China's Options Doom The US

Last month a storm blew over a big oak tree in my yard. The tree split at the base and I could see about a third of the trunk was eaten from the inside-out. Evidently termites have been chomping on the inside of the trunk for years, the tree had weakened and it could no longer stand the 50 mile per hour winds what blow through my town once or twice a year.

The U.S. economy is starting to show signs of life with retail sales stabilizing and stocks rallying, but don't be fooled. The U.S. economy is rotting from the inside-out. For years, termites who live and work in the White House, the U.S. Congress and lead narrow special interest groups have been slowly but surely eating away at the foundation of the U.S. economy. All their spending and borrowing has weakened and is further weakening the economy. As a result, the U.S. economy’s ability to withstand economic shocks, recessions or slowdowns is declining.

Like it was impossible to predict when the next 50 mile per hour wind would blow through my yard, and whether or not my rotting tree would withstand such a force, I don't know when the U.S. economy will blow over by this economic shock or the next recession.

What is clear, the economy is rotting from the inside-out and the last economic shock (the sub-prime mortgage crisis) nearly blew the economy over. It is just a matter of time until we get another shock (like 9-11 or another S&L crisis), and the next time the U.S. economy may not be so lucky.

This is a long explanation, because this economic chain has many links. Read this a couple of times, and if you do, you'll be the only one on your block that truly understands what the U.S. is facing.

The rot is rooted in Washington, with the excessive federal spending and borrowing that has been going on since the first Reagan administration, and continued the next twenty years and is now accelerating at a record pace under President Obama and the Democrat Congress.

For thirty years now, the U.S. government has been spending all this, bringing in only that, and borrowing the difference.

U.S. citizens save only about three or four percent of their income. Therefore, to fund the large annual U.S. deficit (now about $1.9 trillion), the U.S. government is dependent on borrowing savings from all over the world. A recent article I read said 70 percent of all new lending to the U.S. government comes from foreign sources.

Foreigners lending to the U.S. government involves two steps. Let's say Wolfgang Besser of Germany wants to lend money to the U.S. government. He first must exchange his Euros for U.S. dollars. Second, he takes those dollars and buys Treasury bonds or lends his dollars to the U.S. government. The act of selling his Euros and buying dollars strengthens the dollar on the foreign exchange market.

Given the U.S. deficit is so large, the U.S. government has become a global black hole that is sucking-in credit from around the globe. Given these two steps are happening on such a massive scale, it has made the dollar strong.

A strong dollar gives U.S. citizens and businesses high purchasing power in the world market for goods. For example, let's say in China it costs 20 yuan (the Chinese currency) to buy a pair of shoes. Let's also say for the sake of this example, the exchange rate for the dollar vs. the yuan is 1 to 1. That means a U.S. importer can start with $20 dollars and exchange it to 20 yuan and then buy 1 pair of shoes in China.

Next, let's say the dollar doubles in value relative to the yuan and the exchange rate becomes 1 to 2. Thus the U.S. importer can start with $20, exchange it for 40 yuan and buy 2 pair of shoes in China. In terms of U.S. dollars, the price of those shoes is now half. The strong dollar lowers the price of goods made in China and elsewhere around the world.

Now it is time to add another link to this economic chain. As the U.S. government's fiscal deficit has grown, it has caused the dollar to strengthen. A by-product of that is it has made imports much cheaper to buy and that is why the U.S. has been importing so many goods from around the world.

Think of the steps that take place when a U.S. importer buys shoes from China. He starts with $20 dollars, goes to a Chinese bank and exchanges his $20 dollars for 40 yuan. That is, he gives the Chinese bank $20 and is given 40 yuan. He takes that 40 yuan to the Chinese shoe manufacturer and he buys the pair of shoes. The importer then brings those shoes back to the U.S. and sells them at Walmart for a profit.

Because of this transaction, the Chinese bank has an extra $20 U.S. dollars in it. At this point, the Chinese bank has three choices

Choice C: It can save the $20 dollars by lending it back to the U.S government, and buying a Treasury bond that earns interest for the Chinese bank.

Because of this long chain of events, starting with the large U.S. deficits being financed by foreigners, we've got a dollar that is overvalued. That strong dollar leads to all these U.S. imports from China and elsewhere. As a result, China now holds $1.6 trillion in U.S. dollars.

China is holding $1.6 trillion in U.S. dollars. That doesn't include the hundreds of billions of U.S. dollars other exporters like Japan, Middle Eastern oil producers and European countries hold.

Looking back at the three choices China has concerning its U.S. dollars, you'll see all three have harmful consequences on the U.S. economy.

Choice A: China can use its $1.6 trillion of dollars to buy U.S. assets. And it has. China has been buying U.S. real estate, U.S. companies and I believe U.S. politicians. Whenever any individual, company or country spends more than it makes and borrows the difference, it is forced to put-up its assets for sale to help bridge the gap between its income and spending.

American has been and is up for sale and we were experiencing a slow but sure economic invasion that we can not defend ourselves against.

Choice B: China can immediately sell its trillion of U.S. dollars on the foreign exchange market and buy yuan, yen, Euros or any other currency. This will cause a long-term downtrend in the U.S. dollar.

Remember, the U.S. government has a $1.9 trillion deficit it has to fund and most of that credit comes from foreign lenders. Will Wolfgang Besser of Germany continue exchange his Euros for dollars, then lend those dollars to the U.S. government for 5 years, if when he gets back those dollars they are worth half of what they were worth before? No way.

If China dumps its dollars and the dollar begins a long-term downtrend, foreign lending to the U.S. will dry up. Yet, the $1.9 trillion U.S. government deficit will still have to be financed, so U.S. interest rates will have to rise significantly to entice U.S. citizens to refrain from spending and instead lend their money to the U.S. government. Rising interest rates will kill U.S. economic growth and there is a risk the U.S. economy could collapse under the weight of all its debt and declining national income.

Choice C: China can save the $1.6 trillion and lend those dollars back to the U.S government by buying Treasury bills, notes and bonds. China has done this in the past to a tune of about $700 billion. China is also continuing to lend new dollars back to the U.S. government that it is continuing to receive due to its trade surplus with the U.S.

Not only will this year's U.S. deficit be $1.9 trillion, but we are looking at deficits that big for years to come. If China slows or stops lending new money to the U.S., interest rates will have to rise significantly to entice others to lend to the U.S. Depending on how high rates have to go, best case it will slow the economy. If rates have to go extremely high to attract the savings the U.S. government needs to borrow, an economic collapse will occur.

The other way this can go bad is China decides to stop lending new money to the U.S. and it also decides to sell some or all of the $700 billion in U.S. T-Bonds it already holds. That is, China decides to call back their existing loans.

This will cause interest rates to rise significant to entice others to lend to the U.S. government. Again, rates will rise and that will cause a deep recession or economic collapse in the U.S.

Some may say, Alex, there is a choice you are missing. The U.S. government can spend less and balance its budget. That is possible, but given the Obama administration's deficits are 4 to 5 times the previous record, that is not likely.

Best case is China continues to hold all the T-Bonds and dollars it has and it continues to lend even more money to the U.S. and its dollar reserves rise and rise. That won't continue to forever. Sooner or later, that will end, and given the concern China is expressing about all the new U.S. spending/ borrowing and printing of money, I think China’s appetite for U.S. dollars is on the decline.

Sooner or later the termites in the tree in my yard ate enough of the tree truck that any wind storm was going to blow it over.

In time another nasty economic wind will blow. This last time it was the sub-prime mortgage crisis. Next time it will be something else, and it will scare the Chinese and other foreign lenders even more and they’ll look to jump out of this U.S. Dollar Tree before it gets blown over. If the Chinese and other foreigners slow their lending, stop their lending or sell the dollars and T-Bonds they hold now, Tim-ber!

The result will be increasing interest rates that will blow over the U.S. economy like a 50 mile per hour wind that downed the rotten tree in my backyard.

When will the economy be blown over, and what will the collapse look like? I don't know. It depends how long foreign lenders remain confident lending to the U.S. government. They may continue to do that for another 10 years. They may change their mind tomorrow.

It is like an earthquake to a degree. Usually there is a tremor or two and then the big quake hits. The sub-prime mortgage crisis and the fact that it nearly took down the financial system in September was a tremor. We may have another tremor or two, before the collapse.

Take steps to get yourself out of debt, pay off your house and your car and put yourself in liquid assets. That's the best advice I can give you.