The Prospect of Monetary Crash

The future for the U.S. dollar is the most important concern for the world economy, and for investors. This is not merely Yankee arrogance; so many economies outside of the United States are pegged to the dollar or depend on its value to support their own economic health. Addison Wiggin explains…

The dollar’s slump is of great and immediate concern because, while the dollar has been slipping only gradually in the recent past, the rate of decline has picked up momentum. A dollar crash will have disastrous implications for global financial markets. At the end of 2001, the euro was worth $ 0.8915, but it has been on a steady upward march since then. On the last trading day of the third quarter in 2007, the euro hit a high of 1.4282. A target of 1.50 is very much within range.

How do all of those surplus countries play into this falling dollar picture? Remember, former Fed chairman Alan Greenspan observed that in economics, the sum of all surpluses equals the sum of all deficits.

So when a surplus country stops investing that surplus in U.S. dollars, its currency will increase against the dollar. This realization has profound implications. Not only does the dollar continue to fall against other currencies; as it does so, it accelerates the undesirability of pegging currencies to U.S. currency or investing in Treasury bonds and other debt. In other words, it becomes less and less viable for foreign investors and central banks to fund ever – growing U.S. debt.

This is not just a problem of U.S. consumer debt trends. We may be the addicts, but we have codependents and enablers around the world. Just as the U.S. consumer is addicted to spending excesses, foreign exporters have become addicted to selling goods to Americans. The problem is with sellers, as well as buyers. The governments in those other markets are as concerned about the U.S. dollar’s fall as Americans are (or should be). Why? The fall of a dollar is the same thing as a rise in other currencies. So the competitiveness of the foreign export economy is damaged more and more as their own currencies increase in value. Just as a falling dollar hurts the buyer (Americans), a rising currency hurts the seller (foreign economies) in the same degree.

The United States is only one side of the problem. As the consumer, our dollars have tremendous influence throughout the world, if only because so many central banks (e.g., China’s) have pegged their currency to the dollar – and at the same time many exporting nations are seeing their currencies going up in value, making it untenable to continue exporting at the same rates as in the past. So we have, through trillions of dollars of debt accumulation, created a de facto dollar standard in much of the world economy.

The debt is based, however, on a worldwide bubble economy, perhaps the biggest bubble in world history. The whole theory behind this comprehensive "bubblization" (a new word for you, referring to the combination of federal deficit, trade, mortgage, housing, dollar, and credit bubbles all working together) has grown out of the economic theories of the Fed. Although Mr. Greenspan was the chief culprit behind the theory that spending is good, more spending is better, and the most spending is best, we can’t pin the whole thing on him. Like the U.S. consumer, he had enablers and codependents everywhere. His helpers include an array of bankers, corporate executives, and investors – all buying into the Greenspan version of the U.S. economy and how it just might work.

Now Mr. Bernanke, who happily puts himself out there as the leading economic forecaster and wise man, also contends that bubbles can’t be recognized until they burst. That’s like saying you can’t tell that your house is on fire just because smoke is billowing from the windows; you have to wait until it bursts into flame. The truth is, bubbles are easily recognizable well in advance of bursting, but we cannot know when they will burst. The dollar bubble is going to burst, and that is inevitable. The effects on the economy of that burst are going to be serious. As long as investors, consumers, and business managers continue to base our financial decisions on assets of inflated and unrealistic value, we are denying this inevitable outcome. The more we depend on those inflated values, the more damage we will suffer when the bubble bursts.

In the case of Japan in the recent past, its pattern was somewhat different from the U.S pattern of today. Japan’s deficit budget spending went into business investment, which in turn expands productivity and trade profits. Spending on business equipment and plans, commercial buildings, and other production – based infrastructure had a specific effect: When Japan’s economy slowed down, it merely came to a halt and has remained chronically slow ever since. In comparison, U.S. deficit spending is overwhelmingly going into consumer spending with very little business investment or consumer savings to offset that trend. Thus, the U.S. trend in GDP is led by consumption and not by investment. So the use of deficit spending has everything to do with the consequences of deficits, and ultimately with the effect of a dollar crash. Unlike Japan’s economy, which merely flattened out as a consequence of deficit spending, the U.S. economy is likely to see a more devastating change in the entire economic landscape – with the accompanying price inflation we have to expect as an outcome.

Regards,

Addison Wiggin
The Daily Reckoning
May 22, 2008

P.S. There is a day of reckoning for the U.S. economy just around the bend – and it’s going to require some fancy footwork from those wanting to protect their already existing assets…and still be positioned to turn a nice profit. There are at least seven ways you can do this, even if the markets continue to tank…stocks continue to fall…and even if the entire world economy goes up in flames.

Addison Wiggin is the editorial director and publisher of The Daily Reckoning, and executive publisher of Agora Financial, a multi-million dollar financial research firm and publishing group based in Baltimore, Maryland.

"When sorrows come, they come not single spies, but battalions…"
– Hamlet

Yesterday brought more sorrows. Stocks fell – with the Dow down 227 points. Oil rose to $132. The dollar fell to $1.57 per euro. And gold hit $928.

But what’s this? Bonds – strangely – fell too. This could be a very important, like the dog that didn’t bark. Usually, when stocks fall bonds go up. Investors anticipate lower yields as the economy cools and fewer borrowers compete for funds. But now, the bond market seems to be worried about something else…and we think we know what it is.

We have long mistrusted numbers. And we especially distrust numbers coming from the Labor Department, public officials of any sort, or Wall Street, or the media, or Congress, or the family.

"I saved a lot of money by buying this jacket," a daughter reported yesterday. "It was on sale. Don’t you like it?"

"Well…yes…but how much would you have saved if you never bought it at all?"

"Daddy…don’t be silly…I needed a summer jacket…."

Maybe we are being silly today…but we see money slipping through our hands. And so does everyone else!

Prices are going up for nearly everything – milk, bread, gasoline, liquor…all the essentials.

In the United States, reports Martin Hutchinson, the official inflation numbers are the worst in 17 years…but the raw numbers even more alarming. Of course, the raw numbers are never even mentioned. They are like a forgotten aunt, consigned years ago to a nursing home; nobody comes to call…nobody even asks about her.

In March, the raw data showed consumer prices rising at a 10% annual rate. But by the time the Labor Department’s goons got finished with it, they reported a CPI going up at an annual rate of only 3.6%. ‘Seasonal adjustments,’ they called it. Then, in April, when the raw data came in at a 7.2% annual inflation rate, they seasonally adjusted it down to only 2.4%. They didn’t seem to notice that the season had changed!

Hutchinson: "Both adjusted’ figures were greeted by the stock market with a sharp upward move. In the ten years to 2007, no seasonal adjustment has ever exceeded 0.3%, plus or minus; the probabilities that the March and April seasonal adjustments were randomly arrived at by the same method as those of the last decade were thus 0.18% and 2.3% respectively (so the probability of two such anomalies in successive months was 0.0041%, about 1 in 25,000.) If the raw March and April figures are adjusted by the average March and April seasonal adjustments of the last decade, consumer price inflation in those two months averaged 7.4% per annum."

You can fool some of the people all the time, said Abraham Lincoln. He didn’t know any modern economists or professional fund managers. But he must have anticipated them. They’re pricing stocks and bonds as if inflation were still under control – on the Labor Department’s say so.

Who knows? Maybe they’ll turn out to be right. Stranger things have happened. But here at The Daily Reckoning…we reckon prices are rising more than most people think…that’s there’s more inflation to come…and that the bond market is catching on. That’s why bond prices went down yesterday; investors are worried about inflation. At long last – perhaps – the bond vigilantes are awaking from their long, deep slumber.

Readers will remember the bond vigilantes – perhaps only by reputation. Back in the ’70s inflation rates rose. Bond buyers took a terrible beating. Then, they strapped on their guns. Henceforth, it was said, the feds couldn’t get away with causing inflation; because the bond market wouldn’t let them. As soon as bond investors saw inflation coming, they would act like vigilantes – selling off their bonds and forcing up yields. Higher yields cooled off the economy…and reduced inflation.

By way of full disclosure, this is not the first time we thought the bond vigilantes were saddling up and riding off to stop the Fed from destroying the dollar. At least twice in the past 5 years we thought so…only to find that they were just on their way to a saloon to join the party!

Back to the first point – that the numbers lie: A couple of English newspapers had the same suspicion – that official numbers were bent and distorted, always to the downside, of course. So, they sent their reporters out into the real world to buy things.

"The results are ‘alarming,’ says one tabloid…"the most savage increase in living costs for a generation." What did the papers actually find? The Daily Express came up with an increase in consumer prices over the last 12 months of 11.5%. The Daily Mail’s tally came in at 15%.

That’s getting to be serious inflation. And we suspect there’s more coming. And less, too.

A news story in the Financial Times tells us something very interesting. "The gap between input prices and what can be passed on to consumers is at its widest for 20 years." For example, a 4-pint bottle of milk has gone up 16.5% in the United Kingdom. The price of milk from the farm has soared nearly three times as much – 45.8%. Or take bread. Wheat is up 56.9% over the last year. But a loaf of bread has only gone up only 8.5%. Crude oil is 62% more expensive today than it was a year ago. But a can of oil…or petroleum products generally, at the retail level…are up only 25.4%.

What does this mean? Probably two things. Maybe more. First, input prices have jumped so fast retail prices have not been able to keep up. It may also mean that retailers don’t think the raw output prices are permanent…or that they, the retailers, can afford to pass them along without losing customers. It may also mean that commodity or wholesale prices have gone up too far, too fast.

One thing is certain, the gap can’t last. The retailers can’t buy oil 62% higher and sell it only 25% higher – not for long. Either the price of crude comes down…or the price of retail petroleum products goes up.

Which will it be? Inflation or deflation? More inflation at the retail, consumer level…or a collapse of commodity/wholesale prices?

Our guess, as usual, is that it will be both.

*** There are two types of consumer price inflation. There is wage-push inflation…and cost-pull inflation. Or, is it the other way around? Doesn’t matter. The most familiar type of inflation comes when an economy heats up…companies need more labor…so workers demand more money. Employers meet the new wage demands…and then raise prices to maintain profit margins. Result: consumer price inflation.

The less familiar type of inflation happens when retail prices are pulled up by higher input costs. This is a very different kind of inflation because it provides consumers with no way to pay the higher prices. So far, we’ve seen very little increase in wages. As prices go up, consumers must cut back. This has the obvious effect of reducing demand…and reducing price pressure. Just as wholesale prices work their way down to consumer prices, so does consumer resistance work its way back up to producers. Effect? De horses go down and den dey come back. Doo dah. Doo dah. Producers cut back on production in the face of lower demand. Result: prices fall.

But here we introduce three wrinkles – each one the size of the Rocky Mountains.

First, have you heard that word: "decoupling?" We were afraid to use it; we thought it described the end of a porno movie. But now we discover that it really refers to the parting of the ways…between the mature economies of the United States and Europe…and the growing economies of the rest of the world. It was presumed for a very long time that "if the U.S. sneezes, the rest of the world catches a cold." Well, now we’re not so sure. The rest of the world seems to have developed immunity to America’s germs. We don’t know; but maybe a consumer slowdown in America would not keep the Chinese, Indians and Russians from buying. Result: the normal corrective feedback loop would be twisted and broken. Prices would still go up, even though the U.S. economy was in a slump. This would put Americans in a terrible position – where they were earning less money but their costs of living were still going up.

Second, global prices are denominated in dollars. And the custodians of dollars – the feds – are determined to keep Americans spending money, even if they don’t have any. ‘Rebate’ checks… mortgage bailouts…lower rates…lower lending standards – the feds are going all-out, trying to keep the money flowing. Our guess a year ago was that this flood of liquidity would buoy up oil, gold and commodities. It certainly has done that. But will it continue?

This brings us to our third crease. Many commodities seem to us to be near bubble territory. Oil, for example, is an important commodity. But it’s just a commodity. It has users. It has producers. Barring a war, the relationship between supply and demand doesn’t change overnight. How is it possible, then, that the price should double in less than two years…or that it could go up another $25 before the end of the year (as much as the entire oil price 5 years ago), as T. Boone Pickens predicts? How could it go to $200, as Goldman predicts?

The answer is simple – the price is rising on speculation, not supply and demand. Oil may already be in a bubble.

Five years ago, there was only $13 billion invested in oil market indices. Now, there’s $260 billion, according to an article in the FT. In the futures market, oil is usually sold short – as oil companies hedge future production. In 1990, only 13% of open interest was long. Today, 58% is long.

Besides, markets work. When prices go up it draws forth new supply. In yesterday’s news, for example, we found that oil companies are spending four times as much on exploration and drilling as they did eight years ago.

Of course, there are reasons to think oil may go higher – a lot higher. But markets are markets…and bubbles are bubbles. And there’s one thing you can count on – bubbles always pop.

Until tomorrow,

Bill Bonner
The Daily Reckoning