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Five Things You Need to Know: U.S. Declares Economic War

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Obama administration fires a Smoot Hawley shot across the bow?

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Kevin Depew's Five Things You Need to Know to stay ahead of the pack on Wall Street:


1. Beyond the Zero Bound

Beyond the zero bound. Although that title refers to economics, it sounds vaguely related to science fiction, doesn't it? Then again, perhaps science fiction is precisely where it belongs.

Yesterday Swiss National Bank (the Swiss central bank) Vice President Philipp Hildebrand delivered a speech outlining the central bank's options for acting in the current financial crisis. With interest rates virtually at zero, the central bank is no longer able to utilize policy options that target short term rates. So, what can they do?

One additional step would be for the central bank to purchase government bonds outright. A more extreme step the central bank could take would be to directly purchase longer-term corporate bonds. But the most interesting step, from this seat, is the one where the central bank intervenes in the currency markets.

"Measures to bring the franc under control - or even to devaluate the currency should the need arise - include a sale of Swiss francs against foreign currencies," Hildebrand said. "In an extreme case, the SNB can pledge to buy foreign currency infinitely at a fixed exchange rate," he added.

2. Why Currency Intervention Matters

Why is this talk from a Swiss central banker important to us? Two reasons.

First, Hildebrand, according to the Reuters translation of his speech, outlined explicitly something U.S. central bankers (global central bankers for that matter) are each thinking: "Real deflation has to be avoided at all costs."

Second, the intervention into currency markets parallels the newly-minted (yes, a pun) Obama administration's own shot across the global foreign exchange bow. According to Bloomberg, this morning presumed Treasury Secretary Tim Geithner said "OBAMA 'BELIEVES CHINA 'MANIPULATING' CURRENCY' and "OBAMA TO 'AGGRESSIVELY' TRY TO CHANGE YUAN POLICY."

3. Economic War

The term "manipulator" relative to currency is a serious one and not just one more piece of hot campaign rhetoric. "Currency manipulator" is a formal designation set by the Treasury Department that paves the way for explicit sanctions. (Five Things first looked at this issue relative to China in 2006 here.)

Far from being simple rhetoric, and it is guaranteed China will take these Geithner soundbites seriously, the charge of "currency manipulator" will be viewed by China as a strong signal the incoming administration is determined to end the present mercantilist policies where the U.S. takes on increasing debt to consume the good that China manufactures, with the proceeds of the current account surplus recycled back into the U.S. financial markets through purchases of U.S. Treasuries.

This is a fundamental shift but not for the reasons most analysts and media outlets will state; namely, that it means China will non longer purchase U.S. Treasuries, interest rates will soar and/or the dollar will collapse. No, that is wrong. First, the most important purchaser of U.S. Treasuries at present are U.S. banks, not foreign governments. Second, this shift, rather than kick starting an inflationary spiral, will actually exacerbate the deflationary debt unwind by increasing volatility, reducing liquidity and reinforcing risk aversion and balance sheet repair. Eventually this will translate into higher cost of capital, but that is a longer-term issue, not the present one, which is rebuilding or maintaining solvency for corporations and individuals.
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