Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.

Sam Ewing

Inflation is an economic term that describes a general increase in prices and a fall in the purchasing power of money . A little inflation is normal and even good for a healthy economy. Inflation becomes a problem when it grows too quickly. Money losing value at a rapid rate can lead an entire economy to spiral out of control. All governments and central banks try and control inflation with regulation and monetary policy. Inflation is expressed as a percentage.

Rise in prices – In 1950 you could buy a cup of coffee for $0.22 while today an average cup of brew costs $2.38.

Falling purchasing power of money – A basket of goods that cost $100 in 1950 would cost $1,108 today.

Inflation = Rise in costs of goods and services
Inflation rate = % increase or decrease in prices over a period of time

What Causes Inflation?

Inflation is always and everywhere a monetary phenomenon, resulting from and accompanied by a rise in the quantity of money relative to output.

Milton Friedman

In simpler terms, inflation occurs when there’s an increase in production costs OR when demand for products and services increases faster than supply. Inflation can come about in many different ways. All these causes are most commonly classified into three main types of inflation.

3 Main Types of Inflation (By Causes)

Cost-Push Inflation

Prices increase when the cost of production increases. If it costs more to make a product or provide a service the companies will pass that cost on to consumers by increasing the price of those products and services. Here are some things that can cause cost-push inflation:

• Increase in prices of raw materials – If the price of oil rises, all industries that rely on oil for production will increase their prices to offset that rise in cost.
• Natural disasters  – Natural disasters can disrupt supply chains or destroy a production facility. This makes it more expensive for businesses to operate and they will raise their prices to make up for the loss.
• Scarcity of a resource – If a resource needed for production is scarce that makes it more difficult and expensive for businesses that rely on it to operate. Overfishing leads to fish being scarce and that’s why the price of fish is rising.
• Low unemployment rate  – When the unemployment is low companies increase wages to attract more workers. Production costs rise due to increasing wages and the company raises the price of their product.
• Increase in mandatory wage – When businesses are required by law to increase the wages of their workers they will raise their prices to offset the added expense.
• Government regulation – Increased regulation often means added expenses for businesses that have to invest in new equipment or additional workforce in order to comply with new rules.
• Rise in business taxes – When the government raises business taxes the cost of production, and consequently the prices, will increase across all industries.
• Declining productivity – A workforce with declining productivity will work less for the same wages. This means that companies are paying the same amount to produce fewer products.
  

Demand-Pull Inflation

Prices increase when demand increases faster than production. If everybody wants to buy something that is in limited supply they will be willing to pay more money for it and the companies will charge more for the same product or service. Here are some things that can cause demand-pull inflation:

Growing economy – When things are going well, people have jobs and they are confident that the good times will last they tend to spend more money and create demand.

• Inflation expectations – Inflation is nothing new and people actually count on it. when you expect prices to rise in the future, you’ll buy more things now.
• Increase in the Money supply – When governments print too much money this creates an oversupply of money in circulation. The same goes for when central banks lower the interest rate and banks start lending out more money to people.
• Low interest rates – When the interest rates are low people tend to borrow more money, which means that they have more money to spend.
• Government spending – When the government invests in infrastructure or hires people money gets injected into the economy causing prices to rise.
• Tax cuts – When a country lowers its taxes people end up having more money to spend.
• Innovation – People love new technology and will pay more for it. If a product offers something unique and innovative the demand for it will be very strong.
• Marketing – A strong demand for a product or a service can also be created by marketing alone. Think how the demand for Apple products is always high even though their prices are way higher than their competitors.
• Unbalanced recovery from a downturn – If the economy is stalled by an external event (like a pandemic) demand may recover more quickly than production capacity, especially if governments make stimulus payments. This may cause demand to temporarily exceed supply.

Built-In Inflation (Wage-Price Spiral)

Workers want higher wages to keep up with the cost of living. When prices rise due to cost-push or demand-pull inflation people expect higher wages so they can keep their lifestyle and standard of living. Higher wages make companies increase the price of their goods and services. This raises the cost of living and makes workers demand higher wages.

Increase in the Money Supply And Inflation

Most people will correlate governments printing money with inflation. An increase in the overall money supply can sometimes lead to both cost-push and demand-pull inflation. Money supply creates inflation only when the money is printed faster than the economy grows. Keep in mind that the money supply is not just hard cash, but also credit, loans, and mortgages.

Monetary Policy – When central banks lower interest rates it’s cheaper for banks to lend money. Banks will then lend more money to businesses and individuals who will spend it. More money being spent increases demand, which increases prices.

 Fiscal Policy – If the government cuts taxes, makes stimulus payments, or increases benefits, people have more money to spend. If business taxes are cut businesses can increase wages or hire more people. People have more money, they spend more, demand increases, which increases prices.

Exchange Rates – When there’s more money in circulation the currency loses value in relation to foreign currencies. This makes imported products more expensive because now your currency has less purchasing power. The governments can also choose to lower the exchange rates to make local products more competitive. This will also lead to imports being more expensive.

It might be worth pointing out that increasing the money supply only increases demand if the extra money ends up in the hands of consumers. For example, in the wake of the 2008 recession interest rates were very low but loan criteria were very tight. This meant that the cheap money flowed mainly to the rich. As a consequence, we saw rapid inflation in asset prices (rich people buy stocks and real estate) and much less inflation in consumer goods.

Who Benefits and Who Gets Hurt by Inflation?

Inflation does not impact everyone the same. Some people get hurt by the fall in the value of currency while others can benefit from it.

Losers:

• Savers. If the inflation rate is higher than the interest rate, savings are decreasing in value.
• Retirees on fixed incomes. If you have a fixed pension or interest income from investments your income will not grow with inflation.
• Workers on fixed-wage contracts. If your wage doesn’t rise with inflation, it is effectively getting smaller.
• Borrowers with variable-rate loans. Governments often raise interest rates to try to make their currency more desirable. That can push interest rates on variable-rate loans up.
• Lenders of fixed rate loans. If you lent money at a fixed rate you are getting paid back in less valuable currency.

Break Even:

• Workers whose salaries are indexed to inflation will not be adversely affected by inflation.

Winners:

• Debtors win, especially if their debts carry fixed rates. They pay their loans back in less valuable currency.
• Owners of land and physical assets. These assets tend to hold their value through inflationary periods.

How Is Inflation Measured

To measure inflation we need to use a device called an inflation index. There are multiple ways to measure inflation and that’s why several inflation indexes exist. It’s impossible to keep a track of price changes of every single product or service in the economy. That’s why inflation indexes follow price changes of only a small number of goods and services. 

Consumer Price Index (CPI)

The most well-known inflation index is the Consumer Price Index (CPI). CPI examines the average price of a hypothetical basket of goods and services in order to see if there are any changes in the overall cost of living. Different items in the basket carry different weights. These weights reflect the varying importance of items in the consumer’s shopping basket (having a roof over your head carries more weight than having a gym membership). The increase or decrease in prices of all the items when expressed as a percentage represents the inflation rate.

What’s In The Basket Of Goods?

Each country can use its own methodology, define its own basket of goods and assign different weights to each item in the basket. This makes sense because people living in different places will have different everyday needs and priorities. The items in the basket change almost every year to better reflect the current needs and wants of consumers. Here are the main categories of the basket of goods the U.S. (urban consumers):

• Food and beverages – Food you consume at home and outside of the home, non-alcoholic and alcoholic beverages.
• Housing – Costs associated with owning or renting a home, utilities, household furnishings, and maintenance.
• Apparel – Clothes, shoes, jewelry, and watches.
• Transportation – New and used vehicles, fuel, vehicle parts and maintenance, fees like parking and registration, public transport.
• Medical care – Health insurance, drugs, physician services, dental services, eye care, hospital services, nursing homes…
• Recreation and entertainment – Video and audio, pets, sporting goods, hobby supplies, toys, club memberships, lesson fees, books, and magazines…
• Education and communication – Tuition, educational books, postage and delivery services, phones, computers, internet…
• Other goods and services – Tobacco, personal care products, laundry, legal services, financial services, funeral expenses…

What’s in the Baskets Around The World?

Each basket of goods is commonly sorted by the main categories above and in most countries the items in those categories are the same. But still, there are some curiosities to be found around the world: 

• France – Frogs legs and snails – Confirming all the usual stereotypes
• Italy – Dancing lessons and disco – Because Italians know what’s important in life
• South Africa – Automated pool cleaners
• Germany – The price for a chimney sweep – Lots of dirty chimneys in Germany.
• India – Cereal grinding charges
• UK – Dating agency fees – 
• Italy – Pizzerias and places selling sliced pizza are listed separately
• Japan – Hearing aids, power-assisted bicycles, and knee supports – Just proof of how old the Japanese population is
• South Africa – Sandwich maker/ toaster
• Norway – Package holidays
• Turkey – Cold tea

Speed Of Inflation

There are four main types of inflation, categorized by their speed. They are creeping, walking, galloping, and hyperinflation.

Creeping Inflation (The Good One)

This is when the inflation rate rises by up to 3% each year. It is good for economic growth since it drives consumers to buy now and avoid higher prices in the future. That boosts demand while production and wages have enough time to keep up.

Walking Inflation

This is when inflation is still in single digits, between 3% and 10%, and lasts for a longer period of time. Inflation usually becomes a cause for concern when it goes over 4%. This type of inflation is damaging to the economy because consumers start buying way more than they need in order to avoid higher prices in the future. When that happens, the production and wages cannot keep up. Producers will increase their prices due to higher demand and because the wages are not growing people will not be able to afford some goods and services.

 Galloping Inflation

This is when inflation rises above 10%. At this rate, inflation becomes a serious problem and is hard to control. Money loses value at such a rapid rate that the wages have no chance of keeping up with the prices. It has huge adverse effects on the population of a country, especially the poor and the middle class. In order to control galloping inflation countries need to adopt strong fiscal and monetary measures.

Hyperinflation (The Scary One)

When inflation reaches 50% a month (over 1000% a year) it is called hyperinflation. This is the most extreme form of inflation and there have only been 58 episodes of hyperinflation in recorded history.

Prices rise several times in a single day – something that costs $10 in the morning could cost $100 when you finish work in the afternoon. Money is becoming worthless at such a rate that the government has to print money in larger and larger denominations. You can end up paying $150 billion (Elon Musk’s current net worth) for a loaf of bread…

Prices rising at such a devastating rate leads people to start hoarding goods, leading to shortages of everything. In most cases, people will face severe food shortages. Savings, investments, and pensions become worthless because of the fall in the purchasing power of money. People stop using banks which leads to banks and other lenders going out of business. The collapse of the whole monetary system is inevitable.

The Worst Cases of Hyperinflation in The Last 100 Years

05. Greece, October 1944

Highest monthly inflation: 13,800%
Prices doubled every: 4.3 days
Highest denomination: 100,000,000,000,000 (one hundred trillion) drachmai

04. Germany, October 1923

Highest monthly inflation: 29,500%
Prices doubled every: 3.7 days
Highest denomination: 50,000,000,000,000 (fifty trillion) marks

03. Yugoslavia, January 1994

Highest monthly inflation: 313,000,000%
Prices doubled every: 1.4 days
Highest denomination: 500,000,000,000 (five hundred billion) dinars

02. Zimbabwe, November 2008

Highest monthly inflation: 79,600,000,000%
Prices doubled every: 24.7 hours
Highest denomination: 100,000,000,000,000 (one hundred trillion) dollars

01. Hungary, July 1946

Highest monthly inflation: 13,600,000,000,000,000%
Prices doubled every: 15.6 hours
Highest denomination: 100,000,000,000,000,000,000 (one hundred quintillion) pengo

The post How Does Inflation Work: An Illustrated Guide for the Rest of Us appeared first on FinMasters.

Gas prices in the United States reached unprecedented highs in the summer of 2022, creating a significant challenge for consumers and contributing to elevated inflation. Gas prices have become a contentious political issue, sparking debates over who is accountable.

While the urge to find someone to blame is understandable, the reality of commodity prices is often complicated. Simple answers are frequently incomplete or inaccurate.

So, why did gas prices rise? Let’s take a closer look.

1

Where does the money we spend on gas go?

On average, the cost of gasoline breaks down like this.

• Cost of crude oil: 54%
• Refining costs and profit: 14%
• Distribution and marketing: 15%
• Federal and state taxes: 17%

This breakdown may change at any given time, but the differences are usually minor. Sometimes one or more elements of the price will surge and drive higher prices.

3

Why are gas prices different in different states?

The single biggest difference in gas prices from state to state is taxes.

Some states also require specific fuel blends to control emissions, which may be more expensive.

Transport costs also vary. The farther a state is from major refineries, the higher these costs will be. The high cost of piping fuel over the Rocky Mountains adds an additional cost for gas on the west coast.

4

Why is gas more expensive in summer?

Gas is usually more expensive in the summer. There are three reasons for that.

• People drive more in the warm months, creating additional demand for gas.
• The US requires the use of a different fuel blend in the summer to reduce emissions and air pollution. Summer-blend fuel is more expensive.
• The US hurricane season starts in June. Gulf Coast refineries are vulnerable to hurricane damage, which may cause supply interruptions.

The difference between summer blend and winter blend prices is usually three to six cents a gallon, though it may be increased by supply issues or unusually high demand.

5

How are oil prices set?

Oil prices are set in the global market by the global supply/demand equation. Oil prices are based on bids made by traders who buy and sell contracts for future delivery. These traders are constantly trying to anticipate supply and demand when the contracts mature.

There are two basic types of oil prices.

• The spot price is the price that you would pay to buy oil right now, for immediate delivery.
• The futures price is the price you would pay for a contract for delivery in the future. This price may vary with the delivery date: a three month contract might be different from a six month contract.

If a trader buys a contract for a future date and the contract price is lower than the spot price on that date, the trader has made money. If the spot price is lower than the contract price, the trader loses.

Oil traders bid based on the expected spot price when the contracts mature. They look at expected conditions in the future, but not very far in the future. Most contracts are for delivery in three to six months, and that’s the forward horizon traders consider. They are not concerned with conditions years down the line.

7

Why do oil prices change so much?

Oil is a very important commodity and relatively small changes in supply or demand, or even threats to supply and demand, can move prices dramatically.

Oil prices are extremely volatile, ranging from under $20/bbl to almost $140/bbl over the last 25 years.

Oil prices move in cycles. When supply is plentiful prices drop. That encourages oil use, and demand grows. Producers with high production costs stop pumping, cutting supply. Those trends increase demand and decrease supply, and prices rise.

When oil is expensive, users cut back and use less. Producers pump more to take advantage of the high price. That leads to lower demand and higher supply, and prices fall.

Outside of those broad cycles, many factors can affect prices. Political instability or war in producing countries can drive traders to rush to lock in supply, pushing prices up fast. Rapid economic growth can push demand up. Recessions push demand down, as we can see from the dramatic price drop in 2008.

The abbreviation BBL refers to a single barrel of crude oil. One oil barrel is 42 US gallons, approximately 159 liters or 35 imperial gallons.

You may come across these measures as well:

• kbbl or Mbbl – one thousand barrels
• MMbbl – one million barrels
• Gbbl – one billion barrels
• mbpd – million barrels per day

8

Do OPEC or oil companies control oil prices?

The Organization of Petroleum Exporting Countries (OPEC) does not directly set oil prices. They can influence supply by reducing or increasing output, which affects prices.

OPEC assigns production quotas to member countries. When oil prices are low they reduce these quotas to push prices back up. When prices are high they increase the quotas.

Members do not always follow these quotas if they feel that the quota conflicts with their national interests. Some members are unable to pump enough to fill their quotas.

What Is OPEC?

OPEC is an acronym for the Organization of Petroleum Exporting Countries. OPEC was formed in 1960 by Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela as an intergovernmental organization with an aim to regulate the worldwide supply of oil and its price. Many economists have cited OPEC as a textbook example of a powerful anti-competitive cartel.

Today OPEC has 13 member countries which in 2020 accounted for 37.13% percent of global crude oil production and 79.87% of the world’s “proven” oil reserves. Saudi Arabia is the biggest producer of all OPEC members, accounting for 9.5 million barrels per day.

A group called OPEC+ was formed in 2016 bringing together OPEC members and 10 non-OPEC oil-producing countries.

Oil companies earn high profits when oil prices surge, and some have accused them of price gouging. It’s true that companies could sell gas for less and still earn a profit. It’s also true that many companies have chosen to put money into share buybacks and dividends rather than expanding production capacity.

At the same time, the oil company business model is built around volatile oil prices. They lose money when prices drop and make up for it when prices are high. Oil companies would say that we have to look at profits averaged over both high and low periods to get a real picture of their operations.

9

Why do we have to worry about OPEC? Can’t we produce our own oil?

Oil prices are set in the global market, and the US price tracks the world price closely. Even if the US doesn’t use any OPEC oil, changes in OPEC production will still move the global price and the US price.

For example, the United Arab Emirates (UAE) produces around 3 mbpd of oil. Almost all of this is sold to Asian buyers. If the UAE stopped producing, the refiners that are now buying oil from there would look for other suppliers. Demand would rise and the price would go up for everyone, even countries that don’t use any UAE oil.

10

Why are oil prices so high right now?

Oil prices were in a cyclic high period from 2010 to 2014, with prices continuously between $80 and $110 per barrel.

Prices crashed in 2014 and stayed in a low band (with a brief spike in 2018) until 2020 when the COVID-19 pandemic drove prices to extreme lows. This extended period of low prices drove many producers to reduce both production and investment in new production.

As demand recovered after the pandemic many producers were unable to increase production. Demand soared and supply couldn’t match it. OPEC in particular is pumping roughly 6 million barrels per day (mbpd) less than they were before the pandemic.

This supply shortfall was magnified by sanctions on Venezuela and Iran (which have the world’s largest and 4th largest reserves), export cuts due to political instability in Libya, and Russia’s war on Ukraine.

The US gasoline supply is also being hit by a lack of refining capacity. A large refinery in Louisiana shut down in 2021 after flood damage, and another refinery in Philadelphia closed after a serious fire. US refining capacity is down 1 mbpd from 2019. Refiners are also rushing to produce more profitable jet fuel as air travel ramps up again post-COVID.

12

Why does the US both export and import oil?

The US government does not control the sale and purchase of oil. US producers can sell to any buyer, foreign or domestic. US refiners can buy from any supplier, foreign or domestic. Aside from sanctions on some sellers and buyers, the government has little control.

Different refineries are designed to use different types of crude oil. Many refiners buy different grades of crude oil and blend them to get the ideal mix for their refineries. Some of these grades are not available from domestic producers.

Some refiners also have long-running supply relationships with foreign suppliers that they don’t want to disrupt. In some cases, the links are very close. One of the largest refineries in the US, in Port Arthur, Texas, is owned by Saudi Aramco, the Saudi Arabian state oil company. If they buy from Saudi Arabia they are buying from their own company.

14

Why do US Presidents always ask the Saudis to pump more oil when prices are high?

Whenever prices are high, US presidents ask the Saudis to pump more oil. There are several reasons for that.

• Reserve capacity. The Saudis are one of the only producers with a large reserve capacity. They are now pumping under 10 mbpd. Their official capacity is 12 mbpd. That may not be realistic, but they can certainly pump more than they are pumping.
• Central control. The Saudi government owns the oil industry and can change production levels with a single instruction. The US government can’t tell its producers how much to pump. The Saudi government can.
• Leverage. The Saudis rely on the US for military equipment and defense assistance in a potential conflict with Iran. In theory, this gives the US some leverage over the Saudis. In practice it doesn’t always work: the Saudis don’t always follow US requests.

When the US asks the Saudis to pump more oil, they are not asking the Saudis to send more oil to the US. It doesn’t matter who buys it. If more oil goes into the world market there is downward pressure on prices.

16

Has the cancellation of the Keystone XL pipeline affected US gas prices?

Shortly after taking office, President Biden canceled Keystone XL, a proposed branch of the existing Keystone pipeline. Some say this decision increased gasoline prices. Is it true?

The US currently imports near-record levels of oil from Canada, over 4 mbpd. Much of this oil is heavy, sour (high sulfur) tar sands oil. 

Some of this oil is used by US Gulf Coast refineries that used to use Venezuelan oil, which is very similar to tar sands oil. The rest is exported directly from US ports.

Canada is currently at near-record production levels and its oil is coming to market. Upgrades currently in progress to the existing Keystone and Trans-Mountain pipelines will carry more oil than Keystone XL would have.

Oil prices (again) are set in the global market, and in global terms, the impact of Keystone XL is a small drop in a large bucket, with minimal impact on prices.

18

What could the US do to make gas cheaper?

The US government actually does not have much power to reduce gas prices. The government does not control the oil industry (we’re not Saudi Arabia) and can’t order companies to increase output or open new refineries. Even if US output rose 1 mbpd to match peak levels the impact on global prices would not be large.

The government could reduce taxes, but as we saw above, state taxes are larger than federal taxes.

Dropping sanctions on Iran and Venezuela could increase supply and push prices down but it will take years for these countries to ramp up production. It wouldn’t be a quick fix.

So there’s not much government can do. If there’s one consolation, it is that oil price spikes do pass. High prices encourage producers to ramp up production and provide capital to expand. They also encourage users to cut back and use fuel more efficiently.

If history is any guide, prices will fall, not because of anything government does, but because that’s the way oil markets work.

The post Why Are Gas Prices so High? 18 Questions Answered! appeared first on FinMasters.

What Is a Trade Deficit?

A trade deficit occurs when a country imports more than it exports during a given period. This is also called a negative balance of trade. The simplest way to think of a trade deficit is to say a country is spending more than it takes in.

As of November 2023, the United States had a trade deficit of $63.2 billion^[1]. This was an improvement from the deficit of $72.9 billion in April.

Common Question: What do you call a trade balance where exports exceed imports?
This is called a trade surplus. 

How to Calculate a Trade Deficit

To calculate a trade balance start with the total value of exports and subtract the total value of imports. If such a result is positive, it is a trade surplus, but if it is negative, it is a trade deficit.

Every country has its unique way of calculating, accounting, and keeping records of exports to other countries and what it, in turn, imports from this same country. Within each global entity pair, there will be one that will have a surplus and another that will have a deficit.

                         $253.7 - $316.9 = -$63.2 billion (trade deficit)

Note: The trade balance isn’t only based on a country’s goods but also on its services. 

History of the U.S. Trade Deficit

The United States trade balance moved from positive to negative in the 1970s and has remained negative since then. The deficit increased significantly beginning in 1990 but rebounded in 2009 and has become more severe gradually since then.

In the chart below, the deficit gets larger as the line gets lower.

And here’s a short video showing the trade deficit by country and how it changed from 1960 to 2022.

A country with a negative trade balance typically sees its currency depreciate compared to other currencies worldwide. Its economy suffers adverse effects, ranging from price inflation to loss of jobs. In contrast, a trade surplus typically results in a strong economy. 

This pattern is not universal, and there can be important exceptions, as we’ll see later.

Causes of a Trade Deficit

Several factors can drive a trade deficit. More than one of these factors may be in play at any given time.

A General Drop in Productivity

When a country lacks productivity and growth compared with others, it becomes less competitive. Other nations are becoming more productive and are producing goods for less. A trade deficit occurs as buyers turn to products from less expensive countries.

The declining country loses export opportunities and must increase imports because it can’t produce enough to meet its needs.

Resource Dependence

A trade deficit may occur when a country has a limited supply of a necessary resource and must import it. Countries that have to import all or most of their oil, for example, may be forced into a trade deficit when oil prices are high if they don’t export enough goods to cover the cost of their oil imports.

High Production Costs

High production costs can be driven by several factors. Countries with high wages or high taxes may have difficulty producing goods that can compete in export markets, which can limit their exports.

Some countries (Germany, for example) maintain a trade surplus despite high wages and high taxes by focusing on high-value goods that buyers are willing to pay for and competing on quality rather than price.

Strong Currency

Many people assume that a strong currency is a good thing, but a high-value currency is actually a liability for a trading country. When a currency’s value is high the country’s exports become more expensive and imports become cheaper. This can create or worsen a trade deficit.

In theory, free trading of currencies should correct these distortions. It doesn’t always work that way. China has deliberately intervened in currency markets for decades to keep the value of the yuan low and promote its exports. The value of the US dollar, meanwhile, has been artificially inflated by demand from global trade.

The consistent strength of the dollar makes US exports expensive and US imports cheap and has a significant impact on the US trade deficit.

Effects of Trade Deficits

A trade deficit has multiple effects on a country. Initially, some of these may be positive. Over time, more negative impacts may creep in.

Lower Prices

If imported goods are cheaper than locally produced ones, imports may rise, generating a trade deficit. That may not be a bad thing for consumers, who benefit from lower prices. The availability of low-cost imported goods helped to hold US inflation at below-average levels from the late 90s through 2020.

Falling Employment

A trade deficit typically means increasing reliance on imported commodities and/or manufactured goods. This, in turn, means fewer commodities or manufactured goods manufactured domestically, and fewer jobs available.

If domestic production costs are high, manufacturers tend to move to other countries, bringing prices down but moving jobs out.

Deflation

A country that consistently sends money out reduces the available money supply inside the country. Less money and fewer jobs can cause weak demand leading to deflation.

Weaker Currency

If a country imports more than it exports, it will typically see the value of its currency fall. It is buying more of other countries’ currencies than others are buying of its own currency. That pushes the value of the currency down.

That process is to some extent self-correcting. A trade deficit pushes the value of a country’s currency down, which makes that country’s products cheaper and discourages imports, helping the trade deficit to stabilize.

Why the US Is Different

The US has maintained a trade deficit since the 1970s. At the same time, the US dollar has retained a high degree of strength, the US economy has grown consistently, unemployment has remained generally low, and there has certainly been no deflation.

This seems contradictory. Why hasn’t the US trade deficit, sustained over so many years, damaged the US economy?

It’s All About the Dollar

The answer lies in a unique feature of the US dollar. The dollar is not just the US currency. It’s a global currency used in a large majority of trade transactions.

The US dollar is used in a large majority of global trade transactions. In 2019, the US dollar was involved in 88% of global FX transactions^[2], indicating that almost 90% of world trade transactions are conducted in US dollars.

If a South Korean utility buys oil from Kuwait, they pay in dollars. If a Thai construction company buys excavators from South Korea, they pay in dollars. A German company that imports bananas from Ecuador will pay in dollars.

If a country has a trade deficit, they have to buy more dollars than they are earning. This depletes their dollar reserves and leaves their currency less valuable since there are more sellers than buyers.

For the US, of course, this isn’t a problem. Other countries have to earn their dollars by selling goods and services. The US doesn’t have to earn its dollars because it can simply print more of them.

Will Printing More Dollars Weaken the Dollar?

In theory, printing more dollars should devalue the currency. As we see in this chart of the US dollar index, which compares the value of the dollar to that of a basket of other currencies, that hasn’t happened.

The value of the dollar has held up despite continuous growth in the money supply because demand for dollars, driven by rising global trade, has expanded even faster than supply.

This means that the US can run a persistent trade deficit without seeing the dollar lose value.

The high demand for dollars to underwrite global trade also sustains the US trade deficit. Because the dollar is in high demand its value remains despite the deficit, making American exports more expensive and imports cheaper and sustaining the deficit.

Where Is the Deficit Now?

The US trade deficit has steadily increased since 2014. In the last few months, the deficit increased from $58.6 billion in August 2023 to just $63.2 billion in November. The increase was driven primarily by record US imports prompted by sales of cell phones and other household goods, passenger cars, crude oil, transport, travel, computer accessories, civilian aircraft and parts and other industrial machinery. Exports were up 2.2%, and imports increased by 2.7%.

It is not clear whether this trend will continue. The US deficit will vary with import and export levels and with prices of key commodities, but it seems unlikely that the US will move to a trade surplus any time soon.

Fortunately, the impact of persistent deficits has traditionally been muted. After all, the US economy has consistently expanded despite running deficits for many decades. In short, don’t expect the deficit to end, but don’t listen to people who say the deficit will break the US economy!

The post What Is the U.S. Trade Deficit and Why Does It Matter? appeared first on FinMasters.

Claims that China “owns the US” or could leverage the US debt to China as a weapon are common, yet they often stem from misconceptions about the nature of U.S. debt. By examining who holds the U.S. debt and how the US borrows and manages its debt we can accurately assess these concerns.

How the U.S. Borrows

Most nations borrow money, but they don’t use the same process that individuals use. Countries don’t apply for loans. They use a process more similar to the way a large corporation borrows

The process starts with the U.S. Treasury, which issues bonds. These bonds are sold at auctions, and anyone can buy the bonds, including the Chinese government. As the U.S. Treasury explains, it “delivers securities to bidders who were awarded securities in a particular auction. In exchange, Treasury charges the accounts of those bidders for payment of the securities.” These Treasury bills are either issued at “par” or the bond’s face value, or a discount, to the winning bidders.

Each bond has a fixed maturity date. The owner collects the interest specified in the bond, and on the maturity date, the US government pays off the principal.

Who Owns the U.S. Debt?

America’s total outstanding debt is above the $33 trillion mark.^[1] The U.S. must pay interest on all of that debt. That interest rate changes over time and fluctuated between roughly 1.5% and 5%^[2] during the past decade. In 2023 alone, the U.S. spent $879 billion just to service the interest on the federal debt^[2]; this doesn’t even address the principal debt itself.

This can help us to understand why anyone or any nation would choose to loan money to the U.S. government. Over time, the interest payments can add up, making lending to the U.S. Treasury a potentially lucrative and highly secure investment.

Who or what owns the $33 trillion in U.S. government debt, though?

Anyone can buy U.S. Treasury bonds at an auction; if they win the auction, they get to own the bonds. Buyers can also purchase a Treasury bond secondhand through the bond market.

The majority of America’s debt is held in the U.S. U.S. Public holders collectively own $17.3 trillion worth of America’s debt^[2], making them the number-one U.S. debt holder. So, this ought to come as a relief to anyone who’s worried about China having a monopoly on America’s debt – it simply isn’t the case.

The second U.S. debt owners are Foreign Holders with $7.6 trillion worth of American debt. The third place belongs to Intragovernmental holders, with $7.2 trillion of U.S. debt.

Holders of US National Debt

Breakdown of Holders of US National Debt

How Large Is the U.S. Debt to China?

Thus, we can rest assured that the majority of America’s debt is, indeed, held domestically. Still, there are foreign holders of U.S. debt, and China is among them.

America’s top foreign debt holder is an Asian nation, but it’s not China. It’s Japan, with around $1.088 trillion. China comes second after Japan, with roughly $778 billion of U.S. debt.

US Treasurys Owned by China (2000-2023), in USD billions

China’s $778 billion puts it ahead of the U.K. ($669 billion), as well as other runners-up^[3] such as Switzerland, Belgium, France, and Taiwan. Pick any two of those countries, and China currently owns more U.S. debt than both of them combined.

We have to put things into perspective, though. Being number six on the list doesn’t make China a huge U.S. debt holder. Since China owns less than 4% of outstanding U.S. debt, it’s not accurate to say that America is somehow beholden to China.

Why Does China Buy US Debt?

China has a large trade surplus with the US: they sell more to the US than the US sells to them. That means they accumulate large numbers of dollars.

Chinese exporters earn dollars, but they need yuan to pay their local costs. If they went out and sold their dollars on the open market, they would push the value of the yuan up and the value of the dollar down.

The Chinese government doesn’t want that to happen. Their economy is built on exports, so they want to keep the yuan’s value low to keep their exports competitive. Export-dependent countries usually want to keep the value of their currency low.

So the People’s Bank of China steps in and buys the dollars from the exporters at a rate it sets. The exporters get their yuan, and China keeps the value of the yuan at an advantageous level.

That leaves the People’s Bank of China with a whole lot of dollars that it needs to keep somewhere safe and earn interest in the process. The only really practical way to do this – is to buy US bonds.

Can China “Call In” the US Debt?

Some people fear that China can effectively bankrupt the US by “calling in the debt”, or demanding immediate repayment. This fear is misplaced.

US bonds have fixed maturities: The U.S. Treasury emphasizes that these bonds are paid at par value upon the maturity date.

This means that the bonds, despite what some people might believe or fear, are not “callable”; the bondholder gets the agreed interest rate, and the principal is paid when the bond’s term ends.

It’s as simple as that. There’s no risk of China or anyone else “calling in the debt.” U.S. Treasury bondholders can’t do this. They can sell their bonds, but they can’t demand immediate repayment.

What Happens if China Sells the Debt?

Bond owners aren’t required to hold their Treasury bonds until the maturity date. These bonds can be sold on the secondary market. Anyone who owns a bond can sell it.

Bonds are sold at a discount to face value. Some of the interest has already been paid to the original owner, which makes the bond less valuable.

The bond market works on supply and demand. If someone wants to sell a lot of bonds at the same time, the price goes down.

That’s especially true when interest rates are rising. To sell an old bond with a low interest rate, you’d have to offer it at a huge discount. If you don’t, the buyer will simply buy a new bond with a higher interest rate instead.

If the Chinese dumped US bonds, they would lose a staggering sum of money. They might push the dollar’s value down, but that would make Chinese exports more expensive and hurt China more than the US.

In this scenario, China’s bondholders would simply be selling their U.S. Treasury bonds to another investor; there’s still no “calling in” of the debt. So, in short, there’s no threat here. This should help to quell any concerns that China’s U.S. debt holdings are a threat to U.S. security or that they somehow give China leverage over the U.S.

The Bottom Line

The US and China are strategic competitors, and many observers see the relationship between the two countries entirely through that lens. This leads to the belief that China buys US debt for a strategic reason and intends to “weaponize” the debt.

China and the US also have a deep and complex economic relationship that involves a great deal of interdependence. China buys US debt not because it’s a potential weapon but because they need a place to park their dollars without letting the value of the yuan rise.

America’s growing debt is cause for concern, but there’s no real reason to worry about a China “debt threat.” There is no way for China to “call in” the debt, and besides, the majority of the debt is owned by U.S. interests. So, while China does own a slice of America’s debt, it doesn’t pose a hazard to the nation’s security or its integrity.

The post How Large Is the U.S. Debt to China? appeared first on FinMasters.

We’ll break things down.

What Is GDP?

Gross Domestic Product measures the value of every good and service that an economy produces. While you could calculate GDP for any economy over any period, it’s typically used to measure national production over the course of a year. The higher a country’s GDP, the stronger its economy is because it produces goods and services with higher value.

To put it another way, you can think of GDP as being similar to a score in an arcade game. Higher scores are better, and you don’t want to see a situation where you’re losing points instead of gaining points.

The idea is simple but fully understanding it can be more difficult. Calculating the value of absolutely everything an economy produces is complicated and there are multiple different ways to calculate GDP.

Different Types of GDP

Economists use GDP for many purposes, such as comparing the economy of two different countries or tracking changes in the size of an economy. To help with these comparisons, they’ve come up with multiple types of Gross Domestic Product to track, each with pros and cons and different purposes.

Nominal GDP

Nominal GDP is the simplest type and also one of the most frequently used. It’s simply the value of everything an economy produces without making any adjustments or worrying about things like inflation. That also means that it is the easiest to calculate.

This means it can be used for comparing different economies or measuring output but is less useful for comparisons across time periods.

Real GDP

Real GDP measures Gross Domestic Product with adjustments for inflation.

Inflation is the process through which money loses purchasing power over time. If you’ve ever heard your grandparents talk about buying a loaf of bread for a nickel even though it costs a few dollars today, you’ve heard about the impacts of inflation.

Because of inflation, nominal GDP can rise even if an economy’s true production remains static.

For example: Picture a country that makes $1 million worth of widgets and absolutely nothing else. The next year, that country produces the exact same number of widgets. If inflation is 10%, the country will sell those widgets for $1.1 million. The country’s GDP has risen to $1.1 million due to inflation, even though it produced exactly the same products.

Real GDP adjusts for the impacts of inflation, so the real GDP of that country would be the same in both years. To calculate real GDP, you choose a baseline year and adjust nominal GDPs in the other years measured for inflation compared to the baseline.

To change real GDP, an economy has to actually change its economic output. Changes in its currency value won’t matter. This makes real GDP useful for comparing changes in an economy over time.

Per Capita GDP

GDP per capita accounts for the number of people participating in the economy and looks at how much an economy produces per person.

Consider two countries, each producing $1 trillion worth of goods and services. If one country has a population of 100 million and the other a population of 1 billion, their economies likely look very different despite having the same production. Workers in the smaller country must produce more or higher value goods than workers in the larger country because there are far fewer of them.

For example: India’s GDP is around $3.39 trillion, and Denmark’s is around $395 billion. India’s per capita GDP is around $2,389, while Denmark’s is almost $66,983. India has a much larger economy, but the average Dane is far more productive and enjoys a much higher standard of living.

Per capita GDP is a good measure of a country’s prosperity, if not of its total economic strength.

You can calculate a country’s GDP per capita in either real or nominal terms. All you have to do is divide the GDP by the population.

Purchasing Power Parity

Different products cost different amounts in different places. This is true even within a country, but the effect is very pronounced when you start comparing prices across countries.

Purchasing Power Parity (PPP) is a measurement of the prices of a specific basket of goods and services in different countries. In general, the strong a country’s currency, the higher its PPP will be. Higher PPPs also correlates with a higher standard of living.

GDP PPP is a measure of economic output that adjusts a country’s GDP for factors that influence PPP, including exchange rates and purchasing power. This makes it useful for comparing the economic output of an economy in relation to its cost of living.

How to Calculate GDP

Calculating GDP is complicated, there’s no hiding that fact. It requires figuring out the worth of everything that an economy produces, from the smallest item to the most expensive luxury goods. It also needs to account for the value of services, which can be even harder to track.

There are no perfect solutions for calculating GDP, so economists use a few different methods.

Production

The production approach calculates GDP based on the value of all of the final goods that an economy produces. The formula is:

Gross Value Added – Intermediate Consumption = Value of Output (GDP)

The issue with this method is that it is all but impossible to figure out how much an economy is producing or how much that production is really worth. In many cases, goods and services can go untracked.

For example: If you have a woodworking hobby, you might make some furniture for your home. You’re producing goods that have value. However, if you never sell your homemade furniture, the things you create will never show up in economic calculations even though they should influence GDP.

Similarly, the economic value of housework and childcare provided by stay-at-home parents is not part of GDP.

The production method also ignores the underground economy, which includes goods and services that aren’t reported to the government. This can include the sale of illegal goods and services, bartering, or under-the-table transactions.

Income

Instead of looking at production, the income method of calculating GDP considers all of the money that companies and people in an economy earn. The formula for this method is:

Total National Income + Sales Taxes + Depreciation + Net Foreign Factor Income = GDP

Total National Income is the sum of all wages, rents, interest, and profits.

Net Foreign Factor Income is the difference between the income an economy’s citizens and businesses produce in other countries versus the income produced by foreign citizens and businesses produce in the domestic economy.

The income method can be easier than the production method. One reason for this is that people and companies have to report their income for tax purposes.

While it makes sense that the money people earn in an economy will be roughly equal to the value of the goods and services the economy produces, this method has a few flaws.

One is that production can increase without a commensurate increase in incomes, especially for everyday workers. Another is that it fails to account for people who save and invest money rather than spend it.

Expenditure

The expenditure approach to calculating gross domestic product adds up all of the money spent in an economy to determine the value of the goods it produces.

The theory is that if an economy produces a product, it must get sold to someone. If you just figure out how much money gets spent, you’ll know how much everything produces is worth.

The formula for the expenditure method is:

Consumption + Government Spending + Investment + Net Exports = GDP

Consumption is all private spending on goods, but not on things like real estate or other major investments.

Government spending includes government spending on goods and services as well as wages paid. Things that reallocate money between groups, like unemployment benefits or subsidies are excluded.

Investment includes spending on things like capital equipment, inventory, and housing.

Net exports is the difference between the value of a country’s exports and its imports.

A drawback of the expenditure approach is that it ignores the true value of a product or service and only looks at what was paid. If someone overpays for a product this approach only looks at the money that changed hands rather than what the product was really worth.

Why Does GDP Matter?

GDP matters because it’s one of the best tools that economists have to measure economies. That means that GDP gets used to quantify changes in a nation’s economy over time and to compare different economies.

In general, when a country’s GDP is growing, that is a good thing for its citizens. Modern economies tend to rely on constant growth resulting in continuing employment and wage growth for citizens. It also tends to lead to growth in a country’s investment market.

On the other hand, when GDP falls, it indicates a country is in recession or moving toward recession. Unemployment is likely rising, and people face financial issues. Politicians often respond to falling GDP by taking steps to try to boost the economy, such as reducing interest rates or increasing the money supply.

While GDP is a good rough indicator of economic health, it also has limitations. It does not consider wealth distribution or inequality, which can lower the standard of living of the average citizen even if GDP rises. GDP doesn’t consider environmental damage, sustainability, or the value of non-market transactions.

For those reasons, GDP is primarily a quick rule-of-thumb indicator. It matters, but it has to be considered alongside other factors like the Gini index (for wealth inequality) and the Human Development Index (HDI). We can’t ignore GDP but we also can’t rely on it exclusively!

The post Understanding GDP: What It Is and How It’s Calculated appeared first on FinMasters.

Governments and central banks stockpile gold for a number of reasons. Perhaps they don’t fully trust the currency, or maybe they’re bracing for economic turmoil. After all, gold has a decent track record of maintaining its value during times of high inflation.

Gold doesn’t carry counterparty risk (the possibility that the other party in a transaction may not meet their obligations) as currency and bonds do. Also, gold can help to diversify a nation’s wealth reserves.

Whatever the reasons may be, some nations have amassed mighty hoards of the precious yellow metal.

If the gold price rises significantly over the coming months and years, the balance of economic power could shift dramatically. Hence, there’s really nothing shocking about countries storing gold, but the amounts – and which nations are atop the list of gold holders – may surprise you.

1. The United States

Ironically enough, the nation that ended its gold standard in 1934 currently holds first place among the countries with the largest gold reserves. According to the World Gold Council, the U.S. central bank had 8,133 tonnes (sometimes also known as metric tons) of gold as of November 20, 2023^[1]. The gold is held at various locations, including Fort Knox, Kentucky; West Point, New York; and Denver, Colorado^[2].

Central banks often hold a nation’s gold. In the U.S., however, the gold is held by the Treasury in custody for the Mint, not by the Federal Reserve.

2-4: Germany, Italy, France

Europe is low on certain commodities, including oil and natural gas, as the Russia-Ukraine crisis and its resultant sanctions have reduced inflows dramatically. Certain E.U. nations aren’t short on supply of one particular commodity, and of course, that’s gold.

Germany takes second place among gold hoarding nations with 3,355 tonnes, while Italy and France are nearly equal with 2,452 and 2,437 tonnes, respectively.

Even before the Russia-Ukraine crisis and sanctions, however, the E.U. was already eager to shore up its gold supply. In 2021, after two decades of gold accumulation in the E.U., the European Central Bank declared that gold was “an important element of global monetary reserves, as it continues to provide asset diversification benefits.”

Today, there’s little doubt that Germany’s Bundesbank, Italy’s Banca d’Italia, and France’s Banque de France remain staunchly bullish on gold as a reliable store of wealth.

5: Russian Federation

The Russian Federation’s 2,333 tonnes of gold puts the country in the top five global gold holders. This is an interesting case, as Russia had reportedly been shoring up its gold reserves for years prior to its invasion of Ukraine.

Russia’s gold, which is stored in vaults located in Moscow and elsewhere in the country, was worth around $140 billion during the early stages of the Ukraine invasion. It might be speculated that Russia had built up its gold supply years in advance, in anticipation of the invasion of Ukraine. The idea, apparently, would be to insulate Russia from the impact of sanctions that would diminish the value or usability of the ruble.

Then there’s the question of how Russia could sell its gold if it wished to do so. It’s been speculated that, even as some nations impose sanctions on Russian gold, the country could still sell its gold to China, India, and/or Kazakhstan.

6. China

China might not have made the top five on this list, but the nation’s 2,010 tonnes of gold is nothing to sneeze at. It’s one of only two east Asian countries on the list of countries with the largest gold reserves. However, it’s difficult to substantiate China’s exact place on this list as the country doesn’t necessarily have a perfect track record when it comes to transparency in releasing economic statistics.

Still, it’s not unreasonable to surmise that China does, indeed, have a whole lot of gold stored up. One commentator has even gone so far as to suggest that China actually has more gold than the U.S. – around 20,000 tonnes is the estimate – an interesting possibility to consider, but difficult to prove.

Why would China choose to hoard so much gold? One reason might be the country’s evident desire to “de-dollarize,” or reduce its dependence on the world’s most commonly used reserve currency, the U.S. dollar. Both China and Russia may have ramped up their gold storage over a number of years in order to de-dollarize.

Also, just as Russia has invaded Ukraine, there are concerns that China may follow suit and invade Taiwan. If so, then China’s years-long accumulation of gold might have had a specific and controversial purpose all along.

7. Switzerland

Switzerland’s love of gold is no secret, and the Swiss National Bank’s hoard of 1,040 tonnes solidifies the nation’s spot as a top-ten gold holder. Switzerland is widely believed to have the world’s largest per capita gold reserve.

There was even some controversy this year, as Switzerland reportedly imported gold from Russia in May.

Russia is a large-scale bullion producer while Switzerland is the world’s biggest refining and transit center for gold. Customs data indicates that in May, Switzerland received a whopping 3.1 tonnes of gold, valued at approximately $200 million, from Russia.

According to the Federal Office for Customs and Border Security, the “import of gold from Russia into Switzerland is not prohibited by the Ordinance on Measures Relating to the Situation in Ukraine.” On the other hand, the “export of gold to Russia is prohibited by the existing sanctions regime.” So, there may be debate over whether Switzerland’s purchase of gold from Russia violates the terms and/or spirit of European sanctions on Russia.

8. Japan

Finally, we can round out our list of top global gold accumulators with the Bank of Japan, holder of 846 tonnes of gold. After Japan, the next biggest gold holders are India, the Netherlands, Turkey, Taiwan, and Uzbekistan.

2022 has been an interesting year for gold in Japan, to say the least. The metal’s price in Japan hit an all-time high in February, possibly driven by geopolitical risk along with concerns over a weakening Japanese yen.

Then, in June, Japan joined the U.S., Britain, and Canada in banning Russian gold exports. This joint action would “directly hit Russian oligarchs and strike at the heart of (President Vladimir) Putin’s war machine,” according to British Prime Minister Boris Johnson.

Is Holding Gold an Advantage?

Gold holdings can be advantageous. Gold is widely seen as a hedge against inflation and fluctuating currency exchange rates, and it’s widely sought as a way to diversify national assets.

Holding gold also has disadvantages. Gold reserves do not earn interest, so moving resources into gold can deprive a country of interest income.

The countries with the largest gold reserves are not necessarily stronger or weaker than other nations. They may just have different priorities and choose to hold their wealth in different ways!

The post 8 Countries With the Largest Gold Reserves appeared first on FinMasters.

US stocks entered a bear market in June 2022. But what does that mean? How much will stocks fall, and how long does a bear market last?

Of course, there are no guarantees and the future isn’t always the same as the past, but knowing more about bear markets can give us some badly needed perspective on what’s going on today.

What Is the Difference Between a Correction and a Bear Market?

A correction is a broad-scale drop in stock values of over 10%.

If major indices fall more than 10% but less than 20% before recovering, it’s called a correction. If they cross the 20% line, it’s called a bear market.

Corrections are common. Markets experience a correction around once a year, on average, and drop 5% around three times a year.

The chart above shows that five different corrections occurred during the 2009-2020 bull market.

How Long Does an Average Bear Market Last?

The average bear market has taken 13 months to go from the peak to the bottom and 27 months to get back to the level of the previous peak.

As we can see from the chart above, bear markets that are not accompanied by recessions tend to be relatively short and relatively mild. We can also see that bull markets tend to run much longer than bear markets.

Bull market periods show an average cumulative return of 468% and last an average of almost 9 years. Bear market periods last an average of just under 1.5 years with a cumulative average loss of 41%.

That’s why stock markets have consistently gained over the long haul despite recurring bear markets.

What Causes a Bear Market?

A bear market occurs when investors sell more stocks than they buy for an extended period. But why does that happen?

It’s important to distinguish between the trigger of a bear market and the cause.

Selling can be triggered by many causes: geopolitical events, bad economic news, indications that a recession is coming, increasing interest rates, inflation, and more.

These are triggers, not causes. Paradoxically, the cause of a bear market is usually a bull market. As we’ve seen, bull markets typically last longer than bear markets, and the gains during a bull market exceed the losses during a bear market by a large market.

The longer a bull market goes on, the more aggressive investors get. Popular stocks get bid up to unrealistic valuations. Borrowed money flows into asset markets, pushing prices higher. Market success draws new investors into play, drawn by FOMO – the fear of missing out.

This often results in a full-fledged market bubble. The bear markets of 2001, 2008-2009, and 2022 were all preceded by market bubbles. When valuations rise to completely irrational levels and debt levels peak, even a small trigger can send investors flocking to the exits. As stocks fall, fear of missing out turns into fear of getting stuck, and investors rush for the exits, sending prices down.

Think of a bursting balloon. The pin is the trigger. The air pressure inside the balloon is the cause.

Can Stocks Rise During a Bear Market?

Stocks can certainly rise during a bear market, just as stocks can fall during a bull market. These terms describe overall trends over extended periods. It’s common to see a brief bounce or even a few weeks of gains before stocks hit bottom.

There’s often a 10% to 20% gain near the bottom – colloquially known as a bear market rally or a “dead cat bounce” before the final plunge.

The post Bear Market Guide: Definition, Causes and How to Invest appeared first on FinMasters.

This can be really confusing for investors, considering the abundance of conflicting opinions on the topics. So here is a quick review to help you understand what’s going on.

Why Rates Matter

Interest rates are often called the price of money. They determine how expensive capital is to access for companies, but also for individuals and even governments.

We all know from our personal experience how this works. When the bank gives us a loan at a lower rate, this reduces costs of the debt we are taking out. Low rates allow us to take on more debt while paying the same amount of interest.

We are leaving a period of exceptionally low interest rates, well below historical averages. This means that getting into debt never was cheaper.

This had a few consequences:

• People and investors could take out much larger loans to pay for real estate and other assets.
• Companies could manage a large debt with minimal interest expenses.
• Governments could borrow more without worrying about interest spending.
• Speculators poured borrowed money into stock markets.

If interest rates go up, the opposite happens. Debt becomes expensive and suddenly we cannot afford some of the things we previously paid for with debt.

Why Rates Change

The Federal Reserve controls what is called the federal funds rate, which is the rate banks pay to borrow from other banks. Other interest rates throughout the system are based on that rate. Central banks in other countries have a similar rate-setting function.

When an economy is in recession or unemployment is high, the Fed lowers rates. This is meant to encourage investment and spending, pushing more money into the economy.

As the economy starts growing and unemployment reduces, the Fed typically begins to raise rates, aiming to avoid inflation of both asset prices and consumer prices.

The rate-setting process is supposed to be apolitical, which is why the Fed is separated from direct political interference. In practice, politics are deeply involved. Political pressure tends to lean toward lower rates, which are associated with a “hot” economy. Politicians like a hot economy, even when it raises the risk of a dangerous bubble.

How Rising Rates Impact Assets

Rising interest rates have different effects on different classes of assets.

Real Estate

Real estate purchases are typically financed with debt, so changes in interest rates have an immediate impact on real estate markets.

Mortgage rates are now almost at 7% in the US, the highest since 2002. This means the monthly payment for a house at an unchanged price is going up significantly. This should reduce the demand for housing.

This might cause a real estate price decline or even a crash. This might also just cause people to pay more for properties of equivalent value.

It is worth noticing this only affects new or renewed mortgages or mortgages with variable rates. People that have locked in lower fixed interest rates with fixed-rate mortgages will keep paying their low rate.

Stocks

Interest rates affect stocks in two main ways: the impact on companies and the impact on investor behavior.

Many companies “roll over” their debt. This means they never really pay their debt, just pay the interest and renew their old bonds with new ones. In this case, rising rates mean the new bonds will cost the company a lot more in interest expenses going forward.

Some companies are also highly reliant on cheap debt to keep afloat or grow. Others rely on customers spending on credit cards. These companies’ profits might suffer in an environment of rising rates.

Other companies will not care at all and look a lot better in comparison.

This is why a rising rate environment favors skilled stock pickers. A solid balance sheet, low debt, cheap valuation, or high profitability will be very valuable in an environment of rising rates.

Higher interest rates don’t just affect companies with debt, though. When interest rates are low and markets are rising there’s an overwhelming incentive to plow borrowed money into asset markets, especially for big institutions that can borrow very cheaply. That’s one of the main reasons why stocks, cryptocurrencies, and other assets boomed from 2017-2021.

When rates rise borrowed money tends to flow out of markets, depressing the values of even quality companies. That hurts investors who bought at the top, especially if they bought at the top with borrowed money. For others it creates a valuable entry point.

Long-Term Bonds

To understand the effect of interest rates on long-term bonds, we need to look at how they work. A bond is a promise to give back money in a fixed period of time (like 10 or 30 years) plus paying a fixed amount of annual interest during that period.

A value of a bond is always compared to other bonds. If “old” bonds pay 2% interest and new bonds give 4% interests, the old bonds are less valuable. This means that the value of the old bond has declined. Overall, a steadily rising interest rate environment is not one where you want to have long-duration bonds in your portfolio.

In theory, the profits on a bond are the interest it provides. In practice, such profits need to be higher than inflation to be “real” profits, instead of just “nominal” profits.

So the current environment of high inflation and rising rates is really not favorable to bond investors. Especially as most bonds issued over the last decade yielded very low returns, and even negative yields for some government bonds.

How Rising Rates Impact Inflation & Currencies

Interest rates are closely tied to both inflation and currency exchange rates.

Why Are Rates Rising?

Inflation is a sign there is too much money in the financial system. One way to reduce that is to give people and businesses an incentive to take on less debt. A good way to do that is to raise rates. And this is just what the Federal Reserve is doing.

The problem with this response is that if inflation is also due to supply constraints, increasing rates will only have a limited impact. They could even restrict investment in new production that would alleviate supply constraints. So we might see inflation persist, which could drive rates even higher. Historically, rates had to be brought higher than inflation to bring inflation down.

Overall, rising rates are a useful tool to help bring inflation down. But the recent increase might not have been enough and there’s probably more to come. If inflation stays high, we would need rates to double or triple from current levels.

Currency Wars

Another effect of rising rates is on the relative values of currencies. As a rule, money will flock to currency offering a better return. Currently, the dollar is offering higher rates (through government bonds) than other major currencies like the Euro or the Japanese Yen.

This led to the dollar becoming a lot stronger. High inflation in the Eurozone and a brutal energy crisis (which I explained in detail here) did not help either.

A stronger dollar makes American exports less competitive, but also make import less expensive. This too can have wide consequences on companies’ valuation and profit, depending on their business model. This will be good for EU and Japanese exporters, and good for US importers. It will be bad for US exporters.

Many other countries and foreign companies do business in their currency, but carry debt in dollars. A strong dollar makes that debt more expensive (on top of rising rates).

This can lead to a wave of bankruptcy and default, including for entire countries, as is already the case for Sri Lanka. Even developed countries like the UK could be affected.

This is why many countries, like Japan, will try to limit the devaluation of their currency against the dollar.

Conclusion

Rising rates have a very important macroeconomic impact on the world’s economies. They affect investors through their impact on corporate, through currency exchange rates, and by restricting inflows of borrowed money to support stock prices. In an environment of rising rates, risk tends to be higher and safer, more profitable, and lower debt companies are likely to perform better.

The positive aspects for US investors:

• Rising rates support a stronger dollar.
• A strong dollar makes US imports cheaper.
• A strong dollar support consumers’ spending by decreasing import costs.
• Rising rates might help to keep inflation under control.

The negative aspects for US investors:

• Currency devaluation can hurt overseas investments measured in USD.
• Overindebted companies and consumers might not be able to manage higher rates.
• Rising rates decrease demand for big-ticket items like homes and vehicles.
• Rising rates increase the risk of a recession.
• Rising rates make US exporters less competitive.
• Rising rates restrict the use of borrowed money by investors, decreasing demand for assets across the board.

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We’ll break it down.

What Is the National Debt?

The US government raises money through taxes and spends the money it raises on various programs, such as national defense, health care, welfare programs, education, and more. Often, the government wants to spend more than it raises in taxes, which means it has to borrow money to finance its spending.

When regular people want to borrow money, they usually go to a bank and apply for a loan. The government, however, can’t do that. Instead, it sells government loan securities, like Treasury bills or bonds, to investors. These investors can be regular people, businesses, other countries, or even departments of the US government.

US government debt is seen as some of the safest debt for investors to hold, so many people looking for a safe place to invest will try to buy US government bonds.

How Much Does the US Owe?

As of September 2022, the US national debt stands at $32.66 trillion dollars. Over the past 10 years alone, the U.S. federal debt has increased by more than a third. It went from $20.73 B in 2021 to $33.88 B in 2022.

U.S. National Debt Over the Last 100 Years
(Inflation Adjusted – 2022 Dollars)

The Two Types of National Debt

The US Treasury operates the Bureau of the Fiscal Service, which manages the nation’s debt. It regularly publishes “Debt to the Penny” which tracks the US government’s debt down to the individual penny.

The Bureau of the Fiscal Service breaks the US national debt down into two broad categories: intragovernmental and public.

Intragovernmental

Intragovernmental debt is debt that the Treasury owes to other federal agencies of the United States government. In a way, you can say this is debt that the United States owes to itself.

At the time of writing, of the country’s roughly $30.8 trillion in debt, $6.6 trillion is intragovernmental debt.

It’s a bit odd for the government to owe money to itself, so you might wonder why different federal agencies would buy government bonds. The reason is that some agencies bring in more money than they spend.

Rather than letting their cash reserves build up, these agencies buy government bonds to move the cash somewhere it can be used. It also lets these agencies earn interest on their excess income.

Another major holder of the country’s debt is the Federal Reserve. The Federal Reserve, as the central bank of the United States, sometimes buys and sells federal debt to adjust the money supply in response to economic conditions.

Ultimately, this all means that a significant portion of the US government debt is owed to other parts of the US government.

Public

Public debt covers all US government debt that is owned by parties that are not US government agencies. That includes individual investors, state and local governments, mutual funds, companies, and other nations.

At the time of writing, of the country’s roughly $30.8 trillion in debt, roughly $24.1 trillion is held by the public.

Intragovernmental Holdings and Debt Held by the Public 2022-2022
(Inflation Adjusted – 2022 Dollars)

Who Owns the US National Debt?

According to the government, the largest holder of US government debt is American investors. Overall, the American public owns $9.8 trillion of the government’s debt.

In fact, the top three holders of US government debt are based in the United States.

Once you get past the top three owners of government debt, you begin to see other nations show up in the list of America’s creditors. The top ten holders of US debt hold a total of 83% of the government’s public debt.

If you count American investors alongside intragovernmental debt, 53.6%, more than half of the debt, is owned by American entities. The largest individual foreign holder, Japan, owns roughly 4.2% of the national debt.

How Much Does the National Debt Cost?

Having debt means paying interest on that debt and government debt is no different.

US government debt is typically seen as some of the safest debt on the market and it receives top ratings from credit rating agencies, which means that the government is able to keep interest rates relatively low.

In 2022, the government spent $476 billion paying interest on its debts. Put another way, 2% of the country’s GDP went toward debt service.

In part due to rising interest rates, the Congressional Budget Office projects interest costs to rise to $1.1 trillion, or 3.2% of GDP, by 2029.

Is the US National Debt a Problem?

The $30 trillion question is whether the United States national debt is a problem. The answer largely depends on who you ask.

Many economists and lawmakers agree that some level of deficit spending and debt is necessary, or at least not the worst thing in the world. Taking on debt can let the government spend money on important projects or stimulate the economy during a recession.

However, most economists and lawmakers agree that excessive debt is a problem. Having too much debt means spending a lot of money on interest payments, which reduces the amount of tax revenue the government can use for government services.

The problem is that nobody really knows or agrees where the line is. People know that ballooning national debt can force spending cuts and tax increases, but there’s little agreement on where the problems begin. Some feel that the government has already crossed that line while others believe that the debt could double or more without being an issue

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That dominance has prevailed for many years. But how was that dominance established? What effect has it had on the US and on the rest of the trading world? How long will it last?

Just How Dominant Is the Dollar?

The dollar’s dominance in global trade and among global reserves is hard to overstate. Dollars account for a large majority of global foreign exchange reserves.

The dollar is also the currency most often included in foreign exchange transactions by a wide margin.

A large majority of exports are invoiced in dollars, except within Europe.

The Index of International Currency usage, which combines multiple factors, including reserves, transaction volume, debt issuance, banking claims, and others, shows just how dominant the dollar is.

The overwhelmingly dominant role that the dollar plays in global trade is often controversial and often misunderstood. It has been called an exorbitant privilege and an exorbitant burden. It has spawned a legion of conspiracy theories.

To begin exploring this dominance and its impact, we’ll start at the beginning.

How Did the Dollar Become Dominant?

International trade has always been dependent on finding an acceptable medium of exchange with a defined and agreed value. For centuries there were no standard solutions: Florins, guilders, and Mexican silver dollars were widely accepted and used in different times and regions, but there was no common standard. Some countries linked their currencies to gold and others to silver or used precious metals as trade currencies.

By the 18th century, the pound sterling emerged as the dominant trade currency, a condition that prevailed through 1914.

Britain and most other European countries suspended gold convertibility during the First World War, leading to a period of financial chaos when nobody was sure what any currency was really worth. Hyperinflation and economic depression in many countries played key roles in the emergence of fascism and the buildup to the Second World War.

The Bretton Woods Agreement

In 1944 730 delegates from 44 countries met in Bretton Woods, New Hampshire, with the lofty goal of setting up an orderly system for defining the value of money and enabling global trade on consistent terms.

Given the economic dynamics of the day, the choice of the US Dollar as the index currency was natural. The decision was that the US dollar would be linked to gold and that all other currencies would have a fixed value against the dollar.

Countries that were unable to maintain their exchange rate could petition the newly formed International Monetary Fund for a rate adjustment.

The Bretton Woods Agreement did not mandate that trade would be conducted in dollars, but it left the dollar as the obvious choice for trade.

The Collapse of Bretton Woods

After the Great Depression and the Second World War, the world craved order and stability, and the Bretton Woods Agreement seemed orderly and stable. The dollar was linked to gold and everything else was linked to the dollar. Gold ruled, and currency had defined value. Hyperinflation seemed impossible.

Reality is never that stable and rarely obeys the orders of humans.

The stability of Bretton Woods was its own undoing. With currency values fixed and accepted, global trade surged. Since the traders all wanted dollars, demand for dollars surged with trade.

With the demand for dollars rising, banks outside the US began making dollar loans, often for more than they had on deposit. The number of dollars in circulation exploded, each of them a claim on the US gold reserves (people of a certain age will remember the panic over “Eurodollars”). High government spending on social programs and the Vietnam war added to the burden.

By the late 1960s, it was apparent that the US simply didn’t have enough gold to meet the demand for dollars. In 1971 the US abandoned the gold standard and adopted a free-floating exchange rate set by supply and demand. The Bretton Woods system ceased to exist.

After Bretton Woods

When the Bretton Woods agreement collapsed, countries adopted different arrangements: free-floating currency, pegs to a single currency or a basket of currencies, or participation in a currency bloc. Today the free-floating system dominates: currency values are set by supply and demand.

The collapse of the Bretton Woods agreement did not break the dominance of the dollar. If anything, it enhanced it. Traders still needed a consensus currency to work with, and the dollar was the obvious choice.

Why the Dollar?

A trade currency needs certain features, and there’s no other currency that has them to anything like the extent that the dollar does.

• Liquidity. There has to be enough currency in circulation to support the demand from international trade.
• Universal acceptability. Almost everyone, anywhere in the world, accepts dollars as payment for goods and services.
• Universal convertibility at market-determined rates. Many countries deliberately manipulate exchange rates. Traders don’t want that.
• Reliable, transparent settlement systems. Traders want money to flow fast and smoothly.
• Incumbency. Inertia is a potent force, and it’s always easier to keep using what you’ve been using unless there’s a compelling reason not to.

It’s important to remember that most world trade is conducted by private companies, not governments. They aren’t concerned with politics or policy, they want smooth, easy, convenient transactions and they want to be paid in currency with predictable value that they can spend anywhere.

Is The Use of the Dollar Mandatory?

A widely circulated conspiracy theory holds that the use of the dollar is somehow required in international trade, particularly in purchases of oil. This is, of course, not true.

If we look at the export invoicing charts cited above, we’ll see that while the dollar dominates trade, it doesn’t have a monopoly. Close to 80% of trade in Europe is invoiced in currencies other than dollars, along with nearly 25% in Asia and 20% in the rest of the world. This would not be the case if the use of the dollar was required.

But What About the Petrodollar?

A variation of the mandatory dollar theory involves “petrodollars.” The belief is that oil transactions can only be conducted in dollars, and if someone trades oil in any other currency, the dollar will collapse and its dominance will end.

This theory has no basis in reality. The price of oil, like the prices of most globally traded commodities, products, and services, is quoted in dollars for convenience, but the parties to a transaction are free to settle in any mutually agreeable currency. If the Kuwait National Petroleum Company wants to sell oil to a South Korean utility and take payment in Thai Baht or Italian Lire, nobody will stop them from doing it. In practice, though, almost everyone uses dollars.

Oil and gas are important commodities, but they do not dominate world trade or demand for dollars. Together they make up about 9% of global trade, including the substantial oil and gas trade of the US itself. A move by some countries away from dollars for oil trading would not have a dramatic impact on the global use of the dollar or the value of the dollar.

The term “petrodollar” does not describe an oil trading system. It is simply a dollar earned by trading oil. The term gained prominence in the 1970s when economists worried that oil-producing nations were accumulating dollars faster than they could spend them, and it’s still around. There is nothing about “petrodollars” that poses an imminent threat to the US or the dollar.

The Dollar’s Dominance: Privilege or Burden?

In the 1960s, Valery Giscard D’Estaing (then the Finance Minister of France) referred to the dollar’s role as the international trade and reserve currency as an “exorbitant privilege.” The term has endured and is regularly used in financial discussions.

Why is it a Privilege?

Most exporters want to be paid in dollars. If a country wants to import, it has to earn dollars with its own exports before it can spend dollars on imports. If the value of the exports won’t cover the cost of the imports, the country has to borrow.

Because the US pays for its imports in its own currency, it doesn’t need to earn dollars to pay for its imports. It can simply print more dollars, allowing the country to run a trade deficit without the penalties that others would suffer.

More recently, the ubiquitous use of the dollar has allowed the US to use the dollar as a weapon by threatening or imposing sanctions that would exclude countries from dollar settlement systems. These sanctions have rarely been effective (countries can trade in other currencies), but they are still perceived as a unique capability for the US.

Why is it a Burden?

Having a currency used as a trade and reserve currency also creates problems for a country.

Overvalued Currency

A trade currency is always in demand, and that keeps its value high relative to other currencies. We tend to think of a strong currency as a good thing, but it often isn’t.

A strong currency makes a country’s imports cheaper and its exports more expensive. That created an incentive to import and a disincentive to export. It’s also a huge incentive for companies to move key functions overseas, where they can be paid for in cheaper currency.

The persistently high value of the dollar is a major reason for the US trade deficit and the move toward “offshoring” business functions. An artificially strong currency cuts exports and hurts jobs.

Loss of Control

A trade and reserve currency is no longer only a national currency. It becomes a global currency. Banks all over the world accept US dollar deposits and issue US dollar loans. Many banks issue loans far in excess of their deposits, effectively creating new dollars.

Any currency that becomes a global currency will be in the same situation. The issuing country will not only have an overwhelming incentive to print more of its own currency but will lose control of the supply of its currency generated outside its borders.

Will the Dollar Remain the World’s Currency?

We hear constant speculation that the dollar’s reign as the world’s trade and reserve currency is coming to an end. The less exciting truth is that this will probably not happen any time soon. The dollar may not be the perfect global currency, but there are very few attractive alternatives.

The dollar is far ahead of every other possible contender.

The only realistic contenders, the Euro and the Chinese Renmimbi or Yuan, each have serious drawbacks. The Euro does not have a unified Treasury or bond market behind it. The Renminbi is held back by a high degree of government intervention in exchange rates and capital flows. Neither currency has anything close to enough liquidity to underwrite international trade.

 Common Question: Why does China have two currency names?

The currency of the People’s Republic of China is called the Renmimbi, but a unit of that currency is called a Yuan. It’s as if there were different terms for “the dollar” and “a dollar.” In practice, the terms are interchangeable.

More important, neither China nor the EU would want their currency to become the dominant trade and reserve currency. China is the world’s leading exporter and the EU is second. A move toward the use of their currency as a global trade medium would inevitably push the value of their currency up and the competitiveness of their exports down. For export-dependent economies, this is potentially devastating. China has consistently intervened to keep the value of its currency down and support its exports.

Could There Be a New Currency?

Proposals for a world currency are not new: economist John Maynard Keynes proposed a global currency called the Bancor at the Bretton Woods conference, but the proposal was rejected.

More recently, it has been suggested that the International Monetary Fund’s Special Drawing Rights or SDR could emerge as a global currency. That would mean introducing the SDR as a medium for private transactions, not just government transactions with the IMF, and the IMF would need to have the power to control the supply of the SDR. Given the general mistrust of the IMF in much of the world, this isn’t likely to happen.

Still, others have proposed a blockchain-based cryptocurrency, but nothing even remotely appropriate for the task has emerged, and the wild fluctuations in cryptocurrency prices are not conducive to use in trade.

It is very unlikely that any currency will take over the dollar’s current dominant share of reserves and trade invoicing. What is likely is that the use of other currencies will gradually increase, slowly eroding the dominance of the dollar without a move toward a clear replacement. As global currency exchange rates and mechanisms become more transparent, this becomes more viable.

That is not necessarily a bad thing for the US. A gradual reduction in demand for dollars would allow the dollar to achieve a less inflated value, boosting exports, making imports less desirable, and creating less incentive to move business functions out of the country. That would help the US more than it would hurt.

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