How to Sell the Dollar, Part II
Today, we bring you part two of Addison’s essay, which is taken directly from the newly-released, updated version of his bestseller, Demise of the Dollar. Read on for a look at how the Fed and Treasury actively devalue the dollar – a very timely subject…
Seeking to spur the economy to growth, the Fed and the Treasury have been actively devaluing the dollar. Many dubious excuses are given – protecting American exports, saving jobs, preventing deflation, for instance – but there is no question that Capitol Hill is actively engineering the dollar’s demise: 18 rate cuts since 2001, three tax cuts, massive deficits, and record money creation bear cold witness to its manipulations.
You don’t spend your way to prosperity; no nation ever has or ever will. But guess what? That very idea is the basis of U.S. and Fed monetary policy. Never in U.S. history have the imbalances in the economy been so pronounced, or so dangerous. "My experience as an emerging markets analyst in the 1990s taught me to be on the lookout for signs of financial vulnerability," observed analyst Hernando Cortina in a Morgan Stanley research note. [The signs] include ballooning current-account and fiscal deficits, overvalued currencies, dependence on foreign portfolio flows, optimistic stock market valuations coupled with murky earnings, questionable corporate governance, and acrimonious political landscapes. Any one of these signals in an emerging market usually raises a red flag, and a market that combines all of them is almost surely best avoided or at least underweighted. I didn’t imagine back then that one day these indicators would all be flashing red for the world’s biggest and most important market – the U.S. A by-the-numbers analysis of America’s macro accounts in a global context doesn’t paint a flattering picture."
Yet for growth-starved financial markets, perceptions and hope are often more important than economic reality. According to the macro indicators that the International Monetary Fund (IMF) uses to assess emerging-market economies, the United States fell between Turkey and Brazil.
Hernando Cortina politely concluded: "Investors contemplating the purchase of U.S. dollar-denominated assets would be wise to factor in significant dollar depreciation over the next few years."
"Households have been on a borrowing spree," added Northern Trust economist Asha Bangalore. Household borrowing as a percentage of disposable personal income hit a new high of 12.4 percent in the second quarter of 2003. This measure of household borrowing reflects mortgage borrowing, credit card borrowing, borrowing from banks, and the like.
Household borrowing is not only at a record high but a new aspect has emerged – household borrowing advanced during the recession unlike in every other postwar recession when households reduced borrowing. The good news is that consumer demand continues to advance with the support from borrowing.
The bad news is that no economy has ever borrowed its way to prosperity. Despite the conspiracy against it, the dollar has avoided a downright free fall. That’s because dollar investors across the globe are still convinced that, given favorable credit conditions, the U.S. economy will surely reenter the heyday of the late 1990s, taking dollar – denominated assets to new heights. But someday soon, we think, investors will be disabused of their illusions. Sure, the stock market rallied briskly in the recent past, but the U.S. economy continues to struggle. Unemployment persists. And the twin deficits loom larger and larger. If and when America’s creditors – domestic and foreign – decide the country’s massive, record-breaking level of debt is reason enough to get out of their dollar investments, the dollar will have nowhere to go but down, precipitously.
We don’t know when the exact moment of truth will arrive, but we know it cannot be far off. Excessive debt is not the only ominous development in the U.S. economy. Just as foreboding is the American consumers’persistent belief that they are wealthier than they actually are. U.S. financial assets are, once again, in the grip of a large bubble. Take stocks, for instance: It may not be 1999, but investors are sure partying as if it were. If the S & P 500 – an index made up of the country’s largest companies – were to trade at its historical fair value, or at a price-earnings (P/E) ratio of 15, it would have to decline by 50 percent off its high. But bull markets don’t typically start at fair value. If a new bull market were really starting – and stocks were actually undervalued – the S & P would be trading 67 percent lower, at a P/E of 10. But it’s been so long since investors have seen P/E ratios in this range, they seem to believe stocks will never descend from their lofty heights.
The U.S. stock market is once again in the grip of a bubble. The Fed’s frantic reflation campaign, government’s tax cuts, and easy credit have worked their way into stocks, causing the market to burgeon and billow outward in a way completely dissociated from any real measure of value.
In fact, the rally in stocks has been so strong that it has rekindled investors’belief in a new bull market, full economic recovery in the United States, and a return to the glory days of the 1990s. But a funny thing has started to happen. The U.S. stock market is soaring. Normally, that means the dollar would go with it; when a country’s stock market goes up, demand for its financial assets usually goes up, too. But the dollar is being dragged down by debt – government debt, personal debt, and corporate debt. Investors want a bull market, and so they’re making one. But the dollar reflects the real state of the American economy…and it knows better.
Foreign investors are especially burned when stocks and the dollar part company. At first blush, the rallying U.S. stock market seems like a very inviting place for their capital. All denominations are welcome, but not all guests are treated equally well. For example, the S & P 500 soared 26.4 percent in 2004, in U.S. dollar terms. Yet euro – based investors in U.S. stocks would have realized only a 6 percent gain for the year.
Foreign bondholders are faring no better. Foreign central bank holdings of Treasury and agency securities total over $ 1 trillion. So, roughly speaking, every 10 percent drop in the dollar’s value impoverishes our foreign creditors by about $ 100 billion on their U.S. Treasury holdings alone! That’s real money.
How is it possible that stocks continue their winning ways, even while the dollar continues its losing ways? These two inimical trends are strange bedfellows indeed. What makes the pairing particularly bizarre is the fact that our nation relies so heavily upon the enthusiasm of foreign investors for U.S. assets. What is the Fed doing, and why? One writer has pegged the answer:
"The Federal Reserve Board is working to raise the inflation rate, while the U.S. Treasury is trying to talk down the dollar exchange rate. Not every day does the world’s hegemonic power pursue a policy of currency debasement. Still less frequently does it have the courtesy to tell its creditors what it’s doing to them."
Indeed. The Fed and Treasury are engaged in a kind of collusion to lower the dollar’s value. And that’s a very dangerous game to play, especially for a country like the United States, which relies so heavily upon foreign capital to finance its economy. It has become fashionable in the corridors of power in Washington to advocate "market-based" exchange rates – code for "weak dollar." A weak dollar, it is widely believed, will lead to a strong economy. Hmm.
In the olden days, of course, the Fed was supposed to pursue "monetary stability." But in the enlightened twenty-first century, the Fed has much grander designs. It imagines itself a kind of marionette master to the world’s largest economy, making it dance whenever it wishes, simply by tugging on one little interest rate, or by tugging on the dollar. And so it tugs, and tugs, hoping to revive the economy.
The U.S. Treasury Department is also conspiring with the Fed to weaken the dollar. Hasn’t Treasury Secretary Snow touted the weak dollar as a surefire cure for the struggling U.S. manufacturing sector?
And hasn’t the dollar been tumbling? And yet, isn’t the manufacturing sector struggling just as much as it was when the price of a euro was only 83 cents, instead of $ 1.25? It’s obvious to almost every citizen who does not live in Washington, D.C., that devaluing the dollar to stimulate economic growth is a fool’s mission. A couple of years ago, 255 dollar bills purchased one ounce of gold. Today, an ounce of gold costs more than 400 dollar bills. And on the day that an ounce of gold costs 1,000 dollar bills, our manufacturers will have become so competitive that they will be exporting firecrackers to the Chinese, or so the gang on Capitol Hill believes. But in fact, we will all be poorer for embracing the idiocy of "competitive devaluations." The problem is, once a devaluation trend begins, it is almost impossible to stop.
The solution comes from repositioning, and the best cues for when, how, and where are found in the gold market – which prospers during times of geopolitical uncertainty and traditionally rises in value when the dollar falls. The gold price has jumped 367 percent from April 2001 to January 2008, from $ 255 to $ 936. The metal’s impressive rise inspired a dramatic rally in gold shares that has vaulted the XAU Index of gold stocks to an all-time high of $197.3 on January 14, 2008.
What does the gold market know? That the Fed’s reflation campaign will succeed too well? A little bit of inflation – like a little wildfire – is a difficult thing to contain. And the gold market seems to have caught a whiff of inflationary smoke.
Or does the gold market know that Iraq will continue to serve as a breeding ground for terrorists and a habitat for anti-American terrorist acts? As the Iraq situation continues, the dollar will suffer…a lot. Or maybe the gold market knows only that U.S. financial assets are very expensive, and worries, therefore, that U.S. stocks selling for 35 times earnings and U.S. bonds yielding 4.5 percent are all too pricey for risk-averse investors to own in large quantities. A vicious cycle is hard to stop. The dollar’s descent is the most worrisome – and influential – trend in the financial markets today. And yet, as long as Cisco is "breaking out to the upside," few investors seem to care about the dollar’s slide into the dustbin of monetary history. The dollar’ s demise is not inevitable, just highly likely.
When a currency falls, in theory anyway, interest rates usually rise. A government whose currency is falling apart tries to make assets denominated in that currency more attractive by paying higher rates of interest to potential investors. And if the government doesn’t raise rates, the market will do it by selling off bonds and driving yields up. And so, in theory, you would normally expect to see a falling U.S. dollar accompanied by rising U.S. interest rates. The difficulty from the Bush/Greenspan/Bernanke perspective is that rising long-term rates pose an enormous problem: They make it significantly more expensive for debtors – from U.S. consumers to the U.S. government – to service their obligations. And these costs are not negligible.
In fiscal year 2007, for example, the government was obliged to pay out a whopping $ 429 billion in interest expense on the public debt outstanding. At a 1 percent rise in interest rates, that would add $ 43 billion in interest expense. And to meet this added interest expense, the government would, of course, have to float even more bonds, and at the higher interest rate.
This scenario is the government’s nightmare. When the falling dollar eventually pushes interest rates up, the Treasury will have to issue more debt at higher interest rates simply to pay off its existing debt. But if the Asian economic juggernaut were to discontinue recycling its excess dollars into U.S. government bonds and Fannie Mae debt, the dollar would suffer mightily. How much longer until our luck runs out?
In some way, shape, or form foreigners lend our consumption-crazed nation $ 1 trillion every year. We Americans, in turn, use the money they send our way to buy SUVs, plasma TVs, and costly military campaigns in distant lands. However, we do not forget to repay our creditors with ever-cheaper dollars. Someday soon, foreigners must lose interest in subsidizing our consumption habit. That the dollar’s decline comes at the urging of the same nation that prints the things is an irony that is not lost on the world’s largest dollar holders. Reading the tea leaves, many Asian central banks are still exploring ways to lighten up on their U.S. dollar holdings.
"The Chinese aren’t lapping up our Treasury paper for its great investment attributes," writes Stephanie Pomboy of MacroMavens, "but [rather] because of a mechanical need to maintain the yuan/dollar peg."
The dollar is a currency fated to tumble. The dollar’s resistance to its debt load, fueled by the machinations of central banks and the misguided faith of dollar investors, undoubtedly qualifies as a trend whose premise is false. Sometime soon this trend will be discredited.
May 1, 2008
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.
It is May Day in Europe. It is a holiday for almost everyone. But here at The Daily Reckoning’s mobile headquarters, we keep reckoning day in and day out.
And what we reckon today is that two extraordinary things happened yesterday – related to one another and equally absurd.
Yesterday, the Fed did what it was widely expected to do – it lowered rates by 25 bps, bringing the key Fed lending rate down to 2%, or about half the rate of consumer price inflation. And that is where we begin to wonder. What kind of a bank would lend money for less than the inflation rate? Isn’t it sure to lose money?
Yes, of course…but it’s a long, long story…
The other extraordinary thing that happened was that the U.S. federal government began sending people "tax rebates." Of course, they are not tax rebates at all. Everyone who filed a tax return will get $300, whether he owed any taxes or not. A taxpayer will get another $300. Plus, children and dependents will get $300 each.
Alas, today’s news tells us that much of the presumed benefit from the giveaway program will be lost because of higher fuel and food prices.
(And here we offer some helpful advice: We’ve heard that SUVs aren’t selling very well anymore. Maybe the feds should give every family an SUV – one made in America, of course. That would be good for the auto industry – and then people could take the money they save from not having to buy a new car themselves and use it to buy gasoline and groceries.)
The U.S. government is already $9.3 trillion in debt (not to mention the other $40 trillion ‘financing gap’). It is giving out money it doesn’t really have – $106 billion worth. But it is doing so for good reason – or so it believes. The president of all the Americans – George W. Bush – said that the handouts will be "good for the consumer economy."
Lending money below the inflation rate…giving out money you don’t have, when you are already so deep in debt you will never get out – how could any of this be good for the real economy? But by this time we are so far into Never-Never Land that we will never find our way back.
A consumer economy may benefit from consumer spending – but only if consumers have money to spend. If giving away phony money, which you don’t really have, could make things better – why stop at $300 a head? Why not give away $1,000 a person…or $5,000?
Likewise, if it’s a good idea to lend money at 2% below the inflation rate…why not lend it at 10% below the inflation rate?
The really extraordinary thing is that the brightest minds in the nation think they can control the economy in these extraordinary ways. But they would think so, wouldn’t they? The guy who believes drinking doesn’t affect his driving is always the guy with the whiskey bottle.
Meanwhile, there was some ordinary news yesterday too. The Dow eased off 11 points. The euro stayed at $1.55. And gold lost another $11 – dropping to $866. Wouldn’t it be nice if the price would fall below $800! Maybe it will; maybe it won’t. But Dear Readers are urged not to lose heart. This bull market in gold isn’t over yet. The real excitement is still ahead.
*** Our commodities superstar, Kevin Kerr, recently went to meet with corn and soybean farmers (as well as feedlot operators) and he told MarketWatch, "the conversation was positive but also fearful."
"The overwhelming sense of farmers here is that the average urbanite is unfazed by what farmers are going through. After all, costs for the average farmer are up more than 100%. Profit margins have narrowed or become non-existent and fuel costs, especially diesel, have been a killer.
"Farmers feel that the average consumer blames them and think the farmer is getting rich of these food costs; when in reality there are no yachts in Waseca, Minn., only farmers trying to grow their crops and take care of their families.
"The increase in input costs has been as big a burden on farmers as it has on the rest of us. The average person living in the city is relatively unconcerned as long as the water is running, they have a job, the ATM works and there is food on the shelf. Most urbanites are likely more concerned with who got the boot on ‘American Idol’ then the possible approaching food disaster.
"One thing is for sure, agriculture markets are not like other commodities, and demand and pent-up demand are real. This year, the corn crop needs to be a bumper crop or there will be a shortfall. It’s likely that we will have a low yield crop, and $7.50 corn is a real possibility.
"Corn-based ethanol remains the law of the land, and like it or not, nothing is going to change in an election year. All bets are off until we know who will be president."
*** Brazil is booming. Its bonds were upgraded yesterday. Now, they’re considered investment quality. The Brazilian currency is rising against the dollar. Exports tripled in the last five years. The country is now a net creditor with the rest of the world – with $171 billion in reserves. And its stock market is the best-performing major market in the world this year.
Ah yes…the world turns. Now, the banana republics get rich, while the rich go bananas.
The Daily Reckoning