The Downward Spiral
In late January, the Senate confirmed John Snow as our new U.S. Treasury Secretary, the 73rd in the government agency’s two-hundred-plus-year history. Snow, like Paul O’Neill and Robert Rubin before him, promised to follow a strong-dollar policy and take steps to help spur on a U.S. economic recovery and long-term growth. Well, I know you’ve just started your new job, Mr. Snow, but I’ve got some sobering news for you. You and your pals can keep talking about this alleged “strong-dollar policy” until you’re blue in the face, but it’s not going to make a lick of difference if you don’t start managing our currency more responsibly. The dollar is not just in decline; it’s a mess. If something isn’t done soon, I believe the dollar could lose its status as the world’s reserve currency and medium of exchange – which would lead to a huge decline in the standard of living for U.S. citizens like nothing we’ve seen in nearly a century.
“Oh, Jim,” the disbelievers crow. “You’re just being extreme. That would never happen. After all, the dollar has reigned supreme for several decades.”
True, but it seems to me that people forget that that supremacy isn’t a gimme. A sound currency, after all, reflects solid economic fundamentals: little to no debt, a trade surplus, a stable balance of payments – the difference between a nation’s receipts of foreign currency and its expenditures of foreign currency – and growing international reserves.
Dollar Supremacy: The US Balance Sheet
That’s not exactly the picture you get when you look at the U.S. balance sheet. Our national debt to foreigners is now around $6.4 trillion, with interest payments alone last year totaling $333 billion. We’re importing far more goods than we are exporting. International reserves remain around $60 billion, but we’re attracting far less direct foreign investment every year. Our current account deficit runs at roughly $500 billion a year, or five percent of our gross domestic product. Think of it this way: it costs us about $1.3 billion a day in the foreign markets just to keep the dollar afloat. Our $60 billion of reserves against our obligations would last 3 minutes if creditors begin cashing in. We’re like the untrustworthy brother-in-law who keeps borrowing money, promising to pay it back, but can never seem to get out of debt. Eventually, people cut that guy off.
As a result, the U.S. dollar continues to fall against its foreign counterparts, down 18 percent against the euro in 2002 and 10 percent against the yen. That’s not the worst it has been in history, but it’s certainly a substantial slide. With a war, a slow economic recovery and future threats of terrorism looming on the horizon, there’s little reason to believe things are going to improve.
What’s worse, little is being done by Washington’s economic gurus to pull us out of our economic quagmire. Faithful readers know I believe Alan Greenspan is the grand maestro of this economic debacle. Our esteemed Federal Reserve chairman is the first to “buy any assets” or lower interest rates to pump money into the economy and give investors the illusion that things aren’t as bad as they really are. Greenspan is ringing the bell signaling to sell dollars. Sometimes I wonder if our central bank is just going to print money until we run out of trees. People say that inflation is a dead issue, but you wouldn’t guess that shopping where most of us buy things or checking reality over on the commodity pages. History teaches us that such imprudent monetary and fiscal behavior has always led to economic disaster. During the early 1920s, rampant inflation destroyed the value of the German currency. German workers had to be paid twice a day just to survive; it took a wheelbarrow full of bills just to buy a loaf of bread. In England during the 1970s, the government continued to boost its money supply, injecting its economy with liquidity, until debt levels spun out of control. Suddenly, no other countries would buy their sovereign bonds. Finally, the International Monetary Fund had to step in and bail the Brits out. Quite a shift for a country that only 50 years earlier was the single richest nation in the world. But during that time, they lost their Empire and endured currency controls for 40 years.
Dollar Supremacy: Look South to Argentina
Want a more current example? Just look south, to Argentina, where the Argentine currency recently lost so much value that the government prohibited its citizens from making withdrawals at the bank. You could also look to several Asian “tigers” whose currencies collapsed in the 1990s…or to Malaysia, where in 1997, the government blamed everything on “evil foreigners” and blocked bank accounts. So why doesn’t our government do something about our flagging currency? At least, over the short term, the declining value of the dollar does have its perks. A declining dollar is certainly good for domestic manufacturers who must compete with foreign companies. As the dollar drops, their manufacturing costs decline, and it’s much easier for these companies to compete. The global economy is already sluggish, and the falling dollar makes U.S. exporters far more competitive. Again, it’s the illusion that things are better when they really are not.
Remember also: Our manufacturers may be better off, but foreigners then suffer, so the world as a whole shows no improvement. That is why similar practices in the 1930s were known as “beggar thy neighbor”.
While this helps U.S. manufacturers, it’s not necessarily good news for consumers. The cost of imports, like foreign cars and foreign liquor, will rise. Since foreign goods will become more expensive, U.S. companies may respond by raising their prices, even slightly, because they can. In the end, the dollar loses value, but we’re still paying the same real amount for many goods.
The bigger problem for the American economy is that foreign investors and foreign governments may soon lose their appetite for the declining U.S. dollar. Interest rates, which are now absurdly low, will need to rise to give foreign investors an incentive to invest and hold on to our currency. If not, these foreign governments and investors may look for somewhere else to hold their money. Historically, when investors recognize that a currency is being debased or devalued, they tend to look for sanctuary in currencies that remain stable at the insistence of the population. For years, the Swiss franc was synonymous with monetary stability. While currencies like the Swiss franc or the Japanese yen or the Danish krone – all of which I own – are in better shape than the U.S. dollar, I don’t have a whole lot of confidence in them either. All of these countries’ governments have adopted the U.S.’s dangerous habit of manipulating their own currencies to compete in the world market. It’s a double-bind of sorts: Singapore’s government wants to keep its currency strong and sound, but if every other country’s currency is declining against the Singapore dollar, their exports become prohibitively expensive and it becomes impossible for them to compete. They are forced to play monetary monopoly, shuffling the money supply, adjusting interest rates, just to make their products competitive.
Dollar Supremacy: The Euro
And what about the euro? It’s certainly stronger than the U.S. dollar, which is down 18 percent against the euro for 2002. I believe the success or failure of the euro is one of the most important questions of the twenty-first century, one with profound implications on the global economy. The world needs the euro, because it needs an alternative to the dollar. There really are only two currencies with enough liquidity to be the world’s currency – the U.S. dollar and the Japanese yen. (The Swiss may have a sound currency, but there just aren’t enough francs out there.) The European Union has everything going for it – an enormous population base, a balance of trade surplus. Most of its nations are creditors, not debtors. If the euro succeeds, people may actually stop using the dollar as a medium of exchange and as a reserve currency. That said, I believe that the euro is a flawed currency. Many of the European Union’s 12 member nations just don’t run a tight ship. Germany, which became the poster boy of fiscal responsibility in the mid-twentieth century, has again started running up huge debts. (Have they forgotten about the wheelbarrows?) The Portuguese are running an enormous deficit. The French recently said they are going to ignore the treaty establishing the euro. What’s going to happen when these countries can’t balance their books? Is Brussels going to send tanks into Lisbon? I doubt it. It may take years, even decades to root out all the problems in the EU’s inherently flawed system. Remember: Hundreds of billions of dollars (yes, dollars, for the moment) have been invested in this new currency. Banking systems have changed. Accounting systems have changed. Even parking meters have changed. If it fails or even struggles, there may be huge economic losses. So by default, the issue of the euro is one of the world’s most important issues:  If it works, the replacement of the U.S. dollar as the world’s currency will surely impact us all.  If it fails, hundreds of billions will be lost.
In the meantime, I actually own some euros, because the currency is less flawed than the U.S. dollar. How long does the dollar have? A year? A decade? I’m not so sure. As long as there’s no other currency stepping up to the plate, and the EU continues to struggle with the euro, the U.S. government will likely be able to continue to jiggle the books, essentially floating our enormous tab on the backs of the rest of the world. No country in history which has gotten itself into such a situation has escaped without at least a semi-crisis eventually. But remember: whenever there has been an economic crisis like this, a new player has always emerged on the economic landscape. A century ago, few people would have believed that the dollar was going to emerge out of the 19th century as the dominant world currency. There’s always a phoenix that rises from the ashes. Who will it be for the 21st century? My guess is the Chinese yuan may eventually have its day in the sun – certainly if the euro fails. The nation has a recipe for a sound currency – a huge population, an enormous balance of payments surplus, and a sizeable GDP to match. China is now the world’s largest importer and the world’s second-largest creditor (Japan is first). For the moment, its currency is not convertible, which must change now that it has been admitted to the World Trade Organization. There are still a lot of cultural barriers to get over – rampant xenophobia and fear of capitalist interests – but nothing assuages fears like steady flows of money into your coffers.
Gresham’s law says that bad money tends to drive out good money. Well, whether we like it or not, whether we want to believe it or not, the U.S. dollar has become bad money. Despite proclamations from Washington about a strong dollar policy, I see no reason to believe that the dollar won’t continue to decline, that we won’t continue to borrow like beggars and put Band-Aids on gaping wounds in our fiscal, monetary and tax policies. That is, until the day when our creditors say enough is enough. And that day may not be far off.
for The Daily Reckoning
March 12, 2003
Many are the reasons given for the sluggish performance of the U.S. economy and its stock market. The upcoming war against Iraq is usually at the front of the list.
Who wants to make a major investment now? Who wants to put his money on the line…or make a major business commitment? “I think I’ll wait until after the war is over…” is the standard postponement.
We have never understood the desire for war. Not that we don’t like war; au contraire, we like war as much as anyone. What is more gratifying than to see your enemies get blown up?
That was just the problem; we never understood how Iraq became the enemy du jour. We thought Osama bin Laden was public enemy #1…
But, little by little, the fog has lifted, and we’re beginning to see the lay of the land more clearly. Frankly, we were startled and alarmed when we got our first peek at it, but after a day or two of reflection, we’ve become to appreciate it. If nothing else, the next few years ought to be very entertaining…
You see, dear reader, an article in Esquire magazine finally clarified the administration’s war aims for us. As we suspected, Iraq has not been targeted because Saddam is a monster or because it supports terrorism. And what nation doesn’t have ‘weapons of mass destruction’?
“The real reason I support a war like this,” explains Thomas P.M. Barnett of the Naval War College, “is that the resulting long-term military commitment will finally force America to deal with the entire Gap [the part of the world which is not notably pro-Western] as a strategic threat environment.”
There, now you know. And now we turn to economist Stephen Roach to show why we bring this up:
“Despite the desire to bring American troops home quickly after a likely victory in Iraq, the risk of a prolonged presence in the defeated nation seems quite likely. Lasting American military presence in the Middle East could well be a lightening rod for further backlash and terrorist activity – hardly the stuff of resolution either. “Without a decisive postwar resolution, recovery dynamics in the global economy are likely to be impaired. The downside to oil prices could be limited. The uncertainty factor could persist – leaving businesses reluctant to hire and consumers unwilling to spend. While the case for war is being framed publicly on grounds of national security, I have little doubt that these economic concerns also creep into political discussions in Washington.
“Yes, there are also logistical considerations,” Roach continues, “Middle East weather and troop morale [for example] that appear to be affecting the rush to battle. But there are also more mundane economic considerations: the longer the delay, the greater the chance of recession – and an economy that backfires for yet another Bush Administration.”
Roach is wrong…and right. He is wrong about the desire to bring U.S. troops back from Baghdad. Once in place, they are expected to remain there – a more or less permanent outpost of the new American empire. Whether this will be good or bad, we cannot say. But it will not give Americans the swift, happy resolution they are looking for. Plus, it will be expensive. Who will pay for it?
Meanwhile, what else is happening in the markets? Addison?
Addison Wiggin, covering the financial news as Eric makes his way to a Supper Club meeting in the Bahamas…
– The “race to the bottom” regained our attention this morning. We’re talking about the Dow and the Nikkei, of course. The Dow dropped 44 points to end the session at 7,524…but like the tortoise of La Fontaine’s famous kid’s tale, the Nikkei has been putting on an impressive ‘slow but steady’ show as of late: yesterday, the Japanese index shed another 179 to close out the day at 7,862 – a new 23- year low!
– Still, don’t count the Dow out entirely. As we keep saying, you would think that with a sharply falling dollar, an 85% reduction of foreign direct investment over the past 2 years and repeated threats that the U.S. could ‘go it alone’ in Iraq, something’s gotta give…a brief shot of panic could give the Dow the hare-like speed it needs to end this tale in legendary fashion.
– Alas, we’ve noticed that the Dow displays remarkable tortelesque qualities of its own. The race to the bottom between these two mammoth world market indices may just turn out to be one long, boring, over-bloated decline…in which, by the year 2013, we see the Dow slowly settling in at around 2365 – its own 23-year low. Yawnnn, stretch.
– Indeed, if the U.S. markets and economy do continue to wend their way into the meandering, soft, slow deflationary path cut by the Japanese over the past 13 years, we’re not only likely to see a lower stock market, but we’ll probably get another taste of recession in the near future. Economists have been begrudgingly reducing their growth forecasts…but maybe not enough: “The odds of a recessionary relapse are high and rising,” writes Stephen Roach. The Richmond Fed reports that manufacturing activity is easing off.
– “I can’t help but think,” Roach continues, “that the President’s economic plan is in serious trouble. If national unemployment now starts to rise as the economy falters, the idea of offering tax relief to wealthier Americans (i.e., cutting dividend taxes) simply won’t fly in the Congress. It will then be back to the drawing boards on fiscal policy – a bitter pill for the White House to swallow.”
– Bloomberg estimates that state and local tax increases will come close to $80 to $100 billion – thus neutralizing Bush’s tax cut.
– And don’t be surprised if the Fed cuts rates again. The policies in place still reflect those of their Japanese role model – reducing interest rates in order to try to revive the economy. The U.S. is getting lower de facto rates as well as de jure ones. Long T-bonds just hit a new high, putting yields at a 45-year low. – But that seems to be what happens après-bubble in the modern age. Unlike the days of yore, when speculative bubbles – like the one Mississippi’s John Law had his hand in – raised people’s spirits and bank accounts, then dashed them again within a matter of months, today’s mass-markets appear to prolong the period of economic expansion…and likewise, the tortuous, drawn-out decline.
– The S&P 500 shed 6 to 800 yesterday…the Nasdaq dropped 7 to 1,271…spot gold dropped, too – $4.30. Ho hum…
Still in Paris…
*** Paul Krugman notes, in the New York Times, that projections by the Congressional Budget Office have swung by $7.4 trillion over the last two years. Twenty-four months ago, the CBO estimated that the federal government would run a $5.6 trillion surplus in the next 10 years. Now, it says the figure will be $1.8 trillion in the opposite direction. Krugman says this $1.8 trillion figure is far too optimistic. Most likely, the deficit will be at least $3 trillion, he says, and much is the result of trying to maintain a ‘security’ force in miserable hell- holes like Baghdad.
*** Rushing to a conclusion, we guess that the U.S. government will go broke. It will have obligations that it will not be able to pay. Foreigners, upon whom it relies for credit, will cross the street rather than have to meet Uncle Sam on the sidewalk. Unable to borrow enough cash, the U.S. government will resort to the Bernanke solution: it will create money ‘out of thin air.’
The trouble is, investors will not appreciate this new money as much as they did they old. The dollar will crash (more from ‘investment biker’ Jimmy Rogers below…). Long T-bonds – now at record highs – will get dropped. U.S. stocks will sink – eventually reaching levels similar to those in Japan after its 13-year bear market.
What a strange and remarkable thing! The U.S. government graciously and unselfishly attempts to police the whole world – and the ungrateful foreigners refuse to pay for it. Thomas Barnett and other macro-geopolitical hallucinators will find it unfair, and perhaps intolerable. In their minds, the U.S. is providing a necessary and valuable service – security.
“It is the right thing to do,” says Barnett of the anticipated war, “and now is the right time to do it, and we are the only country that can. Freedom cannot blossom in the Middle East without security, and security is this country’s most influential public-sector export.”
The trouble is the one we identified earlier. The Bush administration may export security – whether the world wants it or not. But how will it get paid? Perhaps it thinks foreigners will continue to take U.S. dollars and dollar-assets no matter how many of them are put into circulation. But foreigner investors are not permanently stupid, just episodically so, like U.S. investors.
A modest final prediction, based purely on a hunch: exporting ‘security’ to people who don’t want it, at a loss, when you are already hugely in debt to the rest of the world, will prove neither rewarding nor stabilizing. Buy gold.
But who knows what will happen in the short run. Maybe the war will go better than anyone expects (even though expectations are already very high). And maybe the price of gold will drop while stocks rise. If so…buy more gold.
*** “It is fascinating to watch the deconstruction of the dollar,” a friend, Mimi, told her husband in her sleep. In her dream, the dollar fell to $5.2 to the euro. When the dreams of opera singers are troubled by the currency markets, it is time to take cover. (For a few suggestions on how you can “take cover”, see this special report prepared by our friends at Everbank World Currency markets:
2003: Decline Of The Dollar)
*** Here’s something interesting: a list of all the places the U.S. has bombed since WWII:
El Salvador 1980s
Well, all these episodes turned out well…didn’t they?