The Currency Chain Gang

The U.S. dollar and the Chinese renminbi remain joined at the hip…but for how long?

The boom on Wall Street in 2003 was not irrational, but it could draw investors into a trap. The boom itself is a recovery from the declines of the previous three years. The market has not broken through its 1999 and 2000 highs, and it is unlikely to do so in the coming months, though I expect Wall Street to continue to be quite bullish through the election in November.

The market has been reacting to the renewed growth in the U.S. economy and the strong rise in corporate profits. In the third quarter 2003, the U.S. economy grew at around 9% annualized, an unexpected rate of growth for a mature economy. In the same quarter, corporate profits rose by 30% and broke through the $1 trillion barrier for the first time.

I find in the last few weeks that I have regularly been referring to "trillions." When I entered journalism, we counted in "millions"; the inflation of the 1970s taught us to think in "billions"; the 21st century is teaching us to think in "trillions." I wonder who the first "trillionaire" will be. So far as I know, no individual has yet reached the $100 billion mark, though Bill Gates may have done so at the top of the Internet boom.

Consumption Boom: Nervous Foreigners

I did not expect so strong a performance from the U.S. economy, and I am still uncertain about the underlying causes. We do, however, know that it was led by U.S. consumption. It was not savings or exports that did it, nor was it a higher inflow of foreign funds. Foreigners have become nervous of the dollar. I am nervous of this boom in consumption, since it has been financed by a boom in debt, based on the huge borrowings from Japan and China. The prosperity of the United States in 2003 has not been the product of U.S. earnings but of borrowing the earnings of Asian countries.

The world trade and currency relationships reflect this tension, and have been following exactly the forecasts we have been making. On this, your editors and I have the same analysis. It is not an analysis of any single currency, of the dollar, the euro, the yen, the pound, or the renminbi, but of the unsustainable relationships between them. We also treat gold as another currency and use movements of the gold price as a very significant indicator of the underlying balance of the market. Gold has broken through $400 per ounce and seems set to go much higher. Analysts regard $500 as only the next step.

In the last month, our current forecasts have all been on track. The dollar has continued to fall against all the other currencies except the Chinese renminbi, which is tied to it. This has largely corrected the overvaluation of the dollar, but has not corrected the trade deficit of the United States, which currently runs at $500 billion, or half a trillion dollars. It has also produced an acute undervaluation of the renminbi, which is reinforced by China’s extremely low labor costs.

The yen has risen closer to the 100 yen-to-the-dollar relationship. In order to maintain export competitiveness, the Japanese have continued to buy dollars on a massive scale. The U.S. trade deficit with Japan is therefore recirculated and used to finance the U.S. deficit.

Consumption Boom: Euro Rising

Britain and Europe are on the receiving end of this movement of the dollar. The euro has risen to its highest level ever. The pound, which has a different trading pattern to the euro, has fallen against the euro but risen by more than 20% against the dollar. The result is that European exports, which already had high costs, have ceased to be competitive, particularly with the exports of Asia.

Germany is sometimes referred to as "the engine of Europe," but the German economy is sick and has fallen back to zero growth. Germany is a manufacturing and exporting country, and German manufacturers are not competitive in world markets. In the whole Eurozone, youth unemployment is one- sixth, a social disaster.

Even China is not free from problems. An undervalued currency is obviously helpful as a way of undercutting one’s neighbors and promoting exports. China has tens of millions of workers to introduce into its expanding modern economy. But an undervalued currency introduces inflationary pressures, and China is beginning to suffer from them.

At some point, the renminbi will have to be revalued against the dollar, or floated. Floating would be much the better solution. The present situation, in which the dollar and the renminbi are tied together, but all the other major currencies are floating, is illogical and damaging for all of them. President Abraham Lincoln said that one cannot have "two nations – one slave and one free." It would be equally true to say that the world cannot have two sets of currencies, one floating and one fixed. That is particularly true when the fixed currency is the most competitive on Earth.

The dollar will not be able to settle down to a more stable rate so long as it is fixed to the renminbi. Nor will the euro return to a more competitive level. At present the United States and China are like two fugitives from a chain gang, tied together at the ankle. It may, however, be difficult to cut off their fetters until the U.S. presidential election is out of the way.


William Rees-Mogg
for The Daily Reckoning
January 12, 2004

Editor’s note: Leading political editor William Rees-Mogg is the former Editor-in-Chief for The Times of London and a member of the House of Lords. A version of this essay originally appeared in the January edition of Strategic Investment, to which Lord Rees-Mogg is a frequent contributor.

For more, see: The Investment of a Lifetime

Erring on the side of recklessness.

Who can know how long this stock market rally will last? Or whether employment will really pick up or not? Or, when the Chinese will stop lending?

But Americans have decided to go ahead – as if everything will turn out all right, no matter what. The thought occurred to us when reading the latest employment reports.

It is still a "jobless recovery" as near as we can figure…or even a jobless non-recovery. We suspect it will soon be a jobless bust…but hold that thought for a minute; today we’re not making predictions, we’re merely marveling at the extraordinary optimism of American investors.

While investors are optimistic to the point of recklessness…people who actually know something tend to be more cautious. While the little guys buy appalling stocks at outrageous prices, the real pros – Soros, Buffett, Templeton, Rogers, Grantham et al – head for the exits. And now we find our friend Marc Faber saying that business managers are currently 4 times as likely to sell their stock as buy it.

And when managers hire new employees, again they show timidity, not temerity; they are more likely than ever before to pick up ‘temporary’ workers, rather than full- time ones.

Faber quotes Jose Rasco of Merrill Lynch:

"…The temporary worker is the marginal worker and is the first in the door. If demand remains strong, then companies can hire those workers on a full-time basis. If that’s the case, then maybe we will see a traditional recovery led by job creation and income generation. Or, conversely, the rise in temporary workers could be a sign that employers are beginning to apply accounting principles to human resource departments. Instead of hiring someone on a full- time basis, corporations may be moving their labor risks from being a fixed cost to a variable cost. Rather than bringing someone on board and paying them a full-time salary and benefits, companies can keep them as temp/flex workers whose workload can be adjusted with the vagaries in demand. With companies lacking pricing power, and input prices rising…what can a company do to expand margins? The answer is obvious. The easiest way to boost corporate profitability is by lowering its biggest fixed cost: labor!"

You may be shocked to discover this, dear reader: in America’s consumption-led economy, real wages are actually going down. The rush of money into stocks over the last 15 months has not come from increased earnings…but from increased debt. Lower rates encouraged consumers to re- mortgage their homes. Mortgage debt rose…but so did other consumer debt.

Where then did the money go?

"…It seems that only a small part of it was spent," concludes economist Gerard Minack. "Yes, the household sector is still running a cash flow deficit (spending more on consumer and capital items than it receives in cash flow), so the shortfall had to be financed. That cash shortfall was $113 billion in the year to June. But that is relatively small compared to the increase in borrowing. As it turns out, it seems that much of the Fed-facilitated borrowing has gone into Wall Street."

The household sector became the biggest buyer of stocks in the first half of last year – buying $416 billion of them, despite the fact that real incomes were falling.

Real wages have gone down over the last 10 years. But the cost of labor still goes up – because health insurance premiums and other costs have been rising at double-digit rates.

This is very bad news for the American proletariat. Even though he gets less money, his employer is still under pressure to get rid of him!

And here we have another little wrinkle in the fabric of modern, degenerate American capitalism. Corporate managers have no loyalty, neither to their shareholders nor to their workers. They pay themselves extravagantly, sell their own stocks short…and treat employees like inventory. The idea seems to be to cut costs on everything but themselves…to hire the cheapest employees possible, just in time, in order to meet short-term objectives.

Nobody holds anything in stock anymore. No excess food in the pantry. No excess products on the shelves…no excess money in the bank, no excess employees on the payroll. Inventory is an expense item. Erring on the side of recklessness, Americans live hand to mouth…paycheck to paycheck…as if nothing will ever go wrong.

"NO ONE is making long-term investments," writes Hirschel Abelson after surveying the dozens of companies in which his fund invests. Neither in equipment, nor in people. Of course, this is no way to build an economy or make people rich. In the modern, globalized economy, if an American is to continue earning 10 times as much as a Indian, he has to produce 10 times as much. Which means, the society in which he lives has to invest massive amounts of money in new equipment and training. Instead, corporate America seems to care only about cutting expenses to make the next quarter’s numbers…and its own stock options.

The approach is not only reckless…it is hopeless.

"…We are at the point where peak efficiency has begun to take hold and sources for further cost-reduction are becoming harder to recognize," Abelson continues.

Eventually, business managers run out of costs to cut. Then what?

Over to Addison for the news:


Addison Wiggin in Paris…

– Just as we were getting used to bashing Paul O’Neill for toeing the party line, the man up and got himself fired for failing to do so. Now we’re dangerously close to becoming fans…if not for his views, then certainly for his gumption.

– Then again, Mr. O’Neill could just be trying to sell copies of his new tell-all book, "The Price Of Loyalty." In any case, O’Neill told viewers of the CBS rag 60 Minutes last night that removing Saddam Hussein was a top priority of Bush the younger upon taking possession of the White House. O’Neill saw no convincing evidence of Weapons of Mass Destruction during his tenure. Furthermore, he was told by the Vice President that Reagan proved that "deficits don’t matter."

– What a relief it must be for the president to have the docile Mr. Snow as a Treasury Secretary instead, huh? In contrast to turncoat O’Neill, Snow is still among the faithful – even going so far as to cheer on the president’s audacious new space plan. After all, every president worth his salt needs a space plan. Why not a ridiculous and completely insane one? Why Snow, rather than a NASA official, was talking up the plan to build a colony on the Moon and send Americans to Mars remains a bit of a mystery, however.

– But then again, Snow is a "can do" optimist. Exactly the guy Bush needs to get the job done. He’s just as confident the U.S. can put a man on Mars and cut the deficit in half while doing it…as he is that they can jumpstart consumer capitalism in the deserts of Iraq…that he talk the Chinese out of their desire to hollow out the American manufacturing sector and sell dirt-cheap gee-gaws…and that the American consumer, going bankrupt at an historic pace, will miraculously provide the necessary ‘stimulus’ to end the ‘jobless’ part of the Great Jobless Recovery of 2003. Ho hum…all in a day’s work.

– We here at the Daily Reckoning are fairly confident that as long as John Snow says these things in public, he will be able to keep his office at the Treasury. Heck, even if the plan doesn’t work 100%…even if the rest of it goes south…Snow will at least find himself on the short list for a luxury suite on the moon, far, far away from the toil and trouble that will undoubtedly come from cleaning up the mess they leave down here on the earth.

– Meanwhile, back to reality. Friday’s new job numbers make the mission to Mars the more plausible of Mr. Snow’s two speech subjects. Far from the 200,000 new jobs he was expecting in December, what Snow got instead was the discount version of the report. An anemic 1,000 new jobs were created in December. In fact, only 144,000 jobs were created in the whole of the fourth quarter. "That bad piece of jobs data makes me wonder," wrote Everbank’s Chuck Butler this morning, "how long the ‘exceptionally strong’ labor productivity story can continue."

– "How long" has become a familiar refrain around these parts. We ask the question so often, our wives have begun ask tune in with us.

– In the face of continued job weakness, we lamented on Friday (although admittedly a bit confused by reports on the subject), we noted that personal debt is being relied upon by as diverse organizations as the American Banking Association and the American Bankruptcy Institute to bring the economy back from the brink of recession.

– How long can that trend continue? Well here’s a disturbing and tiresome clue from our friend John Mauldin: "Consumer short-term debt…is approaching a historical turning point. Having risen at an abnormally fast rate for ten years, it must soon adjust itself to the nation’s capacity for going into hock…which is not limitless. Whether the rate of growth in consumer debt will slow down is no longer the question…it must slow down."

– Surprise: That quote was taken from the March 1956 issue of Fortune magazine. Other sources throughout the years have made similar comments, which were all obviously wrong. "How long?" Mauldin asks. "My guess is [financial reckoning day] will not be this year…there is still some room left on the credit card."

– Perhaps reserving seats now for the next shuttle to Mars is not such a bad idea.


Bill Bonner, back in England…

*** Why bother to stockpile labor? China has millions of laborers: "Other Asian lands ran out of unemployed people as they developed and had to shift to more sophisticated output to accommodate increasingly expensive labor," writes Gary Shilling.

"China has not. Almost half of its 320 million farmers are not needed to work the land, by the reckoning of the Ministry of Agriculture. There are around 80 million redundant workers in government and government enterprises, not to mention the 100 million squatting in the coastal regions, looking for work, and also the soon-to-be- employable youth – a quarter of the Chinese are under age 15. So China has 500 million potential new workers. "How long could China maintain 8% annual economic growth before exhausting this huge pool of unemployed? About 30 years, assuming 4% annual productivity growth – no great feat for a developing country that can adopt modern technology. Also, the growing Chinese middle class promises strong domestic demand, which will reduce dependence on exports and lead to greater imports. Maybe one day each of those 1.3 billion Chinese will drink one can of Pepsi. "But if you are awed by China’s current and potential power, think twice. Recall the awe over Japan during its 1980s bubble days. Remember how we were all going to be sweeping up around Japanese computers? My contrarian forecast in 1988 was that Japan’s bubble was about to break. I feel the same way now about China." "…China’s two recent growth engines are highly vulnerable. First are exports. Official data show that from 1997 to 2001 exports averaged 21% of GDP but accounted for 48% of GDP growth. And most of those exports go directly or indirectly to the U.S.. American consumers have ended their 20-year borrowing-and-spending binge and are embarking on a saving spree…So the outlook for Chinese exports is glum…"

*** We flatter ourselves with more fan mail: "I am an active reader of the Daily Reckoning," begins one letter. "Whenever I am getting too pleased with the upward movement of the stock market and my ‘greedy’ inclinations, a dose of your column puts some reality on the picture. As a daily reader, I am quite clear on your point of view of the current situation and the dire consequences you paint for the future.

"Rather than repeating the same story on a daily basis, I would ask that you occasionally present a constructive investment strategy that could help me, a naïve investor, increase the possibility of economic survival if your prophecies come true. If the objective of your analysis is to make me want to subscriber to the various newsletter advertisements interspersed with your invective against the system then I would be most disappointed."

*** "Yup! Your critics are right!," says another. "They would have made a ton of money investing in the absolute wreck of the market! Of course you told them to buy gold (stocks coins and bullion) and instead of a ten-month run they would have celebrated two anniversaries of undeserved success by now. With a little thought they could have cake walked from March 2000 until the present but that’s another story. You guys are what you say you are; a well run, easy- to-read journal that costs nothing.

"Your contrarian view is the most powerful antidote to the moronic positivism we get in the mainstream media. The individual who wished you were more positive (06/01) and wanted you to talk up alternate energy or some such thing really needs to look more closely at himself and the world he lives in. There are very real barriers preventing the accomplishment of ‘good’ things in this world. You touch on many of them in your work and there are many many more. Your role (to me) is to shine a light on the intellectual corruption and self interest that passes for reasoning amongst the most powerful in our society. Please keep up the good work. You are a true rarity."

*** Another do-gooder gone bad. That is what we make of press accounts of Armin Meiwes’ prosecution.

Poor Meiwes thought he had a solution to the problems of poverty and overpopulation. He was no doubt discussing his program with Bernard Brandes just before the two cut off Brandes’ most private part and ate it. Then, wouldn’t you know it, Brandes died, either as a result of blood loss from the butchering or as a consequence of the fact that Meiwes slit his throat. And now the British press has made a big stink about it, branding Meiwes the ‘Cannibal of Rotenburg.’ But Meiwes is not merely a pervert; he’s an activist.

"We could solve the problem of over-population and famine at a stroke," said he, according to the testimony in The Times of London. "The third world is really ripe for eating."

But wait, a fellow omnivore thought he saw a flaw in Meiwes’ utopia: "If we make cannibalism into the norm, then everyone will start eating each other and there will be nobody left."

"That’s why I’m not keen on eating women," Meiwes replied.

It seemed never to have occurred to either of them that…just perhaps…not everyone would want to be eaten. Here at the Daily Reckoning, for example, we got through all last week without anyone being eaten…or even expressing a desire to be eaten. But of course, we’re contrarians.