The Real Fiscal Cliff

Even casual news watchers hear commentary that the U.S. has a growing fiscal debt to China--$3.5 trillion in 2012.  The Daily Caller reports it as “the largest nation-on-nation trade deficit in the history of the world."

What most Americans do not know is that because of this huge trade deficit, the Chinese Central Bank collected billions of excess dollar reserves each year that they simply piled into U.S. Treasury Notes in the past.

Washington loved this arrangement because it helps run trillion dollar budget deficits.  But as Washington cranked up their money printing presses and record low interest rates, China lost close to a trillion dollars by holding U.S. debt.

Two officials—Zhou Xiaochuan, head of the Chinese Central Bank and Xia Bin, monetary policy committee member of the Central Bank—announced that it was time for a fiscal policy change.  They knew that staying in Treasuries for the long-term was a losing proposition.

Their plan was not meekly pulling all the money out of Treasury Notes.  It included a vision of short-term loss for long-term gains by closing the U.S. ‘greatest export machine’ and ultimate source of global dominance for the last 40 years--the petrodollar.

Tracing the history starts in1944.  The 44 Allied Nations gathered in Bretton Woods, New Hampshire.  Their mission was to create a set of agreements to manage and stabilize international trade after the war.  Their brainchild, The Bretton Woods Agreement, established the dollar as the 

world's reserve currency.

This international game-changer gave the United States a distinct economic advantage, but with one caveat...every dollar the Fed printed would be redeemable for gold at a standard rate of $35/ounce.  It was put in place to ensure the Fed didn't print dollars with reckless abandon.

But with massive expenditures on the Vietnam War, the Fed did print more dollars than it had in gold to exchange.  The rest of the world became suspicious of America's ability to pay.  Nations began to demand the gold they were promised.

In 1971, President Nixon recognized he would not be able to meet the obligations and closed the gold window.  It was the first American default and it set off a rapid decline in the value of the dollar.

Oil prices soared.  Inflation rose to 15% and higher.  GDP fell 3.2%.  Unemployment hit 9%.  P/E ratios crashed from 16 to 8.  Stocks had the worst 15 year period in history, even worse than the Great Depression.  The government imposed wage and price controls which caused gas shortages around the country.

In 1973, then-Secretary of State Henry Kissinger hatched a genius plan.  America had great military might and Saudi Arabia needed protection for its vast oil empire.

Kissinger exchanged America's military might for Saudi Arabia's promise to sell oil exclusively in U.S. dollars.  Meaning, any country that wanted to purchase oil from OPEC was forced to use U.S. dollars.  Anytime another country wanted to buy oil from the Middle East, they had to first convert their currency into U.S. dollars.

Since oil is required in modern economies—and the Saudi’s are a main player in the oil trade—this put the U.S. in a unique situation again.  Countries around the world would have to export goods and services to get the dollars they would need to buy oil.  America, on the other hand, could simply "print" the dollars it needed to buy oil.

The U.S. could run massive trade deficits because we exported the most valuable commodity in the world--the U.S. dollar.  America was the world's largest creditor.

In order to get the dollars they needed to buy oil, countries flooded the U.S. market with cheap cars, cheap TVs, cheap clothes…  We simply flooded the world with cheap currency.

By the early 1980s we began to run our first trade deficits that grew to trillions of dollars by the 1990s.

There was one more, ultimate, part of that agreement with the Saudi’s:  OPEC countries were required to invest their profits in U.S. Treasury Notes.  It fed demand for more government debt, allowed reckless government borrowing and created the greatest bull bond market in the world.

It wasn't just the government that borrowed.  Consumers borrowed $14 trillion, corporate debt rose to $11 trillion, financial debt grew to $17 trillion and unfunded liabilities like Social Security and Medicare were up to $90 trillion.  It adds up to $140 trillion in total debt or about 10 times greater than our whole domestic production.

The house of cards is maintained by that simple 1973 agreement—and why it is so important the U.S. maintains the petrodollar.

It is why we are willing to go to war with anyone who challenges the petrodollar.  Saddam Hussein, Muammar Gaddafi and Iran know the pressure America will exert to prevent this crisis from occurring.

Now China sees itself in a position to end the golden age of America and usher in an age of Chinese dominance by taking away the biggest source for our seemingly inexhaustible demand for Treasuries.

The China plan is simple: 1) monopolize the gold supply around the world; 2) accumulate needed natural resources for internal growth; 3) build global alliances to help with the plan and 4) eliminate the dollar from international oil trade.

The Chinese know that their currency—the Yuan—will never beat the U.S. dollar if it is only another "fiat" currency, that is, a currency backed with nothing but empty promises.  So China is creating something that has been missing from the global economy for 30 years--a gold-backed currency to take over the role as the world's reserve currency.

China is the world's largest gold producer at more than 350 tons of gold a year—almost 20% more than the world's second largest producer.  It is not exporting a single ounce of gold.

In 2012, China imported roughly 500 tons of gold.  That is more than the entire holdings of the European Central Bank.  More importantly, China imported twice the gold as it purchased in U.S. Treasuries.

They add to their reserves in other ways: allowing citizens to legally own gold and buying gold mines across the globe.

Gold is so commonplace that it is sold in stores similar to the Chinese version of our 7-11 Stores.  In August 2010, China Gold International put in a $742 million bid to buy Skyland Mining.  In August 2011, Stone Resources put in a bid to take control of Crescent Gold, an Australian gold mine.  In November of 2011, Zijin Mining Group put in a $227 million bid to buy Gold Eagle Mining and the Baiyin Group bid on the South African mine, Gold One International.  In April 2012, Sovereign Gold partnered with Jiangsu Geology & Engineering to buy two gold mines in Australia.

We do not know the extent of China's gold rush because China has not revealed the amount of its gold reserves since 2009.  In 2009 the China Youth Daily quoted State Council advisor Ji Xiaonan as saying, "We suggested that China's gold reserves should reach 6,000 tons in the next 3-5 years and perhaps 10,000 tons in 8-10 years."  That would make China's Central Bank the largest gold reserve in the world, ahead of the U.S.’s approximate 8,000 tons of gold reserves. It would put them in position to take over the role of an international economic leader that the U.S. gained through Bretton Woods.

Just like the U.S. did in 1944, China needs to build global support for their initiative.  It cannot be done alone.  The remaining parts of their strategy brilliantly interweave to do just that: 1) obtain resources to sustain a rapidly growing economy, 2) rid themselves of devaluing dollars and 3) gain powerful allies.

Energy and resources are keys to economic growth.  It is estimated that in the next five years, 1½ billion consumers will join the ranks of the middle class demanding TVs, cell phones, dishwashers and cars.  In addition to moving their U.S. Treasury Notes (as are other nations) to Euro Bonds, the Chinese are also spending their 3 trillion in U.S. Dollar reserves securing oil supplies from Africa, i.e., investing $6 billion in oil rights in Nigeria and $7 billion in oil and mining infrastructure in Guinea.

They also invested over $6 billion in securing rights to various Canadian tar sands projects, The China state-run oil company, Sinopec, paid $7.2 billion for Addax Petroleum (which has sizeable assets in Iraq and Nigeria), loaned Petrobras, the Brazil state oil company, $10 billion that will more than triple oil exported to China, paid $3 billion for the rights to mine copper under Mount Toromocho in Peru and another state-owned Chinese company, Chinalco, paid $13 billion for rights to Australia's aluminum sector.

China is doing more than purchasing resources on the open market.  It is supplying aid, goodwill and investments in resource-rich countries through its China Export-Import Bank because they understand they need strong, global backing in their plan.

In the last seven years, China invested as much as $75 billion in Latin American countries--more than the World Bank, Inter-American Development Bank and the United States Export-Import Bank combined.  They directed many of those resources to countries like Ecuador, Venezuela and Argentina that the West ignores because of past cold war relations.

China pledged $12 billion in railway lines in Argentina, gave $1.6 billion for a hydroelectric dam in Ecuador and $20 billion for infrastructure construction in Venezuela.

China agreed to grant Russia a $6 billion loan for infrastructure in exchange for the Russian coal supplies over the next quarter century.  They negotiated to expand the capacity of the Greek port of Piraeus up to 250% in exchange for easier access to European shipping lanes.  They pledged $20 billion across Africa to build roads, railways, schools, hospitals, agriculture and manufacturing projects and small and medium-sized business development.

In short, the Chinese government, collaborating with Russia, Iran, Venezuela, Nigeria and others, set a new direction for the international energy trade that threatens the petrodollar.

From examiner.com: Oil | September 12, 2012 | By: Kenneth Schortgen, Jr. | Dollar No Longer Primary Oil Currency as China Begins to Sell Oil Using Yuan--"On Thursday, Sept. 6... just a few days ago, China made the official announcement. China said on that day, our banking system is ready, all of our communication systems are ready, all of the transfer systems are ready, and as of that day, Thursday, Sept. 6, any nation in the world that wishes from this point on, to buy, sell, or trade crude oil, can do using the Chinese currency, not the American dollar.--Interview with Natty Bumpo on the Just Measures Radio Network, Sept. 11.

Nigeria agreed to swap a major portion of its dollar reserves for Yuan reserves.  Standard Bank researcher Simon Freemantle says, "We, rather conservatively, anticipate that around 40 percent of [Chinese]-African trade would be settled in [Yuan] by 2015."

China and Brazil signed a currency swap worth $30 billion, in a deal which, according to the Wall Street Journal is said to encourage Chinese investment in Brazil’s oil sector.

Russia announced it will supply China with all the crude it needs or wants and they won't transact using the U.S. dollar.

Iran signed major deals to drop the dollar from oil deals with China, Russia and India.

China signed a $5 billion deal to buy oil from the United Arab Emirates in Yuan.

Sinopec completed an $8.5 billion deal in Saudi Arabia to help build oil infrastructure.

Saudi’s are richer than ever and remain much linked to the USA because they relax better under the American defense umbrella.  But if Saudi Arabia or its OPEC constituents waffle from the petrodollar, America will face its real fiscal cliff.  Commodity-producing allied countries around the world would experience a similar fate.

To Summarize: We choose to move ourselves closer to the ending edge of our comfortable economy a little more each day, hence the fiscal cliff.  A big, commodity bull market is in place, the petrodollar is in trouble, as is our bond market, the leadership torch of the global economy may be passing from America to China and other emerging markets…and the real story does not come from daily NYSE reports or CNBC soundstage talking heads!  The story already happened--slowly, over many years as greed, arrogance, misplaced priorities, false notions of self-importance, imprudence that global power structures and systems remain the same forever and short-term, narcissistic, xenophobic, nationalistic choices aligned by assuming there is no collective consequence.

PostScript: If it is unimaginable that movement toward the real fiscal cliff remains unabated, consider that the hottest topic regarding domestic security today focuses on the size of a knife blade that should be allowed on an airplane.  Observing American priorities is like watching Theater of the Absurd.