The Face of Inflation: Does the U.S. Have a "Peso Problem" revisited

[Milton Kuo]

Re: The Face of Inflation: Does the U.S. Have a "Peso Problem" revisited

...

If you cannot stomach the risk such a basket of stocks entail, then you should not be in stocks. No use yearning after their returns if you reject the risk.

Also worth checking out any number of other (better than treasury!) options, such as Everbank MARKETSAFE CD's indexed to diversified baskets of foreign currencies (which will also hugely devalue relative to gold BTW) but which will at least not be totally at the mercy of US Gov. CPI lies governing their interest rate yield!

Yet another option are Everbanks MARKETSAFE instruments indexed to the price of Gold and Silver! You buy them, they go up in lockstep to the rise in the metal, and if the metal goes down, your original principal is guaranteed.

There may be a lot more research you could do here? One of those MARKETSAFE gold indexed CD's may return you 200% in the next five years, while securing your principal, and you are looking only at buying short term US treasuries? Why?

Why not start looking into everything else you can do!?

I think the goal behind Raja's idea is to put equity that would otherwise do nothing to work in a practically risk-free investment: government paper. As he has stated, the worst he can do, compared to not withdrawing the equity, is pay the spread between the cost of borrowing and the interest earned. I don't believe the original intent was to borrow money and put it into potentially high-yield (a euphemism for junk) investments.

If all goes right, he buys government bonds at a point where the spread is large enough that he actually earns more in interest than he pays. Ideally, inflation is eventually brought under control and the spread then becomes a source of guaranteed, free income. It has been noted, though, that government bonds are callable so this scenario will probably never be fully successful.

If inflation continues to stay high, he can still buy government bonds that yield more than what he pays in interest. True, the profit made is being eroded by inflation but it's profit that would not have otherwise existed had he not taken the HELOC and played a carry trade.

The key, however, is that the borrowed money is put into something highly liquid with practically no probability of loss-of-principal. Blue-chip stocks don't fit that bill and those Everbank MARKETSAFE instruments tied to gold and silver almost sound too good to be true :eek:. The returns on the yield-spread strategy may be improved by investing the profits into stocks or other higher-yielding investments.

Finally, the beauty of the above carry trade is that once the long-term bonds are bought, all the investor has to do is sit back and let the profits roll in for the next decade or so. There is no need to worry about lost principal or the hassle of reinvestment. However, this is all moot due to the callability of the bonds.

[Guest]

Re: The Face of Inflation: Does the U.S. Have a "Peso Problem" revisited

Milton -

Is anyone looking carefully at the gap between the coupon offered on the short term treasuries Raja would be rolling over and the real inflation rate?

This together wth the exquisite timing required to obtain a decent buy window on the long term bond at a "top" seem to me like swiss cheese in this strategy. I.E. - Full of holes.

With all respect to Raja's conservatism, and I mean that as a compliment, as conservatism is indeed still quite rare while a lot of people are still taking flyers. But Jim Rogers commodity index fund has a good deal less "risk" than you suppose if you are plugged in solidly to what's changing inexorably in the world.

When you have sat on a beach for twenty years and are familiar with the tides - are you willing to place a bet to a newcomer that the next morning the tide will come back in? The newcomer will doubt you, but you will know exactly what low risk you undertake of being wrong!

Bottom line, if you are a total agnostic - that is you say "I can't hope to "know" anything well enough to be fairly sure I'm right", then of course by default you have to employ strategies that seek to tie themselves to the supposedly 'zero risk" categories.

You wrote << practically risk-free investment: government paper. >>

Personally, I think this is a questionable assumption in our US environment going forward. Declared coupons will be disneyland numbers compared to what the coupon rate should really be. The coupon offered on Govt treasuries will be chasing the real inflation all the way up! Try climbing that ladder up to a nice juicy 20% long bond opportunity, and you may find someone put slippery vaseline all over the ladder rungs - and it's a long climb.

[raja]

Re: The Face of Inflation: Does the U.S. Have a "Peso Problem" revisited

Milton,

Thanks for your response regards my "carry-trade" plan . . . .

It was good to see that at least one person sees it the way I do, although I appreciated c1ue's and Lukester's feedback.

the beauty of the above carry trade is that once the long-term bonds are bought, all the investor has to do is sit back and let the profits roll in for the next decade or so. There is no need to worry about lost principal or the hassle of reinvestment. However, this is all moot due to the callability of the bonds.

I liked everything you said . . . until the last line.

Saying it's "moot" suggests that it's not worth doing at all. Why would this be so?

From the info I've been able to gather on the web, T-bonds in the past have been callable only after 25 years, and when the bond is issued, the earliest possible call date is stated. (Otherwise, I would imagine it would be much harder to sell the bonds.)

So, if one collects 15% profit using OPM for 25 years instead of 30 years, that's not so bad, eh?

You did say in another part of your post that , "the scenario will probably never be fully successful", but that's far different from it being "moot".

Then again, perhaps I misunderstood what you meant, or I'm missing something about the scenario itself . . . .

[Andreuccio]

Re: The Face of Inflation: Does the U.S. Have a "Peso Problem" revisited

Milton,

Thanks for your response regards my "carry-trade" plan . . . .

It was good to see that at least one person sees it the way I do, although I appreciated c1ue's and Lukester's feedback.

I like the idea of a carry trade, too. I've been doing one for the last year that's worked out well. I borrowed about $100,000 on credit cards at 0% and put it into MM accounts at 5%. It's irrelevant what inflation is. I get 5k, about 3.5k after taxes. Even if inflation eats 10%, that's still 3.15k of found money with no risk. I might have done a lot better in equities, but it's money I couldn't afford to lose: I needed to repay it within the year, so why take the risk? The only real downside was maxing out those cards has played havoc with my FICO score, but that will sort itself out once I pay them off.

As to your idea, I would look at a few issues. First, depending on the rate you get on the loan and the short term investments, you'll have some carrying costs and some losses up until the point you lock in long-term. Can you absorb these costs? Do you have sufficient cash flow? What if long term rates don't go up to where you expect, or they don't go up for a while? Is it possible you could lose money overall because of that? Your's isn't a risk free bet. You're essentially speculating that interest rates will go up enough long term to make up for your short term losses.

Next, you'll have to make payments on the HELOC or whatever other loan you take out once you lock in long term, so you have to look at cash flow after you lock in, too. Will interest payouts on your long term investment be enough to make the HELOC payments? If the payouts are every 6 months, can you cover the payments easily while waiting for your first interest payment?

Finally, taking out $100k loan will have some impact on your ability to borrow additional money and might tie your hands. As I stated above, for example, my credit rating went down considerably due to my loans. Since it was only for a year, though, and I didn't expect to be buying any houses this year, I didn't really mind.

But you're talking about 25 years. I don't know if a HELOC would hurt or help your credit rating, but there might be other consequences. What if you need to sell the house, for example? There are lots of scenarios where it won't matter, but there are also some where it will. Could you get trapped because you have to pay off the HELOC? Any chance you might need the credit for something else? Also, obviously, you wouldn't want to get a HELOC for a shorter term than your bond.

Good luck.

[Guest]

Re: The Face of Inflation: Does the U.S. Have a "Peso Problem" revisited

Andreuccio -

Can't quite believe your investment project. You halved your credit rating and played investment games with a very large chunk of credit card debt to net $3,500 USD? Why not take a small consulting job or a very minor part time work on the side for the same annual result, without the trashed credit rating you'll have to rebuild?

If you stand back from the lure of zero interest rate carrots dangled before you by otherwise thoroughly rapacious credit card companies, and consider all these lengths gone to, you could have made $20,000 USD with a fair bit of safety with that $100k just by finding conviction in the major commodity themes - that these sector trends don't merely peter out in mid trajectory.

Compare secular trend spotting worth 20% annual returns in an average year a' la' Jim Rogers - with committing $100K on a highly "unorthodox" strategy of borrowing from big CC companies (!!?) for a tiny return?. I might conceivably contemplate the idea if I could get a 20% annual return from it, but I'd still not be enthused about playing around with CC funds.

Or you could have made the same 20% by merely fastening firmly onto an entirely rational belief in the fundamentals coercing global governments to goose liquidity and thereby drive gold bullion up by at least that much in a year, or 18 months at the latest. You read about this inevitable liquidity abuse all over these pages and we all assume it's entirely true - Where then is the conviction sufficient to put serious money behind sound investment initiatives in that direction?

I am sorry, but I cannot imagine playing either home equity or credit card money to venture into the investments you and Raja are endorsing. They are hare brained methods to me. It also implies a lack of vision regarding some phenomenal five year investments strewn all around you!

Look at Charles Mackay, who coolly sold his primary residence in Washington State in the year 2000, or I forget if it was 2001, and watched the housing market soar away upwards from his exit. But he had done his very wide angle view homework, made highly rational macro conclusions, and knew his bet would come out on top.

This is the most serious kind of investing, but it involves at least some belief in one's own reasoning of macro themes - it involves acting as unilaterally and emphatically as Charles Mackay did when he not only sold his home when everyone was clamoring to buy more homes, put then putting a big chunk of his own un-levered cash from his home sale right into gold and then calmly let it all ride.

That has vision, and also is action that trusts totally in it's own rationality to grasp, and bet on the macro themes. I don't certainly match up to what Charles Mackay did, but I aspire to it, and I admire it.

[Andreuccio]

Re: The Face of Inflation: Does the U.S. Have a "Peso Problem" revisited

Andreuccio -

Can't quite believe your investment project. You halved your credit rating and played investment games with a very large chunk of credit card debt to net $3,500 USD? Why not take a small consulting job or a very minor part time work on the side for the same annual result, without the trashed credit rating you'll have to rebuild?

If you stand back from the lure of zero interest rate carrots dangled before you by otherwise thoroughly rapacious credit card companies, and consider all these lengths gone to, you could have made $20,000 USD with a fair bit of safety with that $100k just by finding conviction in the major commodity themes - that these sector trends don't merely peter out in mid trajectory.

Compare secular trend spotting worth 20% annual returns in an average year a' la' Jim Rogers - with committing $100K on a highly "unorthodox" strategy of borrowing from big CC companies (!!?) for a tiny return?. I might conceivably contemplate the idea if I could get a 20% annual return from it, but I'd still not be enthused about playing around with CC funds.

Or you could have made the same 20% by merely fastening firmly onto an entirely rational belief in the fundamentals coercing global governments to goose liquidity and thereby drive gold bullion up by at least that much in a year, or 18 months at the latest. You read about this inevitable liquidity abuse all over these pages and we all assume it's entirely true - Where then is the conviction sufficient to put serious money behind sound investment initiatives in that direction?

I am sorry, but I cannot imagine playing either home equity or credit card money to venture into the investments you and Raja are endorsing. They are hare brained methods to me. It also implies a lack of vision regarding some phenomenal five year investments strewn all around you!

Look at Charles Mackay, who coolly sold his primary residence in Washington State in the year 2000, or I forget if it was 2001, and watched the housing market soar away upwards from his exit. But he had done his very wide angle view homework, made highly rational macro conclusions, and knew his bet would come out on top.

This is the most serious kind of investing, but it involves at least some belief in one's own reasoning of macro themes - it involves acting as unilaterally and emphatically as Charles Mackay did when he not only sold his home when everyone was clamoring to buy more homes, put then putting a big chunk of his own un-levered cash from his home sale right into gold and then calmly let it all ride.

That has vision, and also is action that trusts totally in it's own rationality to grasp, and bet on the macro themes. I don't certainly match up to what Charles Mackay did, but I aspire to it, and I admire it.

Lukester,

Where to start?

First, regarding the credit rating, the trashing is real, (although not half - I dropped about 70 points), but very temporary. As you know, different things go into your credit rating. A major component is late payments, and if I had made any of these, the trashing would have been long term. Those stay on your rating for years.

Another component, though, is ratio of unsecured debt to total credit line. This is where I got trashed. But since the money was in an account that I could access within the few days it takes for an electronic funds transfer to complete, I was able to pay off the balance at any time within about a week. After that it takes about a month for the cards to report the new balance, and voila, credit score back up. So my only real risk was that I might not be able to make that impulse buy on a vacation home.

Once I pay off the balances, my credit score should be back up within a month.

Regarding investments with 20% returns, "vision", and following ones convictions, up until recently I've been very aggressive with my investments, and I've done just fine. But I made those investments with money that was already mine to invest. Not borrowed funds. 20%+ returns come with at least some degree of risk. I'm willing to take risk with my own money, but not with money I need to pay back, particularly in a short period of time. My carry trade netted me 5k pre-tax virtually risk free.

If it's "unorthodox", so what? I don't see what's wrong with borrowing from CC companies: they loan me the money for a year for free, I loan it back to them (Capital One was on both sides of at least part of the trade) at 5%. It's not like I'm spending it on vacations, or, God forbid, keeping it past the teaser rate period.

Finally, there's the issue of time, which you don't really consider. You compare my play with Charles Mackay's, but they have nothing to do with each other. His play was brilliant, and it probably netted him quite a bit of money. But I'll bet he spent a fair amount of time developing and researching his theory. Selling his house and moving was probably also time intensive. (And he had to have a house to sell in the first place.)

My play took me less than 10 hours total. I don't know what you make, but any time I can make $500 an hour, I'm a happy camper. And I made it with somebody elses money, again, risk free. For the same reason, it doesn't compare to a part time job. Nobody I know is willing to pay me $500/hour for part time work. (As an aside, if any of you iTulip member CEO's are
willing to pay me $500/hour, please contact me. :rolleyes

[c1ue]

Re: The Face of Inflation: Does the U.S. Have a "Peso Problem" revisited

Lukester,

Normally I'm the wet blanket, but in this case I actually agree with Andreucchio - just not for the same reasons.

One consequence of the present unfolding events is that credit scores as we have experienced them are going to be relegated where they belong: in the trash bin.

The credit scores were an easy way for the ratings companies to quickly and easily determine a relative risk for loaning money to an individual.

It is now quite clear given the present stress test that any such system is worthless because it is too easy to game.

While the ratings agencies will modify their criteria, the 'credit score gamers' will also continue the arms race. It won't take much for lenders to realize that this type of system is no longer workable - both in the fact that borrowers can see (thus manage) their score and that the ratings agencies ultimately don't care if the ratings work or not (except in the most generic long term sense).

It is this feedback loop which has comprised one of the major legs of this present real estate bubble.

Thus trashing a worthless score is not a big deal!

[Andreuccio]

Re: The Face of Inflation: Does the U.S. Have a "Peso Problem" revisited

Lukester,

Normally I'm the wet blanket, but in this case I actually agree with Andreucchio - just not for the same reasons.

I hate being right for the wrong reasons.

C1ue, are you saying I'm wrong, or just irrelevant?:rolleyes:

BTW, there's something I've been meaning to bring to your attention: there is no "H" in Andreuccio.

[Guest]

Re: The Face of Inflation: Does the U.S. Have a "Peso Problem" revisited

C1ue -

Ecco, a me pare che Andreuccio ha ragione. Per quanto ho capito, tu hai famiglia che hanno origine nella Russia, no? Allora dovresti come minimo tener presente qualche dettaglio della cultura Renaissance Italiana!

Andreuccio da Perugia. Gran avventuriero dell'Umbria!

Andreuccio va scritto "Andreuccio", non "Andreucchio". OK?

Pare che il gran infallibile BOT C1ue ha compiuto un primo errore d'intelligenza. La libreria del US CONGRESS che tiene fra le orecchie (ears) ha malfunzionato (malfunctioned)! :confused:

[Milton Kuo]

Re: The Face of Inflation: Does the U.S. Have a "Peso Problem" revisited

Andreuccio -

Can't quite believe your investment project. You halved your credit rating and played investment games with a very large chunk of credit card debt to net $3,500 USD? Why not take a small consulting job or a very minor part time work on the side for the same annual result, without the trashed credit rating you'll have to rebuild?

The carry-trade Andreuccio mentions with the credit cards uses the best and surest technique to get rich in a FIRE economy: always use other people's money. At a 0% rate and assuming no initial transaction fee, any interest earned in a CD is pure, sweet profit.

The only ways one can lose money on this strategy and the mitigating factors are:

• You fail to pay the bank on time. 5% of OPM is a lot of money--you're going to have to earn it.
• The bank where you bought the CD becomes insolvent. Always make sure your money is government insured; you don't get any extra yield on the uninsured amounts.

As for the hit to one's credit rating, what does it matter? For the relatively well-heeled speculator, credit is a mere convenience and not a necessity.

If you stand back from the lure of zero interest rate carrots dangled before you by otherwise thoroughly rapacious credit card companies, and consider all these lengths gone to, you could have made $20,000 USD with a fair bit of safety with that $100k just by finding conviction in the major commodity themes - that these sector trends don't merely peter out in mid trajectory.

The key words here are "fair bit of safety," which is entirely different from the nigh-100% safety of a federal government insured CD. I don't think anyone is good enough to invest money in stocks and get a guaranteed profit. Investing in stocks means you're going from a play that, barring Armageddon, guarantees a nominal profit to one where you're at the mercy of the markets. A lot of hedge funds promise 20% annual returns with practially no risk yet very few are ever able to fulfill such a promise.

...

I am sorry, but I cannot imagine playing either home equity or credit card money to venture into the investments you and Raja are endorsing. They are hare brained methods to me. It also implies a lack of vision regarding some phenomenal five year investments strewn all around you!

The idea behind the carry trades mentioned here is not to maximize one's gains. Rather, they are vehicles designed to throw off free money with truly limited (in the case of Raja's HELOC carry) or no (Andreuccio's credit card carry) risk. Furthermore, both strategies involve principal that is otherwise idle or OPM. The ideas sound hare-brained because they rely on side effects of the FIRE economy. Being that a FIRE economy is just a con game, it is really all that surprising that some really stupid ideas actually can make money?

Finally, it's one thing to chase yield with discretionary funds where you can afford to lose some of the principal. However, we are essentially investing on margin with these two strategies. There's no point in making things any more exciting than they already are.

[Guest]

Re: The Face of Inflation: Does the U.S. Have a "Peso Problem" revisited

Milton -

With all respect to Andreuccio, who's avatar is I think really cool, (I grew up maybe fifty miles away from where his chosen avatar character lived his life in central Italy - so Andreuccio please accept my comments in a sporting way).

Sophisticated risk savvy arguments abvout the merits of riskless carry trades don't convince me.

These are very elegant, FIRE-economy-savvy scamlets (rhymes with omelettes ) to beat the system. The only problem is, you need to employ large amounts of OPM committed capital for chump change returns. Or in Raja's case, large amounts of your own money for almost zero returns.

If you wanted to employ these gambits to make real money you'd have to scale these carry trades up by a factor of ten, and then unforseen risks really do creep in. Try borrowing 2 million on your personal credit to earn 3.5%, and doing this little caper and see how comfortable you'd feel with the whole creaky leverage thingy.

How are you going to trump the FIRE economy by figuring out how to wring $3500 USD from one hundred grand of borrowed money, while taking a year to accomplish it? Inflation alone risks making this merely an academic exercise.

This kind of play is like getting dazzled by one's own smooth methodology, by an elegant concept for squeezing profit from ultra low risk gambit, and yet after a full year of your life goes by you've only gained some very small pocket change?.

The thing that will in the end stump you in this approach is that while it employs a flawless planning and execution, so you feel you've pulled off some smart riskless coup, you've really only gotten distracted from your serious investments because it returns little to nothing!

I keep comparing this to what Charles Mackay did. It's almost painfully simple. No outsmarting of any FIRE economy system, no carry trade, no sophisticated and agile footed plans for a small short term result. Just one, very big shift and allocation - giving up the warmth and coziness and beguiling emotional security of one's own home (imagine that Raja!), to allocate a really significant part of all one's total worth to un-leveraged gold, right when everyone else is going absolutely GAGA about leverage and carry.

That's only the first part of this play. Then you have to have the conviction to sit like a Buddha (and no banality or disrespect is intended to this wonderful and inspiring diety) and the calm and detachment to let this simple bet against massively abused leverage worldwide accrue all of it's power - across an entire decade.

You put this one simple hand of cards on the table, and that's your only play, for a decade.

This is to my mind the real sophistication. We've seen "carry this" and "carry that" and "leverage this and that" for years now, until the system is creaking at the seams from it's overuse.

Wouldn't it be an eye opener, a real "kick in the head" as Dean Martin used to say, to see after ten or fifteen years with 20 / 20 clarity, that the single, simple trade Charles Mackay described (sell one's much-cherished home, buy a boatload of gold early and dirt cheap, and hang onto it) outstripped all the other carefully thought out and far more frenetic hedge, carry, option, stock, bond carries, short, long and straddle option trades - all of this stuff cycled through two or three dozen times over ten years while chasing small profits - endlessly agonizing back and forth with great expenditure of overwrought brain power, trying to out-contrarian the contrarians?

Could all that stuff concievably end up being be left in the dust by the returns of this "keeping it real simple" approach?

You know what? I'm guessing that is exactly what's going to happen.

[Milton Kuo]

Re: The Face of Inflation: Does the U.S. Have a "Peso Problem" revisited

Milton,

Thanks for your response regards my "carry-trade" plan . . . .

It was good to see that at least one person sees it the way I do, although I appreciated c1ue's and Lukester's feedback.

I liked everything you said . . . until the last line.

Saying it's "moot" suggests that it's not worth doing at all. Why would this be so?

From the info I've been able to gather on the web, T-bonds in the past have been callable only after 25 years, and when the bond is issued, the earliest possible call date is stated. (Otherwise, I would imagine it would be much harder to sell the bonds.)

So, if one collects 15% profit using OPM for 25 years instead of 30 years, that's not so bad, eh?

You did say in another part of your post that , "the scenario will probably never be fully successful", but that's far different from it being "moot".

Then again, perhaps I misunderstood what you meant, or I'm missing something about the scenario itself . . . .

I'm tempted to say something cryptic and then disappear but the truth is I don't know what the heck I'm talking about. For some odd reason, I thought that federal government bonds were callable after five years. At 25 years before being callable, though, the prospect of free money makes the strategy worth considering.

However, I do wonder if this carry trade will ever work as it did in the past. If bond rates go into double-digit range, it's entirely possible that the government will further shorten the non-callable period. Such an implicit option on the bonds may make them less palatable to investors but I question if it will truly make them more difficult to sell. My understanding is that the U.S. bond market is the biggest and most liquid of the world's bond markets. Assuming the United States isn't on the fast track to zero, I don't see any other bond markets (yet) that can scale to handle all the money from the world's pension funds.

[GRG55]

Re: The Face of Inflation: Does the U.S. Have a "Peso Problem" revisited

The U.S. dollar had a "Peso Problem" and the markets are now correcting it.

April 9, 2006 in Face of Inflation: Does the U.S. Have a "Peso Problem" we laid out a worst case scenario for the U.S. economy and dollar when the markets are finally allowed to devalue dollar. It explained that the U.S. may have what has been termed by economists a "Peso Problem."

"No one knows the precise origin of the term peso problem, but it is often attributed to Nobel laureate Milton Friedman in comments he made about the Mexican peso market of the early 1970s. At that time, the exchange rate between the U.S. dollar and Mexican peso was fixed, as it had been since 1954. At the same time, the interest rate on Mexican bank deposits exceeded the interest rate on comparable U.S. bank deposits. This situation might seem like a flaw in the financial markets, since investors could borrow at the low interest rate in the United States, convert dollars into pesos, deposit the money in Mexico and earn a higher interest rate, then convert the proceeds back into dollars at the same exchange rate and pay off their borrowings, making a tidy profit.

Friedman noted that the interest rate differential between Mexico and the United States must have reflected financial market concerns that the peso would be devalued. Otherwise, the interest-rate differential would soon disappear as investors increasingly took advantage of it. In August 1976, those concerns were justified when the peso was allowed to float against the dollar and its value fell 46 percent."

- FEDERAL RESERVE BANK OF PHILADELPHIA BUSINESS REVIEW SEPTEMBER/OCTOBER 2000: Understanding Asset Values: Stock Prices, Exchange Rates, And the "Peso Problem" (PDF)

The article proposed that the relationship that existed between the Mexican peso and the U.S. dollar in the early 1970s had developed between the U.S. dollar and the currencies of several of its trade partners. The exchange rate between the U.S. dollar has been effectively fixed by China and oil producing countries, although not fixed with respect to the British pound, euro, or Canadian dollar. As a result, the dollar has been steadily losing ground to those currencies while the exchange rate remains relatively level with respect to the currencies of trade partners that manage currency exchange rate values via a currency peg or, as in the case of China, a virtual peg. The interest rate differential between the U.S. and its trade partners, especially Japan and China, likely reflects financial market concerns that the dollar will be devalued.

With this week's emergency .5% rate cut by the Fed, the US$'s "Peso Problem" has been pushed to a crisis, starting with the announcement today by the Saudi central bank that it will not lower interest rates to import more U.S. inflation in order to help bail out the U.S. economy as it heads into a post housing bubble recession. Soon the dollar may float against the currencies of all oil producers, yuan, and others.


How far might the dollar fall and what kind of the economic impact can we expect? Unfortunately, the worst case scenario that we formulated to shock our readers into action April last year is beginning to play out.

Although the U.S. economy maintained its rapid growth during most of the 1990s and 2000s, it was progressively undermined by fiscal mismanagement and a resulting sharp deterioration of the investment climate. The GDP grew about 4 percent annually during the administrations of President Bill Clinton (1993-2001) and during that of his successor, President George W. Bush (2001-2009), except for a brief recession following the collapse of the stock market bubble in 2000. But asset prices fluctuated wildly during the decade, with booms and busts in the stock, bond and real estate markets.

Fiscal profligacy combined with the 2008 oil shock exacerbated inflation and upset the balance of payments. The balance of payments disequilibrium became unmanageable as capital flight intensified, forcing the government in 2008 to devalue the dollar by 30 percent.

Although a bubble in bond and real estate prices from 2001 to 2006 allowed a temporary recovery, the windfall from sales of financial assets to foreign central banks also allowed continuation of the Bush administration's destructive fiscal policies. In the mid-1980s, the U.S. went from being a net exporter of goods and to a significant importer. Sales of financial assets became the economy's most dynamic growth sector. Net foreign purchases of U.S. financial assets grew from 50% of issuance in 1996 to nearly 80% in 2005. Rising foreign borrowing allowed the government to continue its expansionary fiscal policy. Between 2001 and 2006, the economy grew more than 4 percent annually, as the government spent heavily on the military and the real estate and financial sectors provided more than 50% of private sector employment.

This renewed growth rested on shaky foundations. The United States' external indebtedness mounted, and the dollar became increasingly overvalued, hurting exports in the late 2000s and forcing a second dollar devaluation in 2010. The action effectively ended the U.S. dollar's status as a reserve currency. The portion of import categories subject to controls rose from 10 percent of the total in 2008 to 24 percent in 2010. The government raised tariffs concurrently to shield domestic producers from foreign competition, further hampering the modernization and competitiveness of U.S. industry. As unemployment rose to more than 20%, government policies to limit immigration fueled further increases in wage rates and inflation.

The macroeconomic policies of the 2000s left the U.S. economy highly vulnerable to external conditions. These turned sharply against the U.S. in the late 2000s, and caused the worst recession since the 1930s. By mid-2010, the U.S. was beset by rising oil prices, higher world interest rates, rising inflation, a chronically overvalued dollar, and a deteriorating balance of payments that spurred massive capital flight. This disequilibrium, along with the virtual disappearance of the U.S. international reserves--by the end of 2010 they were insufficient to cover three weeks' imports--forced the government to devalue the dollar three times during 2012. The devaluation further fueled inflation and prevented short-term recovery. The devaluations depressed real wages and increased the private sector's burden in servicing its dollar-denominated debt. Interest payments on long-term debt alone were equal to 28 percent of export revenue. Cut off from additional credit, the government declared an involuntary moratorium on debt payments in August 2013, and the following month it announced the nationalization of the U.S. private banking system.

The entire projection is speculation based on our understanding of historical determinism from the starting point we chose in mid-2006. It is meant to give a sense of how these kinds of imbalances tend to play out, although the likelihood is very low that events will unfold precisely in this way.

Even with a year of hindsight, our only major revision is to note that the process is happening sooner than we expected, and rather than being triggered by an oil shock in 2008 was triggered by a crisis in U.S. credit markets in mid 2007. In any case, we believe it's safe to say that indeed the dollar did have a "Peso Problem" and the markets are now correcting it.

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Here's some related commentary from Brad Setser's Blog over on the RGEMonitor site:

Central banks came close to financing the entire US current account deficit over the past four quarters

Brad Setser | Oct 02, 2007
I have been reserve-obsessed for quite some time now. The uphill flow of funds from the emerging economies to advanced economies strikes me as the defining feature of today's global economy. That flow is entirely a central bank and sovereign wealth fund flow.

Indeed, the IMF's data makes clear that it is still mostly a central bank flow despite all the recent attention granted to sovereign wealth funds. The central banks of the world's emerging economies accounted for $320 of the world's $340b in (valuation-adjusted) reserve growth in the second quarter, and $283 of the $303b (valuation-adjusted) increase in the first quarter. Sovereign wealth funds are comparatively small, at least in flow terms. They receive something like $30b in new inflows every quarter, or about 10% of the recent increase in central bank assets. Obviously, a big shift in the way China manages its foreign assets could change this.

One of the concluding paragraphs:
I should note that the high-frequency US data doesn’t show quite as large official flows as the IMF data on dollar reserve growth (with a couple of key gaps filled in by assumption) implies. But the high-frequency US data (the TIC data, and the BEA data that is derived from the TIC data) clearly fails to pick up a large share of Chinese, Russian and Gulf inflows. The annual survey is a bit better, especially for China and Russia. And when the US BEA data was revised after the last survey around, it – when combined with the BIS data on central bank dollar deposits in the global banking system (adjusted to avoid double counting the deposits in the US data) showed dollar reserve growth that topped my estimate of dollar reserve growth derived from the COFER
data.

[Andreuccio]

Re: The Face of Inflation: Does the U.S. Have a "Peso Problem" revisited

With all respect to Andreuccio, who's avatar is I think really cool, (I grew up maybe fifty miles away from where his chosen avatar character lived his life in central Italy - so Andreuccio please accept my comments in a sporting way).

Excellent. We'll have to talk sometime. I'd have answered your other post in Italian but I'm so out of practice...it's been a while.

If you wanted to employ these gambits to make real money you'd have to scale these carry trades up by a factor of ten, and then unforseen risks really do creep in. Try borrowing 2 million on your personal credit to earn 3.5%, and doing this little caper and see how comfortable you'd feel with the whole creaky leverage thingy.

If you, or anybody else, wants to loan me 2 million on the same terms the CC companies gave me, I'm in.

How are you going to trump the FIRE economy by figuring out how to wring $3500 USD from one hundred grand of borrowed money, while taking a year to accomplish it? Inflation alone risks making this merely an academic exercise.

Inflation only decreases the return. It's still guaranteed, only diminished slightly. My pay at work has diminished by the same amount over the year due to inflation, yet I keep showing up for my job. And, given that I only put in a few hours total to do this, I still made way more per hour that I would have made working.

This kind of play is like getting dazzled by one's own smooth methodology, by an elegant concept for squeezing profit from ultra low risk gambit, and yet after a full year of your life goes by you've only gained some very small pocket change?.

I didn't spend the whole year working on this. I set it up, then put the payments on automatic bill pay. I've probably spent more time explaining it to you than it took aggregate to complete the whole transaction. And while $5000 isn't going to make or break me, if somebody handed you 5k for doing essentially nothing, would you refuse it.

The thing that will in the end stump you in this approach is that while it employs a flawless planning and execution, so you feel you've pulled off some smart riskless coup, you've really only gotten distracted from your serious investments because it returns little to nothing!

It didn't distract me at all. It was just a little bonus for a few hours, if that, of work. You might as well say I shouldn't show up for my job because the pittance I make isn't worth the time and the distraction from my serious investments. (Actually, that might be a valid arguement. I think I'll take a few days off. )

I keep comparing this to what Charles Mackay did. It's almost painfully simple. No outsmarting of any FIRE economy system, no carry trade, no sophisticated and agile footed plans for a small short term result. Just one, very big shift and allocation - giving up the warmth and coziness and beguiling emotional security of one's own home (imagine that Raja!), to allocate a really significant part of all one's total worth to un-leveraged gold, right when everyone else is going absolutely GAGA about leverage and carry.

That's only the first part of this play. Then you have to have the conviction to sit like a Buddha (and no banality or disrespect is intended to this wonderful and inspiring diety) and the calm and detachment to let this simple bet against massively abused leverage worldwide accrue all of it's power - across an entire decade.

You put this one simple hand of cards on the table, and that's your only play, for a decade.

Apples and oranges. Charles Mackay made a huge, brilliant bet, with his house and money. I worked a small angle I found that gave a guaranteed payout with OPM, no risk and little time invested. There's no reason I, or he, couldn't do both. (Except I don't really want to sell my house.) They are in no way mutually exclusive.

Anyway, I didn't design the FIRE economy, I just live in it, and I've got a couple of little mouths to feed. Gotta' make a buck somehow. :cool:

[Andreuccio]

Re: The Face of Inflation: Does the U.S. Have a "Peso Problem" revisited

The carry-trade Andreuccio mentions with the credit cards uses the best and surest technique to get rich in a FIRE economy: always use other people's money.

A kindred spirit.

At a 0% rate and assuming no initial transaction fee, any interest earned in a CD is pure, sweet profit.

There was a small transaction fee. 3%, but capped at $75. In the year since I set that up, I find the cap disappearing in offerings I receive. Banks are now charging 3% with no cap, making this particular carry trade much less attractive.

The only ways one can lose money on this strategy and the mitigating factors are:

• You fail to pay the bank on time. 5% of OPM is a lot of money--you're going to have to earn it.
• The bank where you bought the CD becomes insolvent. Always make sure your money is government insured; you don't get any extra yield on the uninsured amounts.

Precisely. I set it up on automatic bill-payments with my bank. I could draw down the CD if I needed to to cover the monthlies. I've been unwinding it the last couple of days, and this is the trickiest part. Screw up, click the wrong button, and try to pay it off out of the wrong account or something and all of a sudden I've got a bounced check and a months worth of interest due at 9%/year. :eek:

If I were actually over $100k, I would have split the deposits into two FDIC insured accounts.

As for the hit to one's credit rating, what does it matter? For the relatively well-heeled speculator, credit is a mere convenience and not a necessity.

Um, "relatively" is the operative word here. But it's not like AMEX is going to cancel my card because I drop from the 700's to the 600's. I've already got a house and a car. What do I care?:rolleyes:

The ideas sound hare-brained because they rely on side effects of the FIRE economy. Being that a FIRE economy is just a con game, it is really all that surprising that some really stupid ideas actually can make money?

Hey, who you callin' stoopid?:mad:


Thanks for clearly stating the arguements.