The Notion of Safety

There is so much that I read about economics that strikes me as not just flawed, but so completely idiotic that it makes me want to light my hair on fire. I ran across just such an article this morning

http://www.forbes.com/sites/steveforbes/2014/05/19/why-one-ivy-league-economist-thinks-the-u-s-dollar-is-invincible-and-what-this-means-for-investors/

Forbes Magazine interviewed Cornell economist Eswar Prasad on his view of how the dollar became invincible. He started out making a very salient point, the massive issuance of Fed liabilities and government debt should have weakened the dollar considerably. It has not as there has been nearly infinite demand for dollars and dollar receivables.

I agree with this. As I have pointed out in other posts, the Asian crisis of 1997-8 convinced the emerging countries of Asia that having large dollar balances were needed to protect themselves from periods of sustained financial outflows during periodic bouts of panic.

They then went on a binge of dollar accumulation, and we see from IMF COFER reports that foreign exchange reserves held worldwide grew nearly seven fold between 1999 and 2013.

This has been a fundamental driver in allowing the U.S. to experience three major asset bubbles over this time.

Professor Prassad:

Now, emerging markets want a lot more foreign exchange reserves, which need to be held in government bonds. Financial institutions have to hold more safe assets, and private investors want more safe assets. The supply has shrunk, the euro zone isn’t quite what it seemed like it was—the safe part of the euro zone is quite small, actually. Germany and a handful of other countries.  Japan and Switzerland, don’t want money coming into their economies. So, who’s left?  The U.S. And the U.S. is doing its bit for the world by prodigiously providing large amounts of safe assets. That is U.S. government securities.

What I want to challenge here is the good professor’s notion of safety.

Yes, the U.S. started issuing prodigious amounts of securities after the financial crisis as budget deficits were running at nearly 10% of GDP per year for a while. What I don’t quite understand is just how anything in the financial world that is issued in prodigious quantities can be considered safe?

Even today, the budget deficit amounts to about 4% of GDP while government debt yields next to nothing and GDP growth limps along at Depression era rates. Someone that has to borrow 4% of GDP per year in a system where GDP grows less than 2% per year is going to have a financial accident at some point.

Additionally, government tax receipts are artificially high currently given the out of control explosion in equity prices driving massive capital gains tax payments for the government.

I have a hard time viewing these securities as safe under these conditions. Unfortunately, an even bigger issue exists, holders of Treasury debt must compete with other asset classes as well and this problem is monumental.

There is an old children’s riddle; which weighs more, one pound of cotton or a pound of lead? The answer, of course, is that they both weigh the same.

Applying the same rationale, which is more valuable, $1000 in equities or $1000 in Treasury debt? Again, they both have the same value and are exchangeable for the same amount of goods and services.

Just looking at the prodigious amounts of Treasury debt that has been issued is pretty meaningless since we must look at how fast we have been issuing other dollar based claims (stock values, other new debt issuance, real estate increases, the value of small businesses etc.) as well to see if Treasury holders have an increasing, decreasing or constant claim on the amount of goods and services that exist in the system.

If a Treasury holder earning his 100 basis points per year sees an infinite number of other dollar based claims being created each year he just might want to consider that the debasement is making him worse off over time. Wouldn’t an investment that buys much less tomorrow be an unsafe security holding?

You can see where I am going with this. According to the Fed’s Z.1 reports, we can see that Household Net Worth (total dollar receivables) has increased $31 trillion over the past ten years, or about $3 trillion per year (and this excludes those dollar based receivables that foreigners are piling up in Prasad’s dash for safety). Given that GDP averaged about $15 trillion per year over this time frame, we can see that dollar claims grew at a rate of about 20% per year relative to GDP. Unfortunately, real GDP growth averaged less than 2% per year and savings as a percent of GDP averaged about 1% over this time period. Real goods and services to back up all of these incremental dollar based claims do not exist. Either the value of these dollar based assets must fall or the value of goods and services must increase enough to balance all of the claims we have been creating. This would mean CPI type inflation.

Dollar based assets cannot be considered safe. The inference of safety here neglects the basic notion that these dollar based receivables are claims on goods and services and these claims are growing far faster than the goods and services that back them up. This is the fundamental economic imbalance of our time. All dollar based assets are being debased and are very unsafe if one wants to preserve purchasing power.

In the investing world we often see that good ideas in the beginning become silly when everyone starts to participate. Tech stocks were a good idea in 1990 and a very bad idea in 1999. Las Vegas real estate was a good idea in 1999 and a very bad idea in 2007. For the emerging market countries having dollars in 1997 would have been a good idea and, it seems to me, a very bad idea today.

What Professor Prassad hasn’t noticed is that the emerging market countries have started to change their behavior over the past couple of years. As I noted in my initial post on this blog, holdings for foreign central banks at the New York Fed have been falling of late and have fallen in each instance of emerging market turmoil since 2011. Perhaps they have already discovered something that the good professor has not; dollars issued in infinite size aren’t all that safe any longer. The move by China and Russia to conclude their huge gas deal recently, almost certainly to be settled in a currency other than dollars, is another indication that emerging markets aren’t viewing the dollar as the safe haven that they once did.

Anything issued in near infinite amounts, as we see with dollar based assets today, cannot be considered safe. I have a word for economists who think otherwise, gullible.

 Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.