The level of monetary expansion we’re undertaking isn’t even enough to convince China to let the yuan rise against the dollar. If we actually did print money like Mugabe and experience those levels of hyperinflation, the social contract would break down, police forces would quit, and we’d be fending for ourselves. I don’t see this happening. There will be a more gradual capitulation of the public sector before it completely falls off a cliff.

Metallic currency systems require that materials which could be put to productive industrial uses or made into ornamental consumer goods are kept off the market under armed guard. If physical settlement of bills in gold is required, then this adds a further transportation expense that drags upon economic growth .

Investors are certainly right to be wary of the risks to dilution of their non-inflation linked financial assets due to expansion of a fiat currency, but its benefits are immense and overlooked by loonies with their conspiracy theories about fractional reserve banking.

I agree that we can’t idiotically allocate capital to wasteful government programs and economically destructive regulatory regimes indefinitely. A moderate drop in the currency, a rise in inflation due to increased import costs, and an end to foreign financing of our federal debt and associated housing programs will be the trigger to force us to change our ways. The bond vigilantes will raise the treasury rates and there will be some shedding of federal programs and promises. What ends up getting cut will depend on who is in control when the transition occurs.

Conversely, China cannot permanently export vastly more than it imports. Their currency peg is the primary source of the trade imbalance, but demographics and national stability dictate that our currency will remain stronger than the calculated purchasing power parity for some time, so we’ll continue to run a trade deficit, albeit a smaller one, for a time even if the Chinese let the yuan float. The risks of revolutions and targeted expropriation of assets by the state are much higher there, so it’s less useful as a store of value. In order for China to stop buying our debt, they have to let their currency rise so that they stop having cash that they need to plow into USD investments.

The export market developed first in China and its masters currently have greater influence with the Chinese government than those attempting to build a domestic economy. Given the recession, the government does not want to risk a rise in the yuan making exports uncompetitive because the domestic market cannot at this time adjust quickly enough to provide jobs to displaced factory workers. Keeping the yuan pegged though causes Chinese factories and human capital to be oriented towards the production of goods that are misaligned to domestic demand.

The longer and deeper the undervaluation of the peg, the greater the result of this distortion. Furthermore, nations have a tendency to inflate away their debts over time. Would we allow ourselves to owe China 50% of a year’s GDP? I highly doubt it. What’s the exact point at which we begin printing at such a rate as to force them to let the yuan rise? As I’ve said before, that’s the real elephant in the room. As they perceive negative returns to holding their dollars instead of spending them and their workforce ages, these trade flows will reverse and they’ll buy stuff from us.

I find all the talk of the displacement of the dollar to be strange. Honestly, the concept of a ‘reserve currency’ is something for which I’ve never understood the necessity. Nations, companies, and individuals can take the responsibility for holding various currencies in the proportions needed for their operations. Exchange traded derivatives can offer means of providing stability of cash flows as measured in local currencies or hedged foreign purchasing power. There is no need for an internationally orchestrated system of dollars or special drawing rights. A system of freely floating currencies polices the fiscal insanity of governments and reflects the market expectations of goods and services to be produced by each nation both now and later. If we avoid sandbagging our economy through excessively costly government administration costs, wealth redistribution programs, automatic unionization programs, and imaginary green energy daydreams we’ll be able to work our ways out of this mess.

Aside from the fact that Fannie, Freddie, and Ginnie have basically crowded out the private mortgage market, going forward, mortgage bond investors will be less inclined to accept bonds based upon such lousy collateral (assuming they don’t have federal guarantees). I expect that investors will demand simplicity in deal structure and rigidity in collateral underwriting standards going forward. I’d be more concerned with the fact that Fannie, Freddie, and Ginnie are continuing to write stupid loans with federal backing than with the possibility that fools in the private market may be fooled again.

I’d like to point out though the symmetry between the subprime mortgage market and the student loan market. Universities do not hold the credit risk for the loans student take out to attend them. If they were required to hold a portion of the default risk, then there’s a chance they’d pay more attention to aligning educational programs to the demands of the job market and only accepting students with the ability to graduate in a timely and successful fashion. Given the phaseout of the FFEL programs, I really doubt we’ll be moving in this direction any time soon. Get ready for taxpayer bailouts of these loan programs to journalism and art therapy graduates.