An Unstable Dollar Standard

The Daily Reckoning PRESENTS: What to do about the U.S. dollar? Everyone has their own opinion, but can all agree on one thing: a correction is unavoidable. Dr. Hans Sennholz shares his views on the matter…


We live in a period of worldwide economic expansion and prosperity. The world economy is said to grow this year at some five percent, which will be the third year above the historic average. Even if, in the coming year, the growth rate should decline a little, the global economy looks bright and prosperous. Led by some Asiatic countries, especially China and Japan, more countries than ever before are reporting rapid economic expansion.

But no matter how bright the economic outlook may be, the international prosperity is exposed to a looming risk, which has even grown in recent months. The war in Iraq and the skirmishes in Afghanistan are an ever-present danger that may destabilize the Middle East and spread the conflict to more countries. The Islamic republic of Iran, which does not hesitate to confront American interests and concerns, may upend the peace at any time. But the greatest concern of many economists is the global economic imbalance, which is clearly visible in the huge balance-of-payments deficits of the United States and in the corresponding surpluses of the creditor countries. Americans are said to consume some 70 percent of the world’s savings, while Japan, China, and other developing countries are financing the deficits and accumulating American IOUs. Many economists are convinced that such disproportions and imbalances are unsustainable in the long run.

Surely, American foreign debt has increased significantly, but so has individual income and wealth. Total domestic debt has risen visibly over the last decade, but so have productivity and income. This economic harmony nevertheless is burdened by considerable risk of global imbalances that may cause disruption and upheaval in the future. The debt-and-credit differences of the large national economies continue to grow, the balance-of-payment deficits of the United States surpass all national surpluses. In 2005 the deficits amounted to some $790 billion, which, in relation to gross national product, exceeded six percent. So far this year, it may exceed $800 billion, or 6.5 percent of GDP. Moreover, the federal government continues to suffer huge budget deficits which enlarge the national debt and add weight to the international concern.

The American mountain of debt is matched by large balance-of-payment surpluses in developing Asian countries, as well as by most oil-exporting countries. Many creditors welcome the surpluses. They keep the exchange rates of their currency low, which, in turn, boosts their exports and gives employment to millions of workers who, with American assistance and technology, are learning to produce for the world market. Chinese banks now hold nearly $1 trillion, which is the highest reserve position in the world, having passed Japan this year with some $865 billion. Without such dollar purchases, their currencies would rise immediately, which would boost all export prices, curb exports, and depress economic production and employment.

A few critics believe that the U.S. trade deficits may be the greatest threat to the economic order. Yet the deficits have neither impaired the U.S. dollar nor undermined the position of the United States as the primary economic engine and power. Many observers, therefore, question and disclaim the dangers of American balance-of-payments deficits. They not only cast doubt on official statistics that may exaggerate the case, but also point to the stable rates of exchange in which all participants maintain voluntarily. Stability, after all, benefits everyone.

This economist, nevertheless, is convinced that a correction is unavoidable. All markets function to adjust and readjust any maladjustment. They are burdened and strained by the growing mountain of debt, raising the question of American ability to meet its obligations. If there ever should be any doubt about the stability of the American economy, the worldwide demand for U.S. dollars would decline, causing the dollar exchange rate to plummet. American imports would decline, dampening the surge of consumption and slowing the very growth engines of export countries such as Japan, China, and many others. The whole world would feel the American instability. A weaker dollar and rising import prices also would accelerate the inflation rate which would pressure the Federal Reserve to raise interest rates. Higher rates would slow the American economy and boost the rate of unemployment.

Despite such international imbalances, the U.S. dollar has not weakened significantly in recent months, and the world economy has not fallen into a global recession. At first, Asian central banks, and then also the oil-exporting countries, financed the huge deficits. It is in the economic interest of the Asian developing countries to keep their exchange rates low in order to keep export prices low and thus keep the export motor running. Massive purchases of federal obligations support the exchange rate of the dollar and increase Asian currency reserves.

It is in the interest of the United States, as well as the Asian countries, that the U.S. dollar maintain its high exchange value. Some American economists like to speak of a “Bretton Woods II” arrangement, which would resemble the international system in effect between the Second World War and 1973. Participating countries supported each other’s currencies and thus sustained stable exchange rates.

In Bretton Woods I, the member countries supported each other’s currencies – in Bretton Woods II, they eagerly support the dollar. The European Central Bank, which actively pursues employment policies, manages to avoid the influx of U.S. dollars by keeping interest rates very low and liquidity plentiful. According to some estimates, the quantity of money in euro countries, since 2000, has increased some 25 percent faster than the gross product. In the United States, it has grown some 10 percent, and in Japan by 15 percent. The European Central Bank even surpassed the Bank of Japan, which is inflating its currency in order to counter powerful deflationary forces. In short, euro liquidity is plentiful and interest rates, seen historically, are exceptionally low.

As the U.S.-Asian imbalances continue to mount, the forces of readjustment are gaining strength. There are indications that the imbalances are correcting slowly and in an orderly fashion. Most governments agree that greater flexibility of the exchange rates, especially of the Asian currencies, is an orderly step toward the correction of the global imbalances. But most governments cling to their old policies. The interest rate differences are closing slowly, which causes more and more investors to shun the dollar risk. Moreover, the American real estate market has cooled off significantly without dramatic crashes. The boom, according to Fed Chairman Ben Bernanke, has given way in an orderly and moderate fashion. But there cannot be any doubt that the decline in the housing market will be felt throughout the economy in months to come.

Some Americans will have to curtail their spending which is bound to slow down the economy. Will it drag the world economy with it? The rate of expansion in many Asian countries undoubtedly will decline, but by less than pessimists predict. Most economic expansion in China, India, and other developing countries in recent years has been driven by domestic demand and supply. Yet we must not underestimate the weighty and consequential role played by the United States in world financial markets. A huge debt casts a shadow on any market; the rapidly growing international debt of the United States is clouding the world economy. It cannot grow perpetually; it will be settled sooner or later either in an orderly and upright fashion or in financial crisis and economic recession.

The finale of the scenario may be played by the Federal Reserve System. It may seek to reassure and pacify numerous Asian creditors by maintaining high market rates of interest or at least approximate them, or cater to the notions and wishes of most legislators and their constituents who usually favor monetary stimulation. Sooner or later Federal Reserve governors will have to choose between economic consideration or political preference. Their choice will determine the future of the U.S. dollar.


Dr. Hans Sennholz
for The Daily Reckoning
December 12, 2006

Editor’s Note: 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:

“India happens to be a rich country inhabited by very poor people.”

– Indian Prime Minister, Manmohan Singh

There is a worldwide boom going on. We see it in London…in Paris…and here in India, too.

“Four years ago, you could have bought as much of this stuff as you wanted for $200 a square foot,” said a friend from Bombay, waving his hand towards a block of old buildings near the Taj hotel. “Now, you’d have to pay two to three times that much.”

Even at $200 a square foot, looking at the dilapidated buildings, we wondered how it could be worth it. But we took his point; things have gone up.

‘This is the best market ever,’ says Jim Cramer, or words to that effect. He is talking about the stock market. He likes it because profits as a percentage of GDP are near a record high. Google is climbing towards $500 a share. Already, it is worth more than the entire Thai stock market. We wonder what investors are thinking? Which would you rather own, dear reader, Google’s profits in five or ten years…or those of all the publicly listed companies in Thailand?

Also up is Goldman – to a new high, based on record high profits. The people who own the stream of profits – stockholders, generally the wealthy – have no complaints. They’ve become much more wealthy in the last few years…even while the average fellow has actually gotten poorer.

Of course, we notice that even at Goldman things can’t be as rosy as they say.

A recent Bloomberg report tells us that Wall Street’s hotshot firm is turning to curious places for its new recruits:

“Goldman Sachs Group Inc., the world’s biggest hedge fund manager, hired 17 traders from Amaranth Advisers LLC to expand the firm’s investments in fixed-income markets, said a person briefed on the matter…

Amaranth collapsed in September after bad energy bets wiped out 70 percent of its $9.5 billion in assets. New York-based Goldman, the world’s largest securities firm by market value, is dedicating more capital to risky strategies after its $10 billion Global Alpha Fund fell 11.6% through November and as returns worsen this year across the hedge fund industry.

Still, capital assets worldwide have been nourished by a flood of liquidity.

“Capitalists are in clover,” says the latest edition of the Economist. “Profits have soared since the dark days of 2001 and companies are so flush with cash that they are buying back their own shares, merging and acquiring each other as if the good times will never end.”

Encouraged by the profit picture, investors have bought stocks. They haven’t made a dime in real terms – measured neither in gold, in euros, nor inflation-adjusted dollars has the Dow really gone up. But investors stopped thinking clearly about 10 years ago…maybe more. Since then, they’ve been listening to people such as Jim Cramer.

We interrupt ourselves to try to understand how the world works. Virtue begets virtue. The businessman who makes an honest profit does so by providing a good service at a good price. He controls his costs and thus finds that he has made a profit – which signals to him that he might be able to provide more services to more people.

But if virtue begets virtue, what does fraud beget?

The profits enjoyed by U.S. firms are real. But they have a strange provenance. In fact, they were begat in a swindle. The liquidity that made the world spin so hotly was not honest savings…it was funny money from central banks and debt.

“Profits are very dependent on whether the economy is expanding or contracting,” the Economist explains. “Businesses have fixed costs and when demand is strong, revenues rise faster than costs; when demand is weak, they fall faster.

“Nick Carn, a strategist at Odey, a hedge-fund group, says it is pretty simple: companies’ revenues are determined by the pace of consumer spending; their costs are largely driven by wages. Profits have grown because Americans have borrowed money to spend more than they have been earning. This cannot continue forever.”

Also in the Economist report is the news that financial services (which contribute over a quarter of all profits) are expected to produce 31% annual growth in profits. Strip them out, and the rest of the market will muster only 2%.

Whence cometh this profit bonanza? It is the misbegotten fruit of a sordid coupling – between savings that didn’t exist and people who had no business borrowing. Combined with low, globalized wage costs, it produced record profits for the lenders and the producers. Businesses could sell more product with little rise in labor expense. Lenders could lend money that no one had saved to hedge funds and homeowners and make a bundle. And it will all work beautifully, as long as nothing goes wrong.

But what could go wrong? What will almost certainly go wrong is that the homeowners will have to cut back. Then, the lenders and hedge funds will be in trouble too. Get this – the last six years have seen the biggest property boom ever. Yet, the average American homeowner actually has less equity in his house than he did in 2000. What he has a lot more of is mortgage debt. And when his house falls in price, that debt is going to chafe his neck like a noose.

The NY TIMES reports that property prices are down a lot more than people think. An auction was held in Naples, where people sought to get rid of their houses fast. Supposedly, housing is up 20% in the city. But when this auction put willing and able buyers together with ready sellers, actual prices were much lower than expected. Sellers took haircuts of 15% – 40% from what they paid for the properties a few years ago. Overall, prices were down about 25% from 2005.

The TIMES quoted an expert from Boston who estimated that prices in that city, too, were off about 20%. And in Northern Virginia, a drop of 10% to 15% has been estimated.

These are not the same as the price information reported in the paper. Sellers are reluctant to accept such losses. Instead, they let properties stay on the market. But these auction prices reflect the truth – when sellers are forced to mark their houses to market, prices are lower than they thought.

More news:


Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis…

“OK Luke Skywalker, meet your new comrade… Big Al Greenspan! Yes, he did use to work for the dark side, but recent words from the man known on the dark side as ‘Mr. Bubbles’ have us believing that he has seen the error of his 18 years on the dark side.”

For the rest of this story, see today’s issue of The Daily Pfennig


And more thoughts…

*** Here’s the stat of the month,” writes Outstanding Investment’s Justice Litle.

“From 8 out of 1,000 – to 1 in 3.”

The statistic Justice is referring to has to do with another ‘creative financing’ opportunity – pay option loans. In 2003, only about 8 out of every 1,000 people buying a home or refinancing a mortgage in California got a pay option loan – and this year, even as the real estate market is showing signs of wear and tear, 1 in 3 loan applicants chose this option.

And with the pay option loan, homeowners own a little less of their house as time passes.

Take Will Hertzberg, of Corona, California for example. As he so eloquently put it to the LA Times, “I am rather screwed.”

The Times continues, “Like hundreds of thousands of other homeowners around the state, Hertzberg has a mortgage that lets him choose how much he pays each month.

“Like many of them, he always chooses to pay as little as possible.

“For the moment, this allows the 56-year-old Hertzberg to continue living in his tract home despite being only marginally employed. But his debt is swelling, and his mortgage company controls his fate.”

And, interestingly, homeowners like Hertzberg control the fate of the housing market – and, some would argue, the overall health of the economy. Since these borrowers generally take the cheapest option every month, the borrower is betting the housing market will be better in a few years than it is today. If the house goes up in value, it will be possible to refinance and the day of reckoning can be put off once again.

“But the day of reckoning is arriving early,” writes the Times. “By paying the minimum, Hertzberg has increased the size of his loan in a little over a year from $320,000 to $332,616. His lender, Calabasas-based Countrywide Financial Corp., recently sent him a letter warning that when his loan hits 115% of its original size he’ll run out of credit with the company.

“That will happen in about two years if he continues to take the smallest payment option. Then his minimum payment will automatically go up 150%, to $2,848 a month.

“‘If I could afford that,’ he said, ‘I wouldn’t have needed this loan in the first place.'”

“‘I’m waiting for a 100-year loan,’ he said. ‘My heirs can worry about paying it off.'”

*** We came; we saw; we almost conked out.

India is overwhelming. Shocking. As soon as we venture outside of the hotel, we are stalked by beggars. We brush them off…we ignore them…but they stick like mud. They seem nice…not at all threatening – but they are annoying. You cannot walk along in peace. One little girl followed us around for blocks, tenaciously. A cute little thing; we would have adopted her on the spot if the opportunity had been offered.

We took a plane down to Pune on Friday morning. Pune is a town of about three million people, not far from Bombay. It is more open than Bombay, at least the part of it that we saw. But it is just as squalid. People live in shacks, tents, crumbling buildings…and in gaudy new apartment complexes. There are people everywhere…no matter where you look there are always dark figures moving around. What are they all doing, you wonder? How do they all stay alive?

But when you wander through the open-air food markets, you find a lot of very good-looking vegetables.

“The government is rather free-market,” our host explained. “But not completely. It still controls the prices for many basic things, because there are so many desperately poor people who can’t afford to pay market rates. This globalization has certainly benefited Indians who are educated. But it’s not clear that the poor are better off. They now have to pay higher prices…and there’s not much work for them.”

Oddly, housing and office prices have soared, but there is little available supply.

“I’d like to buy more space, but there aren’t any sellers,” we were told. On the other hand, developers are said to be adding so much space that in some cities there is a 10 to 20 year over-supply. What is going on?

“I don’t know, but it looks like speculators have forced up prices…even though there are not really that many people around who can afford to pay the prices. I’d be very careful before buying anything here now.”

Our plane from Pune back to Bombay was cancelled, so we got one of the last seats on the train. We were in a train car that looked as though it should have been decommissioned about thirty years ago. The cushions were torn and worn. Many of the metal parts were broken, and often rigged up in an amateurish way. This was first class. There were two classes lower – including one with wooden seats that looked like a cargo cabin.

Our car was packed.

We got to our seats and found them already taken. But we gladly gave them up; the woman in the seat next to ours was clearly mad. She spoke in a witch-like voice in Marathi, the local language, to no one in particular. The couple sitting next to her seemed to be taking care of her and thanked us for letting them have the seats. Later, they offered us a piece of fruit.

People in India typically speak two or three languages. They speak the local language – there are 21 official local languages. Plus, to get along together, they all learn Hindi. And in addition, most people now encourage their children to learn English.

When we finally got to Bombay, three hours later, we were shocked again. There were thousands of people living in the station…cooking on the platforms, squatting as they ate their dinners, sleeping…not on benches, but on the hard concrete. Some of the sleepers looked dead. Thin as the rails themselves, they looked as though they had been there for weeks. Maybe they were dead; no one seemed to notice.

On Sunday, we passed Bowen’s Memorial Methodist Church and went over to the Catholic cathedral. Bowen’s was open…a very modest place…dark and dirty…from which we heard the sounds of Christmas carols. The Catholic Church, by contrast, was as gaudy as any we have seen. With a rich combination of Portuguese and Hindu colors, it was like an ad for a paint company. Mauve, purple, lavender, rose, lime, maroon – we saw colors we hadn’t seen in years.

The mass was conducted in English. But as our ears were not yet attuned to the Indian accent, we missed most of the sermon, but at least we knew how the story turned out.

*** The definition of Hinduism given by Sathya Sai Baba, one of Hinduism’s best known gurus, was “Help Ever, Hurt Never” a friend explained. Not so different from the Golden Rule, we realized.

“But Hindus have never been a proselytizing group,” our friend continued. “That’s why you don’t find Hindus anywhere except India, except when Indians have emigrated. Instead, we don’t mind anyone practicing his religion. We’ve always been tolerant of other religions. We have Christians here…and many Muslims. In fact, we now have two leading figures in our government – one of whom is Muslim, the other, Sonia Gandhi, is an Italian Catholic.”

*** Saturday night, we took a cab up Marine Drive…along the waterfront…to a restaurant called the “Salt Water Grill.” It was built out on the beach, with sand floor and umbrellas over each of the tables. It was the sort of restaurant you’d expect to find in Miami.

It must be a popular spot. By 10PM it was full – with a mixture of Indians and Westerners. And it wasn’t cheap. The least expensive bottle of wine was $50.

India is a resource- rich, poor country with a lot of very rich people. On the way to the airport there is a Rolls Royce dealership, and luxury apartments are said to sell for $5 million. Meanwhile, it will cost only 50 cents to take a wild cab ride all the way across town.

The Daily Reckoning