The last few weeks I have been reading and thinking about China's currency peg. Now I realize more and more that not only it is a huge problem, it is also at the root of many of our problems. We like to blame our corporations for being so willing to outsource into China and Asia. But we have to remember that that willingness is a product of China's undervalued currency. Our capitalistic system was working as intended in seeking to allocate capital to where it is treated best. But because the game is rigged, China underpriced everyone else and stole everyone else's jobs and technology.

(Note that by China, I refer to China's government, and not Chinese people. Chinese people or citizens are for the most part clueless as to what their government is doing.)

Here are what China has done in the last 15 years that make it successful in pegging RMB at an artificially low rates for so long:

1. It pays out bank deposit rates lower than inflation rate. Basically, it not only absorbs the newly printed RMB (that were created to buy the surplus USD) through bank deposits, but also destroy some of it by paying out lower interest rates than inflation rate. This takes away household savings and reallocates it as exporters’ subsidy.

2. It prevents RMB from flowing outside China where it may get true value bid, forcing accumulated RMB to be kept in domestic banks which pay out below-inflation rate.

3. It prevents RMB from getting into workers’ wages in favor of keeping it in the hands of exporters to get permanent cost competitiveness, through labor law. For example, labor from countryside is not allowed to establish residency in coastal China, suppressing their bargaining power. It also allows exporters to treat them any way they want, again leaving laborers from getting a stronger bargaining power.

4. It develops infrastructure (roads, bridges, power generators, dams) fast in order to produce a very high productivity growth to mask the effect of inflation on prices.

5. It forces foreign companies to transfer their knowhow by requiring it to partner with Chinese companies. Against, the goal is to accelerate productivity growth in order to mask the effect of inflation.

6. It encourages theft of intellectual property so that its exporters have a permanent cost advantage vs. foreign companies, denies foreign companies of their profit, and accelerate productivity growth via IP theft and technology cloning.

7. It invests massively in education, again with the goal of very high productivity growth.

Some of the moves are smart and rational when we think of them in isolation. However, when they were carried out as components or parts of a highly mercantilistic currency policy, they are advancing the mercantilistic policy. Mercantilistic policy creates winners and losers. The winners are:

• Chinese exporters as they receive protectionism and subsidy from the household sector
• China government as they concentrate power and wealth in their hands
• Chinese banks as they get access to cheap capital by paying out low deposit rates
• US multinational company (MNC) executives as they reduce their cost through outsourcing, but keep prices constant, pocketing the difference as compensation.
• Wallstreet banks
• US MNC shareholders

Losers:

• US labor, as they are squeezed by lower wages, and higher unemployment rate
• Chinese labor from inland cities and rural region, as they supply cheap and disposable labor, their bargaining power is artificially suppressed by residency restrictions and labor laws (or shall I say, the lack of labor laws?).
• In the long run, both countries lose because they misallocate resources. China will misallocate resources to export capacities, even after the enterprise is no longer profitable or with razor thin margin. US will misallocate resources to bubbles as it seeks to mask the imbalance problem by printing money.

The imbalance must be corrected, or the crisis needed to correct it will be severe.

How to Prepare for the Coming Hard Time in the USA

Current situation. I believe at the moment, we have long past the point where deflation in prices would occur. That was supposed to happen in 2008 and 2009, but was stopped short by Quantitative Easing 1 (QE1). Now the outcome is clear: massive printing to support gov deficits and to support asset prices. All this mess about foreclosures will just strengthen the resolve of Fed to do a second round of QE (QE2), perhaps as massive as QE1. Rather than dealing with title ownerships and legal process, it is better (for big banks) to inflate to the moon so that in home prices increase in nominal terms, and people are less likely to default. It is better to be paid back in devalued dollar and avoid legal entanglement, rather than suffer massive loss on MBS through the legal process. This is likely something that they knew back in 2009 when the Fed started QE1. Currency crisis. In terms of what to do when the SHTF, you can look at what occurred during and after the currency crises of the past. For example, the Asian currency crisis of 1997-1998 brought instant hardship to the population as their purchasing power declined significantly. Some with weaker gov institutions replaced their governments multiple times until the currency stabilized. Some with stronger gov institutions survived intact. Public utilities continued without interruption in most cases. But crime rates did increase as decrease in purchasing power pushed people with marginal morality over the edge. Before the public became convinced that the currency adjustment has completed, trades for expensive items (electronics, computers, etc.) were carried out using US dollars. The currency adjustment was very violent, a lot of volatility, up until the point where foreign debt was forgiven. All assets denominated in the local currency suffered declines, which cause foreign money to come in and scoop them up. Prediction of how things will unfold in the USA. If things repeat in the same manner, we will see the following scenarios in the US: USD crashes, perhaps by 50 to 70%, and lower purchasing power ensued for several years Gold and silver, and some fiat currencies, increased in prices significantly to reflect the decline in USD, but also to reflect people's preference of being paid in alternative currencies that are more stable. Thus, if USD crashes by 50-70%, gold and silver prices will not increase by just 2-3x, but by higher, may be 3-4x. However, the USD crash will overshoot to the downside, and gold/silver prices overshoot to the upside. Timing it will be very tricky, so be careful. Our democracy will not collapse. What we will have is a change in government, switching violently between Republicans and Democrats, until the situation either stabilizes, a viable third party emerges, or we elect a president who is truly competent. Foreigners with strong currency will try to scoop up cheap US-denominated assets Banksters mostly get away with their ill gotten gains. That's what happened in Indonesia, for example. The plunderers, the elite family, no longer held real power but were protected by the new power. This prospect upsets me the most. Workers reject the decline in purchasing power and demand higher wages. At first, their effort will not be successful, but after a few years, they get what they want. Not enough to offset the total loss of purchasing power, but compensate a big portion of it. Unsustainable debts will be defaulted or forgiven. Not through USD crash. I think it really takes real defaults of gov bonds in order to reduce the debt level. Loss of purchasing power makes it harder to service debts, so I think the only possibility is to default. In some countries in Asia, deposits were never returned to depositors. Here we have FDIC so it won't happen. But I'm worried about 401K. Jobs will come back as US labor will be cheap enough to be competitive, adjusted for the technology leadership that we still have. Not all kinds of jobs, but ones for which we become marginally competitive. May be advanced manufacturing? May be IT? Research? A whole generation learned the hard way that home prices do not always go up. But, after a few years, they will start to latch on to stock bubbles in emerging market. How to prepare. Stock up on precious metals mining shares and some foreign currencies to protect your purchasing power and as a safety buffer during the currency adjustment time Be extra vigilant and live with a low profile to avoid attracting crimes to yourself The best way to protect purchasing power in to invest in yourself in the skills in sectors in which we can become competitive after 50% USD crash. Gold and silver cannot do this, unless you have tons of them that last a life time. What sectors? I have no clue. According to itulip, they are TECI (Transportation, Energy, Communication, Infrastructure). We can debate it. Direct your children into these sectors, once you are able to identify them. Equip them with hard skills (math and science). Start forming labor union if you can for your own profession. You need it in order to have stronger bargaining power to restore part of your loss of purchasing power. Closing comments. Inflation, USD crash, and some form of protectionism will be our future. Wars between nations will be fought again over the control of natural resources. They will be done covertly through finances, currencies, trade alliances, regime changes, etc., unlike WW2. I believe these outcome are unavoidable. They were avoidable in 2008 and early 2009, but our gov and Fed have chosen the wrong path. Now it is no longer time to discuss what will happen. I think it is clear what will happen. It is time for action. Try to get into a position where you can change things for better, to impact our society in a good way in any way we can. Regardless of our background and religion, surely we can agree that justice, fair play, and compassion are things we strive for in life. Don't forget to tell your children and their friends of how we got into this mess, so we can avoid a new one for at least another 80 years.

Advice to Boomers and Gen-Xers

Go to the ant, you sluggard! Consider her ways and be wise, which, having no captain, overseer, or ruler, provides her supplies in the summer, and gathers her food in the harvest. [Proverbs 6:6-8]

The concept of retiring before one becomes unable to work or dies is a new and untested one. For as long as human history, it has always been the case that one retires when he/she dies or when he/she is unable to work anymore. Only recently, in the last 50 years or so, people aspired to early retirement. I think this is an anomaly in history, a one-off period of prosperity and favorable demographics.

The generation prior to boomers can retire early because boomers provide the labor they need. There are a lot more boomers than their predecessor generation. Boomers will either not be able to retire early, or retire with lower living standards, because the following generation (Gen-X) is much smaller to provide labor for them.

Think about demographics. Money, income, investment return, are of little relevance. Retirement is equal to consuming things without producing them, or consumption without labor . For one group of population to retire, other groups must provide excess labor and production to support it. One generation can afford that only if the next generation provide all the labor and excess production to support it. This is impossible for baby boomers, as Gen-X generation will not be able to have excess production and labor as much as boomers provide excess production and labor to the predecessor generation.

Advise for boomers. Don't think that you will be able to retire both early and comfortably (see my previous post on demographics). Having both is impossible, having one may be possible. Keep your skills sharp so you can still work into late age. Consume less so you do not put a heavy burden on the younger generations to provide excess labor and production.

Looking at demographics, in the next 10-15 years, Gen-Xers are going to be the sandwich generation. They must produce excess labor and production to support boomers who have retired, and at the same time support the millenials as they have not fully entered the labor force. This can only mean one thing. Gen-Xers will have jobs, in fact each of them will have 1.2 jobs vacanted by boomers. However, since their excess labor and production will be needed for boomer retirees and not-yet-productive millenials, their income will be heavily taxed. Inflation will be the rule of the day too. Only after millenials enter the labor force in droves, Gen-Xers' life will be better. Advise for Gen-Xers: prepare accordingly. You will need that good health to work 1.2 jobs. You will need ingenuity to invent new ways to increase your work productivity. You need to be nice to the millenials and train them well so they can join you to supply the excess labor and production to support boomer retirees.

Comparing the costs of staple food

For those who are looking ways to penny pinch, here are some useful statistics for you.

How much does it cost to buy 1000 calories (about half of daily intake of an adult - or about 1 meal). This assumes a bag of rice at $23 for 25 lbs, one 1lb box of pasta at $1.25, one 14.5oz cereal at $3 per box, one 1lb8oz loaf of bread at $3, and one pack of 2.6oz instant noodle at $.25. Here are the numbers ($ per 1000 calories), from least expensive to most expensive (the cheapest is in bold):

Rice: $0.56
Instant noodle: $0.65
Pasta: $0.78
Bread: $1.56
Cereal: $1.78

So, rice provides the cheapest calories by a wide margin. Compared to rice, pasta is 40% more expensive, cereal is more than 3 times more expensive, bread is almost 3 times more expensive. Compared to pasta, bread and cereal are about 2 times as expensive.

Here is one reason why Asians have more disposable income for the same income level. Their food is cheaper by a wide margin. Not only that, rice tastes good with just salt and oil and a bit of egg (fried rice). In contrast, pasta only tastes good with Prego sauce, which is quite expensive per jar.

Killing the Golden Goose

My opinion on one of the biggest costs in Japan financial bailout. After the Japan RE bubble burst in the late 80s, Japan government attempted to keep RE prices high to fight of loan defaults. Banks are allowed to accumulate easy profit from artificially low interest rates, and from postponing mark to market (sort of like what is happening in the US right now). And it succeeded in deflating the bubble slowly, over 20 years. Even now, RE prices are very high compared to income. For example, in Tokyo, a 2-bedroom condo about 600 sqft costs $400,000. The critical age for family formation is late 20s and early 30s. However, workers at that age have a monthly income of only about $2500 - $3500, which means that the price of such a condo is between 9.5 to 13 times income. Clearly, it is very difficult for young couple to purchase a condo in Japan, let alone a landed house. I believe that this ultimately accelerates the decline in fertility rate among Japanese women. Even if they want to marry, form a family, and have kids, they cannot afford the condo to house their young. Now the government attempts to encourage women to have children and are paying a few hundred bucks to them if they will. However, what is a few hundred bucks compared to $400,000? Hence the strategy has not been effective. It is just not economical to have children in Japan. In my opinion, shrinking labor force is the real price of keeping bubbles from deflating. While labor may shrink naturally as women postpone marriage age, I believe strongly that the steep decline in fertility rate is caused by unaffordable living cost. I predict this is what is going to happen in China. Housing is very hard to afford in cities vs. income. When bad loans go sour, government will bail out banks using taxes, inflation, low interest rates, etc. They will succeed in keeping house prices high, but there will be a huge cost. Because the household sector is penalized in order to bail out banks, they will suffer. The huge cost will be a negative incentive to form families that support future labor pool. Just as it was in Japan, this will accelerate the decline in labor pool, no matter what incentives government may give to young couples. Will similar things happen in the US? I believe so, but only partially. There are still a lot of states, towns, and cities, in which housing prices remain low, at 2-3X yearly income. One thing that lends support to my theory is some of my friends from Asia. They come from countries that are known to have very small family, yet living in the US they have a relatively large family. So family size is not a function of ethnicity or country of origin. Rather, it is a function of affordability of family formation.

Who are the Financiers? Part 2: the Relationship of Debt System and Taxation

Let's briefly summarize Part 1. Part 1 demonstrates that in a debt-based system, over time wealth and power tend to be concentrated in the hands of a few, at the expense of many. Note that the society described in Part 1 is very basic. It did not assume the existence of a central banker, it did not assume fractional reserve lending. However, it assumed that the money supply is constant, something that may be the case when a unit of money corresponds to a unit of gold, for example. Hence, Part 1 demonstrates that even when money is backed by gold, even when there is no central bank, and even when there is no fractional reserve lending, a debt-based money system may lead to the concentration of wealth and power in a few hands. (This point is largely missed by many of gold-back currency proponents)

A neat little story posted by Bill Gross (the famous mutual fund manager at Pimco) gives a vivid example of Part 1's main observation. The quote is taken from Bill Gross' June 2010 Investment Outlook:

"Debt will get you in trouble – on both sides of the dollar bill as Shakespeare wisely counseled long ago: Neither a lender nor a borrower be. That probably seems like a strange admonition coming from a guy who helps to lend $1 trillion of it – and I suppose it is. But there was a time back in 1968 when lending got me in lots of trouble – deep doo-doo, to tell you the truth – and I’ve regretted it ever since. I was a Naval officer back then, sailing between the Mekong Delta and Manila Bay. Strangely enough, it was in the Philippines, not Vietnam, where I lost my moral compass and ran aground. I started a shipboard replica of a “payday” lending company operating under the principle of “two will get you three.” Sailors in port were always short of cash and yours truly – engaged to be married and operating under a self-imposed one-beer, nine-o’clock curfew – was more than willing to extend them a hand. The “two gets you three” scheme sounded harmless enough, because, heck, what’s a buck between friends when you’re about to hit the beach and party hearty! Still, as the “payday” characterization connotes, the money was due only a few weeks down the road when we were back at sea and receivables could easily be collected. And the annualized yield, as most of us investor types can easily calculate, was well in excess of 1,000% annualized. Well, there’s usury and there’s grand larceny, and my payday-hayday scheme was clearly in the latter category. The amounts were small – paychecks were only a few hundred dollars – but 200 compounded into 300, which turned into 450, 675, 1,000 – well, you get the picture. It didn’t take too many ports of call before Uncle Sam’s next payday became the property of Uncle Bill, and I became the financial godfather of the USS Wish I’d Never Enlisted. Oh but loose lips sink ships, and it wasn’t too long before the authentic godfather – El Capitan – got wind of Ensign Gross’s growing fortune. Rather than cut himself in on the scheme, he did what every good captain would do. He made me give it all back and confined me to the ship for the rest of my tour. No beer, no sightseeing in Tokyo on the way back home. No nothing. Two got me three for awhile, but it eventually got me into a heap of trouble. Well deserved, I’d say, and I’ve learned my lesson. Never made a 1,000% loan since!"

The above example illustrates what can go wrong over time in a debt-based system. In a relatively short amount of time, Bill accumulated much of the wealth of his colleagues. His captain stepped in and pushed the "reset" button, requiring him to return all the wealth that he had been accumulating. The reset mechanism has proven crucial in breaking the concentration of wealth and power in the hands of a few in this case.

I want to address another issue. Quite a few people pointed out that in capitalism, if you lend your money, you risk not getting paid back. For example, the borrower may run away with the money, the borrower may use the loan to purchase a cattle that later dies, purchase a home that later is blown away by hurricane, etc. There are many scenarios in which the borrower will not be able to pay back the loan. Since you risk your capital, you should be compensated for it. For example, if on average 1 in 10 loans is completely not paid back, to get back $100 that you lend, you need to charge an interest in the amount of ($100-$90)/$90 = 11.1%. However, charging 11.1% only gives your money back, it does not increase it. So what incentive do you have to loan it in the first place? Why not just keep the money and enjoy it? Hence, you would like to charge an interest rate that is higher than 11.1%. Of course, sometimes you will not be able to precisely calculate your risk, hence you may ask for additional interest rate just in case the risk is higher than your estimate. For example, in the above example, you may charge 14% instead of 11.1%.

I completely agree that if you lend your money, you take the risk of not getting paid, so you need to be properly compensated by charging interest on the loan. In fact, such a system is the essence or soul of capitalism: if you take risk with your capital, you get rewarded, provided that you estimate the risk correctly. You will lend the money to a group of people at higher interest rates if they have a higher risk of not paying back the loan, and at lower interest rates if they have a lower risk of not paying back the loan. This forces all lenders to constantly evaluating risks, and capital is lent out to people with the best economic prospect (those who use the loan to produce an income stream that enables paying back the loan) and best behavior (those who truly intend to pay back the loan). This ensures allocation of capital that maximizes income growth and rewards prudent borrowers as well as prudent lenders. Therefore, charging interests on loans by properly accounting for default risk is fundamentally essential to an efficient allocation of capital and to maximizing economic growth.

However, note carefully that that does not change the fact that over time, a prudent lender (who calculates his risk well) still accumulates power and wealth. The problem of wealth and power concentration can and will still occur as described in Part 1. Therefore, we should conclude that capitalism is by its own insufficient in addressing wealth and power disparity between lenders and borrowers. Capitalism must then be paired with a reset mechanism, such as one beautifully illustrated in Bill Gross' writing.

What is the best reset mechanism? I have no clue. But let me offer a list of examples that can help slowing the concentration of wealth and power:

1. Progressive taxation system. Increasing the percentage of income that is taxed as the income increases reduces the speed (but does not eliminate the eventual possibility) of concentration of wealth in the hands of the few.
2. Taxation distinction between earned income vs. unearned income. Since interest income rides on the labor of the borrower (estimating risks is not labor!), we can distinguish the laborer's income as earned income, and lenders' interest income as unearned income, and can tax unearned income at a higher rate.
3. Taxing the wealth accumulation at certain events such as death. This taxation is very potent if used correctly, as it can reset the concentration of wealth completely. For example, anybody can accumulate wealth in his lifetime through charging interests on loan (ensuring efficient allocation of capital), but at death, some fraction of his wealth (e.g. 50%) or all wealth above a certain limit is taxed.

Note that in the US, these taxation systems are already employed to some extent. However, the system is quite flawed. Financiers are able to go around them easily. For example, while it is true that there is progressive taxation on salaries, capital gains, which are the main source of income for financiers, are taxed at a lower rate (e.g. Warren Buffet famously said that his tax rate is lower than his employees' tax rates). Unearned income tax rate should be higher than earned income tax rate, but instead is lower. Estate tax, which taxes wealth at the time of death, has been attacked heavily by many rich people on the ground that it places tax on income that was already taxed.

Note that these taxes are crucial in providing the reset mechanism to a debt-based system, or any capitalistic system. Taxation is a means to redistribute wealth, and it is a healthy thing to avoid super-concentration of wealth in the hands of a few. Taxation is not equal to big government or government embarking in a spending binge. In fact, big government itself helps concentrating power in the hands of a few. Thus, tax revenues should be used only for essential public spending, and the rest distributed back to taxpayers in the form of lower tax rate (skewing the distribution toward people with earned income and fewer assets), rather than being used by the government for pet projects.

Who are the Financiers? [Part 1]

In my last post, I talked about the "financiers" and their role in enslaving the public through bubbles in asset prices and through inducing the public to take debt purchasing bubble-priced assets. In this post, I will talk about who the financiers are.

Have you ever gone to a get-rich quick seminar? I have. Typically, there will be one charismatic speaker making a presentation to an audience. The speaker has a slogan that sounds really nice and appealing such as "The secret to wealth is to transform from working hard for money, to letting your money work hard for you". Isn't "money working hard for you" an interesting term? How can money work for you? Money is a dead object, by definition a dead object cannot work, let alone work hard.

The way money can work for someone is if it is lent out with interest. This is called "debt". For example, if A has $100 and lend out the money to B with a 10% interest for 1 year, then B agrees to pay A back his original money ($100) plus the interest ($10) for a total of $110. Let us assume that in the world where A and B live, there is a constant amount of money in circulation. In order for B to get the $10 that he didn't have before, he has work hard to make sellable goods or services so that others are willing to pay him $10 or more in exchange for B's labor. Using this money, B returns $110 to A after one year. Therefore, A's money has grown because of the labor of some one else, in this case B. Thus, it is inaccurate to say that money can work hard for some one. It is more accurate to say that money can buy labor of some one else.

Now imagine that A is the only lender in the world. The total money in the system is, say, $1000. Initially, A owns $100, and the rest ($900) is owned by others. A lends out $100 to the world at 10% interest for one year, and gets back $110. In the second year, A lends out all his money $110 to the world, and gets back $121 ($110 principal + $11 interest). And so on. Here is what happens with A's wealth:

Year 0: A has $100, world has $900

Year 1: A has $110, world has $890

Year 2: A has $121, world has $879

Year 3: A has $133, world has $867

...

Year 10: A has $259, world has $741

...

Year 20: A has $672, world has $327

...

Year 24: A has $985, world has $15

In just 24 years, A has accumulated almost all the money in the world, leaving the whole world to own just $15! As I mentioned before, A has accumulated all the money. Since money is essentially a claim on other people's labor, A has a claim on the rest of the world's labor. In other words, A has become a king, controlling what the rest of the world's wealth and labor.

Going back to the original question, A is the financier, while B and the rest of the world are the public.

We can make one interesting observation: any system that relies on debt is bound to be unstable at some point, as over time, wealth gets concentrated in the hands of the few, at the expense of many.

In addition, once wealth is concentrated in the hands of a few, loan cannot be paid back, since there is no longer enough money in the world to pay back debts. In the example above, if A lends out all his money in Year 25, nobody will be able to pay back the debt because to pay back the debt, the world needs $1,083.50. It simply does not have that much money! So what will happen is that the world defaults their debt, and A takes possession of the collateral of the debt. What collaterals? Whatever the world pledge to secure their debt. It could be their land, their daughters, their obedience, etc. Therefore, the second observation is that a debt-based world, over time, becomes incompatible with democracy as it leads to the concentration of power in the hands of the few.

Take time to digest the two observations that we just made. The observations are very basic but are powerful in helping us to understand the monetary system in the world today.

What does the Bible say about debt?

God recognized the danger of a debt-based system, and the concentration of wealth and power in the hands of the few. This is His word in Leviticus 25:37-43:

³⁷ You must not lend him money at interest or sell him food at a profit. ³⁸ I am the LORD your God, who brought you out of Egypt to give you the land of Canaan and to be your God.

³⁹ " 'If one of your countrymen becomes poor among you and sells himself to you, do not make him work as a slave. ⁴⁰ He is to be treated as a hired worker or a temporary resident among you; he is to work for you until the Year of Jubilee. ⁴¹Then he and his children are to be released, and he will go back to his own clan and to the property of his forefathers. ⁴²Because the Israelites are my servants, whom I brought out of Egypt, they must not be sold as slaves. ⁴³ Do not rule over them ruthlessly, but fear your God.

A few important observations:

1. Verse 37 speaks against lending money at interest, which is a statement against using a debt-based system.

2. Verse 40 describes a reset mechanism. In the year of Jubilee, basically every 50th year, the debt system is annulled, and wealth and power re-distributed to the original state. Every person, even if he has already become slave, due to his/her inability to pay back his/her debt, can go back to own the land that his/her ancestor once owned, and wipe out his/her debt.

3. Verse 42 predicts that a debt-based system leads to slavery.