Monday, March 01, 2010

When Debt-Junkies Go Broke, So Do Mercantilist Pushers

This Week's Theme: "I've got a bad feeling about this..."

Merchantilist nations with competitive advantages due to currency manipulations are the pushers/lenders; the consumer nations are the junkies.

This week's theme will be familiar to anyone who has seen the original Star Warsfilms in which Luke, Leia or Hans Solo utter the ominous words "I've got a bad feeling about this..." just before a crisis strikes.

I've got a bad feeling about the Eurozone and here's why: when debt-junkie consumerist nations go broke, so do their merchantilist pushers.

China, Japan and Germany are the merchantilist "pushers," the nations which are structurally dependent on exports for their growth and profits.

The U.S., the U.K., and the "PIIG" countries (Portugal, Ireland, Italy and Greece) are debt-junkies, endlessly borrowing vast sums to enable their addiction to public "Savior State" spending and private consumption.

Like any good drug pusher, the merchantilist nations lower the price of their goods via currency manipulations to hook the addict nations on their goods, and then feed the debt-junkies' consumerist "habit" with low-interest loans drawn from the immense profits reaped by selling to the junkies.

This arrangement is enhanced by a global environment of low-cost, abundant credit pumped out by central banks and governments everywhere.

The "trade" (heh) of goods paid for with money borrowed from the pusher continues to be a "good deal" for both pusher and junkie until the debt-addicted nations can no longer borrow enough to feed their "habit" and pay the interest on their fast-rising debts.

This occurs because it takes more and more debt to create a GDP "high" (the euphoria of endlessly rising consumption and resultant "growth" in GDP), just as the heroin addict finds it takes more and more "junk" to produce the desperately desired euphoria.

Merchantilist China's manipulation of currencies to create an unbeatable competitive advantage is very straightforward: it pegs the renminbi to the U.S. dollar. This is manipulation by fiat: it's more less the equivalent of strong-arm tactics to "introduce" the potential addicts to the exceedingly affordable pleasures of the "junk" (smack).

Germany pursued a much more subtle and pernicious strategy: the euro. In a poorly understood but brilliantly merchantilist move, highly efficient Germany roped the potential debt-junkie nations into the eurozone, in which all nations would become more efficient by sharing the common currency.

This sounded good to the consumerist nations, but they didn't understand that the euro gave Germany a stupendous structural competitive advantage: in effect, the euro raised the costs of less-efficient labor and capital in the PIIG nations, locking them into a currency which made German goods cheaper than domestically produced goods.

In the pre-euro era, when overconsumption and over-borrowing began crippling a PIIG economy, the imbalance could be corrected via currency depreciation. That is, the Greek drachma would fall in value versus the German mark, effectively raising the cost of German goods to Greeks, who would then buy less German products. Over time, the currency devaluation would restore the supply-demand and credit/debt balances between merchantilist and consumer nations.

Merchantilist nations' exports falter when consumer nations reduce consumption, so the merchantilists either peg their currency or manipulate it via other means (the euro) to keep the cost of their goods low. In the initial addiction phase, everyone is delighted with the arrangement; the merchantilist pusher-nations rapidly increase exports and profits (German exports rose by an astonishing 65% between 2000 and 2008), and the debt-junkie nations find they can borrow immense sums of money at low interest rates to support their consumerist habit.

Please see this BusinessWeek article for more on this topic: Angela Merkel, the EU's most powerful leader, has to save Europe from itself.

But eventually the "honeymoon" ends as the costs of servicing the stupendous debts incurred start rising, trimming consumption and imports as the debt-junkie nations have to divert more money to paying interest on past debt.

This makes global lenders nervous, as it becomes increasingly obvious that the rate of borrowing is completely unsustainable; the cliff of default is visible just ahead.

As noted above, this looming default is exacerbated by the pernicious need for ever-larger amounts of borrowed money to sustain feeble GDP "growth" (is it really growth if it's all based on borrowed money?). Borrowing rises astronomically, and as the risks become painfully obvious, interest rates rise, too, boosting the costs of servicing the debt accumulated in the "honeymoon" phase.

Now the merchantilist pusher-nations (China and GermanY) are getting angry with their hapless junkies. They foolishly assumed the junkies would be able to borrow endless sums from someone other than the pusher-merchantilists themselves.

But alas, nobody except the oil-exporting nations is raking in the massive profits from exports which can be lent to the debt-junkies. The merchantilist pusher-nations are now the "last lender standing": there is no one else willing to lend to the obviously doomed debt-junkie nations except the pushers themselves.

The merchantilist pusher-nations are now in a bind. If they stop lending more money to the consumerist junkie-nations, then their exports and profits will dry up, triggering domestic turmoil. But if they continue bailing out the junkie-nations so they can keep buying the merchantilists' exports, then the merchantilists will become dangerously exposed to the inevitable default of the debt-junkie consumer nations as they attempt to overcome the growing imbalances by borrowing ever-greater sums of money.

China has attempted to bypass the merchantilist dilemma by squandering trillions of yuan in domestic stimulus which has mostly ended up in malinvestments like real estate speculation. China's real estate bubble is now so gigantic that its collapse is inevitable. The losses will be as spectacular as the crash.

Please see my article on AOL Daily Finance for why this is predictable: Why China Can't Cool Its Overheated Real Estate Boom

Germany is harrumphing and whining, but they face the same bleak choice as China: either bail out the debt-junkie nations so they can continue to buy more goods from export-dependent Germany, or let them collapse in default or withdraw from the eurozone, at which point they will no longer be able to afford to buy German goods.

The unhealthy pusher-junkie relationship always ends badly; the junkie runs out of the ability to borrow more money to feed his habit, and the pusher has to abandon him to the gutter to either expire or suffer the agonies of debt-withdrawal.

The debt-junkie nations are already moaning in pain, and the merchantilist pusher-nations are annoyed and impatient. But it's the pushers who manipulated the currencies to create unbeatable competitive advantages, and so they have no one to blame but themselves.

They are now kicking the hapless debt-junkie nations in the ribs, demanding that they borrow the money needed to support their consumerist habits from somewhere, anywhere. But the lenders willing to extend cheap abundant credit have vanished. Now there is only increasingly costly credit available to the doomed junkie-nations, and even that will dry up soon enough as the end-game of default becomes ever more inevitable.

The biggest debt-junkie, the U.S., is blissfully high on the illusion that it can borrow money at near-zero-interest forever. It will soon be kicked in the ribs by reality and the delusionary high will turn into agonizing pain.

The merchantilists has supported the U.S. debt-junkie for years, enabling it to add trillions of dollars in debt every year. Now doubts are creeping in as it is becoming obvious to everyone that even the U.S. cannot borrow $1.6 trillion a year forever. Interest rates are about to notch higher, and at some point they will explode higher, dooming the debt-junkies, the U.S. included, to default or ever-higher interest rates.

What few seem to realize is that once the profits and reserves of capital dry up, then the well of cheap, abundant credit will be dry, too.

When the junkies go broke, so do the pushers.

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