User:Tyrjo/DollarRiskAnalysis

I've been thinking about the connection between real estate, consumer spending, government deficit and inflation. I've begun a little essay that attempts to tie all these factors together. I'd like your help to see if my understanding is correct.

The precarious position of the dollar can be revealed by considering interest rates. A lender is content with low long term interest rates if they are confident that the currency will have the same purchasing power when the loan comes due as it does today. If the currency is likely to decline in value (inflation), a lender will charge more of a premium for that loan to cover their expected loss. Therefore, the cost of credit is influenced by a currencies depreciation (e.g. inflation).

Inflation is a measure of a currencies utility. The more real goods a currency can purchase, the more utility it has and the more people will be willing to possess and trade with it. A trade imbalance of real goods between countries of different currencies builds or reduces the utility of their respective currency. For example, the US buys far more goods from China than they buy from us, thus a Chinese bill has greater utility. If a dollar can buy anything and everyone, it is a great thing to have in your back pocket. Conversely, if tomorrow, the dollar can only be used to buy dental floss, then most dollars become useless as there is low demand for dental floss.

As long as there are sufficient things available for purchase in dollars, the countries with whom we maintain a trade deficit have no trouble exchanging our currency for things they need. For example, a Chinese business exchanges its dollars (USD) into Renminbi (RMB) by taking it to a bank. Large central banks in China, and therefore the government, thus accumulate large piles of USD. What they cannot immediately spend, they seek to invest, so as to earn a rate of return on their cash equal or better to the rate of inflation. This investment on the government scale is easiest to do by selling the dollars back to the U.S. government in exchange for bonds. Effectively, this is a loan of capitol to the U.S. which it must repay with interest. Thus, China now holds bonds which are outstanding debt for the U.S. It has effectively loaned us money.

If China percieves that the money it has invested will retain its purchasing power, it is willing to loan the U.S. money at a low rate. However as its expected purchasing power declines, it will demand a higher return. Thus, controlling inflation is critical to the government obtaining inexpensive credit.

As we know, the U.S. government is spending far more money than it earns. It can do this by a) increasing the amount of debt sold to foreign investors which i) decreases the likelihood that all of those investors will see their principle returned or b) increasing the supply of money which ii) drives up the prices of goods since producers, seeking to maximize their profit, sell the same amount of product to the now increased purchasing power of the market, thus devaluing a currency. In both cases, the attractiveness of investment option "a" declines and "b" must increasingly be used to fund the government's deficit.

Thus, deficit spending by the government is likely to cause inflation as the amount of outstanding debt increases. Inflation causes a rise in consumer prices and reduces the amount of consumer spending, as more of a fixed paycheck must be spent on increasingly expensive needed goods. This reduction in economic growth is quickly converted into a direct attack on political leadership, as the population wants a government that helps them make money and thus improve their standard of living. Therefore, a democratic government must control inflation to maintain the status quo.

A government can control inflation by requiring a higher rate of return on the money it loans to the economy (via central banks). This higher interest rate requires repayment of principle and then some, thus pulling currency out of general circulation, reducing supply. However, this tool must be used very carefully.

As one example of how delicately rate hikes must be used, consider real estate. The availability of cheap credit, starting at the federal level, has encouraged people to overextend on their houses relative to their income. As interest rates rise, those who financed using variable rate loans will be the first to reduce their spending as more of their income must be used to cover their rising monthly debt. Looking to stop their loss, they will eventually sell their homes, accepting any offer that come the close to paying off their existing debt.

Unfortunately, this affects the equity of their neighbors. Their "fire sale" puts negative pressure on the resale value of similar houses in the neighborhood. Even those on fixed rate loans may see the market value of their house decline below the loan value. If the reduction of consumer spending due to high energy costs and variable rate loan sufferers is sufficient, it will increase consolidation/outsourcing pressure in business, costing the fixed rate homeowner his job. Now unable to meet his fixed rate loan, he is forced to sell into a deflating market at a loss and his consumer spending will be further reduced as this group of people consume capitol servicing old debt. The result is an ever widening circle of recession.

The key question is "Can the federal government control inflation sufficiently using nominal changes in interest rates?" The gold investor's assertion is no, because deficit government spending is increasing the supply of money, far faster than it can be safely removed via interest rate hikes. This inflation reduces the attractiveness of the dollar to foreign business causing a) an increase in the price of imports and b) a reduction in the continued funding of U.S. debt at low interest rates. Thus, consumer spending is forced lower, and the government must spend more to obtain credit.

This naturally reduces the spending power of the government. However, a government has a certain number of fixed obligations to meet in order to preserve the political status quo. The more inelastic these obligations, the greater the pressure to create cash to service them. Cash is generated by a) taxation or b) printing money. "b" is politically far easier and far less obvious.

The U.S. government has a tremendous amount of bills that simply must be paid. Politically speaking, we must protect our oil supply and we must fund entitlements. These inelastic requirements will remain in place as the market attempts to correct the real value of the dollar by a) selling used bonds, which reduces the amount the U.S. can charge to sell new bonds, and b) requiring more dollars for goods. The government is likely then, to use the only tool available, the printing press, to meet its obligations. This will work initially, as it takes time for dollars to trickle through the system. However this increasingly large imbalance will be corrected by the world declaring "no confidence" in the dollar and raising their prices by massive amounts.

The precursors then will be a) a reduction in the rate of funding of U.S. debt and b) a decrease in price of U.S. debt instruments (bonds, etc). Given the awareness of U.S. debt, these factors will be carefully watched and minor movements will be likely trigger large "beat the market" selloffs by speculators. These selloffs, if large enough, will draw in central banks as they are forced to limit their losses. As this selloff is recognition of dollar inflation, foreign economies will quickly move to raise their export prices. These increases will be almost immediately passed to consumers, exposing the true amount of inflation generated by deficit government spending.

Thus, it is of critical importance to eliminate any variable rate debt as soon as possible to avoid suffering from an inflationary economy.

Second, any fixed rate debt should be on assests that remain as close as possible to the real market value, as compared to a historical average in sound currency or commodity (gold or oil).

Finally, it is vital to protect the current purchasing power of any existing capitol one holds by converting that capitol into a form resistant to a) inflation b) import price increases and c) real estate depreciation.