»The Daily Reckoning by Bill Borner

No Higher Authority Than God Himself

- By Bill Bonner

Bill Bonner
Poitou, France

Stocks still going up...

What does Mr Market know that we don't know? Plenty. He knows everything. Millions of facts. Millions of opinions. Millions of guesses. A damned know-it-all.

Mr Market is always right, too; there is no higher authority except God himself. So, if Mr Market says stocks should go up, who are we to argue?

'Don't fight the tape,' is another old-timer expression on Wall Street. When stocks are going up, you don't want to be short. When they are going down, you don't want to be long.

As simple as that sounds, it doesn't help you much. Because you never know which side the tape is on. Mr Market is a cunning, wily, and tricky fellow. He's perfectly capable of leading investors up and up...only to knock them down from a higher place. Also, he's known to give out the word that it's 'all clear' in the stock market...while brewing up the storm of a century. Or you might hear him singing the blues about how awful everything is...and then discover that he's been buying the whole time.

So, even though the Dow has been going up...we'd be careful about drawing any conclusions. Mr Market could be up to his old tricks; the tape could reverse at any time.

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And we kinda think it will. Economist Richard Duncan points out that the booms and bubbles of the last 35 years had a very particular cause. They weren't the product of Mr Market's caprice nor of investors' shrewd judgments. Instead, an almost magical money system drove consumption, production, and asset prices to new highs all over the world. What a hoot! Wages rose ten times in China. Stocks rose 16 times in the US.

And now it's over....

Here's how it worked: Once the world's money was cut off from gold, in 1971, things got a little funny. Americans spent money they never earned and never saved - dollars, created 'out of nowhere.' Much of this new money went overseas, where foreign nations - notably China - had to print their own money to keep up with it.

But you've heard this story before... China makes. The US takes. And in the process, it leaves dollars in the hands of the Chinese. The build-up of these foreign currency reserves is both the cause and the measure of the globalized boom the world has enjoyed since the early 80s. As Americans bought more goods from China, they sent more dollars abroad. These dollars boosted the world's money supply...and set heads a'spinning, wheels a'turning and chimneys a'smokin'.

China (and other countries too) filled the orders and banked the revenue. Chinese merchants and manufacturers took their dollars to the Bank of China to exchange for local currency. The dollars piled up in the BoC. What could it do with so many? Buy US bonds! This lowered interest rates in the US and increased the amount of money bidding for American assets.

That, roughly, is how we got where to we are today. China's supply of foreign currency reserves rose from zero in 1979 to $4 trillion in 2014. Worldwide, reserves grew by $12 trillion. Here, you can easily see the difference between this new credit system and the gold-backed money system that existed before it. You could never add $12 trillion to the world's supply of gold reserves. All the gold ever mined only has a present value of about $6 trillion.

This big increase in the global money supply was what set off the booms and bubbles of the last 35 years. But now, what's this? The bubble machine is broken?

The Bank of China is no longer adding to its dollar reserves; it is lowering them. About $400 billion has been clipped from China's forex reserves since 2014, most of it was dollars.

This drop in reserves signals a big change in China...and the whole world's financial picture. Imports into China - mostly raw materials - are dropping at a double digit rate. Exports are rolling over too.

There is nothing like easy money to cause people to make mistakes. Americans over-spent. China over-produced. Now, American households can't step up their buying (they owe too much already)...and China has too much capacity.

China's growth, by the way, has been heavily concentrated on building factories and infrastructure - capital investment. China spent $4.3 trillion on fixed capital investment in 2013, ten times more than in 2000. But when you produce too much already, building more factories only makes the situation worse. Prices fall. Producer prices in China have been falling for 43 consecutive months.

Adding output capacity - often done with the connivance of local governments - was largely financed on credit. Bank loans rose three times since 2007. These loans must now be going bad. Non-performing loans should be shooting up. Recession should be coming. Instead of driving the world economy forward, China should become a drag on the whole world economy.

What does this mean?

China can't allow its industrial economy to sink without a fight. It will have to devalue the yuan in order to try to get more market share. It still has 80% of its workers earning less than $10 a day. A lower yuan will reduce real wages further and make China's exports cheaper than ever.

And then, what about the rest of the world?

As the yuan goes down, the dollar, yen, and euro will have to go up. Commodities - priced in dollars -- will stay down. Corporate profits will fall. The stock market 'tape' will go down. Consumer price increases, too, will remain low...or go negative.

Deflation. Deflation. Deflation.

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