The Great Calamity Waiting to Happen
Long ago, we predicted the dollar’s collapse.
Despite the soaring deficit in the current account, it went from strength to strength. Our opinion, however, has not changed.
What has happened with the dollar since 1995 is more or less a repeat of the experience of the first half of the 1980s. Thanks to booming financial markets and the prevailing perception of superior economic performance, the United States attracted capital inflows that easily covered the soaring deficit in its current account.
Yet we took the opposite view. Noting the exploding U.S. budget deficit, an unprecedented consumption boom and the soaring trade deficit, we kept warning of the dollar’s inevitable plunge – in contradiction to the bullish consensus that believed in the U.S. economy’s renaissance through supply-side Reaganomics.
The final outcome of the dollar’s bull-run in the early ’80s is now well known. The reversal came when the U.S. economy slowed down in 1984-85. Inexplicably, the dollar even surged at first, but soon began an even sharper decline. Yet in the summer, it seemed to start a new rise. As all major governments, except for Japan’s, wanted a lower dollar, the fears of renewed appreciation galvanized the celebrated Plaza Accord of Sept. 22, 1985.
Although the following joint interventions of the central banks to weaken the dollar were on a very small scale, the U.S. currency went – with strong intermittent fluctuations – into a long, steep slide that ended in May 1995.
The single most important question at this juncture is definitely whether any decline of the dollar will be orderly and limited in scope or whether it will be as precipitous and prolonged as the fall between 1985-95. It seems the latter is unimaginable for most people. Longer-term forecasts generally project a stronger dollar next year, reflecting the U.S. economy’s recovery.
It is our definite view that the U.S. currency is destined to slide to new lows, that is, below those of May 1995. Basic to this assessment is the recognition that the imbalances that have accumulated in the U.S. economy and its financial system in the wake of unprecedented credit and debt excesses during the past six or seven years vastly surpass those that accrued in the early 1980s before the dollar’s ensuing collapse.
The crucial test of a country’s economic development from a long-term perspective are the changes in two aggregates: investment resources (savings) and investment incentives (profits). By these two measures, the U.S. economy’s growth structure has been literally devastated in the past few years. National saving, net investment and profit margins are at all-time lows. Their malignant counterparts are a record-high share of private consumption in GDP and soaring foreign indebtedness.
Pondering the dollar’s vulnerability, comparisons with conditions and events in the early 1980s are certainly informative. At the time, everybody was awed by the exploding gap in the U.S. external current account. When the dollar’s collapse started in 1985, it soared to a record amount of $122 billion, equaling 3% of GDP.
During the last two years, the U.S. current account deficit has run well above an annual rate of $400 billion, or about 4.5% of GDP. However, the biggest difference between the mid-1980s and the early 2000s is, by far, the international investment position of the United States.
In 1985, the international investment position of the United States went into negative territory for the first time. Foreign-owned assets in the United States of $1,061 billion compared with U.S.-owned assets abroad of $949 billion, for a net of negative $111 billion.
At year-end 2000, the market value of foreign holdings amounted to almost 10 times the amount of 1985: $9,377 billion, vs. U.S.-owned assets abroad of $7,189 billion, resulting in net foreign indebtedness of $2,187 billion. With another deficit in the current account of $417 billion and continuing increases in the current year, net foreign indebtedness is rapidly approaching $3,000 billion.
We mention these figures in particular for two reasons: first, because they are widely unknown; and second, they provide some idea of the fantastic magnitude of the forces that may come into operation once the dollar’s invincibility comes into question…
Considering the astronomic size of foreign dollar holdings that have accumulated in past years, the stage is definitely set for a bandwagon against the dollar. And its trigger is just as obvious: growing disillusionment about the U.S. economy and its asset markets.
Keep a watchful eye. Disappointment about the trumpeted U.S. economic recovery is the critical near-term event.
for The Daily Reckoning
p.s. There is a view that financial markets outside the United States are too small to absorb potential capital inflows from the United States. This view misses the point. Under a system of flexible exchange rates there are no flows of money at all from one country to another. For every dollar to be sold at a certain exchange rate there must essentially be a buyer at that rate. In the absence of buyers, the exchange rate collapses. Look out below.
Our man on Wall Street, Eric Fry, isn’t on Wall Street today. Instead, he’s taking the day off. So, I’ll give you the news myself: Another bad day for the street Eric isn’t on. But that’s the trouble with a bear market – there are a whole lot of bad days.
The Dow fell 155 points. Another day like that and it will be below 9,000…
What’s more, the Transportation Index fell too. Richard Russell reports that it dropped low enough to confirm a bear market, according to Dow Theory.
The dollar was down too. It is getting close to the 1 euro level. Will it stop there? Don’t count on it. Just do the math. If you want to earn even 5% on your money – safely – you have to buy treasury bonds of more than 10 years to maturity.
But if you’re a foreign investor – and foreigners own about a third of all treasuries – you lost more than 7% of your money as the dollar went down in the first 6 months of this year. Or, imagine that you had bought U.S. stocks. You’d be out 7% or 8% on the currency move, plus down 10% or so on the stocks.
How long would that go on before you took your money out of U.S. financial assets?
But Russell notes that there has still been no stampede out of U.S. stocks. Usually, the herd of investors gets spooked at least once on the road to ruin. So we have something to look forward to, and it could come any day. Already, in Europe this morning, stocks are plunging. One of our reporters just came back from an interview at the Paris stock exchange.
"The interview was cancelled," she reported. "When the market opened, it looked like a crash…nobody wanted to take time out to talk."
We’re in Stage II of the Great Bear Market. Anything could happen. But in a bear market, only bad things tend to happen.
Investors are getting edgy. Consumer confidence dropped in June – the biggest drop since October. There has been no recovery in the job market; consumers are starting to wonder what’s wrong.
The real problem in the U.S. economy is that businesses are not investing. Why not? John Crudele posed the question to Jack Welch: "There’s lots of capacity. Lots of global capacity…You ought to take a trip to Asia and see how much was built up in the go-go days. There is enormous capacity. Just enormous. Tons of capacity everywhere. Thailand. Malaysia. Taiwan. Now China. "There is not a lot of reason to spend on manufacturing…Everyone has too much capacity. Can you think of an industry in shortage right now?" The economy’s problem has nothing to do with interest rates, Welch went on to explain. Money is cheap. But why borrow if you can’t do anything with the money?
"My concern is, can you get a real recovery without a business recovery? My own guess is no." Yesterday, the Treasury had to postpone an auction of 2- year notes. Congress has still not raised the debt ceiling, so selling more debt would be a violation of the law. What happens next? We don’t know, but it wouldn’t trouble us terribly if the federal government were forced to cut back to all but ‘essential services.’ We never cared much for the inessential ones.
And poor Bernie Ebbers is back in the news. The man went from rags to riches and back to rags. He still owes more than $400 million to his former employer, Worldcom. And still they won’t leave him alone. "Worldcom discovers massive apparent fraud," says an MSNBC headline. Worldcom inflated EBITDA by $3.6 billion over 5 quarters, say the news reports.
Seems like it was only yesterday – in fact, it was only yesterday – that analyst celebre Jack Grubman downgraded Worldcom. He had been bullish on the stock, then neutral, as it skidded, slipped and tumbled from $64 down to nearly $1. Now, Grubman thinks it might "underperform." Yesterday, WCOM closed at 83 cents.
Is this not the Greatest Show on Earth, dear reader… almost as full of fraud and buncombe as the U.S. Senate?
Only housing offered a bit a good news to investors yesterday. In May, existing home sales came in at their 3rd highest level ever. In the San Francisco Bay Area, houses sold for 9% more than they did a year ago. What would make the same house be worth 9% more? Could it be that the dollar is worth 9% less?
But a Harvard study "predicts continued industry prosperity," says a Wall Street Journal headline. Wouldn’t it be nice if Harvard or anyone else could really know these things? But looking more closely at the story, we discover that the future all depends on the assumptions you make.
If you assume, as the Harvard team did, that the Baby Boomers will continue to buy 2nd and 3rd houses…and that interest rates will remain below 7%…well, heck, why shouldn’t good times in the real estate industry last forever? But what if the boomers find they don’t quite have the spending power that they hoped to have…and what if interest rates do rise…and what if housing prices fall, so that people cannot sell and don’t want to buy? What if the proximate future is different from the recent past?
*** Edward’s school put on little show on their last day. In one of the skits, the parents of one boy are called into the headmaster’s office:
"Your boy has been caught cheating," he tells the shocked parents.
"No…that can’t be true, not our darling little Oscar," they reply. "What evidence do you have?"
"Ah ha! I not only have evidence, I have proof," says the headmaster. "Look here. Here are Oscar’s answers and here are those of the boy sitting next to him. On the first question, Oscar’s response is exactly the same as the other kid."
"Well, that’s no proof," say the parents. "They both have the right answer."
"Yes, but they use exactly the same words. And look at the second answer. The same answer, in the same words again…and this time they both make exactly the same spelling error."
"Yes, but maybe the other kid is cheating off of Oscar," the parents protest.
"Ah ha!," the headmaster continues, triumphantly. "Look at the third answer. This time the answers are different."
"But if they are different, that proves Oscar wasn’t cheating, doesn’t it?" the parents reply, hopefully.
"Au contraire, it proves he was. Look…the kid next to Oscar writes that he doesn’t know the answer."
"So what did Oscar write?"
"I quote: ‘I don’t know either’."
Bill Bonner, enjoying the show…