Unfavorable Balances

The Daily Reckoning PRESENTS:Much to the surprise of many, the U.S. dollar has shown resilience despite the growing problems with the U.S. economy. But how long can we count on the kindness of foreign strangers to keep our heads above water? Dr. Hans Sennholz explores…


To the surprise and wonder of many economists, the U.S. dollar continues to be rather strong in international money markets despite ever growing American trade deficits. Last year, these deficits amounted to more than seven hundred billion dollars, or six percent of gross national product, increasing the indebtedness of the United States to the rest of the world to nearly one-fourth of GNP. At this rate, American indebtedness is likely to reach one-half of GNP in just five years. Despite the soaring debt, the U.S. dollar rose some 14 percent relative to the euro and even more, relative to the Japanese yen. It lost a fraction toward the Chinese renminbi after the Chinese central bank raised its dollar rate by 0.4 percent. Yet, the dollar seems to be the rock on which most countries rest their currencies.

The financial world, apparently, is ignoring the trade deficits and the rapidly rising American indebtedness. Being accustomed to deficit financing, American officials seem to handle them with ease. Even long-term interest rates are remaining exceptionally low. But many politicians and media spokesmen like to complain about China, especially about its refusal to allow its currency to find a free market rate and thus allow the money market to function freely. They like to look abroad and find fault with foreign demeanor rather than reflect on their own conduct.

Nasty Dollar: Greenspan’s Take

Former Federal Reserve Chairman Alan Greenspan evidently does not agree with these critics. He has a ready explanation for American balance-of-payment deficits, which constitute by far the biggest maladjustment of the global economy. He believes that such deficits are merely the byproduct of a long-term development facilitating the deficits, and that they are the side effect of the ever-increasing importance of the financial industry and its great flexibility. We do agree with the former chairman that the world economy, and especially world finance, has expanded significantly ever since the disintegration of the Soviet Union and the dissolution of the Soviet bloc of countries. Many trade barriers have come down and capital markets have widened to include all but a few recalcitrants. But such an explanation of the size of the trade imbalance does not explain its very cause. In fact, central bankers rarely render accurate accounts of the consequences of the policies they conduct.

Ever since the world discarded gold as the standard medium of exchange, the U.S. dollar has served in its stead. And just like gold or any other commodity, the dollar has been moving from places where its market value is low, to places where it is higher. It is sent to all corners of the world, always guided by its purchasing power. And just as the gold- producing countries usually experienced “unfavorable” balance of payment – that is, the exports of gold exceeded the imports – so does the United States suffer “unfavorable balances,” or exports of dollars exceed their return. But while the quantity of gold mined and offered on the market was always rather small, the volume of Federal Reserve notes and deposits, as well as the fiduciary credits resting thereon usually is much larger. It affects not only international money relations, but also tends to give rise to worldwide business cycles. The Fed has generated numerous boom-and-bust cycles ever since it opened its doors in 1914. The booms are periods of easy money and abundant credit that lead to malinvestments, squandering, scarce factors of production, and encourage over-consumption. In the recessions that are bound to follow, the maladjustments are corrected and the factors of production are employed again for the best possible satisfaction of consumer needs and wants.

Economists like to distinguish among several phases of a business cycle. A central bank launches the first phase by embarking upon money and credit expansion in order to stimulate the economy or finance government budgetary deficits. It may purchase government obligations with money it creates or lower its interest rates, which encourages member banks to borrow money it creates. In the second phase, businessmen tend to borrow these funds and embark upon production that hitherto had not been economical. Business is very rewarding and profitable. In the third phase, feverish activity may cause factor prices as well as goods prices to rise. The specter of inflation makes its appearance, which may induce monetary authorities to raise their interest rates. But these usually trail actual market rates that are rising – and may even accelerate. During this phase, legislators and regulators like to impose price and wage controls and threaten violators with heavy fines and imprisonment. In the fourth and final phase, a new central banker facing runaway inflation may have the courage to raise his discount rate to the market rate, which finally balances the demand for funds with the supply of actual savings. At this time, the economic readjustment and correction – that is, the recession – begins. But before it has run its course and properly corrected all maladjustments, the monetary authorities usually launch another cycle.

Nasty Dollar: As It Stands Today

And where in the cycle are we today? Most symptoms seem to point to the third phase, when goods prices begin to rise and the inflators become inflation fighters. Surely, consumer goods prices have been rising at modest rates because massive imports from China and other Asian countries have diminished the price pressure. But these countries compete for raw materials and energy products, such as petroleum, which has raised those prices significantly. Moreover, American real estate prices have been soaring, which enabled many homeowners to consume the rising equity and go deeper into debt. Yet, foreign central bankers and commercial bankers continue to trust the financial structure and invest some of their dollar surpluses in U.S. Treasury obligations. They recently rushed to acquire a large bloc of new 30-year bonds, which obviously helped to support the dollar and hold interest rates at present levels. They simply ignore the massive level of dollar debt and the large maladjustment of the global economy.

The fourth and final phase of the cycle is not yet in sight. However, we must face and get ready for the ordeal that is bound to come at home and abroad. The Federal Reserve may continue to raise its discount rate until it finally reaches the market rate, at which time the readjustments begin. But even if it should not dare to raise its rate to a level at which the demand for funds is covered solely by genuine savings, the readjustments may commence whenever the distortions come in sight. The readjustment in real estate may already have begun in the form of stagnation and decline in some communities. It may continue to spread as more and more consumers become reluctant to live beyond their means and increase their debt.

The coming readjustments may commence abroad. Some foreign creditors may tire of amassing ever more dollars and supporting the standards of living of a rich and powerful country. They may question the creditability of a debtor who makes no preparation for reducing his debt, but actually continues to enlarge it. Even if no important creditor should unload his dollar claims and seek refuge in some other currency, such as the European euro, the Japanese yen, or Chinese renminbi, the clouds of international conflict seem to be gathering, casting a shadow on all international debtors, especially the biggest and brightest. In Palestine, which Jordan ceded to Israel after the 1967 war and is inhabited by some 2.5 million Arabs and 250,000 Jews, the most militant Muslim party, called Hamas, recently came to power. It is unlikely that it will call a halt to the bloody Intifadah uprising and suicide bombings in Israel. Encouraged and supported by Muslim fanatics from its kindred neighbors, it may unleash a bloody clash of arms, which soon may trigger a grave crisis of world finance. It surely would bruise and mar the U.S. dollar.

In Iran, the issue of weapons of mass destruction has led to acute tension and confrontation with the European Union and the United States. They still are trying to persuade Iranian authorities to abandon the development of nuclear power and arms, which would constitute a deadly peril to some of its neighbors and especially to tiny Israel. If they should fail, and Iran edges ever closer to the possession of nuclear arms, there is serious speculation that either the United States or Israel may strike at the country’s nuclear bases. Such an assault undoubtedly would enrage the world of 1.3 billion Muslims in 206 countries, and topple the international debt structure that is resting on the U.S. dollar.

There are times when precaution is wise and profitable. It keeps a watchful eye on present dangers and on things to come.


Hans Sennholz
for The Daily Reckoning

Editor’s note: The Fed has remained irrationally confident in the U.S economy – because they can’t afford from American consumers to see the truth – that the basis for this confidence is a shamelessly fraudulent farce of trumped-up statistics.

Dr. Hans Sennholz is president emeritus of The Foundation for Economic Education (FEE) in Irvington, NY. His essays and articles have appeared in over thirty- six major German journals and newspapers, and 500 more that reach American audiences. Dr. Sennholz is also the author of 17 books covering the Great Depression, Gold, Central Banking and Monetary Policy. You can write to him at this address: hans@sennholz.com.

Nobody loves a good deception more than investors…unless it is voters. The Dow shot up more than a hundred points yesterday.

And would you believe it? Consumer spending also shot up last month! Retail sales just posted their biggest increase since May of 2004. As a consequence, China is bringing in so much U.S. cash that they’re running out of space to store it. Merchants cart it over to the bank, where it is exchanged for local currency. So much new money has been created to keep up with the inflow of dollars that M2 – a measure of money supply – is rising at nearly 20% per year in China. No wonder the place is booming.

Oh, what a tangled web we weave. The U.S. Fed practices to deceive consumers with cheap money and then, consumers deceive their own retailers. These retailers then deceive their suppliers, who deceive their bankers, who deceive their borrowers. The borrowers build factories and office towers all over China. Whew! It makes your head spin and your skin crawl.

How do we untangle this web? We begin by wondering where consumers get the money to spend. After all, the Fed is now on a tightening cycle…threatening to raise short-term rates to 4.75% just to assert Ben Bernanke’s bona fides. And the house price bubble that was responsible for so much consumer spending since 2003 seems to be leaking. The number of unsold houses on the market in November was the highest in 20 years. Nearly three million houses were awaiting buyers on Thanksgiving Day, 2005.

And those houses that are already in homeowners’ hands are getting more expensive to own. The teaser rates under which they were purchased are expiring. Now, they’re paying interest at higher rates. According to Barron’s, there is a huge quantity of sub-prime mortgages that must be reset. How can these people continue spending more than they earn?

Maybe the January figure is a fluke. Or, maybe consumers are just pressing the pedal to the metal, as they say. They’re already flying along at breakneck speed. Why not give the old engine a little more debt juice and enjoy the ride? You’re dead at 60 MPH anyway, so why not go 80? Wheee!

Here in Britain, inflation is disappointing central bankers. As in America, they wanted to deceive the public at a fixed and controlled rate – a minimum of 2% per year. But in the latest 12 months, only 1.9% of the pound’s purchasing power fell off. Last month, prices actually fell (the pound grew larger). What does this mean? It means the economy is slowing down.

“It’s hard not to conclude that recession is on the way in the U.K.,” says our friend James Ferguson. “Growth has never before been as low as it is now (1.7%) without continuing on into recession. We know…that there is a close relationship between house prices and retail spending because of the mortgage-equity withdrawal (MEW), and we know that MEW in the last 12 months has dropped by an amount equivalent to 3% of GDP. You can’t just walk away from a hit like that, not when consumption makes up two-thirds of GDP.”

Oh, woe is us…woe is us. Whither will you go, Britain? And whither, dear America? The British currency is almost stable; the economy is slipping. Quick, start up the printing presses! Get Bernanke on the phone; ask him what to do. Gently remind him about those “unconventional methods” he favors – destroying a currency to incite a boom. Remind him that if he can weaken the value of the currency, people will be only too eager to get rid of it. Spending will sizzle again. The consumer economy will flourish. At least, that is the simple-minded reasoning that undergirds his oeuvre. It never seems to have occurred to him that people might catch on and dump their dollars before he gets a chance to cheapen them. But in the Bernanke Weltanschauung, he and his central bankers pals are fleet a’foot and sharp a’brain; they’ll always stay one step ahead of the people they’re trying to fleece.

Historically, no national bank, by purely conventional means, has ever failed to ruin its money, but not necessarily when or how it was planned. Bernanke’s obsession, say the experts, is neither with protecting the dollar nor with destroying it, but merely with controlling the rate of disintegration. There, we think the central banker is asking for too much. He is like a killer who asks him victim to stand still so he can stab him slowly. Imagine his surprise if the victim stabs first.

More news from our currency counselor…


Chuck Butler, reporting from the EverBank trading desk in St. Louis:

“Yes, January’s retail sales came in at +2.3%. It is a surprisingly high figure. I guess the U.S. consumer hasn’t finished spending, but then, I’m reminded of the fact that a star shines the brightest right before it burns out!”

For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig


Bill Bonner, back in London with more opinions and ideas…

*** Don’t worry about one of our Big Es, says David Brooks in the NY Times. The U.S. Empire is not in decline, it’s still the rising power, he says. We’re the biggest, best, brightest, most bumptious race in the entire world, he points out. By almost every measure, we’re on top…and we are still investing vast sums in research and engineering to make sure we stay on top.

Of course, that is what can be said at the top of any bull market or the top of any civilization. In the Fin de Bubble period, it appears to almost everyone that you are the best people God ever created; you can’t see any reason why you shouldn’t just get better.

What about falling consumer incomes, you ask? What about the trade deficits? What about government and consumer debt? Oh, don’t worry your little head about them; it’s a New Era. What about squandering the imperial military forces on costly and insignificant wars? Don’t worry about that either. We’re an empire, after all; we have to act like one.

We doubt Brooks is right, but wouldn’t it be nice to think so?

*** Last night, for Valentine’s Day, we went out to see Walk the Line. We sat next to another couple, whose romantic evening must have gotten off on the wrong foot. We guess it started with an argument about nothing, but you never know about arguments. You never know what they’re really about. Sometimes they seem important and are really about nothing. Sometimes they seem like nothing, but are really important.

We leave to St. Valentine, the labor of sorting out distressed couples. But as we heave our shoulder to the wheel of economics and finance, we cannot help but notice that there is always a lot more going on than meets the eye or ear. And walking the line in central banking, as in marriage, can be harder than it looks.