China, the Dollar and Sovereign Debt

Quite a few observers are suggesting that China could/will bring the U.S. down by suddenly dumping its dollar-denominated Treasuries and Bonds, thereby creating a mass exodus from the delicately-perched $US, dramatically raising bond yields and thereby interest rates in general, resulting in a global economic crash and a “reset” in currency values and a realignment of world powers. As the second largest holder of $U.S. sovereign debt (the Federal Reserve has now moved into the #1 position), it is certainly plausible for the Chinese to do this. But in my view this scenario, at least as a deliberate action, as opposed to a reaction to some other external trigger, is extremely unlikely. Why would the Chinese rock the boat unless the perceived benefits outweighed the associated costs (such as loss of the remaining value of their $U.S. denominated paper assets, crippling of their export-oriented manufacturing base, etc.)?

However, our financial system is increasingly perched atop an unstable ledge. Interest rates are held artificially low by constant central bank backstopping of sovereign debt in an attempt to keep the economy (and banks!) from collapsing. Remember, bond yields are inversely related to bond prices! The U.S. Federal Reserve, for example is pumping at least $85 Billion a month into Treasuries, bonds and other debt instruments. The resulting super-low-interest rate environment has created a mad scramble for investments that have a higher rate of return than the 1% or 2% available from traditional “safe” investment vehicles. Middle class savers can either join this scramble into increasingly higher-risk ventures or be savaged by returns lower than inflation. Those funding their own retirements are finding that even $2 Million savings earns a paltry $40,000 in annual interest. Meanwhile, stock markets have surged to record highs and sovereign debt yields, even for Italy and Spain, have declined. All this is taking place while outstanding sovereign debt continues to accumulate. The chart below shows the deteriorating European debt situation.

 The divergence between the actual situation and the financial pricing of risk in bonds and securities is increasing. As recently as last week, S&P downgraded France's credit rating. Did this cause French bond yields to rise? Of course not. They are stuck at a nice 2.2%. In layman terms, everything is increasingly out of whack in the financial, investment and monetary world. Price discovery is dying. Manipulation of interest rates and other markets is forcing money where money shouldn't be and forcing risk to be mispriced by a large margin. New bubbles are forming.

The Chinese and most everyone else with big money on the table know this but are riding out the trend supported by ever-increasing central bank intervention variously labeled as stimulus, quantitative easing, monetary aggregate adjustment, etc. So the Chinese seem to be preparing for that day, whether they, the Chinese, or some other event triggers a run from sovereign debt and the affected currencies, say, the Euro, the British Pound, the Yen and the $US. They have been purchasing large amounts of gold and entering into increasing numbers of Renminbi/Yuan currency swaps with other nations in an apparent move to initiate the internationalization of their currency as a possible prelude to eventual reserve currency status for their currency. 

Perhaps a rapid transition in mind-set is not imminent but some unexpected trigger could cause a rush for the exits at any time. It's really a state of mind as well as a collective assessment of when the end of the rope is reached for central bank printing actions. Most folks know none of this is repayable, after all, and the wiser ones are warily eying the exit doors for signs of  mass exodus. I suspect that the Chinese are in that category. They have too much to lose to be the last ones out the door.

Culture of Ignorance

I've been quiet lately. I feel like I'm in a trance some days, watching the world spin but not really comprehending how or why things are evolving as they are, seemingly oblivious to facts and reality. On occasion, it has struck me that willful ignorance within the world's population, somewhat akin to the lemming paradigm may have something to do with it. But then I drift off.
Today I was jarred out of my periodic apathy again by Jim Quinn's fine post entitled "Culture of Ignorance". He has eloquently put down in words what I've often begun to assemble in disjointed thoughts over the last 10 years or so (maybe longer) but never managed to output in a cohesive way. Well sprinkled by quotes from thinkers, I strongly endorse Quinn's "Part 1 - Culture of Ignorance".

Bitcoin and Gold

I must admit to a certain philosophical attraction to the concept of a digital currency. What does Bitcoin have in common with Gold or fiat currencies? What are the differences? Will Bitcoin, or some future digital currency replace gold?  Let’s take a look at three forms of currency or money:

1) Fiat currencies like the $US, the European €, the Japanese ¥, etc.

2) Gold (and Silver)

3) Digital Currencies such as Bitcoin

	Ubiquity	Threats	Advantages	Disadvantages
Fiat	Wide	Debasement	High recognition/acceptance Long History High acceptance of notes Widely available electronic substitutes and transfer mechanisms.	Debasement Centrally controlled
Gold	Wide	Counterfeiting Confiscation	High Recognition Long History Limited supply No central control No central point of failure	Lower acceptance than Fiat Storage risk and cost Requires electronic substitutes to facilitate transactions
Digital	Low	Software fraud Technology failure Encryption flaw Gov’t sanction	Easy to transfer Easy to store Limited supply No central control No central point of failure Anonymous transfers Irreversible transactions	Low recognition Short history, unproven No physical medium Anonymous transfer-gov’t concern Lost Bitcoins unrecoverable Point of sale delays, storage insecurity Irreversible transactions Difficult to establish value Bitcoin Exchanges are unregulated

Gold and silver have thousands of years of history. Gold-backed currencies then evolved and were around since at least the Roman times interspersed with periodic returns to Gold and Silver after early debasement schemes such as clipping of gold coins or adulterating with copper caused currency collapses. Then came almost totally fiat currencies of the type we have today. They have been around in their recent manifestations for several decades backed by the full guarantee of the state! While some fiat currencies look increasingly shaky the major currencies have, with some exceptions, survived in spite of progressive debasement over the decades with very few near total collapses requiring re-establishment of the currency.

Bitcoin, on the other hand is still very, very new. It had its beginnings in 2008 and got traction largely because its design solved a number of problems that early virtual currencies failed to address. The anonymity with which transfers can be done, its lack of central control, its inability to be debased and its electronic/virtual nature are strong suits. But there are some drawbacks not the least of which is its newness. It is untested relative to the countless trials by fire for gold and silver and fiat. It is not tangible like the paper dollar or a coin. It can easily take 10 minutes or more to verify the authenticity of a Bitcoin. This would be problematic in point of sale transactions at stores, for example. But the real problem for new entrants to the currency game is government. Government relies on central control for taxation and revenue. Governments also detest things that they can’t control, sometimes for legitimate reasons such as crime control but often because it is the nature of governments to meddle in people’s affairs. This to me is the biggest challenge and risk for Bitcoin and subsequent iterations. Will government even tolerate, never mind, endorse such a new currency? I doubt it.

But forgetting government for a moment and taking a lesson from history, most, if not all successful currencies were initially launched by being backed by gold and silver. This is simply because a tangible starting point for value is usually needed for mass adoption. Once confidence in a currency is earned, the backing is typically gradually removed to permit unfettered debasement. Thus, down the road, an interesting approach would be to combine Gold, the “barbarous relic” with a virtual currency such as Bitcoin to produce a gold-backed Bitcoin which would also add the missing physical exchange mechanism. Gold wouldn’t be used for most transactions, though. It would be like your savings account. Bitcoin would be your checking account. Now the government could confiscate the gold and outlaw the Bitcoin - Back to square one! Seriously, though, for digital currencies such as Bitcoin to come out of the shadows will require wide public, merchant and government acceptance, as well as a solution to the delays inherent in verifying authenticity of a Bitcoin transaction. Some accommodation to Government demands for traceability (reduced anonymity) will likely also be a needed compromise.
UPDATE April 7, 2013: Example of Bitcoin Storage security issues: