Inflation in the Twenty-First Century: A Circular Flow No Longer

Kevin Coldiron is a lecturer in the Masters of Financial Engineering Program at the Haas School of Business, UC Berkeley, and host of the Ideas Lab podcast series on the Top Traders Unplugged platform. Previously, Kevin worked for 25 years in asset management, as co-founder of Algert Coldiron Investors (ACI), a San Francisco-based quantitative hedge fund, and before that as head of the hedge fund business at Barclays Global Investors in London.

Kevin is co-author with Tim and Jamie Lee of The Rise Of Carry, which was awarded the 2020 Globie for Globalization Book of the Year. It’s a really good book! Kevin also publishes a monthly newsletter called The Ideas Lab: New Ways To Understand Global Markets, and he is a Treasurer and founding Board Member of Capitalists For Shared Income, a non-profit building a sovereign wealth fund for capitalism.

As with all of our guest contributors, Kevin’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.

When The Rise Of Carry was published my teenage son, a Covid-era stock speculator took a copy to his room. It sat unopened for months.

Then one day:

Son: “Dad, we need to talk.”

Teenager. Talking? Not good.

Me: “Sure, what’s up.”

Son: “Figure 2.3 is way too complicated, no one is going to get it.”

Me: “What?”

Son: “You know, your book. Figure 2.3. The Circular Flow Of Dollars. It’s too busy.”

Me: “You read the book?”

Son: “That’s what I’m trying to tell you. I did. Up until Figure 2.3!”

Figure 2.3 was our attempt to show how dollars circulated through the global economy. Dollars left the U.S. as payments for goods and services, or as part of carry trades, but a lot of them found their way back to the U.S. in the form of Treasury bond purchases. This ‘circular flow’ provided a source of price-insensitive funding for the US government deficit.

It’s a complex story, which we tried to simplify, but it was – clearly – not simple enough.

Below is another attempt at Figure 2.3 – slimmed down to focus just on dollars related to trade flows between the US and China. The persistent US current account deficit means dollars moved from the US to Chinese companies, who then sold them to the central bank in exchange for local currency. Those dollars then became part of China’s foreign exchange reserves and a large fraction of those reserves were invested in U.S. Treasuries [1].

We worked on the book for years before its publication in December 2019 and, as we typed away, the flow was already changing. China began a gradual process of diversifying its FX reserves investment in 2007 and this process has accelerated since 2011.

The picture now looks more like the chart below. The deficit between the US and China still exists, but dollars no longer get stockpiled as reserves. Instead, China has built a sophisticated system for using that money to invest in a range of both foreign and domestic assets. My upcoming interview with Zoe Liu, author of Sovereign Funds: How The Communist Party of China Finances Its Global Ambitions, digs into the details. The key point for this post is that the once circular flow of dollars is no longer.

Why has China stopped buying Treasuries?

First, they own a lot. More than they need to manage the exchange rate, although this is being tested as we speak. Second, after the GFC, Treasuries became low-yielding assets and there was an uncomfortable opportunity cost to putting more money into something that barely kept up with inflation. Lastly, politics – the U.S. cutoff access to Russia’s central bank assets, couldn’t the same thing happen to China?

Other countries made similar calculations. The result has been a halt in Treasury purchases from China as well as major oil and commodity exporters. I’ve tried to capture this in the graph below. The orange bars show the total change in Treasury bond holdings and the grey bars the cumulative current account balance with the U.S.

From 2000-2010, these countries had a cumulative surplus with the US of $3.2 trillion and increased their holdings of Treasuries by $2 trillion. This is the circular flow we wrote about. Since then they’ve continued to accumulate dollars, but have stopped adding to their ownership of Treasuries.

Did the U.S. government react to this fall in demand for their bonds by selling fewer of them? Uh, no.

Did the Treasury bond market react to falling demand by pushing prices down and interest rates up? Until very recently, also no.

So what happened? Who replaced the demand?

First, there was an increase in Treasury buying from “financial centers” – places like the U.K., Switzerland, Cayman Islands, etc. Some of this activity – maybe a lot – was on behalf of those countries that stopped buying them directly. But the real whale was the Fed, which increased its holdings of Treasuries by $4.0 trillion from 2011-2022.

Here is where things stand now:

  • China & the Oil/Commodity countries seem unlikely to buy more Treasuries.
  • Indirect purchases through financial centers will continue, but I bet these taper off as countries worry about the US improving its ability to trace the bonds’ ultimate ownership.
  • The Fed is trying to reduce its Treasury holdings.

In other words, some huge buyers want to stay on the sidelines. Meanwhile, the huge seller – the US government – is going to sell even more because it is projected to run large deficits for…well forever really. And this projection, shown below, assumes long-term rates of only 4%.

Is 4% enough to attract other buyers?

If you believe inflation will be 2% then probably yes. If you believe inflation will be 3%, 4%, or more…then no, bond yields need to be higher. But with rates at, say, 6% the ugly deficit picture above gets uglier.

And that is where the story comes back to inflation.

At some point the Fed is going to get squeezed. It could get squeezed into allowing inflation to run higher because inflation is a stealth tax and what better way to finance a stubborn deficit than a stealth tax.

And it could get squeezed into keeping long-term rates low through buying bonds. Fed bond buying was not inflationary in the pre-Covid world, but purchases designed to finance a deficit would be.

Of course there are alternate scenarios.

For instance, productivity growth might accelerate, bringing both inflation and the deficit down. This is what Mark Mills, author of The Cloud Revolution, and my guest on this Ideas Lab podcast, expects.

I hope this happens! I just don’t know enough to judge the likelihood.

What I do know is that the flow of dollars around the world has changed and that makes the mechanics of financing the US deficit more challenging, which in turn increases the likelihood that inflation will be used as tool to manage it.

[1]To keep the diagram simple, I’ve left out the arrow that completes the circle. The US government deficit, partly financed by Treasury purchases from abroad, puts money into the pockets of the US private sector, which then buys goods and services from China and the loop continues.

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  1. (Figure 2.3 didn’t load for me. Is it local to me?) Thx!

  2. Avatar for jrs jrs says:

    Loads OK for me on Brave.

  3. If I may interject an ET concept into this discussion. “What do we need to be true”.

    The federal fiscal trainwreck happens very quickly at elevated interest rates. My guess is inflation will come down to or below the FEDs 2% target as the BLS will change the formula and/or hedonically adjust the excess inflation away. They will introduce new “incentives” for banks, insurance companies and pensions to force them to become ever expansive buyers of treasuries.

    The Renfields in the financial media will spread the good word , that will put off the reckoning another decade or so.

  4. I can not see the imagine in Safari, but can in Chrome.

  5. Avatar for KCP KCP says:

    Clearly the USA keeps meddling with the laws of balance - moving the fulcrum, reshaping the fulcrum. But ultimately gravity rules here. I keep reading about supply of money from Treasury buyers and the changes in dynamics (one of which Kevin illustrated in this thread).

    I guess my simple question: Is there enough supply in the world of money to sustain an ever increasing share (40% and rising) of the world’s deficits (USA) for a mere 4% (USA) of the world’s population? Doesn’t gravity come in at some point and reset things to a proper balance?

    If the world has other alternatives, clearly rates in USA have to move up or stay higher, but who are the other buyers? Jack/Jill taxpayer, USA institutions, the FED? Doesn’t that supply shift start starving the private sector?

    These scenarios certainly seem to have higher odds of playing out given the geopolitical shifting going on, at least that’s my read?


  6. Avatar for 010101 010101 says:

    That would be the playbook, it could be running out of pages. The commercial banks seeking to hold more short term treasuries will reduce the supply of credit to business; counterproductive if production and exports are hoped to reduce deficits.

  7. I think the more useful comparison is debt and deficits as it compares to our GDP vs that of the world population. Your point still holds just not as striking.

    1960 $1.37T $0.53T 40%
    1965 $1.97T $0.74T 38%
    1970 $2.96T $1.07T 36%
    1975 $5.92T $1.69T 28%
    1980 $11.23T $2.86T 25%
    1985 $12.79T $4.34T 34%
    1990 $22.63T $5.96T 26%
    1995 $30.89T $7.64T 25%
    2000 $33.62T $10.25T 30%
    2005 $47.53T $13.04T 28%
    2010 $66.13T $14.99T 23%
    2015 $75.22T $18.23T 24%
    2019 $87.80T $21.43T 24%

    Of course Govt borrowing crowds out the private sector. I just dont think our leaders look at world nearly the same as we do. I think they know it’s a house of cards They just ask themselves " How can we put off the collapse until WE are out of power. For current Democratic leadership. Biden , Pelosi, and Schumer that’s not very long. For GOP Trump , McConnel and McCarthy its not very long either —so maybe the bill will be paid sooner than expected.

  8. Avatar for KCP KCP says:

    Yes the GDP filter is very helpful (and indicator is better than i thought).

    Odd enough, i just saw a post in a Mauldin publication where Kevin’s plumbing drawing is playing out with the saudi’s…their treasury holdings have fallen from $184B to 108B in…3 years. My hunch is that USD from USA is still flowing at a decent rate to Saudi for oil, especially in the last 3 years.


  9. OK thanks all! Image loaded in Chrome but not in Safari. (I wonder how much other stuff I missed over the years?) Thx!

  10. Short & medium term, I believe long bonds are in for a lot of pain. Long term, I think you’re right but the buyer of last resort will be different. Long term I think we’re going to only allow you to keep your 401ks/pensions but in order for it to be tax free the money has to be invested in USTs. I’d watch for a “Retirement is a Human Right” narrative.

  11. If you are right, we are setting up for a October 19, 1987 moment. Many of these discounted cash flow models currently show the fair value of the market below 3000. If rates continue to rise on the 10 year, those values only go lower.

    I remember one of the writers on this site talking about interest rates as “financial gravity” which I thought was brilliant. They acted that way for the first half of 2022. Earnings have come down and rates have gone up meaningfully in 2023. Valuations have stretched as rates have risen. Something has to give!

    A well known growth stock that makes EV’s is trading at 78X earnings and 80X forward earnings!! People are paying 78X for no growth!

  12. Thanks for your comments. There are different data sources on foreign holdings of Treasuries put out by the Treasury Department. I used the annual data because it seems more accurate, but then its a bit out of date and doesn’t pick up the continued reduction in holdings of some countries like Saudi. In my data the Saudi’s are included in the “China + Oil/Commodities” group. Anyway, my guess is that when annual data for 2023 comes out we will see a further fall in this group’s holdings.

    Here’s a related and (I think anyway!) interesting point. Saudi Arabia has agreed to take payment for oil to China in RMB. I’ve heard that means they’ll need to invest up to $100bln worth of RMB each year. How? What will they buy? It’s much, much easier to recycle dollars than RMB. Which is one reason why the ‘circular flow’ lasted so long.

  13. Avatar for KCP KCP says:

    Couldn’t the RMB just be a SA medium locked into Oil to China/Goods from China? So the currency risks for SA are really price gouging, product quality, availability related to the goods?

    Not sure of the exact upside in doing this but if that is another $100B chunk of money supply not available for the USA, that’s not good.

  14. I’m not entirely sure but I think the $100bln was a net figure, in other words net of what SA buys from China they have $100bln in RMB left over as reserves. Yes, previously that would have been $100 bln in USD. But even if it was still in USD they seemed to have stopped buying Treasuries and now focused on buying pro golf tours, etc.

Continue the discussion at the Epsilon Theory Forum


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