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Minyan Mailbag: Liquidity and the Falling Dollar


World liquidity is being generated by negative real rates out of Asia...

Professor Succo,

Based on what you have written, I come away with the following: The Government is pumping liquidity into the system in massive amounts. Did I understand you to say that one of the reasons that they are doing so is to purposely devalue the dollar? Seeing that an actual dollar crash could be devastating to US markets (in fact wasn't it one of the reasons for the 87 crash?), why would this make sense to roll that dice? In their eyes is it more important to prop up markets than risking the US dollar? Please help me with the confusion.

Keep up the great work,
Minyan Bob


The US government is depending on Asia printing as much as we are to 1) continue to create debt (liquidity) and 2) keep the dollar from crashing. Despite the rhetoric (to keep the US manufacturing base calm), they do not want to see the Chinese allow the dollar to fall.

World liquidity is being generated by negative real rates out of Asia (although I think real rates are negative here as well). Here is how it is being done:

The Fed creates liquidity through the U.S. REPO market: they buy bonds from money center banks with their credit (create credit from nothing). The effect is that the Fed's balance sheet increases: assets are bonds and liability is IOU to a money center bank. The money center bank replaces the asset they sold (bond) with loan to a mortgage company.

The mortgage company lends money to the consumer through a refi.

The consumer spends the new money on a Toyota (TM).

Toyota goes to a Japan bank and exchanges dollars for yen.

Now here is the difference. Normally Japan bank would sell the dollars in the open market for yen to give to Toyota. This would devalue the dollar versus the yen. This would put pressure on the Fed to raise interest rates in order to keep attracting outside capital that we need (trade deficit and capital surplus). So if foreign central banks decided to take less dollars, the Fed could not continue to offer credit at the same price or the dollar would crash.

But what is happening now is foreign central banks are sterilizing the dollar. Instead of selling dollars for yen in the open market, they are printing yen (creating credit) to give to Toyota and then keeping the dollars. They then take the dollars and buy U.S. securities.

So what we are witnessing is a massive continuation of debt building by central banks. That debt is now weighing on markets putting deflationary pressures into the system. Central banks are fighting deflationary pressures by continuing to build debt in the above way, which creates more deflationary pressure in the future. This is all cumulative as evidenced by the massive total debt in the system.

The weight of this will eventually cause deflation unless massive costs can be taken out of the system. This may be caused by a new and cheaper energy source or new technology. But given debt levels it must be massive.

In the meantime central banks, I believe, are fighting this slow down in the velocity of money (the market weighed down by debt service) by actually buying risky assets like stocks. I believe that strange and stubborn bid I see in S&P 500 futures all day long to be foreign central banks recycling those dollars. When they buy risky assets they force the market to reprice risk: the market takes more and more risk to make returns.

In its ultimate form, this is socialism: governments owning large amounts of private assets.

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