Despite remarks of Chinese officials and offhand comments of the US Treasury Secretary, the Fed flow of funds accounts for Q4 2008 indicate that the US Monetary Authority acted, in fact, like a world central banker, supporting the dollar as the primary international reserve currency.

First, public funds used to support AIG were allowed to pass through to foreign banks and investors, boosting dollars available abroad, that flowed back into interbank assets in the US.

Second, the Fed and the Treasury issued over $500 billion in currency swaps with foreign central banks, pushing an extra dose of dollars into international markets that also ended up in US interbank assets. These actions were taken despite the impact on the exchange rate and domestic public opinion.

Since the US monetary authorities are the only source of dollars and since the dollar is the de facto world reserve currency, setting aside criticism of the ad hoc aspect of US government actions during Q4 2008, these actions were not inconsistent with a concern for financial stability beyond US borders.

However, since the Obama administration has come to power, the US Congress has enacted massive “stimulus” measures that bode ill for the eventual value of the dollar and long-term inflation. Although the effects will not be felt for some time, Congress may have already set in motion government spending on a scale that will make it impossible for the dollar to continue as the premier world reserve currency.

US trade deficit continues to grow during crisis

Below are selected figures from the Fed flow of funds table F.107 (Rest of the World), comparing annually and seasonally adjusted flows for Q4 2007 with Q4 2008. Here we see the substantial impact of government intervention in the international dollar market.

In Q4 2008, the US trade deficit was no longer the primary source of dollar funds to the rest of the world, surpassed by direct government intervention in the market. The foreign currency swaps boosted interbank dollar assets in the hands of non-residents, at a time when foreign institutions were pulling out of dollar repos and agency securities on a grand scale.

The combination of the trade deficit and currency swaps, provided funds for non-residents to reduce dollar claims of creditors, while increasing direct foreign investment in the US and in US Treasuries.

Note: Some figures are significantly larger than actual flows, because of adjustment to an annual basis.

Portents of inflation favor real estate and direct foreign investment

The fact is that although foreign central bankers may grumble about what inflation may do to their dollar monetary assets, there is only one way they can, as a group, stop holding dollars — use dollars in the US to buy non-financial assets from US residents.

The flow of funds accounts put foreign holdings of dollar financial assets at $16.9 trillion as of Q4 2008, up $6.4 trillion since 2004 and still growing. With the threat of inflation, that’s a lot of money that could move into US hard assets.

Other countries are hooked on dollars because the US , at least until recently, has favored free trade and has few barriers to foreign exporters who are eager to keep their factories humming and local employment high.

So, if foreign holders of dollar financial assets are spooked by portents of inflation, what would be the logical step for them to take? Certainly, it would not be to buy US debt, but instead hard assets, probably in the form of direct investments and real estate.

If the Bank of China were to decide to dump dollar holdings in the world market, other foreign holders will be on the other side of the trade. By using dollar financial assets to buy hard assets from US residents, the rest of he world would be able to reduce exposure to dollar risk.

Now, it just so happens, that US income-producing, commercial real estate is ridiculously cheap while foreigners have both the cash and motivation (fear of inflation) to pick up these assets. Foreigners also have the cash to clean up REIT finances. The REIT market is already securitized, providing management, local know-how, and easy acquisition.

The increase in direct foreign investment in the US during Q4 2008, despite hard times, suggests movement away from debt into hard assets is already underway.

Why inflation threatens bonds and the dollar

Obviously, inflation is not friendly to bond investors, nor to the dollar’s position as world reserve currency. In recent years, the major support for the US bond market (except for municipal bonds) has come from foreign holders of dollar assets.

A high level of dollar inflation poses a real threat to the US bond market and dollar supremacy, especially since foreign investors, with sufficient monetary motivation, will shift their attention from bonds into US hard assets that offer better protection against a debasing of the currency.

At the same time, inflation will also impact US insurance companies, traditional buyers of debt securities, further constricting supply.

Unless the US Treasury comes up with a bond that offers real protection against inflation (like the Brazilian ORTN of the 1960s), the monetary authorities will not be able to soak up money that is being spent by a profligate Congress. Inflation will get worse, pushing even more money into “hard assets”.

Even so, if the rest of the world, fearing US inflation, moves from dollar financial assets into real estate and direct US investment, their will no longer be the huge captive market for Treasury bonds, represented by the accumulated traded deficits over many years. The government will have no alternative but to print money, inflation will go wild, and the dollar will be finished as a world reserve currency.

However, soaring prices of US income-producting, real estate may, in certain circumstances, prove to be an acceptable backing for an international currency — a new “gold”, so to speak. But, this will not save the dollar.

It would be better, therefore, for the American public to wake up in time from the Obama pink dream and kick the Democrats out of Congress, saving the dollar from seemingly inevitable debasement. If Obama follows the wishes of his friends in the labor unions, enacting protectionist legislation, the country and the dollar will be in for very bad times indeed.

There is an inherent conflict between what is necessary to keep the dollar as the world reserve currency and what is necessary to keep local politicians in office. The United States has reaped huge benefits by having the dollar as the world reserve currency for over twenty years. However, Wall Street’s abandonment of conservative financial principals have combined with a populist political movement to create an environment that seriously threatens the reign of the dollar.

It is ironic the Paul Volker may play a role in administrations that both strengthened and irrevocably weakened the dollar

The United States government, with its massive spending and money printing programs intended to address the current recession, together with social reform programs sponsored by the Obama administration, now runs the risk of unleashing a level of inflation not seen since World War II or the Carter years.

To sop up the money being issued and to scale back over-blown entitlement programs, will take a level of political will not observable in Washington DC today. Furthermore, there is no Ronald Reagan on the horizon to clear up the coming mess. Therefore, it is prudent to consider what the economy might be like under prolonged inflation, such as is often seen in the Third World.

Inflation has many casualties, but one of the sectors most seriously harmed is the insurance business.

Why high, persistant inflation harms the insurance industry

Insurance is a contract in which money is paid today in expectation of return of a greater amount to cover a named risk at some uncertain future date.

That named risk has a value to the insured, generally related to the amount it will cost at a future date to heal the damage related to that named risk.

For example, fire insurance is paid when one’s house burns down. The idea is that the amount of the insurance payment should be reasonably related to the cost of resolving the damage at that future date.

However, in an environment of high inflation, say 20% or more a year, the amount that would be necessary to cover the future risk will be much higher than in a non-inflationary environment. Also, because inflation may vary considerably from year to year, the cost is highly uncertain.

With high inflation, the cost of the premium goes up, well before the salary and wages of the insured. The higher the expected rate of inflation, the greater portion of current income must go to cover the future risk and the less certain that the coverage will be sufficient.

At some point, people stop buying insurance and the insurance business dries up.

Longer term insurance is more vulnerable than short term insurance

The life insurance one buys at the airport to cover the risk of dying on today’s flight is hardly effected by the rate of inflation. However, life insurance with expected payment in thirty of forty years is no longer purchased.

Each class of insurance is effected to a different degree by inflation, but generally, inflation is bad news for the insurance business.

Collateral damage of a disappearing insurance industry

In the United States, the principle buyers of municipal bonds include property and casualty insurance companies. Inflation will adversely effect municipalities, not only by driving up the rates on bonds directly, but also indirectly by reducing demand through insurance companies.

Life insurance companies are major buyers of equities in the United States. High inflation is the kiss of death to the life insurance business. As life insurers fold their tents and slip away into the night, this source of equity will disappear. Prices of stocks will be depressed.

Defined benefit pension plans and annuities are another casualty of inflation. Not only will inflation reduce the value of such programs to the beneficiaries, wrecking havoc on those in retirement, but another source of capital to support employment will be removed.

The impact of inflation on health insurance may be somewhat different than on other lines, principally because of government involvement and political connotations. In Brazil, in the hyper inflation of the early 1990s, doctors were found driving taxi cabs, because the government health insurance program did not provide them with sufficient income to make a living.

The net result of inflation: a smaller capital market

Insurance companies are an important segment of developed capital markets. However, with inflation, their contribution as a source of capital is removed or greatly diminished. The direct results are on equity and long term bond markets.

The current scandal over the bonuses paid to executives of AIG is a gigantic misdirection of anger which should be directed to members of Congress who are directly responsible for the excessive spending that is likely to drive future inflation. This inflation, if not controlled by some future government with far more backbone than the current, by wiping out the life insurance business will do more harm to the American taxpayer than all the irrational behavior of a few misguided executives.

In inflation, investment market may tend to shift to very short term commercial paper and real estate. Life goes on, it’s just different.

Get ready.