Macro Perspectives on Global Liquidity: How Chinese Farmers and Oil Sheiks are Subsidizing American Consumption and its Implications

If you were an economist arriving from Mars and looked at capital flows around the world, you would be very surprised by the patterns you observe. Ex-ante you would have expected the wealthiest countries to be exporters of capital as return on invested capital should be higher in developing countries than developed countries. The UK was a net exporter of capital when it was at the height of its power. However, a glance at actual capital flows shows that the US is an importer of capital with a current account deficit nearing $1 trillion dollars and 7% of GDP.

Where the flows are coming from and what assets they are invested in is just as interesting. US corporations are actually net exporters of capital. The current account deficit is caused by consumer and government consumption. Almost all of the deficit is with China and the Middle East, which to date have been investing in treasury bills. Chinese citizens have an extremely high savings rate, which when combined with the Chinese government’s desire not to let the Yuan appreciate against the dollar, means that China has been buying hundreds of billions of dollars of treasury bills. Similarly, the Middle East is awash in cash given the increase in the price of oil and the low extraction costs. As domestic consumption has not and probably cannot increase beyond certain levels without unleashing inflation or the money getting wasted as it was in the 1970s, most of that excess cash has also been invested in American treasury bills.

As American treasury bills are not yielding very much and as the Yuan and Middle Eastern currencies are reasonably expected to increase relative to the US dollar, you could expect them to make little or negative returns on their US investments. In other words American consumers’ and the American government’s consumption are being subsidized by Chinese citizens and oil sheiks!

If any country but the US had a 7% current account deficit, alarm bells would be going off at the IMF and elsewhere. Fortunately for the US as the dollar is the reserve currency of the world and its debt is denominated in dollars, it can print as much money as it needs to cover the debt. The issue is that being the reserve currency of the world is not a given and geopolitically depending for funding on countries whose loyalty is dubious at best is risky. Optimists will point out that China and Middle Eastern countries have to continue to buy treasury bills and cannot sell their holdings if only to prevent the dollar from collapsing and generating significant losses on their investments. This is not a good argument. For where it to happen, the US would undoubtedly have lost its reserve currency status.

For capital flows to realign four things need to happen:

  • Consumer savings needs to increase in the US
  • Government savings needs to increase in the US
  • Consumption needs to increase in China
  • Consumption needs to increase in the Middle East

How fast this happens will determine the outcome. Historically, such adjustments were rapid and led to massive currency depreciations and recessions (think of the 1998 Asian currency crisis). A year ago, I was extremely bearish about the US economy as I felt we could be entering a perfect storm.

Specifically, I thought global liquidity would collapse as:

  • Short term interest rates rose in Japan ending the Japan carry trade were people would borrow in Yen at a 0% rate and invest in dollars and dollar denominated assets yielding much more than that
  • Short term interest rates rose in the US
  • As baby boomers started to prepare for retirement, I expected the American savings rate to start to increase
  • I expected US consumption to start declining as homeowners on variable rate mortgages faced higher bills leading both an increase in foreclosures, supply of houses, decline in prices and a further decrease in consumption

In addition, the yield curve was inverted, which was usually a harbinger of a recession to come.

I was wrong. Interest rates rose in Japan and the US. There was a real estate correction in the US. Yet throughout the period liquidity remained high. The world is still flush with cash.

Peter Thiel, a brilliant friend of mine who was founder of Paypal and now runs a macro hedge fund called Clarium thinks he knows why – and I agree with him. China also has a current account deficit with the Middle East so arguably all of the excess liquidity in the world is coming from the Middle East. As long as oil remains above $40 – and there are a lot of reasons to believe it will remain around $60 for years to come – the global liquidity glut is not about to disappear.

As both China and Middle Eastern countries seek higher returns on their investment you can expect even more money to flow into venture capital, private equity, hedge funds and real estate – despite the fact that returns have been declining and that people have been predicting a collapse for a long time.

This is why you are seeing frothy valuations for assets around the world:

  • Startups are raising money at high valuations
  • Ever larger private equity deals are happening
  • Hedge funds keep pooling ever larger sums of cash
  • Real estate prices are still increasing globally

So what does this all mean? If you are an entrepreneur trying to raise money – this is a very good time to do so! The fact that oil prices are likely to stay high suggests that the liquidity glut is likely to endure for quite some time, but you never know so take the money while it’s available! From an economic perspective, I think this explains cleanly why we have seen asset price inflation without seeing real core inflation. The last time this happened was in 1978-1979 during the last oil shock. Peter’s contrarian thinking is that this suggests that short term interest rates are not going to go down anytime soon. The asset price inflation and excess global liquidity suggest that central banks should probably have a more monetarist stance and if anything might have to increase short term interest rates. Before Volker the Fed was essentially saying: “Inflation is 10%, our interest rates are 10%, we are neutral.” Volker came in and essentially said “inflation is 10%, but asset and monetary inflation is so much higher that interest rates should be 20%.” He brought core and asset inflation under control at the cost of a severe recession that set the stage for the expansion that has essentially gone unabated ever since except for a few very mild recessions.

In other words, Peter’s contrarian stance is that the yield curve is going to become even more inverted as short term interest rates increase – at least in countries which are paying attention to liquidity growth like the UK and Japan – while long term interest rates remain low given the excess global liquidity. This story’s most likely outcome is a severe recession.

It’s interesting that while I am probably the most optimistic person I know in terms of life, humanity, geo-political outcomes and our long term success as a civilization, I am such a pessimist the US economic prospects in the short and medium run. For once, I really hope I am wrong!

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  • My assets are allocated accordingly.

    In other words, if you buy my argument that liquidity is provided by oil exporters what are the asset classes they would and would not invest in? Clearly they won’t invest in traditional energy, but instead alternative energy or condos in London come to mine.

    Given my contrarian stance here are some guidelines:

    • I don’t own real estate in the developed world. I rent my apartment and house.
    • I don’t invest in alternative energy.

    A few more things to note:

    • I don’t own any individual stocks – not just because of the random walk but also because I don’t have the time to do the research. I have a time consuming day job and would rather do something else in my spare time.
    • I don’t own any long only funds at this time.

    I hope this helps 🙂

  • Always funny to come back 6 months later on our thoughts ? So we are in August now, the toxic waste of CDO and the real estate burst in the USA made impossible to price or liquidate even AAA CDO rated bonds and now all over the world you here that Bear Stearns, IKB in Germany, BNP and Oddo in France; Macquarie in Australia closed such “cash” called funds to redemption, your neighbour is afraid he can’t withdraw his money, can’t sell his house… so Fabrice let’s continue now what do you thing what is your next step ? Do you think FED is going to reduce rates soon, too soon ?, or that the recession in the US is going to touch consumer feeling exporting China and frost the stock exchanges of the world…. Cash is King ?

  • –1–Horny Alley Cat theory of politicians suggests that they regardless of party affiliations do what is most expedient the vast majority of the time. The dollar being the reserve currency is a position of GREAT value. This position is being sold out for a price that is in line with capital flows quoted. Thus this can quickly be summarized in the Alley cat theory terms as **See hole, have sex with it, what me use a condom???** In other words if a thing has any quality it will be shabby-fied by the policians until its been so run down it can no longer be sold. Only good thing that maybe coming out of this is that the world economy is being monetized. First serious ebay sales out of the country for me only started in 07. Before that it was fairly resistant to my attempts. I see no other way that China et al. would ever play fair and buy from the USA. Even Brazil might be coaxed to lower some of their onerifous import duties if they get too fat with greenbacks. –2– The last thing that I do wonder about is this: supposing that ALL governments run on the same sort of alley cat principles then in reality are we not just reaching some thermodynamic monetary equilibrium with the rest of the world? I guess we will either lower the standard of living in the USA or raise that of the rest of the world. However with so much of the rest of the world infected by anti-biotic resistant socialism I have to wonder if possibly the USA has one last ace card up its sleeve in a residual individual resistance to socialism? It would be easy to make the argument we might have played that out also. I guess we get ride this roller-coaster and find out whether we like or ne.