GARY NORTH EXLAINS CHINA'S NEW STIMULUS PLAN

Gary North's REALITY CHECK Gold's price: http://www.GaryNorth.com/snip/300.htm The Federal debt: http://www.GaryNorth.com/snip/544.htm To subscribe to this letter: http://www.snipurl.com/subscribenow Issue 805 November 11, 2008 CHINA PULLS THE SECOND TRIGGER I'll bet you missed the first. I did. So did everyone else, except for one lone observer. The second trigger is this: China announced on Sunday, November 9, that it will launch a two-year program of subsidies amounting to something in the range of $600 billion. http://GaryNorth.com/snip/698.htm There were no details about how the government will do this. The magnitude of this sum is staggering. China has 1.3 billion people. It must therefore tax, borrow, or print the equivalent of $450 per capita. In 2006, per capita income was around $1,700. It's probably still under $2,000. The initial response of the financial press was positive. This policy is pure Keynesianism. This has been the governing theory of Western economies since 1945. The pundits embrace government spending. The Dow Jones Industrial Average opened up 200 points on Monday, the day after the announcement. It immediately turned south. It closed down 73. China is not in a recession. Its rate of growth slowed to 9% in the third quarter. That is down from 12% in 2007. (These are government figures.) It was the fear of 6% growth in 2009 that prompted this announcement. The government is terrified of a slowdown to merely double what the West is predicted to experience in 2009 (IMF estimate). The government of China is following in the footsteps of the failed policy of infrastructure building that Japan adopted in 1990. Japan spent the next decade and a half in slow growth, with mounting government deficits. It is assumed that China can somehow afford this expansion of government spending without distorting the economy. This move is not seen as a return to the Communist policies of the pre- reform era. It is seen as a belated adoption of Keynesian policies of government-directed spending. It is a repudiation of the free market in the name of a managed economy. This was the second trigger. What was the first? THE FIRST TRIGGER This has received no publicity. The man who discovered it is not famous. He published his findings in an English-language edition of a Mexican periodical. He says that he has searched the Web for a month, looking for some announcement and analysis of what the figures reveal. Nothing is on-line. The figures reveal that the world's central banks have ceased buying each other's debt. Take a look at the chart he published. It shows a nearly exponential growth in reserves until August. Then, without warning, they ceased. There was even a slight sell-off of securities in September. http://GaryNorth.com/snip/699.htm Prior to August, reserves had been growing at more than 25% per annum. Could the figures be incorrect? Yes. But the supreme issue is the trend, not the accuracy of the data-collecting. What would cause the world's central banks to stop buying government debt obligations, meaning primarily debt obligations of foreign governments? This answer comes to mind: fear of an international currency crisis so severe that major governments will default. Under normal times, this would not seem possible. But times in which central banks decide not to buy any more foreign currencies are not normal. This development is eerily similar to the situation facing the domestic credit markets. Bankers worry about lending to other banks. The Federal Reserve then intervenes to announce a target rate for the overnight loan rate among banks. This is the Federal Funds market. This persuades bankers that the FED is guaranteeing liquidity and therefore repayment. They lend to each other. There is no central bank for central banks. There is no top of the pyramid. This weekend, there will be a meeting of the G-20 nations. The topic under consideration is a restructuring of the international financial system. There is talk of the creation of a new international central bank. To get central bankers to submit to an international bureaucracy seems like a long shot. Talk of such an institution goes back to the 1970's. It has never been proposed officially. Over the next few weeks or months, this trial balloon will be floated: a new international central bank. If the credit crisis is perceived as severe, or threatening to become severe, central bankers may buy it. This would function as a cartel of cartels. The problem is, this central bank could not control the fiscal policies of the nations. Nations are free to run fiscal deficits or surpluses. There can be interest rate differences. There can be written rules governing deficits, but there is no agency to enforce these rules. There is no common civil government. The complexity of these problems will hamper any attempt by bureaucrats to come to an agreement regarding currencies and a common central bank. Central bankers do not fully trust each other, nor do they trust each other's governments. Under the international gold standard from 1815 to 1914, there was touchstone for honesty: redemption of a nation's currency for gold. This ended in 1914. From then until now, politicians have sought an arrangement in which politicians retain sovereignty and currency exchange rates retain stability. They have searched in vain. INTEREST RATES This new development means that nations must now finance their deficits without intervention of foreign central banks. International investors, domestic investors, and domestic central banks must supply a market for each nation's national debt. Inside the Western countries, we are seeing a lowering of interest rates. We are also seeing the decline in stock markets. These are part of the same phenomenon. Investors are selling stocks and buying bonds, especially government bonds. The perception is that bonds issued by sovereign nations are not subject to default. Their risk premium is low. Investors know that the central bank stands ready to purchase these bonds if taxes are insufficient to keep making payments to bond owners. Investors think they will be able to get out of long-term bonds before inflation hits. But an insurance company cannot easily do this. It wants predictable income to match its statistically predictable outflow. Fear of the stock market, fear of rising risk of default, and fear of the state of the economy combine to provide a subsidy for government debt. For as long as the economy remains precarious, the U.S. Treasury will be able to sell debt to investors at low rates. But every dollar that moves from the private capital markets to the U.S. Treasury erodes the ability of the free market to restore economic growth. This is a downward spiral. As more bankruptcies take place, as more corporate Rocks of Gibraltar sink into the sea of default, the investors will lose faith in the private capital markets. This re-directs wealth into the hands of government. The economy performs worse. This subsidizes the government debt market. What can reverse this? Two factors: (1) economic recovery; (2) price inflation. If the economy appears to be recovering, investors will sell short-term Treasury debt, which today pays less than the rate of price inflation. If price inflation reappears, due to Federal Reserve monetary policy, people will pull out of the government debt market to buy assets that may do well in an inflationary period. The commodities market will recover, not because of increased demand from industry, but as a bubble. At present, the FED is in panic mode. According to the Federal Reserve Bank of St. Louis, the FED has increased the monetary base by almost 800% from mid-September to early November. This was up from 341% between late August and late October. In other words, the rate of monetary inflation is accelerating rapidly. M1 is rising rapidly. What is not rising is the multiplier, which is falling rapidly. Banks are keeping funds as reserves at the FED. They are paid interest now, a new policy adopted on October 3. This retards the expansion of money. It is the equivalent of raising reserve requirements. For now, Treasury rates are lower across the board. Fear is doing its government-subsidizing work. But fear will move from recession avoidance to inflation avoidance. At that point, the Treasury bond market will begin its steady decline. The corporate bond market will begin even earlier. FROM MERCANTILISM TO KEYNESIANISM If only domestic purchasers and foreign private purchasers of debt are bidding for a government's debt, this means that the domestic central bank must pick up the slack. If the People's Bank of China refuses to increase its holdings of Western debt, then two things will happen: (1) it will see its currency rise in relation to foreign currencies; (2) it will export less to those countries. China has responded accordingly. It is now using government spending to shift the economy from exporting to domestic consumption. This is exactly what the West's central bankers have been telling China to do for years. China is not responding to these demands. It is responding to a fall in export demand. Politicians are inherently Keynesian. They do not want unemployment. They see government spending as a way to offset declining private consumption. The new policy will shift consumption from Americans and Europeans to Chinese citizens. This is not being done by the free market. It is being done by the government. It is pure Keynesianism. If this policy is accompanied by increased monetary inflation, the yuan will not rise. So far, it is not clear where the government will get the funds to spend: taxes, borrowing, central bank inflation, or the sale of currency reserves. It could get them by selling dollars and buying yuan. This would raise the value of the yuan and further decrease exports. My guess is that the central bank will inflate even faster. The government is now more worried about an economic slowdown than price inflation. Any recovery will bring price inflation with a vengeance. DECLINING TRADE If central banks are no longer intervening to subsidize their currencies, they will rise in value. But the dollar has risen most. Why? Because of the same reason Treasury rates have fallen: fear of default. The dollar is still seen as a safe haven. Private investors are still investing here even though central banks have ceased to add reserves. Trade is falling rapidly. The Baltic Dry Index has collapsed in recent months. This is the index of trade in coal, steel, and industrial commodities. The decline is nothing short of breathtaking: from 12,000 in June to a little over 800 today. http://GaryNorth.com/snip/700.htm This is a sign of the extent of the recession. It is international. It is killing demand for industrial commodities. This is because producers perceive that consumers are not going to buy their output. This is the way the free market ought to function. The free market lets consumers determine the value of goods. The profit and loss system rewards entrepreneurs who see what is coming and respond. The correct response is to stop buying production goods. It is to move to cash. Batten down the hatches. This is a good thing, if we believe in the legitimate authority of consumers. If they want to cut back on spending for consumer goods, the market should respond. Anything else is wasteful. But the central banks and the politicians want to substitute their judgment for consumers' judgments. They tax, spend, borrow, and inflate. This merely redistributes losses. The big losers will be taxpayers and holders of cash. But, in the meantime, it pays to hold cash. CONCLUSION China has pulled both triggers. Its central bank has ceased to buy Western government debt. Its politicians are moving to a domestic stimulus policy, which will move production toward large-scale public works projects and anything else the government wants to subsidize. Unless China soon resumes the purchase of Western government debt, the yuan will move up. This is bad news for Wal-Mart.