Race to The Bottom

The Federal Reserve's announcement to buy longer term Treasury and mortgage securities is its way of telling the world: "We are going to create money out of thin air; we mean business." Unlike the US Treasury Department, which has to fund operation through through taxation, the Fed simply clicks a few buttons on its computer, and viola! unlimited amount of new money is created to do whatever the Fed desires. The immediate reactions include the sharp decline US dollar against other major currencies, price run-up in financial and physical assets. It appears that it reflects more of the market fear on inflation pressure rather than an approval on its attempt to jump start the economy.

Currencies are of relative value, so the ones with less prudent monetary and fiscal policies depreciates against those with more cautious policies, everything else being equal. What if everyone decides to conduct ultra-loose monetary policy at the same time, as we see with the US Federal Reserve, Bank of England, Bank of Japan, Swiss National Bank? Then these currencies are in the race to the bottom. They might not depreciate against one again very much, but no so in other currencies or in real terms. Currencies linked to commodities, such as Australian dollars, will likely fare better.

We often hear that economists dismiss the concerns on the size of US debt, arguing that as a percent of GDP it is not a big deal, comparing with other developed nations. But they seem to forget one important fact - the US is the largest economy in the world. With 20% of the world GDP, it outsizes the second, third, fourth ... economy by a great margin. By modest estimation, increasing new US debt from 45% of GDP to 65% means the world has to generate 4% more cash to absorb debt issued by US Treasury. That's 2.8 trillion US dollar. Can the world grows 4% annually and invests all the money earned towards US Treasuries? Can China and Japan cough up more cash for the 2.8 trillion when their main source of income, export, are shrinking sharply? Considering the amount of US debt supply the world has to absorb, I reckon that it's the absolute dollar that matters, not the percentage against the US GDP. The Fed is trying to defy gravity in vain.

Another implication on buying long-term bonds is that it will take longer for the Fed to unwind the money supply. Surprise! When the economy picks up or inflation kicks in, the Fed will have to sell these securities before maturity and/or raise short-term interest rates. Either way, investors in the long-term bonds get killed.