The dollar super bubble may finally be popped – by the Israel-Gaza war

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Depending on the extent of disruptions to the oil flowing out of the Persian Gulf, Brent crude prices could shoot up. Inflation would rise and central banks, including the US Federal Reserve, will have to focus on cooling prices again, making it harder for them to rescue the debt market.

Meanwhile, the global money supply could increase by trillions of dollars. After September 11, the US spent an estimated US$6 trillion in the ensuing Middle Eastern wars – it may well repeat this. Such a war chest means more US borrowing: bond yields could surge to the double digits.

For now, yields remain below America’s nominal gross domestic growth of around 6 per cent, so still lower than the “cost of capital”. But rising bond yields are unlikely to slow US borrowing down anyway, when there are powerful political pressures to sustain the fiscal largesse. The US is likely to keep on selling bonds – until demand collapses.

Once bond investors stop buying US debt, the Fed is likely to step in to soak up debt – required at some point by the US debt path anyway – which would temporarily stabilise the bond market. But fears of spiking inflation will eventually return to haunt investors. The ensuing drama in the US debt market could keep global financial stability on edge for years.

Critically though, should US bond yields climb into the double digits, America’s overvalued stock and property markets would tumble. The US stock market is valued at 180 per cent of its GDP, twice as high as the historical norm. Its property valuation is about 170 per cent of GDP – an overvaluation of about 50 percentage points if we take 120 per cent of GDP as the limit of what could be justified. In an asset correction, I estimate the loss to come up to 150 per cent of GDP.
A US financial system growing less stable would make it harder for China to tie the yuan to the dollar. China’s increasingly competitive automotive sector alone could see exports jump to 20 million vehicles in 10 years, creating a trade surplus that makes its dollar “peg” unsustainable.
China’s structural labour shortage also presages wage inflation. This has been temporarily held down by cyclical economic issues, but unless China floats its exchange rate, it would experience massive wage inflation within five years. It would be forced to “unpeg”. This would allow much bigger movements in the dollar.
The massive distortions in the global monetary system, which drives financial bubbles, come from the yuan-dollar peg. When China adopted the export-led development model decades ago, it copied other East Asian economies and decided to adopt a dollar peg in 1994. This officially ended in 2005, but while one-time adjustments have occurred and controlled volatility is allowed, the yuan remains, in effect, a pegged currency.

A small economy with a dollar peg doesn’t change the dollar world. But China’s rapid growth and sheer size changed things.

After the first round of bubbles burst in 2008, major central banks embarked on quantitative easing – in effect reinflating the bubbles. China’s M2 broad money supply rose by 5.6 times from 2007-2022, while the Fed’s balance sheet expanded by nine times. These two numbers explain the rapid rise in asset values relative to economic output in so many asset classes and across the world. The US stock market peaked at 200 per cent of its GDP in value, more than twice the historical norm, while China’s residential property market surged past six times its GDP over the last decade, by my analysis.

Fed’s excesses of 2008 put the world on course for another disaster

This rapid monetary growth lasted so long only because the link between money supply and inflation was cut. This was because China’s labour force entered the global economy by the hundreds of millions and companies shifted their production to China. Whatever money the central banks printed was absorbed by financial speculation. The anomalies in the global financial system over the past three decades can be traced back to that dynamic.

The US went down the path of borrowing and spending because it could. Former Fed chairman Ben Bernanke’s quantitative easing laid the foundation for this. Since 2007, the US national debt has risen from around US$9 trillion to approach US$33 trillion when its GDP has risen by only half as much.

Debt has been an easy habit. It hurts no interest group and as long as the market doesn’t rebel, US debt can easily double in 10 years. But in the end, no matter how delightful the journey, be warned: debt will eventually lead an economy to hell.

Andy Xie is an independent economist

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