exports, the effect of weak Yen. This self inflicted economic hardship has temporarily pushed Japan into a third world like condition with abundant idled labor resource so that increased exports will reempoy a part of those unemployed and create a temporary rebound of its economy; that is the condition that Japanese economy is in today. Under this kind of environment, to let Dollar fall and Yen rise probably is the prerequisit for Japanese economy to return to the normal condition and to grow near its potential growth rate around 2% a year. However, this kind of reversal of decade long artificially weak Yen policy is very difficult for the financial bureaucrats of Japan to swallow; they will certainly try to intervene in the currency market to weaken Yen again. Adding on to this picture we must consider the political reality about the relation between USA and Japan. When Japan started to manipulate the currency market ten years ago to weaken Yen and push up Dollar, it was done with the full consent of USA under the Clinton administration. This time around the current Bush administration understands fully the enormous danger of the unsustainable US trade deficit; it also understands that the only way to cap US trade deficit is to let Dollar fall to its natural level. That is the reason why US Government is opposing other governments, especially Japanese Government, to continue to intervene in the currency market, and is trying to guide Dollar to fall gradually. That is probably also the reason why Japanese Government let Yen move through important price levels of 110 Yen/Dollar and 105 Yen/Dollar without any action. However, the level of 100 Yen/Dollar can be quite different. If Yen rise above that level, it can quickly rise toward the all time high record of 80 Yen/Dollar, and Dollar will be experiencing a crash, not a gradual fall. We believe that US Government will ask Japanese Government to intervene when Yen tries to rise above 100 Yen/Dollar level, Dollar will have a modest bounce, then fall later again and eventually break through 100 Yen/Dollar line in not very distant future. This kind of gradual fall of Dollar will cap US current account deficit to around 5% of GDP, but will not cause the deficit to shrink significantly. Thus the external debt of USA will accumulate steadily and will eventually approach the total assests of USA, creating a condition called "bankrupcy". In the meanwhile we must watch closely the delicate dance of US Government and Japanese Government around this line drawn in the sand, the 100 Yen/Dollar line.
 

Comment 15:Looming Confrontation about the Value of Chinese Yuan (Jan. 31, 2005)

A bill is pending in US Senate to impose 20 plus percentage of import taxes on all Chinese imports unless Chinese Yuan is upwardly revaluated by a similar amount. This bill is sponsored jointly by Democratic and Republican Senators and was introduced about a year ago. The consideration of the bill has been suspended to give US Government time to persuade Chinese Government about the revaluation of Yuan. However, after one year of fruitless attempt by US Government to talk up Yuan, this bill seems to regain the focus and has a good chance to be enacted into the law in 2005, especially under the changed environments among US and international economic policy makers. The school of economists who have pushed for free trade at any cost is forced to argue that the loss of US jobs to developing worlds like China is good for US economy, and is ridiculed in front of the public opinion. Even the Federal R eserve Chairman, Alan Greenspan, has changed his tone. He was reiterating that the large US trade deficit will be taken care of painlessly by "free markets". Now he is issuing a warning about the unsustainability of this enormous US trade deficit and wants currencies to float freely without government intervention to rebalance this imbalance in the globalization scheme. This, of course, means that Chinese Yuan must move up sharply, and US Government apparently shares this view. Only a handful of large Chinese good importers want to keep Chinese Yuan weak so that they can continue to reap huge profits through the import of inexpensive Chinese made goods. In the international front, Japanese Government is most eager to see the upward revaluation of Chinese Yuan, and Europe is not far behind. If Chinese Yuan continues to be pegged to US Dollar, and if US Dollar falls sharply against Japanese Yen, then Chinese Yuan will also experience a sharp devaluation against Japanese Yen and within a short period a large number of Japanese manufacturing jobs will flow to China. To prevent this kind of disaster to happen, Japanese Government will have no choice but to continue to manipulate the currency market with whatever amount of money necessary to support the value of Dollar. The amount required for such manipulation will escalate steadily; from near 400 billion dollar buying last time to one trillion dollar buying soon, then to two trillion dollar buying and so on with no end in sight. Under such consideration, we believe that the above mentioned bill will not encounter any strong resistance domestically nor internationally, and will probably be passed or Chinese Government gives in and revaluate Yuan by a satisfactory amount.

Let us analyze the effect of this 20 plus percentage import tax against Chinese made goods. The reason that multinational manufacturers shift their production lines to China is to take advantage of inexpensive labor cost and the lax environmental and regulatory controls over there. The raw materials and the components for those goods for the reexport to USA are mostly imported into China. The raw materials are, of course, imported from various resource-producing contries, and the components are imported from Japan, Taiwan, South Korea and other places. The added value by China to those Chinese made goods is usually only a fraction of the final price that the goods command when they pass US customs. This 20 plus percentage import tax under proposal will not only tax the portion that China contribues, but will also tax all the raw material and components went into those goods but not contributed by China. Thus this proposed import tax will cause a very sever blow to Chinese made goods, and China will see a sharp curtailment of its exports. Low profit margin goods like textiles probably will be wiped out over night, and those jumped on the China band wagon to expand their textile investments in China will see heavy financial losses. The high margin electronic goods probably will withstand the shock better than the low profit margin goods. As China's export industry is hurt, the capital inflow to China will slow down. Since Chinese economic growth is so dependent on exports to USA and the capital inflow, Chinese economy will experience a major slump if that import tax is enacted. How will this import tax impact US economy? We should note that the indispensable part of the globalization scheme is Japan, and to a lesser part Taiwan and Europe; they are the source of global capitals in the form of their chronicle trade surpluses without the matching capital inflow. Without those capitals US consumers can not borrow and spend, and the whole globalization scheme will just collapse. China is not an indispensable link in this globalization scheme. If goods made in China become not cost effective, the manufacturers will simply move their production facilities to other developing countries like India, Indonesia, Vietnam and so on. Some production of high tech goods will probably return to places like Taiwan, Hong Kong, Singapore, South Korea and even some back to Japan. If we look into the price of a Chinese made garment sold in US department stores, say a dress costing $50, the cost when this garment passes US custom is probably like $5 or below. The 20 plus percentage import tax will only increase the over all price of this garment by about $1.25 out of the price of $50, that is, to increase the price by 2.5%. Thus this 20 plus percentage import tax will not drive up US inflation in any significant way and the intermediate term impact on US economy is minor and temporary.

The long term effect of this import tax on the global financial market is more difficult to analyze. First we must project how Chinese Yuan will move after the imposition of the import tax. If Chinese Government insists on the currency peg, and foreign capital stops to flow into China, it may need to buy back Yuan by relinquishing a portion of its vast dollar reserve to prevent the fall of Yuan. This kind of action will prolong the negative effect of the import tax on Chinese economy. If Chinese Government lets Yuan float without intervention, Yuan will fall against Dollar and the negative effect of the import tax will be nullified graduately until China becomes competitive again as a manufacturing base even with the import tax. However, if Chinese Government tries to freeze the value of Yuan vs. Dollar at that lower level, then the whole history will repeat itself to no one's benefit. If Chinese Government stops to get involved in the currency market manipulation after Chinese competitive power is resumed, then it is the role of a free currency market to self regulate the trade balance, and future conflict between China and USA can be avoided. If Chinese Government tries to retaliate against the import tax by liquidating its dollar holding for Japanese Yen and Euro, the situation quickly becomes very complicated. This kind of action certainly will push Dollar sharply lower against Yen and Euro. If nothing is done, Chinese Yuan will also devaluate sharply against those currencies and China can shift its vast exports to Japan and Europe. In those places the mobility of labor is much worse than in USA. When massive imports from China hit, it will simply push the economies of Japan and Europe into a deep recession, and they will not hesitate to follow the foot step of USA to impose similar import tax against Chinese made goods. This means that China will be isolated from the globalization scheme, whereas US trade deficit will be curbed followed by an economic recession caused by the shrinking trade deficit, that is, US consumers will have less to borrow and thus less to consume. On the other hand if Japan and Europe decides to buy the dollar that Chinese Government releases in the phase of retaliation, whole thing will evolve slowly. US can continue to run huge trade deficits by importing from developing countries other than China, and Japan and Europe will continue to run large trade surpluses. What happens to China under that senario? If Chinese Government still wants to keep the peg, then Yuan will be suspended along with Dollar, and the recovery of Chinese economy and the shift of Chinese export to Japan and Europe will be slow. If Chinese Government retaliate, Japan and Europe come in to support Dollar from a sharp fall, and then Chinese Government let Yuan to float freely without further intervention, then Yuan will fall faster against Dollar than the case of no intervention by Japan and Europe on the behalf of Dollar. In any event once such an import tax is enacted and Chinese exports is curtailed, it will take a draconian effort to reassure multinational companies that China can be a viable export base to USA again. We should also note that if the 20 plus percentage import tax is insufficient to curb the exports from China, the rate of the tax can be arbitrary increased until it really bites and the above arguments become relevant.

What if Chinese Government act before the bill and let Yuan to float up, say by 20 plus percentage points? In that case the effect will be minor than the import tax since only the portion contributed by China in those exported goods will be effected. However, the problem of this approach is that the amount of revaluation of Yuan must be large enough to cause Chinese exports to USA stop growing; this, if happens, will also cause a slump in Chinese economy. If the amount of revaluation is not large enough and Chinese exports to USA does not level off, then the bill of concern will come back sooner or later.

In summary we believe that the show down about the valuation of Chinese Yuan is unavoidable and it will come sooner than many in the markets tend to believe.

Comment 16: Who will not sell Dollar. Who will sell Dollar. (March 04, 2005)

There are a group of economic entities which are determined to supress the value of their currencies versus US Dollar so that they can enjoy a large amount of exports to The United States of America. This is their only economic policy and the obsession of their economic policy makers. Those economic entities must continuously buy and hold Dollar, if not by their private parties, then by their governments. It does not matter whether they hold those Dollar in the form of US Government treasuries, US agency debts like the ones issued by Government chartered mortgage companies, US corporate bonds, stocks of US corporations, real estates located within USA, or takeover US companies as a whole, those activities are equivalent to lend to US consumers to help US consumers to sustain their borrow and spend boom. Only exception is to hoard Dollar bills and store them in warehouses; this kind of activities will take those Dollar out of circulation and does not amount to the lending to US consumers for spending. Those economic entities not only cannot afford to sell their Dollar holdings, but must continue to buy Dollar when there are selling presuures of Dollar against their currencies in the market, since if those governments sell Dollar for other currencies or do not counter the desire of the currency market to sell Dollar for their own currency by buying up those Dollar, their currencies will appreciate against Dollar, and their only economic policy will be ruined. Those economic entities include Japan, China, Taiwan, South Korea and so on.

Oil rich parties like Russia, and Middleeast countries do not care whether their currencies appreciate against Dollar or not. In the general environment that Dollar inevitably will fall against other major currencies due to the unsustainable US trade deficits, it is advantageous for thoes entities to diversify their foreign currency reserves away from Dollar into gold, Euro and Yen. Other weak economic entities which are bothered by the falling value of their currencies against Dollar should also hold appreciating currencies and gold as their foreign currency reserves to help their teetering currencies.

Recently there have been rumors that China will refrain from holding more Dollar, or it may sell Dollar outright for Euro or Yen. Then there have been erroneous rumors that South Korea has been selling Dollar, and then so has been Taiwan, causing one day turmoil in the global markets. We can be assured that those rumored parties are exactly those parties that are not capable to stop buying Dollar, left alone of selling any Dollar holdings since their economic policity makers cannot think of anything other than supress their own currencies to boost their exports. Only economic novices will dance with those false rumors. However, the arguments here does not mean that those parties bound to Dollar will and can sustain their Dollar buying forever since lending money to US consumers for consumption in the form of their trade surplus and US trade deficit inevitably means to put their own consumers in an austerity mode. It will be the day of reconing for Dollar and for this globalization monster when those parties are not capable of buying more Dollar; then the whole world will enter into a great depression. Fortunately the time for such a global crisis is still not on the horizon. It may come within a decade, or may come after a few decades. If such a crisis does not come and Dollar buying can be sustained for a very long time, then a situation called "globalization utopia"(for US consumers) as discussed in Article No. 7 of this website will become the reality.

Comment 17: The Logic behind the Interest Rates (March 10, 2005)

The Federal Reserve System of The United States of America (FED) has been raising short term interest rates in a measured manner since the middle of 2004 under the pretence to damp the risk of inflation. However, in the monthly reported inflation statistics there is no sign of any pending inflation threat. The long term interest rates is moving sideways during this period of rising short term interest rates, implying that the financial market is not anticipating any significant increase in the inflation rate as far as the eye can see. Many are thus confused about the whole picture of interest rate environment. Why does FED insist on raising short term interest rates in spite of the absence of any inflation threat? Why the long term interest rates do not move up in tandem with the short term interest rates? Once we understand the ins and outs of the current global economic environment, we will see the clear logic behind the disparate movements of the short term and the long term interest rates. In a simple phrase, the behavior of the interest rates is just reflecting the value of Dollar and the run away trade deficit of The United States of America.

We have been claiming persistently that the robust economic growth of America in the globalization age is due to the wanton expansion of personal consumption. The rapid expansion of consumption in America is the direct result of the runaway trade deficit. The runaway trade deficit, in turn, is due to the overly inflated value of US Dollar. Up to the middle of 2004, the inflated Dollar is supported by the massive dollar buying operations of the governments of Pacific Rim countries. However, the last episode of such dollar buying has shocked economic observers. In the span of 10 months, from the middle of 2003 to the spring of 2004, Japanese Government alone has bought 380 billion dollars just to prevent the collapse of Dollar against Japnese Yen. If adding the amount of dollars bought by the governments of China, Taiwan, South Korea, Hong Kong and Singapore, the total sum will surpass 700 billion dollars. It is also during that dollar buying frenzy, the first public skepticism has been voiced in Japan in a rather bizarre fashion. An adult comic strip (called "manga" in Japanese) has portrayed the dollar buying operation as a conspiracy of America to keep Japan poor and America rich. The "mango" has caught Japanese public's attention and has forced the minister of finance to openly deny the existence of such a conspiracy in front of the members of Japanese Diet (see article No.8 on this website for the account of this episode). When the next wave of dollar selling comes, it is certain that Pacific Rim countries need to buy up more than one trillion dollars in order to avoid a total collapse of Dollar. Whether or not such a massive dollar buying operation is politically feasible becomes naturally the biggest worry to all that are concerned about the matter. Though FED is officially pushing a rosy view that such a total collapse of Dollar will only correct US trade imbalance but will not induce any serious economic hardship, it is obvious that FED does not dare to test its own rosy senario by letting Dollar collapse in the next wave of dollar selling. Thus it becomes essential to postpone the onset of the next dollar selling frenzy that is sure to come. Then what can be done to prevent an outright Dollar collapse? For US Government to buy up those unwanted dollars is simply not possible, since in order to buy those dollars US Government needs to pay for them with Euros, Yens, Yuans, Taiwan Dollars, Korean Wons, and Hong Kong Dollars that US Goverment is not able to print. Only method left to support Dollar and not let it to test dangerous break-points is for FED to raise short term interest rates, and that is exactly what FED is doing since the middle of 2004. The logic behind this approach is that the rising short term interest rates in America will keep Dollar to move sideways within a band. If Dollar tests the lower limit of the band, then Pacific Rim governments, like Japanese Government, will come in with a moderate dollar buying operation to push Dollar back into the band. The amount of dollars needed to be bought in this scheme will be much less than the case if FED does not raise short term interest rates. Thus the day of reckoning of Dollar can be postponed.

Long term interest rates move according to inflation outlooks. In the past FED raised short term interest rates only to combat the real inflation threats. That is why the long term interest rates have always followed the raising short term interest rates and have moved up accordingly. However, this time the short term interest rates are raised to support Dollar. When Dollar is suspended at an inflated level, America continues to run larger and larger trade deficits. Running large trade deficits is like importing deflation. That is why America's inflation rate has been kept at a very low level in spite of run away consumption, and thus there is no reason for the long term interest rates to make any significant move. This means that the yield curve will flatten out more and more as the short term interest rates rise.

The current approach to use rising short term interest rates to support Dollar has its limits. For the next year or so this measured rise will bring short term interest rates to the range of about 5%, the so called "neutral" zone. As Dollar is suspended at this highly inflated level, America's trade deficits will continue to explode, and thus the selling pressure of Dollar will build up continuously. This means that FED must keep raising short term interest rates beyond the "neutral" zone for a period as far as the eye can see in order to prevent Dollar to collapse. What is FED going to tell American people about the need to raise short term interest rates beyond 5% level without any visible inflation risk? There is already a movement in America to force FED to target inflation rate. The motivation of this movement is obvious. If FED is forced to target inflation rate, then FED cannot raise short term interest rates if there is no inflation! Even if FED concedes at that time that the reason to raise short term interest rates is not to fight inflation but to support Dollar, the critics of FED will use FED's own words to attack FED. They will say that to let Dollar collapse is a win-win strategy. Since on one hand the cllapse of Dollar will wipe out America's trade deficit and bring jobs back to America without significant economic pain as FED itself is claiming, and on the other hand the collapse of Dollar will make the rise of short term interest rates unnecessary; also the collapse of Dollar will finally release the Pacific Rim countries from the bondage of complusive dollar buying. Is the collapse of Dollar really so benign as FED is claiming? We totally disagree with FED about this point. We believe that when Dollar finally collapses, an economic tsunami will be triggered and will wipe out the global economy, but the discussion of this critical issue will be defered to another writing at another date.

Comment 18: Is America sinking into an abyss or climbing toward a paradise? (April 6, 2005)

Some analysts believe that the United States of America (abbreviated as America) is treading a dangerous path by running "twin deficits"--the government budget deficit and the trade deficit. We have maintained that the trade deficit is the bane of America but the government budget deficit has only a secondary importance to the health of American economy. The natural result of relentless expansion of the trade deficit is the steady growth of the gap between domestic demand of credits from the government and the private sector combined and the credits available from domestic savings; the exploding gap is filled by the exploding trade deficit that is nothing but the borrowings from foreigners. We believe that America is already on the road of no return toward an eventual economic crash due to its wanton addiction to the expansion of the trade deficit. The crash of the American economy will bring down the economies of many other countries, large and small, and will mark the end of globalization, as we know it. However, there are opposing views. The commentary by David Malpase titled "Running on Empty?", published in the Wall Street Journal (March 29, 2005, page A16) is a typical example of such views. The author claims that the domestic savings rate is meaningless. His magic number to gauge the health of American economy is the net asset value of America. Most of that consists the home owners' equity in residential houses and the value of stocks held in the hands of American citizens. According to the tabulation of the Federal Reserve Board, this magic number has reached a new peak of about 65 trillion dollars and is growing rapidly. Since the magic number of America is growing much faster than the magic numbers of Europe and the Asian Pacific Rim countries as a whole, the author declares that the American economy will overwhelm all the other economic entities in the world soon, and thus America is ascending to an economic paradise. The purpose of this comment is to analyze Malpase's view and show that the so-called "magic number" is artificially adjustable so that it does not have any relevance to the health of a real economy. The thing to watch is still the trade deficit that will lead the American economy into a black hole.

We start our analysis by considering the following mathematical game:

Let us consider a subdivision that consists of 100 similar houses. We assume that each household has four members and an annual income of $100,000. The market value of each house is $300,000. For the sake of simplicity, we also assume that not a single household has any mortgage on its house outstanding. The total homeowner's equities for the whole subdivision is thus $300,000 x 100 = 30 million dollars.

Now suppose 10 households want to sell their houses and move away. An economic wizard among the remaining 90 households fears that the sell of 10 houses in a not so robust housing market may depress the market value of each house in the subdivision and thus reduce the total homeowners' equity of the subdivision; if the fear of the wizard should become the reality, the magic number tabulated by the Federal Reserve Board will naturally be reduced accordingly. The wizard proposes the following scheme to the other 89 households that will remain in the subdivision.

  1. The remaining 90 households will form a private equity investment fund and the fund will establish a cash pool.
  2. Each of the 90 households will take out a mortgage equals to one-third the market value of each house.
  3. Each of the 90 households will transfer 70% of the mortgage money into the pool of the fund and retain 30% of the proceeds from the mortgage loan to help over future mortgage interest payments.
  4. The fund will use all the money in the pool to buy up the 10 houses of the subdivision on the market, but the fund must treat every one of the 10 houses equally.
  5. In the future if the remaining households need to repeat this process, the fund should also take out a mortgage for each house it owns according to conditions 2 and 3.
The proposal is accepted and is put into action. First, every household among the remaining 90 takes out a mortgage of $300,000 / 3 = $100,000. Each of them transfer 70% of the money that it receives from the mortgage, that is, 0.7 x $100,000 = $70,000 into the pool and retain 0.3 x $100,000 = $30,000 to help cover the mortgage interest payments. The pool now has 90 x $70,000 = $6,300,000. The fund uses the money in the pool to buy up those 10 houses on the market with a price of $630,000/house. Thus the market value of each house in the subdivision suddenly jumps to $630,000 and the total valuation of the houses in the subdivision jumps to 63 million dollars from the original 30 million dollars. After subtracting the total amount of mortgage taken out by the households of the subdivision, that is, 90 x $100,000=$9,000,000, the new total amount of homeowners’ equity for the subdivision jumps to 54 million dollars from the original 30 million dollars. Thus the magic number tabulated by the Federal Reserve Board suddenly increases by 24 million dollars thanks to the proposal of the economic wizard.

To make the game easy to calculate, we assume that the houses in this subdivision always come in a unit of 10 when they need to be sold. After a while let us assume that another 10 households want to sell their houses in order to take the advantage of the inflated price. The remaining 80 households then take out a second mortgage equal to $630,000 / 3 = $210,000 for each household, contribute 70% of that $210,000, that is, $147,000 to the pool and retain $63,000 to help to cover the mortgage interests. The fund does exactly the same for the 10 houses it owns as mandated in Condition No. 5. The pool now has $13,230,000, so it buys up each of the 10 houses for sale for a price of $1,323,000. The market value of each house is now $1,323,000 and the total homeowners’ equity of the subdivision is 104.4 million dollars. Thus the magic number of Federal Reserve Board jumps by another 50.4 million dollars.

Readers should have noticed that this game can only continue up to step 10 when all the houses in the subdivision will be owned by the private equity fund. We have tabulated vital financial statistics at the end of each step, from 1 to 10, in the following: