Making the Right Call

Andy Xie had a recent article in the FT that has caught the attention of Mark Thoma, Brad DeLong, Yves Smith and others. The crux of the article is that the reserve status of the dollar is dependent on China's faith in the U.S. economy and its economic policies. Lately, that faith is waning and if unchecked could cause China to accelerate its move away from the dollar. Since China holds about $1.5 trillion in dollar reserves and is a leader in the Asian world, any move by it to unload its dollar holdings would most likely be followed by other nations and investors and lead to the end of the dollar's reserve status.

There have been variations of this story told for sometime now, but coming from Andy Xie it is worth hearing again. This is because he was incredibly prescient in calling this economic crisis long before it started. Here is what he said way back in 2004:

The global economy has experienced a positive capacity shock through globalization. The need to find an equilibrium should have caused a downward price level adjustment in the developed economies. Instead, monetary authorities, mainly the Fed, are using cheap money to fight this adjustment, causing a massive property bubble that creates superficial demand and stops prices from declining. However, as soon as the bubble bursts, the world will need a bigger downward adjustment because of the extra capacity formed during the bubble.

Most importantly, so much debt has been created that it may lead to debt deflation. Globalization would have caused benign deflation that benefits consumers and causes some industries to relocate to lower-cost locations. But fighting against this sort of deflation with bubbles and debts must lead to deflation...

When the global property bubble bursts, debt deflation could ensue. It is always possible that the Fed could create another bubble to postpone the inevitable. For example, direct purchase of US Treasuries to push the 10-year yield down to 2% could create another property bubble. However, the Fed may repent and Mr. Greenspan could retire. It may not be profitable to bet on the next bubble.

In short, he believed the well-intended but misguided response to offset the benign deflationary pressures in 2003 would ultimately lead to malign deflationary pressures in the future. He made this call in 2004 and that is why it is worth listening to him now.

Update: Rebecca Wilder in the comments section and Chevelle over at Models and Agents question Xie's claims.