A recommendation to read these bulletins from the front!

In the 21st century financial wars, dollars replace bullets as shapers of the geopolitical picture. Journalists, even analysts, do not yet see this change, hence their reports must be read with care.

These are important articles: Overseas Investors Buy Aggressively in U.S. (NY Times) and China turns risk averse as capital outflows (Financial Times). They must be read carefully to get the vital aspect of the story. Brad Setser explains in a post today (read the full post!):

…The collapse of demand for US asset backed securities (at least those without a n implicit government guarantee) has forced the US to finance its deficit by selling off its companies to foreign investors. The Thompson financial data that Goodman and Story highlight suggests that foreign acquisitions of US assets will double in 2007, rising from around $200b to $400b. For the first time since 2000, foreign acquisitions will top US acquisitions abroad, generating around $100b in net inflows. That is not enough to finance a $750b deficit, but every little bit helps.

Goodman and Story also make another important point: a lot of the 2007 inflows came from Europe and Canada, not Asia or the Gulf.

That is important, and not just because European and Canadian flows come from private investors. There is an enormous difference between foreign investment that is result of a process of economic adjustment, and foreign investment that results from a systematic effort to impede adjustment. The European and Canadian flows reflect the adjustment process; flows from Asia and the Gulf reflect government policy decisions to impede adjustment.

…The dollar has fallen substantially against the euro, the pound and the Canadian dollar. That has made US goods cheaper relative to European and Canadian goods. It also has made US financial assets cheap, comparatively speaking. The result: financial inflows into the US and a falling US deficit with Europe and Canada. The cheap dollar is pulling in money, but it is also setting in motion a process that will lead to the elimination of the US balance of payments deficit with at least Europe.

…Inflows from China, the rest of reserve-accumulating Asia, Russia and the Gulf have a different character. They are the result of government policies that impede adjustment – whether policies that impede the appreciation of their currencies against the dollar or policies that avoid distributing the oil windfall to a country’s citizens.

As a result, the foreign assets pile up in government hands. Henny Sender gets this exactly right – all the money coming out of China right now is government money. Only China’s government is willing to take the risk that the dollar might fall as much against the RMB as it has already fallen against the euro.

…The net result:

Government funds are the only large buyers of US assets in the world’s main surplus countries;

The government in question will likely take large losses on their investments, as they are taking currency risk that the market doesn’t want;

These flows aren’t part of a process that will eventually result in a set of changes that will bring the US deficit down. Rather they are a byproduct of policy choices to impede adjustment.

In a future post I will discuss this in more detail, but Setser has described the likely end of this process. The decline of the US dollar has largely competed its first phase, falling against freely traded currencies such as the Euro. In the next phase it will fall against the currencies of the Asian and oil-exporter nations. When this process has run to completion more services and goods of the US will again compete in world markets, our trade deficit will be either zero or small, and our foreign debts manageable in real terms.

The geopolitical implications of this are simple. This means the US will have less income and wealth in real terms. Foreign adventures, whether as tourists or soldiers, will be far more expensive. Like the UK after WWII, we will find the cost of our foreign bases more than we can tolerate. As other powers have grown as we shrink, the age of American hegemony will have ended — and the world returned to more typical multi-polar geopolitical regime.

Please share your comments by posting below (brief and relevant, please), or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

For more information about this subject

A brief note on the US Dollar. Is this like August 1914? (8 November 2007) — How the current situation is as unstable financially as was Europe geopolitically in early 1914.
The post-WWII geopolitical regime is dying. Chapter One (21 November 2007) — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
We have been warned. Death of the post-WWII geopolitical regime, Chapter II (28 November 2007) — A long list of the warnings we have ignored, from individual experts and major financial institutions (links included).
Death of the post-WWII geopolitical regime, III – death by debt (8 January 2008) – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
Geopolitical implications of the current economic downturn (24 January 2008) – How will this recession end? With re-balancing of the global economy, so that the US goods and services are again competitive. No more trade deficit, and we can pay out debts.
A happy ending to the current economic recession (12 February 2008) – The political actions which might end this downturn, and their long-term implications.
What will America look like after this recession? (18 March 208) — More forecasts. The recession might change so many things, from the distribution of wealth within the US to the ranking of global powers.
The most important story in this week’s newspapers (22 May 2008) — How solvent is the US government? They report the facts to us every year.