Imperial Money

[The U.S. is] an attractive empire, the one everyone wants to join.

Max Boot
Wall Street Journal

The dollar has been around for so long it is thought to be as permanent as Rushmore or psoriasis. But today’s dollar is an imposter. It is not the same dollar it used to be back when America was a mere republic.

Nor is it exactly what people think it is. For one thing, it is worth – in terms of what it will buy – about only 5% of what it was worth 100 years ago. For another thing, it is no longer backed by anything or anybody – not even its managers at the Fed have it under control; they dropped the reins several years ago…and haven’t realized it yet. (Daily Reckoning readers are urged to get ready for a wild ride.)

The real dollar was, for nearly the first two centuries of its existence, "as good as gold." It was backed by gold or silver until Richard M. Nixon "closed the gold window" at the Fed in 1971. The dollar as we know it – the green pieces of paper that circulate throughout the world as if they were worth something – has only been in existence for 31 years. Since 1971, neither foreign governments nor individuals have had the right to trade their pieces of green paper for a set amount of gold or silver. It is still green (though an imperial purple might be more in order), but instead of a gold backing it is now thought to be "managed" by the Federal Reserve system, which most people think is better.

Since 1971, the dollar has been allowed to float. Thus, it has fallen, risen, fallen and risen again – with the fashions. It went down by about 50% against other currencies in the early ’90s…then up again by about 40% in the late ’90s.

Where will it go next?

"The dollar remains the world’s reserve currency," opined the Wall Street Journal recently. While noting that the greenback could fall if foreigners were to change their minds about it, "we’re still a long way from that day," said the paper.

How the Journal knows this it does not say. For our part, we admit that we do not know. If we could say with any certainty which way the currency markets would go on any given day, we would at least be tempted to charge a price for the Daily Reckoning.

Still, the day on which foreigners decide to stop financing the U.S. economy’s current account deficit may be closer than the Journal realizes.

As much a bonanza as the U.S. stock market has been for American investors, it has been even more salutary to foreigners. On average, since 1995 they’ve realized a 100% increase in the Dow…plus a 40% increase in the dollar. Not bad.

But so far this year, all major foreign stock markets have been out-performing U.S. indices…and the dollar has recently begun to ease off against foreign currencies too.

"Foreign net purchases of U.S. equities increased tenfold from ’91 to ’01," reports Rob Peebles of the Prudent Bear. "This begs the question, ‘So what?’ But when we put these numbers into context, for example by comparing them to equity mutual inflows, we can see that this foreign money is nothing to sneeze at. In fact, the Securities Industry Association calculates that between 1997 and June 2000 foreign investors were the third largest purchasers of U.S. equities, behind only U.S. mutual funds and life insurance companies.

"After all, factors that piqued the interest of foreign investors are now working in reverse. The NASDAQ has under performed the U.K.’s FTSE 100, Europe’s FTSE 300, and even the Japanese Nikkei over the one, two and three year periods ending in April. The S&P 500 has fared better against those averages, but it too has posted negative returns over each of the periods. "And now the dollar has begun to weaken. That makes bad returns worse when translated into local currencies. Year-to-date, the dollar has lost ground against the Euro, the Canadian dollar, the Swiss Franc and even the Japanese yen, among others. "Given their unpleasant experience, it would be no surprise if international investors thought twice about putting more money into U.S. stocks. And sure enough, foreign buying is losing steam. Net foreign purchases averaged just $5.3 billion a month during January and February. Other than last September, that’s the least interest foreign investors have shown in our stock market since April ’00. February net buying at $2.1 billion was far below the $9.3 billion average over the ’97 -’01 period.

But what would it matter? The Fed wouldn’t let the dollar go down, would it? Won’t the Fed control the money supply to keep the dollar – and the Dow – within an acceptable range?

"The Fed has lost control over the most important tool they have to influence the economy – liquidity, or money supply," says a report from Cornerstone Investment Services. The people at Cornerstone demonstrate that while since January ’99 the Fed has raised rates sharply…and then lowered them even more sharply…the money supply has kept rising steadily. Like a teenager asked to clean his room, M3 paid no attention; it just kept doing what it had been doing for the previous 5 years…going up.

"Somebody else took control of the money supply away from the Fed," says Cornerstone. Even though the Fed hiked rates from January ’99 to the middle of 2000, "issuers of debt didn’t pay attention to the Fed and continued and in fact accelerated their own issuance of debt, offsetting any desired effect Greenspan may have wanted…"

Who were these new competitors to the central bank?

"Fannie Mae and Freddie Mac took over as the key source of liquidity," explains Cornerstone, "ignoring the wishes of the Fed. They continued to pump new mortgages out regardless of higher interest rates."

When Greenspan loped 475 basis points off the Fed Funds rate in 2001, the idea was to stimulate lending. But the banks actually tightened up instead. Commercial loans dropped. Only the consumer kept the economy moving forward – spending money provided by the mortgage industry.

"The important factor to understand is that the Fed has lost control…" continues the Cornerstone team, "there is inevitable pain due thanks to all the debt and there is no easy solution…Now market forces are taking over and they are unpredictable and violent…We know the dollar is vulnerable."

Unlike the WSJ, we don’t know on what precise day foreign investors will think twice. We are not even sure they ever thought once. But that they will think…once or twice…at some point we have little doubt. And when they do, we have a hunch they will think dollar-based investments are no longer a sure thing. They might even take it into their heads to resist the imperial money.

Your correspondent…preparing to leave for a 3-day weekend (it’s Pentecost),

Bill Bonner
May 17, 2002

P.S. While shabby senators strut and puff in mock indignation over accounting practices at U.S. corporations, John Crudele in the N.Y. Post reports the contents of a letter from Treasury Secretary Paul O’Neill. If the federal government’s accounts were done on an accrual basis, Mr. O’Neill pointed out, last year’s loss would have been not $127 billion, but $515 billion. Foreign investors, take note.

Poor John Rigas! Just a couple of years ago the man was on top of the world. The head of Adelphia Communications could not imagine that his cable empire would ever sink. In fact, he believed things would only get better. So the poor fool borrowed $2.3 billion to buy more of it!

But times have changed in the last couple of years. From a high of $87 a share, Adelphia has fallen to $5.69. Yesterday, the press reported that the company missed a bond payment and Nasdaq is considering de-listing it. So, Bernie Ebbers, take heart; things could be worse.

How did Ebbers and Rigas get in such a mess? "The Fed spent a decade financing uneconomic stupidities," explains the Mogambo Guru, "which of course filtered through to explosively rising stock prices and massively redundant mal-investments (e.g. everybody in America started his own telecom business), and now Schumpeter’s creative destruction of these unprofitable mal- investments…"

"The people of America," Mogambo continues, with his characteristic reserve, "were they not so intent on continually proving that they are collectively a nation of mouth-breathing, abysmally ignorant and childishly trusting yahoos, would rise up and storm the offices of the Fed…"

Instead, the yahoos continue to borrow, spend…and go bankrupt. Personal bankruptcies are running 3.5% ahead of last year.

So far this year, our "nothing" investment advice has beaten "something." The Wilshire 5000 is down 3.5%. You would have been better off in cash. Much better off on a risk-adjusted basis. But "stocks always go up in the long run," say the yahoos, reassuring themselves. They have other convenient myths, too: "There are always plenty of jobs, if you’re willing to work,"…"You can always borrow…when you need the money"…"Housing prices always go up"…and "The Fed won’t allow things to go too far wrong."

Oh yeah? More below…

But first, let’s see what Eric has to say…


Eric Fry, in Manhattan:

– Every time the "recovering economy" story starts to gain a little traction…WHAM!…along comes a bolt of reality to mess up the story line. Yesterday, for example, we learned that housing starts fell and jobless claims rose. Neither one of these economic reports was sanctioned by the recovering economy storytellers.

– Despite the downbeat data, plenty of investors showed up to buy stocks yesterday. The Dow gained 46 points to 10,289, while the Nasdaq added 5 points to 1,730. Five Nasdaq points may not seem like much, but it’s enough to qualify as the fourth straight winning session for the beleaguered index.

– Housing starts fell 5.4% in April to the lowest level since October. Meanwhile, weekly jobless claims held stubbornly above 400,000, climbing slightly from the week before to 418,000. Even more troubling is the news that the number of people receiving benefits increased to a 19-year high. Don’t these unemployed folks know that the recession is over?

– While we’re talking about news that doesn’t quite mesh with the notion of a recovering economy, Moody’s John Puchalla points out, "Credit rating downgrades (66) topped upgrades (10) by a wide margin in April." In other words, more than six and a half companies received a credit downgrade for every one that received an upgrade. Again we ask: Don’t these companies with lousy balance sheets know that the recession is over? Somebody should tell them…because they’re messing up all our statistics!

– The news flow coming out of the commercial real estate does not exactly scream, "Recovery!" The supply of office space in Manhattan is soaring, according to Crain’s, and, predictably, rents are falling. "An estimated 4 million square feet of sublets is coming onto an already saturated market," says Crain’s. "This much new sublet space is bound to further depress rents for both sublets and direct space. The Manhattan leasing market is extremely sluggish, and glutted with sublet offerings at rents discounted 25% to 50% below landlords’ prices."

– The commercial property glut appears to be a nationwide problem. Moody’s reports that real construction expenditures on commercial real estate plunged 34.4% year-over-year in the first quarter of 2002 – "the deepest such decline ever for a record that commences in 1968."

– Meanwhile, the New York Times reports, "The warehouse industry is in a slump all over the country, with vacancy rates rising to 9.9 percent nationwide at the end of the first quarter from 7.5 percent in the quarter a year ago." (Note to self: Remind nation’s commercial landlords that recession is over).

– Speaking of overhanging supply, the airline industry has amassed a frequent-flier-miles liability that greatly exceeds what it could reasonably fulfill. This big liability – like America’s current account deficit – – is no big problem, unless everyone wants to cash in at the same time.

– According to The Economist, the airline industry would need about 23 years to clear all the accrued frequent flier miles off of its books – even if no new miles were issued. The current liability outstanding totals about eight trillion miles, which seems like a big number.

– Let’s see…If all these flyer miles were converted into domestic coach tickets, the airlines would need to issue about 25 million free tickets. If, however, the mileage-holders opted for something a little more luxurious – like, say, business class tickets to Europe – the airlines would have to issue about 10 million free business class tickets…Yep, eight trillion is a big number.

– In fact, the number is so big that it makes tech stock valuations seem rather modest. But they aren’t, according to Fred Hickey. In his latest issue of The High-Tech Strategist, Fred Hickey describes how, over the past few months, he came down with the flu, got hit in the face with a basketball, was bitten by a poisonous spider and had a large tree branch fall on his head.

– Thankfully, he’s okay. "The suffering that I’ve experienced," he cheerfully reports, "is nothing compared to the brutal beating that tech stock bulls have taken over the last eight weeks." And Hickey predicts more pain ahead.

– There are two major problems, he says: Tech industry fundamentals are still deteriorating, and valuations are still too high. Dell, for example, despite having lost $90 billion of its market cap, still sells for 38 times trailing earnings – and its earnings are not growing. Intel’s valuation has jumped from about 1.5 times sales in 1990 to its current seven times sales, despite the fact that its annual sales rate is no higher than in 1998. Says Hickey: The bear market in tech stocks is not yet complete. Who are we to disagree?


Back in Paris…

*** Australia is in the news today. South of the Equator, farmers are enraged by U.S. farm subsidies. Reports in Australia say that U.S. farmers will now get half their revenue from government handouts – a level similar to "socialistic Europe." Down Under, the level is only 7%. The Australians are particularly upset because, for many years, it has been the U.S. that has been the most vocal champion of Free Trade. The poor Aussies haven’t caught on; in Bush’s America, "Free Trade," and "Liberty" are just words to be used when it is convenient..

*** Then, my friend Adrian Day reports that an Australian wine, "Black Pepper Shiraz", has been turned back at the border. "Misleading labeling," said U.S. officials, who seemed to think wine connoisseurs would be disappointed when they discovered that there was not actually any black pepper in the bottle. "Morons," said Day.

*** And then there’s the news report that Australia has raised short term central bank rates. "Australia has been the poster child of wildly expansionist money supply," explains Mogambo, "with narrow money expanding at a 22% clip and broad money at a 14% rate, according to the Economist magazine." Expansionist money policies take time to show up in consumer prices, says Mogambo – as much as 3 years or so, "which gives the authorities enough cover to enable them to say, ‘Whoa! Where did this inflation come from? Totally unexpected, dude!" "This is a warning shot across the bow of the USA and every other bozo developed country on the planet, as they are all doing the exact same thing, only not to the insane degree of Australia (yet)…our time is coming…"

The Daily Reckoning