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By Paul Kasriel - The Daily Reckonoing
"World's largest debtor [U.S.] pledges to pay you back in cheaper dollars." In effect, this is what one of the rookie members of the Federal Reserve Board, Ben Bernanke, announced to the world on November 21. He said that the Fed had the tools, and the talent, to borrow a line from that cinema classic, "Ghostbusters," to print unlimited supplies of U.S. dollars. So fear not deflation. The Fed has implicitly pledged, to its dying breath, that it will crank up the currency printing presses to prevent it.
Now, I find it remarkable that a representative of the central bank to the world's largest net debtor nationwould publicly make such a pledge. I don't, however, find it remarkable that this central bank would privately harbor such thoughts. After all, isn't a little (or maybe, a lot) of inflation what debtors want to bail them out of their financial obligations? Doesn't it imply less of a cut in your standard of living if you can pay back some unsuspecting sap in dollars that buy less?
As a nation of net debtors, we want inflation. And this Fed, unlike the one guided by an "old era" central banker, William McChesney Martin, aims to please its domestic constituency. If inflation is what it wants, inflation is what it will get. (Incidentally, Japan is a net creditor nation. Creditors, especially those whose credits have little default risk, generally would opt for falling prices of goods and services rather than rising prices. Might this have something to do with the rest of the world being in a tizzy over Japan's falling CPI, while the Japanese citizenry is less concerned?)
Currently in the U.S., you can earn about 1&3/8% on three-month "wholesale" bank deposits. The October reading on the year-over-year change in the U.S. CPI was 2.0%. So,an investor is receiving a negative "real" return on this investment to the tune of 60 basis points. A global investor could do better by holding comparable paper denominated in other currencies. For example, at the beginning of this week, three-month money denominated in pound sterling was yielding 1.64% after subtracting the U.K. October inflation rate. That's an inflation-adjusted pickup of 229 basis points over a three-month U.S. investment.
Heck, even in Japan, where three-month rates are hovering just above zero, you can earn a deflation-adjusted return of 0.76% - a 141 basis-point pickup over dollar-denominated money. And if Governor Bernanke has anything to say about this, the odds are, in the next 12 months, that inflation-adjusted returns on money market investments will favor those denominated in foreign currencies over those in U.S. dollars. If global investors need to "park" funds, it would appear that there are better currencies in the world to do it in than the dollar. And, if, at the margin, more parking of funds is done abroad, then the dollar will depreciate, raising the U.S. inflation rate all the more.
Currently, the spread between the Treasury note maturing on 2/15/11 and the inflation-protected Treasury note maturing on 1/15/11 is about 1.45 percentage points. These inflation-protected notes preserve an investor's return against a rising CPI. With the October CPI year-over-year change standing at 2.03% and with Governor Bernanke implying that the Fed would crank up the dollar printing presses even more than it already is doing if the CPI's growth should start to weaken, why not buy the inflation-protected note and short the unprotected one? Isn't the current spread between the two likely to widen with inflationistas in control at the Fed?
The rest of the world advances the U.S. about $1.5 billion a day. Back in the 1990s, when we also were getting relatively large advances from the rest of the world, we were using these advances for things that had the prospect of making our future non-inflationary economic growth rate higher. If things had worked out, our standard of living also would have grown faster. This would have enabled us to pay interest and dividends on these advancements to the rest of the world - perhaps even pay back a little principal - without enduring a decline in our standard of living. Indeed, because global investors thought we were using their advancements of funds in a way that would increase the probability of payments to them of principal, interest, and dividends in "honest "dollars, they were more than happy to keep investing in America.
But now, we are using a much lower percentage of foreign advancements for nonresidential fixed investment. Rather, we are using the $1.5 billion a day from the rest of the world to buy bigger cars, bigger houses, and cruise missiles. Bigger cars, bigger houses, and cruise missiles are not the stuff of productivity growth, and, thus, future growth in our standard of living. How might we try to service our foreign debt - debt denominated in U.S. dollars - without enduring a decline in our standard of living?
Enter Governor Bernanke.
We might put pressure on him to crank up the dollar printing press. And what will foreign investors, who already own about 24% of America, do if they begin to sense they are going to be paid back in "dishonest "dollars?
They will flee from dollar-denominated investments.
About the Author
Paul Kasriel is Senior Vice President and Chief Economist at Northern Trust Co and a former Fed officer and university lecturer. Mr. Kasriel is a frequent contributor Apogee Research and the Daily Reckoning. This essay was originally published by Apogee Research.
Source: Apogee Research