(James Saft is a Reuters columnist. The opinions expressed are his own)

Emerging markets could be the first to suffer destabilizing inflation, courtesy of a strong economic rebound, a weak dollar and extremely loose monetary policy in the developed world.

Inflation, in faster growing emerging markets, was not high on the list of worries even months ago, but the speed and strength of the rebound and red-hot asset markets in some places show that it may be a rising threat.

“The surprise could be that inflation in emerging markets really takes off,” Amer Bisat of hedge fund Traxis Partners said on Tuesday at a Euromoney foreign exchange conference in New York.

It is not yet a central case, but should price pressures in countries like China, Korea and Brazil take hold, it will leave policy makers in a bind and would roil financial markets.

Interest rate hikes might only attract more hot capital and may be only partially effective. Rising currencies can be self-fulfilling and higher interest rates in emerging markets make carry trades — borrowing in dollars, for example, and reinvesting in something like Korean won — all the more attractive.

Other methods of stemming currency appreciation, which stokes inflation, may also become more popular; Brazil in October imposed a 2 percent tax on foreign inflows into equities and fixed-income instruments designed to keep the real from appreciating too quickly.

Emerging market central bankers can expect no help from colleagues in the developed world any time soon. The Federal Reserve will find it economically and politically difficult to hike with unemployment near 10 percent.

“Inflation in emerging markets will be U.S. inflation exported,” said Maxime Tessier of Canadian state asset manager Caisse de Depot et Placement du Quebec.

This might actually argue for China to acquiesce to U.S. calls for it to increase the value of the yuan, which will fight inflation at home and would win it friends and influence abroad. It would not be a surprise for China to return to a “crawling peg” under which the yuan is allowed to appreciate upward slowly. That won’t happen immediately; a negotiation and wooing period will allow China to extract maximum value from the United States for implementing a policy it may well need anyway.

And of course, with significant spare capacity, the decision will not be easy as inflation in the Chinese economy will not be evenly distributed.

RED HOT

While the data on inflation is still fairly tame, asset markets in many emerging markets are now red hot.

The World Bank this week raised its growth forecast for developing east Asia to 6.7 percent this year from 5.3 percent, but said the strong recovery brought with it new dangers in booming asset prices.

“As liquidity is working its way through the system, and demand is relatively low, the credit is finding its way to stock exchanges and real estate markets. It’s a danger,” said Vikram Nehru, the World Bank’s chief economist for East Asia and the Pacific. The IMF chimed in, citing surging property prices in Hong Kong and “a risk that prices could become driven more by short-term liquidity conditions, divorced from fundamental forces of supply and demand.”

Authorities in South Korea have also reacted to a surge in real estate price in and around Seoul, imposing regulations to tighten access to mortgage finance.

Officials have taken some steps to slow the flood of loans they unleashed via Chinese banks this year, but not entirely effectively. Loans by Chinese banks have disproportionately found their way into property and financial speculation, but moves over the summer to limit lending sent the stock market into a tailspin which may have scared off officials. China’s  four largest banks extended about 136 billion yuan ($20 billion) in yuan-denominated new loans in October, up 23.6 percent from September’s 110.4 billion yuan, the China Securities Journal reported on Tuesday.

And it’s not just property — the MSCI Emerging Markets Index is up more than 60 percent this year and currencies in many emerging markets have recorded strong returns.

All of this comes with one very large caveat; if, as is very possible, the recovery in the United States and Europe falters in the new year, then the risk of actual inflation in emerging markets will recede along with their exports to the West. A relapse lower too might bring with it a recovery in the dollar, which would inflict huge pain on speculators who are running dollar carry trades and investing in emerging markets assets and property.

Taking a very long view, strong emerging markets make good sense. Capital should flow to emerging markets. Returns there over the long run will be better, at least if the rule of law prevails. Unless policies can tread a very narrow path, that growth will bring with it inflation and rising volatility.

(Editing by James Dalgleish)
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(James Saft is a Reuters columnist. The opinions expressed are his own)

So it can be done after all.

Britain is poised to take tough steps to break up the large banks it rescued, setting it in stark contrast to the United States, which seems set on a policy of shoring up the unfair advantages it grants its too-big-to-fail banks while regulating around the edges.

It is quite a change for Britain, which has a sorry history of self-serving self-regulation in financial services combined with limp and outgunned official control.

Chancellor of the Exchequer Alistair Darling on Sunday told the BBC that Lloyds, RBS and Northern Rock would be partly broken up and assets sold to new entrants into the banking market. Large existing competitors such as HSBC are expected to be blocked from making bids for the assets.

Britain took over Northern Rock after a run on the bank and its rescue of Lloyds and RBS left it with stakes of 43 and 70 percent, respectively.

It is worth noting that if anything Britain is more dependent on its financial services sector than the United States.

Could it be that Britain has determined that a level playing field, strong competition and a lower risk of a crisis might actually make it more competitive internationally? I certainly think so.

It will without doubt improve the situation for the small businesses and individuals that can’t access international capital markets and depend on the banks for access to credit and other financial services.

Before we get all excited and expect the United States to follow suit with Citibank and Bank of America, it is important to recall that Britain’s Labour government is more or less on its death bed and faces an election in 2010 which the bookies and almost everyone else think it is highly unlikely to win.

There is also the matter of the European Union, which has a say over subsidies such as the ones Britain has showered on the banks. RBS said on Monday that it may be forced by the EU to sell more assets than it had planned. Lloyds is also seen likely to raise additional new capital to allow it to stay outside of an asset insurance scheme Britain is running for the banks and which would involve the government taking yet more equity in the participants.

OH WHAT A CONTRAST

The fact remains that Britain and the EU are saying that more competition is needed and taking steps to ensure that the banks which ended up needing state care are broken up. This must have an impact on how other big banks are ultimately treated, even if they did not receive the same level of direct state aid.

The equity buffer that is being required is also remarkable; the banks should end up with core tier one equity of about 10 percent, four times what they were expected to hold before the crisis.

Contrast all of this with the hopefully named Financial Stability Improvement Act of 2009, now wending its way through Congress. As Harvard Business School professor David Moss points out, as currently drafted this bill won’t even allow the systemically important banks it is designed to control be named, a real Monty Python-esque touch.

Think about it: we won’t even be allowed to know the identities of the firms we are potentially on the hook for. Moss points out that this neatly side-steps the idea of taxing too-whatever-to-fail status as a means of encouraging the behemoths to sell up and avoid the costs. The costs remain with the taxpayer, or potentially with a group of big firms after the fact.

The argument the U.S. administration is making, more or less, is that our complex global economy somehow demands that we have complex huge banks. If we don’t allow huge banks to persist, we’ll choke off growth. If we think we can go back to mom and pop banking, we are simply kidding ourselves. And anyway, if the U.S. doesn’t allow it, foreign banks will just scoop up the cream. With Britain and the European Union taking strong steps, that argument is losing traction. And as for complexity, well I’d have to say that the record of complexity in banking is mixed, to be kind, as far as the deal it gives to taxpayers and consumers of banking services. It would be one thing to argue for huge economies of scale for plain vanilla banking processes like clearing, but it is hard to see why that needs to be combined with derivatives and trading.

It would be nice to think the winds are blowing west across the Atlantic, but this is not usually the case.

(Editing by James Dalgleish)

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(James Saft is a Reuters columnist. The opinions expressed are his own)

Don’t expect the year-long rally in risky assets to be undermined any time soon by the Federal Reserve becoming concerned about inflation.

The old metaphor — that the Fed’s job is to take away the punchbowl just when the party starts getting good — just doesn’t apply in the current circumstances. That’s not to say inflation isn’t a threat in the medium term — it is virtually a promise.

But punchbowl thinking dates from a time when firstly the Fed was presumed to have a degree of control over events we now know is not true and secondly to an era when asset prices were the caboose rather than the engine of the economic train.

Even with an economy that is now growing, the risk of a self-reinforcing de-leveraging spiral is enough to ensure that the Fed will not pull the trigger on tightening any time soon.

“Asset prices are embedded not only in our psyche, but the actual growth rate of our economy. If they don’t go up, economies don’t do well, and when they go down, the economy can be horrid,” Pimco bond chief Bill Gross writes in his most recent letter to investors.

Gross argues that leverage inflated the price of assets even as investment in the U.S. real economy flagged. As this happened the U.S. economy became ever more dependent on asset prices and on the sectors, such as finance, which intermediated the borrowing. When the debt and asset bubble is pinched, the whole edifice is threatened, leading to a response like the one we’ve seen: massive and overwhelming aid trained on markets irrespective of the costs.

Pimco data shows that the prices of assets in the United States over the past 50 years have gone up 1.3 percent a year more than would have been expected given nominal growth in the economy, leading to a putative 100 percent overvaluation if you reason that the assets which depend on the economy for income shouldn’t outgrow it.

Unsurprisingly, the real outperformance of asset prices against economic growth has come in the past 30 years, since when debt growth has accelerated.

There are other explanations for why asset prices have outpaced economic growth. For one thing, off-shoring and outsourcing have both suppressed wages in the United States, leading to higher returns on capital, and increased the income that U.S. assets receive from overseas.

It’s obvious that the past 25 years have not been kind to labor, and as its share of GDP has declined the share going to asset owners has increased. In that sense increasing asset prices make economic sense, though there seems to be every chance that workers start to recapture some of what they have lost.

GROWTH, DEFAULT OR INFLATION?

Taxes on capital and profits have also fallen in the United States, and, like wages, this is a trend that could easily be reversed in coming years, especially given the huge amount of public debt that will have to be paid back.

This brings us to the other very strong reason the Fed may have for not pulling away the punchbowl — or water bowl as perhaps we had better see it — even when the party turns inflationary: public debt.

Since the United States have taken a decision to not allow too much of the private debt to default, it has taken on a corresponding increase in public debt which will have to be repaid ultimately. U.S. debt as a percentage of GDP will exceed 60 percent, a level not seen since World War II.

But unlike the post-war period, Europe doesn’t need  rebuilding and though Asia will grow hugely those profits won’t flow to U.S. coffers.

So, if growth doesn’t allow the United States to repay debts, there are two options, neither pretty; default or inflation.

“No policymaker in the developed world — and, by now, few in the developing world — would want to countenance default as an option,” writes economist Spyros Andreopoulos of Morgan Stanley in London in a note to clients.

“This leaves inflation.”

To be sure, the Federal Reserve takes its mandate to control inflation and its independence seriously, but it is going to find itself in a very difficult squeeze, partly of its own making. The debt is high, growth will be poor and the time for private defaults is past. Threats to its independence will only grow.

Given that, and the dependence of the economy on asset prices, it’s not hard to bet that the evil we will be left with is inflation. Whether it is engineered or just kind of happens is less interesting than the reasonably high likelihood that it will happen at all.

For a time at least, that would argue that risky assets, particularly real assets and emerging markets, do well.

Longer term, things get stickier and stickier.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(James Saft is a Reuters columnist. The opinions expressed are his own)

There are encouraging signs that shareholders are becoming more assertive in defending their interests.

The Financial Times reported on Monday that some of Britain’s largest institutional shareholders - including Standard Life, Legal & General and M&G - are working on a plan to bypass investment banks by creating a club to underwrite new issues of equity by small and medium-sized British companies, a move that could save hugely on fees.

What, you may wonder, took them so long?

Second only to taxpayers, investors have been the great patsies of the financial crisis, paying massive costs to a financial services industry which has, to put it mildly, not served them well.

Activist shareholders and investors could be a key force in fixing what is wrong with the financial system. Unleashing their power to act in their own best interests should be a main thrust of new regulation.

The British investor group, reportedly being assisted by mergers and acquisition advisors Lazards, would effectively cut out the middle men by agreeing to take up any unwanted new shares in an offering. This is an idea which if successful could save companies and their owners huge amounts in fees and at the same time deal a blow to investment banking profitability.

Fees charged by banks for equity underwriting in Britain have more or less doubled in the aftermath of the crisis to 3.5-4.0 percent of the amount being raised, with the lions share going to banks rather than to the institutional investors who sub-underwrite.

While banks may argue, and in part be correct, that this is because the past two years have demonstrated the risks of capital market underwriting, it is also patently because there are now fewer banks competing for this business.

To be sure, a club approach is better suited for small and medium sized underwritings and would face huge difficulties for a major share issue involving global investors. But if a test run proves successful it would place pressure on fees for transactions of all sizes.

Even before the crisis hit, fees for investment banking services seemed not to follow with the same fidelity the laws of economics which hold such sway in microchips, steel or even tax preparation.

And it’s not just investors, who consume investment banking products, who have been ill-served. Shareholders in companies, particularly in banks, have provided the capital but have not had their fair share of the fruits.

FOR WHOSE BENEFIT IS THIS ZOO BEING RUN?

That has led to bad decisions, decisions often designed to maximize the benefit to employees at the expense of the shareholders who run disproportionate risk.

Paul Myners, a British Treasury official with special responsibility for financial services, gave an absolutely scathing address last week to the Worshipful Company of International Bankers, assembled for dinner in the Mansion House in the City of London.

Myners, who is reported to be considering holding a competition inquiry into banking fees, took aim at the bonus and compensation culture in the industry.

“It could be argued that some shareholders in banks have been left holding not the ordinary shares they originally purchased, but a new form of subordinated, participating, non-cumulative equity that ranks behind rewards for the senior management, and executives of the firm in which they invested have a prior claim. This cannot be right,” Myners said.

“In case anyone needs reminding, the profits of banks belong to their owners; not their managers and traders.”

I imagine that the bankers were a little less worshipful on their way out then they were on the way in.

I would also argue that what Myners said about banking also holds true - to a lesser extent - in other publicly traded companies, where management is able to extract compensation out of proportion to their likely contribution.

Shareholders, and we are really talking about institutional shareholders, have allowed management to get away with it for years because they thought what they were supposed to be doing was outperforming the market by picking winners.

Much of what passed for skilled investment over the last 20 years has been little more than riding the waves of a debt-fueled economy which seemed capable of providing six to ten percent returns on an unleveraged basis.

Adding value too often meant little more than adding leverage to increase returns. When the current rally ends, as it surely will, investors should take a long look at their long term returns. What they will usually see is that they are poor.

A better strategy for the next 10 years may be to spend as much effort protecting your economic interest in what you own as you do in choosing what to own.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

- James Saft is a Reuters columnist. The views expressed are his own –

Even putting aside the spectacular but hard-to-measure risks of a financing crisis or the loss of its special status, the dollar faces really serious headwinds from boring old fundamentals.

The dollar has been weak for months and markets have been fretting over a host of big picture worries.

Perhaps the world’s oil exporters will stop using the dollar as the medium for petroleum trade. Or maybe the so-far patient and docile buyers of Treasuries will finally turn jittery. Either could be a disaster for the dollar, but you don’t need conspiracies or crises to be bearish on a currency from a country which on some measures has run the largest-ever deficit between what it imports and what it sells abroad.

One of the most interesting side effects of the first part of the financial crisis was that the dollar actually rose despite being the locus of the credit bubble and despite the U.S. consistently importing far more than it exports. That strength, which has now been reversed in part, was largely because the freezing up of markets set off a scramble for dollars.

The acute phase of the crisis is over and a return to something approaching normalcy is not treating the dollar kindly; from its peak this year the dollar has fallen more than 13 percent against a trade-weighted basket of currencies. The current account deficit — the balance of exports to imports — has also been reduced greatly, from a peak north of 6 percent of GDP to below 3 percent at the end of June, with further narrowing in the months since. That is because a weaker dollar makes U.S. products more competitive, but also because the price of oil, of which the U.S. is a net importer, has dropped, and consumption at home is flagging.

It is far too early, however, to say that the dollar adjustment has done its work and the deficit will now close.

“The U.S. current account shortfall was primarily driven by a consumption surge rather than an acceleration of investment on the back of productivity growth and high profitability,” Citigroup currency strategist Michael Hart wrote in a note to clients.
THINGS THAT CAN’T GO ON FOREVER DON’T

That is bad news for the dollar and bad news for the outlook for U.S. growth. A 2005 paper by Caroline Freund of the World Bank and Frank Warnock at the University of Virginia <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=875699> found worse outcomes for the countries that ran current account deficits to finance consumption as opposed to those which ran deficits in aid of investment.

Industrialized countries which, like the U.S., run current account deficits for consumption, find that the currency depreciation that follows tends to be deeper. What’s more, the adjustment in the deficit lasts longer and is often twinned with lower growth. It is not, I suppose, a big surprise that importing more than you export and then consuming it leads to depressed growth. The real wonder is the way in which the U.S.’s special status and the generous financing terms offered by its trade partners made this possible without more immediate damage to the dollar.

There is also the possibility that globalization has permanently raised the “natural” level of the U.S. current account deficit. Huge swaths of the U.S. manufacturing base and a growing wedge of the country’s service sector have been offshored or simply moved out of the U.S. Many of these goods and services are still consumed by the U.S., but now much of the money generated by those sales will be the result of dollars being sold to buy pesos, ringgits or yuan.

This may place more structural pressure on the dollar to fall over time.

Australia’s decision to raise interest rates last week hurt the dollar and for good reason. It demonstrated that as a recovery happens the action will not be in the U.S., but in resource-based economies and in places, mostly in Asia, where the best prospects for productive investment lie. The U.S., where the Federal Reserve will likely need to keep rates low for a very long time, will have a hard time capturing the imagination of investors.

For policymakers, and not just U.S. ones, the puzzle is how to allow the dollar to fall gently without precipitating trade friction or a disastrous loss of confidence. Because it’s more or less in everyone’s interest, it will probably more or less be avoided. A weaker dollar, though, is simply consistent with the outlook for the U.S.

A long shamble downwards rather than a fall off a cliff looks to be in the dollar’s future.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

–James Saft is a Reuters columnist. The opinions expressed are his own.–

When the U.S. dollar ultimately loses its status as the world’s premier reserve currency it will be painful for all involved, almost certainly disorganized, and very possibly a very good thing.

World Bank President Robert Zoellick outlined the risks to the dollar’s status in a speech in Washington on Monday.

“The United States would be mistaken to take for granted the dollar’s place as the world’s predominant reserve currency. Looking forward, there will increasingly be other options to the dollar,” he said.

Zoellick went on to emphasize how choices in the United States on inflation, fiscal policy and financial system reform would help to influence the dollar’s fate.

Quite true. The U.S. cannot simply devalue its way to competitiveness, nor can it appear to be inflating away its debts without risking a run on the currency. The Chinese and others would sell dollars or fail to buy up new debt if they felt the U.S. was behaving both cynically and irresponsibly.

China has good reasons not to force a crisis and devalue its holdings of dollars, but not immutable ones. The two nations are like two men trying to swim to shore while dragging a heavy box of gold, the difference being that the U.S. is tethered to the box while China is only holding on. If China decides the water is too rough it can let go, sacrifice its dollar holdings and swim for it. The United States is not so lucky.

“Exorbitant privilege” is a term coined by an understandably embittered French Finance Minister Valery Giscard d’Estaing to describe the fact that under the old Bretton Woods currency system the United States, unlike everyone else, could simply print dollars to cover current account deficits.

Bretton Woods is gone, but the arrangements which replaced it also tended to underwrite U.S. overconsumption, as purchases of U.S. dollars as reserves by other nations kept funding rates lower despite household or government profligacy.

“The United States is incredibly fortunate that the dollar enjoys this special status,” Zoellick said. “When I work with countries struggling to pay for budgets or finance trade deficits, I reflect on how Americans do not spend a moment considering the unique advantages of being able to issue bonds and print money freely.”

My best guess is that Americans will spend quite a few moments in coming years considering that unique advantage, and that while they will miss it, they should also be sorry they ever enjoyed the right to borrow freely and seemingly without consequence.

THERE’S NO “G20″ IN “TEAM”

Of course the U.S. current account deficit has contracted massively, standing at about 3 percent of gross domestic product in the first quarter as compared to 6.5 percent of GDP in 2006. That’s the result of plunging global trade and steep falls in investment in the United States. And while the personal savings rate has jumped in the United States, which after all it had to since credit was no longer easy, the government has stepped up massively as a borrower, overwhelming households’ efforts to save.

Barclays Capital calculates that the United States now needs to attract 46 percent of the world’s net savings, i.e. the sum of all current account surpluses, as opposed to 54 percent before the crisis broke.

That 46 percent figure is an improvement, but it too is ultimately unsustainable. It’s also arguably starving lots of other places of investment that could ultimately produce higher returns.

The newly empowered G20 group of nations has meanwhile resolved to rebalance the global economy, using peer pressure to force the irresponsible to shape up and the overly tight to start spending at home.

The world’s central bankers and politicians just received an object lesson in what a good idea it is to have a bunch of reserves piled up against a bad day. Even putting China aside, responsible leaders in places like India will have a very tough time trusting in an international body to protect their own best interests. And because that body doesn’t have any real power to compel, it will be ignored. That means that there is a good risk, G20 or not, that everyone is trying to simultaneously keep their currencies low and exports high.

The only body seemingly exempt from market discipline, the United States, is not going to be in a position to resume eating up everybody’s exports. This is a recipe for very slow growth and for rising international economic tension. That doesn’t make the changes proposed at the G20 a bad idea, but they are not sufficient and threaten to be a resolve-softening time waster.

So not so much as rebalancing but a re-basing of growth expectations. Look for continuing dollar weakness alongside that, with the real drama being not the decline but the rate of decline.

–At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–

(James Saft is a Reuters columnist. The opinions expressed are his own)

The simplest way to end the imbalances in the world’s economy is also sadly perhaps the most likely: for the Chinese to stop buying U.S. debt.

This is not going to happen anytime soon, for one thing deleveraging in the U.S. will for a time make U.S. Treasuries look good value, but a buyer’s strike is a heck of a lot more likely than the orchestrated rebalancing the U.S. will push at this week’s G-20 meeting of leading nations.

The U.S. plans to advance a plan at the Pittsburgh summit to fundamentally change the balance of the global economy, which over the past 15 years or so has been characterized by over-borrowing and consumption in the West provided and financed by savers and workers in Asia.

That state of play kept going, as is the way of these things, until it stopped, or rather until one of its wheels fell off. It wasn’t that Asians stopped saving or buying U.S. debt but that speculators, usually in Europe, stopped buying securities, often minted in London, which were being created to front run the flow of capital from Asia to the west.

That popped the asset price bubble and the flow of finance to consumers in the U.S. who, with much gnashing of teeth, began to save again and consume more guardedly.

But the debt bubble hasn’t really popped, it has only shifted shape. Before we had private debts which only could be repaid if assets, mostly real estate, continued to go up in value. Now, a new wave of public borrowing is cushioning the downturn. Asians buy some of the debt and some of the money raised buys goods from Asia.

Theoretically, China and other investors in U.S.  Treasuries buy them because they believe that the U.S. will ultimately tax more, spend less and make good. In reality, it is more vendor financing and a good money after bad attempt to protect earlier investments.

The U.S. points out, in a letter to its G20 partners, that if the savings rises in the deficit countries persist and there is no rise in consumption in the savings-bloc, global economic growth will be poor. The idea, it seems, is for IMF-led international coordination to, on the one hand, jawbone the borrowers so they remain credible while at the same time somehow inducing the savers to allow their currencies to appreciate and induce their citizens to spend.

WILL SOVEREIGNS BE THE NEW SUBPRIME?

A new study of global imbalances by economists at the Bank of England points out that Asian savers will only carry on buying western debt so long as they believe it to be high quality.

“In the short run, increased supply of government bonds resulting from the expansionary fiscal policies pursued in deficit countries has provided an ongoing source of asset supply to meet the investment demand from surplus countries,” according to the Bank of England.

“However, to the extent that savers in surplus countries may become more reluctant over time to invest funds in deficit-country government bonds this would tend to raise the cost of borrowing in deficit countries. This shift in the relative cost of borrowing could be an important part of the process by which a rebalancing of demand from deficit to surplus countries is achieved over the medium term.”

In other words, if Asian savers lose faith in Treasuries or gilts, they will stop buying, causing interest rates to spike. This would cause demand to be rebalanced, all right, but mostly by suppressing it in the U.S. and other highly indebted countries like Britain.

This kind of loss of faith in markets can be very sudden. You could draw a parallel to the way in which investors in securitized debt lost faith in the value of a AAA rating, except this time the loss of faith will be in sovereign borrowers and we really will not be able to blame the ratings agencies as enablers.

China and other exporters of course have good reason to want to avoid this. They are stuck with trillions of dollars in Treasuries and they certainly don’t want to kill the U.S. goose while it is still more profitable to sell it goose food.

There may also come a time when the world’s savers calculate that they can earn more by investing at home.

Essentially much of what a controlled rebalancing would do - weaken the dollar and build opportunity for domestic-oriented investment in Asia - creates incentives for a rapid reallocation out of Treasuries.

Ultimately the rebalanceing must happen. The U.S. for very good reasons wants this to happen little by little, but it does not have to happen that way. Past attempts at a controlled rebalancing have failed and it is hard to see what will make this one different.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

–James Saft is a Reuters columnist. The opinions expressed are his own–

If and when China makes its currency convertible and opens its financial system the stage will be set for a bubble that should make the dotcom and housing booms look tame.

China has recently signaled its key aspirations: for a greater international role for the renminbi and for Shanghai to become a great financial capital. Neither is imminent, but both imply, if not require, a series of steps that, taken in combination with China’s legitimately great potential for growth, could lead to a bubble of magnificent and dangerous proportions.

Magnificent in that, like the dotcom bubble or the railroad boom in the U.S. in the 19th century, a bubble in domestic China is directionally right and will build useful things which will change the world. A bubble, after all, needs a good story and China has one of the best ever.

Dangerous because, like the housing bubble, it will inevitably go too far and could take down banks and banking systems globally.

Perhaps rather than dotcom or housing, the most useful template for China is closer to home; namely the Japanese bubble which preceded its ongoing malaise, according to Dylan Grice, a strategist at Societe Generale in London.

“In the medium term we face the mother of all asset bubbles in China. The fundamental story is a good one; there are just lots and lots of people to sell to,” Grice said.

“If you drop a ton of liquidity on people it is possible that they will do rational things with it, but more likely they will do something pretty stupid.”

The parallels are strong. Both China and Japan successfully industrialized and opted for high-savings, low-consumption economies which concentrated on exports, exporting capital and keeping their currencies artificially weak. The result in both cases was a huge stockpile of U.S. Treasuries.

Both, too, scared their western clients and competitors witless. Remember U.S. autoworkers ritually burning Japanese cars? This of course was mingled with admiration and a sense that the global balance of power was changing, giving bubble thinking a strong push.

Japan slowly and over a long period liberalized its capital account; allowing the yen to float freely and deregulating financial markets.

Grice points out that during some of the 1980s the world fell in love with the yen, figuring that Japan’s new ascendancy meant that it would rise and rise. As a result Japan Inc. could in effect borrow in dollars, swap it into yen and get paid for the privilege. Much of the money found its way into the stock market, sending stocks to stratospheric levels and reinforcing the bubble illusion.

The Nikkei index of stocks went to the moon and Tokyo residents ended up needing 100-year mortgages to afford tiny apartments.

GOOD AND BAD BUBBLES

Of course, that is not where it ended with Japan, which had its bust and which is still struggling with deflation, though that is in part a function of a shrinking workforce.

Japan liberalized its financial system and currency arrangements under strong pressure from the United States.

China almost certainly has more relative real power today and there is every sign that it will open up on its own terms and to its own schedule.

But open it probably will.

Chinese officials have expressed a desire for the renminbi to play a great role in world trade, naming 2020 as a date by which it can play the role of a reserve currency.

That is almost certainly going to require deregulation of financial markets, something also needed if Shanghai is to become a global financial capital.

China now buys Treasuries not because it thinks they are good value, but because those purchases maintain a competitive currency, not to mention protecting existing holdings. As that ends, much of the money will seek out high returns, and as the renminbi strengthens international capital will doubtless pile on and pile in.

That kind of liquidity and deregulation, in combination with strong national pride and a legitimately fantastic story, is a step-by-step recipe for a bubble. So it proved in Japan, so it likely will be in China.

A look at recent experience in China only underlines this. Speculation is rife and billions in government mandated loans have leaked into stock market bets.

China’s government undoubtedly understands all of this and is surely determined to maintain control. They may not find it that easy. Getting rich, as we’ve seen in the United States, is a heady business and it is easy to start to believe your own press.

As the momentum builds and the money rolls in it will be easy to see it as a great country meeting its prosperous destiny.

Given the size of the opportunity and the strength of the story, China’s bubble will be huge. Investors would do well to avoid being in the immediate vicinity when it bursts.

–At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–

–James Saft is a Reuters columnist. The opinions expressed are his own.–

Financial markets have plenty to be worried about but their latest concern — a trade war between the United States and China — should not be on the list.

Aligned self interest and a knowledge on both sides of the causes of the Great Depression should limit matters to a kind of trade war Kabuki, a highly stylized piece of theatre in which the United States shakes its fist and China responds in kind but no blows land.

The Obama administration on Friday slapped tariffs of 35 percent on the import of auto tires from China, reacting to a surge in imports and complaints from the United Steelworkers union. It also acted on the recommendation of the independent U.S. International Trade Commission.

China duly responded, announcing investigations into subsidies made to U.S. chicken producers and auto products, as well as vowing to take its case to the World Trade Organization.

Shares around the world sold off on Monday at least partly in response to the dispute, which awakened memories of the 1930 Smoot-Hawley tariffs and the trade war that ensued, a key cause of the Great Depression.

What’s worse, the United States is not just spitting into the wind of history but also into the face of its largest creditor. China holds about $1.8 trillion of Treasuries and any decision on their part to lighten up would send the dollar into a steep decline and torpedo U.S. plans to fund its fiscal deficit.

That’s just it. The United States and China need one another, and both sides are big enough and mature enough to understand this. China cannot dump U.S. investments without walloping its own portfolio, nor can either side accomplish any of their economic goals without the other as a client.

It is best to understand the U.S. move not as the first salvo in a war, but as a relatively small sop thrown to a domestic constituency, organized labor, that President Obama needs for other purposes, notably health care. It is also, in an odd way, a sign not of weakness but of the stabilization of the global economy. It is only now that things have calmed down that the United States would dare to appease a domestic special interest in this way. Had they done this in February, financial markets would have fallen over in a dead swoon.

The dollar, tellingly, actually rose as a first reaction to the fuss, hardly the reaction you would expect if the Chinese were preparing to dump dollars. Treasuries lost ground, but nothing extraordinary.

STUPID BUT PROBABLY HARMLESS

Technically, the United States is probably within its rights to impose the duties. WTO rules allow this if a surge in imports threatens a domestic industry, even if the trade is not unfair.

Rights and laws aside, the duties are indefensible. They protect less efficient makers and simply punish China, not for unfair trade practices, but for success. They also punish U.S. consumers, arguably hurting living standards more than the loss of the jobs the tariffs are presumably meant to protect.

Expect China to make a lot of noise about this. They also have domestic audiences, and theirs are rightly aggrieved. Expect too the rest of the G20 leaders who will assemble this week in Pittsburgh to say all the right things in public and to play peacemakers in private.

What I would not expect is for this to accelerate into something damaging and destabilizing. The stakes are too high and the political rewards domestically for a trade war are tiny in comparison.

There are, however, longer-term issues which are unsettling. China’s interests and those of the United States are diverging and over time there will be serious conflicts to be negotiated. The system of China trading goods for Treasuries which did so much to raise living standards in China and fill garages with stuff in the United States is no longer tenable.

The U.S. will consume less of China’s stuff and must even compete with China more effectively for exports, probably in areas like military technology where sales will be doubly unsettling for the Chinese.

China, over time, will not want to subsidize U.S. borrowing rates and will want to diversify its currency holdings. This will not be easy or pleasant for the United States but, broadly speaking, is probably in its own long-term interests.

All of this could blow up, especially if it undermines confidence in Treasuries and the dollar. It has not yet, and I think the two protagonists will put off the serious business of working out their conflicting interests until either the global economy returns to robust growth or things in the United States stay bad long enough to change the political math of a real trade war.

We are not there yet, and for at least another year probably won’t be.

–At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–

–James Saft is a Reuters columnist. The opinions expressed are his own–

Rest in peace, Great American Consumer. We will not see your like again.

“Cash-for-clunkers” aside, consumers seem bent on actually paying back debt rather than racking it up, a change that if sustained, as it is likely to be, will dampen economic growth not for months but for years, and not just in the U.S.

Outstanding U.S. consumer borrowing fell by a jaw-dropping $21.6 billion in July, according to data released this week by the Federal Reserve, five times more than analysts expected and the second largest monthly drop since the end of World War II.

June’s borrowing was revised to negative $15.5 billion from what had been an impressive minus $10.3 billion.

Over the past year, the stock of consumer loans outstanding has dropped by 4.2 percent, or nearly $110 billion, leaving the total now lower than it was before the crisis began in 2007.

Over the long term, this is exactly what needs to happen. With household wealth badly hit by the housing and stock market crashes balance sheets are stretched. And with a huge baby boomer cohort hurtling towards retirement age also, spending and borrowing were bound to be curtailed.

The question really becomes how entrenched the trend towards the new frugality becomes.

“Memories of debt are very powerful. The generation that grew up in the 1920s and 1930s, was wary of getting into debt as it - and its parents - had experienced two periods of deflation,” Lombard Street Research economist Gabriel Stein wrote in a note to clients.

“We are now in another period of debt repayment and deflation. The thought that US households will forget 2007-2009 and begin to borrow and spend as they did in the early 2000s, is fanciful at best.”

For years the mantra on Wall Street was “don’t bet against the American consumer,” a creature so fabulously resilient as to be almost super human.

Wars and recessions did little to brook consumption and the debt that grew alongside. Even the September 11 attacks saw healthy month on month growth in borrowing in the aftermath.

Whole industries, some now vanished, were predicated on Americans continuing to borrow and spend. It’s an overstatement, but only a slight one, to say that the global economy was predicated on U.S. consumption, which in turn was predicated on consumers borrowing.

THE NEW FRUGALITY

It is doubtless true that lenders of all stripes are making credit harder to get. But there is a good bit of evidence that individuals are changing their preferences. Much of the cash from stimulus handouts earlier this year was used to pay down debt rather than goosing consumption.

A Gallup poll asking Americans how much they had spent in the past day, not including major purchases or normal household bills hit $63 when most recently measured, down from above $100 a year ago.

Now on the face of it, that reduction must be overstated. If consumption had fallen by that magnitude, we’d be in a depression rather than debating the strength of a recovery.

But of course the Gallup poll is a self reported one, and I would be willing to bet that people are now exaggerating how frugal they are, where once they would have exaggerated how much they were spending. That in itself is an important marker of a social trend. Once you wanted the nice people at Gallup to think you were a big shot leaking money, now you probably want them to see you as a saver.

Gallup also looked at the data by generational group, and found that it was not just those in or approaching retirement who were cutting back on self-reported spending. So-called Generation Xers and Millennials, who followed the boomers into the workforce, are also cutting back in similar scale.

But the issue isn’t the rate of savings but the stock of savings as compared to liabilities. While it is reasonably possible to cut back on spending and so increase your savings rate that is far different from suddenly becoming financially robust.

The other thing to bear in mind is that there is a huge difference between stocks and flows. A person can quite quickly raise her savings rate - as we have seen - but that does not mean that her debts are quickly paid off.

If U.S. consumers cut debt as quickly as Japanese corporations did in the 1990s, it will still take them until 2018 to get their debt down to 100 percent of GDP from recent peaks of 130 percent, according to a study from the San Francisco Federal Reserve.

If the trend in consumer borrowing continues, it will not be long before the conversation will turn back to stimulus, quantitative easing, and a relapse for the U.S. economy.

–At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–