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Bush And The Dollar Decline

 S&A Prospector 

April 26, 2008

Gold Is Dirt Cheap Relative to Crude Oil GOLD IS NOW A SCREAMING BUY According to the indicator we updated earlier this month, gold is now a screaming buy versus crude oil... As we mentioned in that column, gold and oil respond similarly to inflationary pressures... so their prices move in a predictable pattern. Over the last 25 years, one ounce of gold has been able to buy, on average, about 14.8 barrels of oil. Right now, however, that ounce of gold won't even buy you eight barrels of oil. Gold is incredibly cheap. If oil maintains its current price, gold would need to rise 89% to reach its normal ratio. What oil is going to do is anyone's guess... but as our chart of the week shows, the gold-to-oil ratio rarely stays this out of whack for long... – Ian Davis

 

 

 

 

 

 

Inflation Hedges

Gold surges to 28-year high, as dollar tumbles Nov 6,2007

 

Polya Lesova is a MarketWatch reporter based in New York.

 

Jim Rogers on The Dollar

October 24th, 2007

 

The Dollar:98 lb Weakling

Sept 27, 2007

 

PETRODOLLAR & IRAN & IRAQ by Jim Willie CB

 

 

April 21st,

 

The focus on gold and the USDollar alone lacks a crucial factor in maintaining the world currency reserve on its fragile pedestal. The PetroDollar is a term used to describe the close relationship between the USDollar and the crude oil export business dominated by Saudi Arabia, manifested in the superstructure of the global banking system. So one could say the oil world provides the pool from which the US$ exchange rate valuation is applied and enforced. The gold community pays far too little attention to crude oil factors in my opinion, but Adam Hamilton does indeed. Gold investors love to point to Iran war tensions as a factor to lift the gold price, but they might overlook how the associated earthquakes in banking shift the very ground under the world currency reserve.

 

Iran has begun to sell its oil in euro currency transactions, already to China, and next to Japan. The gold market should rejoice, when they are actually not paying attention to this grand development. Petro sales outside the US$ realm represent the first of several tectonic shifts in global banking. Direct impact is assured to gold, once the certain changes are realized to bank systems. Imagine Japan changing the emphasis of their entire FOREX reserves management because they purchase a large block of crude oil from Iran, and pay in euros. How much more Persian Gulf oil will China purchase? How much will their future bills be due in euro terms? This article contains a capsule summary taken from the energy section of the April Hat Trick Letter, with a finale based in dark humor.

 

As a preface, the Gulf Arab currency talks ended with little progress in Medina Saudi Arabia. The meeting was to work toward a monetary union plan by its deadline of 2010. Governor of the United Arab Emirates central bank Al-Suweidi cast doubt in January that the six key Persian Gulf oil producers could hammer out any currency exchange rate regime as preparation for a single currency. The group wishes to clinch a deal like what the European Union has in place. My gut says such a unified currency would help defend the USDollar and its unofficial oil standard, by means of a single controllable device. The USGovt and bankers might require this device in order to exert strong influence on the increasingly independent sheikdoms scrambling to prevent massive losses in the foreign reserves.

Great strain has come when Persian Gulf nations, friendly sheikdoms, decide to diversify their vast FOREX holdings away from US$-based securities. When Qatar last autumn announced some minor diversification of their national FOREX savings account, the US Military ordered a pullout of several thousand troops. There lies evidence of a connection, the quid pro quo in the protection game to fortify the sheiks in power, as they each sit atop national treasures. When South Korea in 2005 twice suggested similar diversification of their FOREX account, suddenly US Military exercises were conducted off their shore, visible from the office buildings. Anyone who misses the linkage between foreign reserves held in US$-based securities and US Military support for the global banking system is at best in need of broader exposure, and at worst ignorant, compromised, or deceived. The USDollar is backed by many forces and factors, including a powerful military on an increasing basis. For four years running, the military has had a prominent presence in the center of the Middle East, inside Iraq.THE PETRODOLLAR BACKGROUND

 

The history of the PetroDollar could be described as a syndicate contract between the United States and Saudi Arabia to subsidize the USDollar, to prop up the Western banking system, to enable the Arab royals (sheiks & emirs) to continue to claim their national treasures as their private property. Without the contract, the United States would not be able to perpetuate the privilege abused by the USGovt and Wall Street, whereby money is printed at will, private entities benefit routinely, trillion dollar budgets are hammered out, and no process exists either for foreign participation or approval. Bear in mind that the Saudi economy has among the highest national debt per capita among prominent nations, and has a pathetic per capita income among its citizens. The Saudi royals have cornered their national treasure, invested broadly across the world in private accounts, in a manner which seems totally beyond simple reproach.

The USGovt requirse three extremely important concessions from the Saudi Royal family. They stand as cornerstones to the PetroDollar system (if not defacto standard):

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• The Saudis must honor oil sales only in US$ transactions from their vast production fields across the kingdom.
• They must recycle their vast ill-gotten wealth (due to its private nature) in New York and London banks, so as to support the US$-based banking system, and thus enable the funding of vast loan portfolios for Western usage.
• They must purchase vast military weaponry in order to secure their grip of power and to keep stability in the hostile Persian Gulf region.

 

An aside, to drive home the point of corruption among Saudi royal families. The dirty little secret in Saudi business life is what is called 'appropriation' among the citizens. The royals are attempting to halt the practice, but that is like Wall Street attempting to eliminate insider information used for profitable gain. Royal underlings extort independent business owners into selling their businesses for 10% of value, under threat of imprisonment on trumped up charges like tax evasion, sexual misconduct, or other serious crimes.

The basis of the PetroDollar contract is that the Saudis keep firm its foundation, that being a strong link between the USDollar and oil sales. A better description is that OPEC members, led in particular by the Saudis, have subsidized the USDollar since 1971 when Nixon broke the Bretton Woods Accord for the gold backed USDollar. That is why in my work, the name PetroDollar Standard has been used, despite the lack of any formal standard. It is a de facto standard. Such a link between oil and US$ serves as a fait accompli for entire national banking systems being US$-based in their foundations. The PetroDollar basis for banking is not well understood nor publicized. That is because its vulnerability is so huge, and US institutions take it for granted. Foreign nations discuss the concept, while US circles do not.

 

If the PetroDollar prop were to be removed, entire national banking systems like the Japanese or Korean or German would shift, which would come as a delivered shock wave to the USTreasury Bond complex. The USTBond system is the active working manifestation of the USDollar, the world reserve currency. Large blocks of FOREX reserves held in US$-based securities would undergo change if the system changed, all harmful to the USDollar. Nowhere has the vulnerable condition of the PetroDollar been more pronounced than in the year 2000 when Saddam Hussein demanded payment for oil in euro currency. Probably near the top in reasons why Iraq was annexed and its oil reserves commandeered, his euro-based oil sales remain near the bottom in stated reasons in the subservient US press & media, if mentioned at all. That issue has returned to the forefront, with Iran.

 

ENTER THE ISLAMIC REPUBLIC OF IRAN

Iran has, with some measure of hesitation if not trepidation, traveled down the same path as Saddam. Back in the summer of 2005, Tehran leaders indicated their intention to create an Iranian Oil Exchange by September of that same year on the Isle of Kish. For various reasons, they delayed. Back then my sources informed me that fear of connection with European and London banks was a deep concern. Once integrated, the Western banks could inflict damage by formal bank seizures or blockage in some manner. Tehran officials also were fearful of computer viruses injected by probing Westerners. Iranian leaders are not so much kooks as thieves, who like their Saudi counterparts, raid their national treasures. In Tehran the practice is more akin to 'skimming' from operations whereas in Riyadh it is outright plunder of wealth.

 

On March 28-th, The International Herald Tribune provided an update on Iranian oil finances, with of course little or no coverage inside the US press. To do so would have put forth a secondary motive for pressure aimed at Iran by the United States. Their national affairs have been reported frequently, mainly nuclear in nature. Little focus has been given to tangents aligned with the oil business and banking systems tied to the PetroDollar itself. The IHT piece said "'More than 50% of Iran's oil income is paid in other currencies. We are reducing the dollar share and asking clients to pay in other currencies,' Sheibany said. Sheibany said that almost all of Iran's European clients and some of its Asian customers have accepted making payments in non-dollar currencies." This is the first public admission, or boasting, made by an Iranian official on non-US$ oil sales. This is highly significant, and could be construed as a realistic cause for war by those who choose to think without the usage of red state prisms or blue state prisms.

 

Iranian oil sales attack the fragile global banking system extended from the Western dominated financial world. There are only two important props to the United States Govt and Economy, according to William Engdahl: ownership of the US$ world reserve currency, and command of the US Military. This was conveyed at the Munich Gold conference last November in a brief private conversation. He is a brilliant man who has specialized in the political, financial, and military aspects of the oil wars, with particular emphasis on the United States versus Russia. See his website which concerns itself with Geopolitics & Geoeconomics.

 

Japan and China have been pushed into a corner by Iran. Of course, neither nation wishes to anger the United States. The precedent is important for payment in oil in euro transactions, much like a crack in the dike. If Chinese leaders were to push for all their oil imports to be purchased in euro terms, then the USGovt and its USDollar and its USTBonds have a big problem indeed. Japan continues to pay for oil sales from Iran in USDollars. Tokyo leaders are dragging their feet. Tehran leaders want euros for their oil sales, but to date do not demand euros, that is clear. Nippon Oil Corp, a major Japanese refiner, along with other purchasers from Japan, received 'inquiries' from Iran to pay for oil sales in euros. It seems like Tehran wants Japanese firms to 'volunteer' to pay in euros.

 

To further complicate the matter, the USGovt has pressured Japan not to purchase Iranian oil. The cited reason was 'doing business with terrorist states' or something to that effect. Consequently, more Iranian oil has been purchased by China and South Korea. In the process Japan has been left vulnerable. Watch both Japan and China in this tug of war, the former subservient, the latter unruly. Details on these several relevant points are provided in the April report.

 

Something is worth stressing related to the Shanghai Coop Org cited at the end of the outlined points. The SCO has the potential muscle of OPEC for new energy supply but also the potential military power of NATO on the security side. Obstructing, undermining, and interfering with the SCO formation and cooperation might be an integral motive for the USGovt and US Military as it engages Iran on its embryonic nuclear program. SCO is a very big problem, also never mentioned in the US press.

Mixed into the dangerous bubbling cauldron is Israel, which has been openly threatened by Iran's leader Ahmadinejad (aka My Dinner Jacket) in a manner to whip up emotion regularly. Mullahs are bad business men, who do not think or plan beyond the next few months, hence do not invest prudently in future oil production. Their refinery business leaks enormous amounts of oil and end product, as much as Iranian leaders leak blather as though addressed to school pep rallies.

 

This is a cat & mouse game, but a deadly one. A crack in the PetroDollar foundation coincides with US Military pressure put upon Iran for its 'nuclear ambitions' when the true motive might be to avert fracture of the PetroDollar system. This is otherwise known as a protection racket coming unglued (see next section).FLASHBACK TO APRIL 2005 (FULL CIRCLE 360)

What is described on the periphery of the PetroDollar foundation is a protection racket. Financial support is provided, or money is outright extracted, from one wealth center or source (here the Saudis with USTBond support), in return for prevention of their ouster from corrupt rule and access to a national treasure. Check out my past public article "PetroDollar & Protection Racket" (click here) from April 2005, which is still highly relevant today. Since the time of that written article, Norway has moved to sell oil in euro transactions in the Brent Crude market. The PetroDollar superstructure, so labeled since it includes not only transactions but also banking systems, is as shaky and weak now as the US Economy and banking system is vulnerable to the housing and mortgage crisis underway. That is not a coincidence in my view.

 

This article has resulted in more reader comments and kudos from fellow analysts than any other article penned by me, bar none. It hit a nerve. Here, two years late, the PetroDollar factor serves as the crosshairs for weapons aimed. The target is not Iraq but rather Iran. In fact the forces described are more relevant today than when written, since the Iraq War is going so badly, military forces are stretched fatigued recycled, more questions arise on accurate intelligence information (falsified or politically steered), and another war is seen as an additional morass and larger disaster potentially.

 

Taken as excerpts from the 2005 article, several quoted points made are:

 

• What we have is a system for purchasing minerals and resources, totally bound in US$ denomination pricing and transaction settlements. The most visible element is energy trade, whose supplies clearly make for the largest bill payments.
• The PetroDollar system is the practical commercial flipside, the visible evidence to the USDollar as world currency reserve in central banks. The financial effect is for banking systems across the globe to accumulate reserves in US$-based assets. What began as a checking account for oil payments has morphed into a gigantic bloated beast of a dangerous financial pyramid whose foundation has corroded and weakened as the USDollar bear market progresses.
• The EuroDollar was created for many purposes. One was to facilitate payment for energy supplies in US$ terms, without the necessary step to convert trade surpluses back to DeutscheMarks or Swiss francs or British pound sterling. A EuroDollar is a US$ held in European banks, not converted to local currency units, and serves as a buttress to support the PetroDollar system.
• The world is 'obliged' to sop up and purchase all the debts we generate, whether they approve or not of our policies, behavior, tendency, or justification for military actions. Almost without enforced discipline, the US system has evolved with unchecked abuse on a massive scale.
• US federal debt, mortgage debt, and indirectly household debt are all absorbed by Asia. Exporters are somewhat bound to buy our US Treasury debt in order to continue selling in our market. Foreign central banks have few alternatives to sock away $20 to $30 billion per month, each month, every month.
• Asia feels obliged to continue, in order to keep their industries and work force busy (avoid unemployment), and to prevent their banking systems from imploding. They cannot abandon support for the USDollar, and demonstrate that support with frequent central bank interventions.
• The PetroDollar system is under new attack. Russia and fringe nations of OPEC are responsible for dissension. Their motive is self-preservation. Rather, they desire a stable or rising currency. If a nation can manage to trade a host of commodities (like oil, natural gas, copper, iron, cotton, coffee) in euro denomination, that national economy would be far less subject to the distress of systemic rising prices.
• The Iraq War had numerous grounds for its justification, surely the weapons of mass destruction among them (although not taken seriously by me here). Also, stemming the sale of Iraqi crude oil in euro denomination was another motive, which in my view was far more important even in March 2003, just as important two years later now. The PetroDollar system is that important to defend.
• OPEC refuses to confront the USA, since it owns no military and is quite dependent upon the USA for its protection. They sell us oil; we protect their leadership (see Kuwait and Saudi Arabia and Qatar).
• The new Shanghai Cooperative Group represents a potential supply network which will have member nations of China, India, Russia, former Soviet Republics, and Iran as its core. Energy (crude oil & natural gas), industrial metals, and more are to be bought and sold by this new network, outside OPEC and its gaggle of disunity and diverse puppet strings held by Washington DC. The COOP is a direct answer to the corrupted OPEC cartel, which seems overly influenced by US leaders.

 

• Pricing oil in euros helps nations to reduce domestic price inflation within their own economies, and to add to incoming revenue from oil sales. Removal of the PetroDollar system would have a magnificent effect on the crude oil price or the USDollar exchange rate or US Treasury yields. An effect on currencys and bonds as a secondary effect. Then we might see a gold effect. An acceleration down with USDollar could trigger a world bank crisis.

 

ENERGY TIDBITS, BROAD IMPLICATIONS

The stability of the PetroDollar depends heavily on keeping the confidence of the Persian Gulf oil producers. JPMorgan activities emanating from the Bank of Baghdad cannot be dismissed. Effectively, after JPMorgan was chosen to run the Iraqi Central Bank, they began issuing letters of credit using Iraqi oil assets to collateralize the loans. What exactly is this powerful bank and derivative book (mis)manager doing with the entrusted Letters of Credit on payments for Iraqi oil? When my writing expressed distrust of US Administrators and their integrity in managing the Iraqi oil, the response was hate email. My distrust was justified. The advent of a large new phenomenon in crude oil futures contracts coincides with the arrival of JPM and the US presence in Iraq. See the data for evidence and oily fingerprints. Details are provided in the April report, where some fine sleuth detective work by Rob Kirby is cited.

When explaining the crude oil price, politics and war account for most variation, not economics bound by supply & demand. It might be

• the prospects of Iran War, or the military barrage probe on Beirut in summer 2006
• the grand scale of US Military sale of crude oil & diesel in late summer 2006
• the Goldman Sachs Commodity Index adjustment of the gasoline weight just three months before the US Midterm Elections
• the State of the (dis)Union message related to the Strategic Petroleum Reserve
• the total relaxation of pressure on Iran during those same Midterm Elections
• the latest pressure on Iran.

An analysis is given. The greatest dynamics for the crude oil price changes emanate from decisions by the White House, the Pentagon, and offices at JPMorgan & Goldman Sachs. Arguments to the contrary seem very secondary and immaterial, much like noise.

 

HATS OFF Lastly, hats off to Peter Schiff during a CNBC interview opposite clownish Ned Reilly on Monday afternoon. It was worth a loud laugh and a captured quote by Peter. The US stock markets are hitting new highs in true Weimar fashion. Pundits and anchors suspect something has gone awry, since the European euro and British sterling currency are pounding away at new highs. The US S&P500 index is not doing well at all in euro and sterling terms over the last 3 or 4 years. Peter made a point that the higher stock prices are offset by a weaker US$ exchange rate and diminished purchase power within the USEconomy. That has been precisely my point for a couple years also. The S&P has maintained constant value, even if higher price. Schiff delivered a quote worth saving on the office wall. Pardon me if not word for word, as I was busy making myself an egg omelet, with onions and red peppers and olives and cheese. My prices for food have dropped by 30% since arrival in Costa Rica. Oh yes, fresh luscious cantaloupes for 80 cents, or a half dozen bananas for 20 cents. Pura Vida! Peter said:

"The Dow and US stocks generally cannot even compete in price with a carton of eggs in the United States, which is up 30% just last year." The challenge for the Dept of Treasury and US Federal Reserve is that in order to defend the USDollar, they must keep numerous fingers well placed in the dikes for the gold market, the oil market, the housing & mortgage market, the China trade war, the hedge fund mushroom, the credit derivative market, and the foreign central bank revolt. The USTreasury market is surrounded by several bands of hostile barbarians. The latest bizarre news has that Freddie Mac will purchase $20 billion in acidic bonds. Do taxpayers get stuck with the bill? Do their bond investors bear the risk? The watch word is desperation. USGOVT OFFICIALS DON'T GOT ENOUGH FINGERS TO PLUG THE DIKES. There are simply too many digits to the debt and money growth (pun intended)!!!

 

 

 

Also see below:

 

 

Econ Sig: The Liquidity Problem

Econ Sig:Bernanke's Puzzle

 

 

Thoughts on the Dropping Dollar

December 19, 2006

 

Too fast? Too slow? A welcome adjustment? An ominous indicator?

 

In early December, the dollar scraped a 20-month low against the euro and 14-year low against the pound. Though the dollar has strengthened slightly since then, questions about the currency remain a focus for economic policy makers. Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke traveled to Beijing for meetings last week and afterward top U.S. and Chinese officials said they agree that increased currency flexibility in China will be a key to reducing global trade imbalances. China's alleged practice of keeping the yuan artificially weak against the dollar is often cited as an important issue for U.S. trade. But the value of the venerable greenback has other important implications as well.

 

The Online Journal asked economists Menzie Chinn, of the University of Wisconsin-Madison, and Kash Mansori, of Salem College, to discuss the dollar's recent drop, their long-term outlooks for the currency and how the dollar's value could affect everything from interest rates to the bloated U.S. current account deficit, which rose to of $225.6 billion -- or 6.8% of gross domestic product -- during the third quarter.

 

 

 

Menzie Chinn writes: I've written in other places why a slide in the dollar might be troubling:

But to begin with, it might be useful to discuss why the dollar is declining now. In my view, the key reason is a plain-vanilla interest differential story.

With the U.S. economy softening considerably in the fourth quarter, money and currency market participants -- rightly or wrongly -- expect the Fed to reduce the target federal-funds rate in the coming year. With the European Central Bank perceived as hawkish on inflation, the stage is set for a widening real interest differential in favor of the euro. Over the short horizon, interest rates are an important factor in the attractiveness of a currency, since investor returns expressed in common-currency terms typically rise with rates.

 

About four weeks ago, in the space of a few days, the dollar lost 1.6% of its value4 against other major currencies. Even now, the dollar is roughly at the same value as it was after the drop. Against a broader basket of currencies, the drop was about half that, but the market volatility is suggestive of how sensitive the dollar is to revisions in expectations. And I think observers are nervous because they are wondering if a dollar decline will trigger a more fundamental set of moves on the part of central banks and other quasi-state entities -- in terms of holdings -- and on the part of private actors like hedge funds. The importance of hedge funds, combined with the rapid expansion of derivatives markets injects a heightened degree of uncertainty5 into the current situation.

 

In other words, while investment bank and professional forecasters are predicting a slow and steady depreciation of the dollar over the next year, a sharp move in the dollar might push the system over a "tipping point" so that a much more discontinuous decline occurs. If market participants are myopic, that provides yet another scenario for a big drop6. On the other hand, this precarious balancing act of the dollar has proven far more durable than many observers had believed possible, and so may survive this challenge.

 

 

 

Kash Mansori writes: Thanks for starting things off, Menzie. I think you've put your finger on two crucial points. Many observers are very nervous about the dollar, and much of that nervousness stems from the possibility that exchange rates are susceptible to rapid and severe movements.

 

Why is that the case? First of all, almost everyone agrees that the dollar will be a lot weaker in the future. Here's why: If you believe that the U.S. current account deficit of almost 7% of GDP will not continue forever -- i.e., if a current account deficit this big is not indefinitely sustainable7 -- then you must think that it will fall. But for the current account deficit to fall, we'll need a weaker dollar, which will make U.S. exports more competitive and imports more expensive. Since the deficit is simply so very big, the eventual fall in the dollar seems likely to be big too.

 

So how might this happen? There's a well-developed economics literature that explains why exchange rates that move by a large amount tend to do so abruptly. In a nutshell, the idea is that as soon as people start feeling that a substantial currency drop is imminent, everyone tries to dump it at the same time, ensuring that the fall becomes precipitous. (Paul Krugman provides a nice summary of the classic economic literature8 on the subject.)

 

Putting this all together, it's easy to understand the jitters of many exchange rate observers. Perhaps we could turn your initial question around, Menzie. Instead of wondering "why now?" maybe we should be asking, "Why hasn't the dollar declined by more than it already has?"

 

As you mentioned, the dollar has not really fallen by that much, other than against the euro. The chart of the dollar's exchange rate shows that the dollar's recent fall still leaves it dollar only 3% below its trade-weighted value of two years ago. In recent months, the dollar has actually strengthened against the Canadian dollar and Japanese yen (two of the four largest U.S. trading partners). This surprising strength of the dollar -- particularly against the yen, which may be "the world's most mispriced currency" -- is the real exchange rate puzzle that we face today, I would suggest.

• * *

 

 

Menzie Chinn writes: Kash you make some excellent points. I agree the question could easily be recast to ask why the dollar has levitated so long in the face of large current account deficits. Part of the answer is asynchronized business cycle and the fact that central banks react to those business cycle effects. Another is the tax holiday on repatriation of profits incorporated into the Homeland Investment Act11. Finally, there's the fact that the dollar is the world's key reserve and invoicing currency, so that booming East Asian and oil exporting country reserves are placed into dollars. A number of these hypotheses and others were examined in a conference on the subject of current account sustainability held at UW-Madison last April.

 

The smooth, slow dollar value decline can be a good thing, helping to switch expenditures away from foreign to domestic goods and thus reducing the trade deficit. This is how exchange rates are supposed to work as an adjustment mechanism.

 

Of course, all might not proceed smoothly. If the dollar decline is precipitous, it might spark inflationary pressures. I don't place too much weight on this possibility, because there is some research indicating exchange rate pass-through has been somewhat lower than it was during the 1980s. However, if incipient inflows of capital fall sharply, U.S. interest rates will have to rise in order to induce more inflows, thereby reducing economic growth.

 

Kash Mansori is visiting assistant professor of economics at Salem College. He writes the economics blog The Street Light, providing commentary and analysis on news, politics, and the economy, with a focus on macroeconomic policy. His research interests are in the areas of international macroeconomics and public finance and frequently emphasize the domestic policy implications of international economic integration. Mr. Mansori received his doctorate in economics from Princeton University in 1998.

Menzie D. Chinn is professor of public affairs and economics at the University of Wisconsin's Robert M. La Follette School of Public Affairs. His research is in the area of international finance and open economy macroeconomics. Recently his work has examined Yuan misalignment, the determinants of U.S. imports and exports, and the future of the euro as a reserve currency. He has also written on how fiscal policy affects interest rates, the interaction between capital controls and financial development, and the determinants of exchange rates. He also co-authors the blog Econbrowser18. In 2000-2001, Mr. Chinn served as Senior Economist for International Finance on the President's Council of Economic Advisors. He received his doctorate in economics from the University of California, Berkeley.

• * *

 

 

Kash Mansori writes: I think you're exactly right, Menzie. What is really worrying is the size -- in absolute terms -- of the adjustment needed to the U.S. current account balance. Still, it's important to remember that the consequences of a rapid dollar decline could also be severe for the rest of the world, especially in emerging markets.

 

This may particularly be the case for the 800-pound gorilla in the room: China. If the dollar plummets rapidly, the Chinese central bank (PBOC) would suffer massive capital losses on its more than $1 trillion in reserves. In addition, the real Chinese economy would suffer a dramatic to its massive export sector.

 

That's why I'm actually relatively sanguine about the possibility that foreign central banks could trigger a sudden dollar decline simply out of a desire to diversify their porfolios; I think that the PBOC and other central banks around the world, such as the Persian Gulf countries, have too much depending on a stable dollar. Instead, what worries me is the possibility that private investors around the world would decide to dump dollars, presumably because they foresee capital losses due to an incipient decline in the dollar. Perhaps myopically, international investors don't act like they expect those capital losses right now. But at some point they might.

 

To help understand what could trigger such a change, let's think about the exchange rate from another point of view. The current account deficit is fundamentally determined by a country's national savings/investment balance. Countries (like Japan or China) that consume and invest less than they produce run current account surpluses. Countries that consume and invest more than they produce (like the U.S.) run current account deficits. From that perspective, only when the U.S. eventually starts consuming less -- perhaps due to a slowing U.S. economy -- can we expect the U.S. current account deficit to fall, and the dollar to start weakening to help make that happen. Of course, once the dollar starts falling, that's when we have to start watching out for the behavior of international investors who may decide the time has come to dump dollars.

• * *

 

 

Menzie Chinn writes: China clearly doesn't have an interest in seeing the dollar decline quickly. So I'm certain that -- in part -- explains why the PBOC is tightly managing the yuan's appreciation against the dollar. But even if PBOC and other holders of large dollar reserves don't want the dollar to depreciate rapidly, they also don't want to be the last one out the door. That's why I view the current equilibrium as balanced on a knife's edge. Any decline in the dollar might be enough to prompt some central banks to try to diversify their holdings. The big question will be how China will respond once the dollar decline takes off.

 

So, while I used to worry a lot about China, now I worry a lot about China and the oil exporting countries. As Brad Setser points out, the oil exporters of the Persian Gulf maintain a much more rigid peg against the dollar than does China. The pace of reserve accumulation is certainly of a comparable magnitude, and when one adds in Russia, the oil exporters probably weigh more heavily in this dimension.

 

Changing the direction of the conversation somewhat, I'd like to spend a minute on the more likely "what-if" scenario wherein the central banks and private investors do not radically diversify out of dollar assets. In my view, this will result in a long-term secular depreciation of the dollar; after all, in the coming years, we will paying more in interest and dividends to the rest of the world than we will be receiving, and in order to keep the current account at current levels, the U.S. will need to export (on net) more. In other words, the "exorbitant privilege" that Gourinchas and Rey highlight (we get higher returns on our assets abroad than foreigners get on American assets) won't be sufficient to offset the massive debt we have taken on in the past decade. This will be true, despite the fact that our foreign-currency denominated assets abroad will rise in value when the dollar depreciates, limiting the deterioration in our net debt position. That's not a calamitous outcome -- merely a slow descent into genteel indebtedness, what Martin Wolf called the "comfortable path to ruin."

• * *

 

 

Kash Mansori writes: The implications of the growing U.S. net international debt are indeed profound. As the interest payments on that foreign debt grow (much of it U.S. government debt, as this graph from the EPI27 nicely illustrates), more and more of the income and output of the U.S. will go toward simply servicing its international debts.

 

But what can a good policy maker to do about it? Treasury Secretary Paulson, along with four other cabinet secretaries and Fed Chairman Ben Bernanke, just returned from Beijing28 where he was trying to talk the Chinese into allowing the dollar to weaken against the Chinese yuan. Would a policy-induced fall in the value of the dollar be helpful?

 

That's not entirely clear. Suppose China agreed to let the yuan rise substantially against the dollar. As I've argued elsewhere29, I don't think that the overall U.S. current account deficit would fall -- not until the savings/investment balance changes (but see Dean Baker30 for another perspective). However, China's contribution to that deficit would. That would have the side-effect of muting the calls of some China critics in Washington31 who have been arguing that the U.S. should put tariffs on Chinese imports. And maybe that's the desired outcome.

 

But on the other hand, foreign purchases of dollars have pushed interest rates in the U.S. down by as much as a full percentage point. If the PBOC were to stop defending the strong dollar, interest rates in the U.S. would surely rise, slowing the U.S. economy even further. While that would be good for the current account deficit -- and will probably have to happen sooner or later -- I'm not sure that's what Mr. Paulson would really like to see right now.

• * *

 

 

Menzie Chinn writes: Kash, you put your finger on the key question. I agree that pushing down the dollar against the yuan isn't nearly enough to remedy the overall U.S. current account deficit. After all, China's deficit is only about one-fourth of the total trade deficit. So what can a good policymaker do? I think there are few policies that might reduce the likelihood of a "disorderly adjustment" of the sort we've been talking about.

 

First, get the budget deficit under control. That includes increasing tax receipts, cutting government spending, reining in entitlements -- these are all going to be necessary first steps to redressing the profligacy of the last six years. Doing so will reduce aggregate demand and hence imports. It'll also reduce the necessity for issuing so much federal debt, and at the same time make us less vulnerable to the whims of the PBOC and other state actors in the international economy.

 

I know there is a lot of skepticism about the importance of the budget deficit in this area. However, my empirical work with Hiro Ito33 indicates that there is a solid link between budget deficits and the current account deficit. Simply stated, we found a one-percentage-point decrease in the budget deficit results in between 0.2 percentage points to a half percentage point decrease in the current account deficit. For the unconvinced, note that between 2000 and 2005, one saw a roughly 4.3 percentage point of GDP swing in the federal budget balance. Let's take a high estimate of how that would affect the current account deficit by using the coefficient of 0.5. This implies a 2.2-percentage-point decline in the current account. Guess what the actual decline in the current account was between 2000 to 2005 … 2.2 percentage points. So In other words, I don't agree with Bernanke's saving glut hypothesis that asserts that the largest source of our current account deficit is located in East Asia. Overspending on our side plays a significant role as well.

 

Second, we still push for flexibility in the yuan. But not because it will necessarily -- in itself -- change the current account deficit. Still, it will help diminish the need for the PBOC to purchase so many Treasuries in order to keep the high value of the dollar. The decrease in demand for treasuries will result in higher interest rates and lower consumption spending including spending on imported goods.

 

Third, because I don't believe we have seen the end of high oil prices, we need a long-term plan to deal with energy use and reduce the growth rate of oil imports. The first best solution would be a tax on gasoline to encourage conservation. The second best -- if that is politically infeasible -- is an increase in the corporate average fuel economy (CAFE) standards. Both were viewed as non-starters in earlier times; now a consensus is apparently building for some sort of action on this front.

 

Clearly, any one of these options has its political challenges. It's no surprise that the easiest one -- pressuring China -- is the only one that has thus far been pursued. But taking action now will reduce the pain of adjustment later on.

• * *

 

 

Kash Mansori writes: You've nailed all of my favorite possible policy actions to help keep the future current account adjustment -- and the dollar decline that will go with it -- from being too traumatic, Menzie. But these policy recommendations are a little like a cardiologist prescribing a low-fat diet and lots of exercise to a heart patient -- it's not fun medicine or easy for the patient to stick to. So I share your skepticism about whether they will actually happen.

 

So what do I think will happen? Here's my guess. I suspect that the rapidly weakening housing market will soon force households to reverse recent trends, and start saving more of their income. That, along with reduced investment spending, will help improve the U.S.'s underlying savings/investment imbalance. It will also cause a period of sluggish growth (perhaps outright recession), but that will have the effect of reducing the expected returns on dollar assets, finally driving the value of the dollar down in a serious way. That in turn will help make exports more competitive and imports more expensive, facilitating the badly-needed improvement in the U.S. trade balance. This doesn't have to be a disastrous series of events. But as I mentioned above, there is a real possibility that a significant dollar decline could turn into a rout, which could turn this slightly depressing but relatively benign scenario into a financial crisis.

 

And will our worst fears play out if that's the case? They might, but the truth is that we just don't know -- we're truly in uncharted territory. Never before has any country been able to run such a large current account deficit for so long38. Never before has any country borrowed such a massive amount of money from the rest of the world in such a short period of time. Never before has the world changed its preference for international assets39 (particularly U.S. assets) so rapidly. Never before have global central banks accumulated such staggering quantities of foreign exchange reserves40. Never before has our domestic financial system been so dependent on international capital for its low interest rates, and by extension, been so vulnerable to events in the foreign exchange markets. And never before has the country most at risk for a painful exchange rate adjustment -- been the owner of world's dominant reserve currency.

 

The U.S. current account balance will fall, and the dollar will fall along with it. But because this situation is so novel, the questions "how?" and "when?" just don't have any easy answers.

 

 

 

Scientists respect data, and adjust their ideas if they do not agree with data. Economists often respect their ideas, and ignore data that are inconvenient to their ideas. The data shows that the currency movement preceeds trade imbalance adjustment by more than two years. 1985 fall of dollar vs. yen only started to curb US trade deficit in 1987. The fall of dollar in 1998 only started to stagnate the rise of US trade deficit and instituted a small fall in late 2000. The fall of US trade deficit is sinchronized with US recession, at least it was so for the 2000 - 2001 recession. The logic then tells us that it is the movement of dollar that is the key. If dollar drops big today, US trade deficit will be curbed two years down the road and a recession sets in along side with the fall of US trade deficit. That is why US cannot afford to let dollar fall. It must see its trade deficit expand and consumer spends strongly beyond their means to please the general public and politicians alike, even with a heavy price of seeing its manufacturers wiped out by foreign competion. China and Japan, along with smaller Asian economies like Taiwan, Korea and so on, cannot afford to see dollar fall since they are so dependent on their export industries and the only intake of their exports is USA; we should note that Europe is not running a hefty trade deficit and Japan is running a trade surplus as large as China. The current global trade imbalance is not on a razor's edge, but is in a stable potential well. US only pays the lip service that it wants China to appreciate Yuan rapidly but actually hopes that China will keep follow its slow Yuan appreciation route, otherwise US trade defict will be cut sharply two years down the road, a recession will set in at that time and politicians will be thrown out of offices. On the other hand if China let Yuan appreciate rapidly vs dollar (diversify it foreign curency reserve out of dollar has similar effect), it means that it must stop its massive dollar buying operation, releases no more Yuan into its domestic market through the dollar buying operation, its infrastructure building industries will collapse along with its export industries, and the current Chinese regeme will fall admist a gigantic chaos. That is why Chinese government will never allow Yuan to float freely. If US Government really wants to force China's hand, it can simply label China as a currency manipulaor, isn't it? In one word, to use trade deficit to boost consumption is like to take drugs to achieve highs. It is very addictive, and cannot stop once you started the route as Reagan administration and Clinton administrations did. Only thing we can do is to watch the drug usage gradually erode one's health until the final demise.

 

C. K. Chen

forcastglobaleconomy.com

 

for additional comments see:

http://forums.wsj.com/viewtopic.php?t=148&start=0&postdays=0&postorder=asc&highlight

 

Also-:

 

 

This website has been advocating the theme that trade deficits influence US economy, as discussed in articles 1, 2 and 2A. When trade deficits expand, US economy booms, and when trade deficits stagnate or shrink, US economy slows down or enters into a recession. US trade deficits are in turn affected by the movements of the exchange rates of US Dollar against the currencies of its major trading partners; the currency movements usually precede the ups and downs of trade deficits by two to three years. At the time when the sudden swing of US Dollar vs. Japanese Yen and Euro has caused substantial anxieties in US stock markets, readers are probably interested to know the relation between movements of US Dollar and stock prices. In this comment we will analyze the effect of Dollar movements on stock prices.

 

Stock markets are auction markets where buyers of stocks and sellers of stocks are always matched. When sellers of stocks become more aggressive than buyers of stocks, stock prices fall. When buyers become more aggressive, stock prices rise. Surrounding the stock markets there is a pool of liquidity readily available for investment and speculation. Buyers withdraw money from the pool to purchase stocks and sellers deposit the sale proceeds back into the pool. In short-term the size of the pool stays more or less constant even stock markets experience large gyrations. However, when stock prices fall, the total capitalization of stocks shrink compared to the size of the pool of liquidity. This creates an "oversold" condition from which more likely stock prices will bounce back. If stock prices rise, the opposite "overbought" condition will develop. The long-term direction of stocks in general will be influenced by the changing size of the liquidity pool. Many factors will shape the size of the liquidity pool. One obvious factor is the monetary policy of The Federal Reserve Board (FED). When FED drains liquidities from the financial system, the liquidity pool for investment and speculation usually shrinks, when FED loosens the monetary condition, the liquidity pool tends to expand. Another not well appreciated factor is the run away trade deficit. When US runs trade deficits, the dollars from the pockets of US consumers flow into the hands of foreign exporters. Since US Dollar is not legal tenders in foreign lands, foreign exporters must sell those dollars at hand to someone and eventually those trade-deficit generated dollars must be reinvested back into US market. The crucial thing to notice is that when those trade-deficit generated dollars come back to US, they are in the hands of large foreign institutions, including foreign governments that collects dollars through currency market intervention to keep their currency undervalued so that they can continue to export to US. Those foreign institutions are not going to use those trade-deficit generated dollars to buy daily usage items in US market, but will put them into the investment and speculation pool. This flow of dollars should be compared to the case that the original dollars from consumers are handed over to domestic producers instead. Domestic producers will use the dollars they receive to pay their workers and suppliers, and those who received the dollars just spend in the normal way. In other words those dollars paid to domestic producers will just go through the normal route through the whole economic system, and only a fraction of the original dollars will trickle down into the liquidity pool of investment and speculation. Thus we can see that trade deficits become a super efficient tool to convert consumption dollars into the liquidity for investment and speculation. As US trade deficit increases to around 6% of the total GDP, the effect on stock prices can be overwhelming. That is the reason why when US trade deficit expands strongly, stock prices receive a strong support, but when trade deficits shrink, stock prices dive in the globalization era during which US trade deficit has jumped drastically.

 

Currency market is also an auction market in which buyers and sellers are always matched. When sellers become more aggressive than buyers, Dollar will fall, and when buyers become more aggressive, Dollar will rise. Beyond the auction markets of currencies, we can imagine that there is a pool of dollars ready to be sold for foreign currencies, and there are also similar pools of foreign currencies ready to enter currency markets to buy dollars. When dollars are sold, the buyers simply return the received dollars back into the pool, so in short-term the overall amount of dollars in the pool does not change even the exchange rates of Dollar moves violently. The long-term direction of Dollar is influenced by the change of the size of the pool of dollar compared to the corresponding pools of foreign currencies. The sizes of the pools of Dollar and foreign currencies are determined by many factors. The sizes are influenced by the monetary policies of various central banks, including FED. The pools are also affected by the currency market intervention of foreign governments that tends to expand the sizes of the pools of corresponding foreign currencies. Trade deficits are also a factor that will increase the size of the dollar pool.

 

A monetary action of FED can serve as a common factor that will move the sizes of both the liquidity pool for investment and the dollar pool surrounding the currency markets. If FED tightens the monetary condition, the size of liquidity pool for investment and the size of dollar pool to buy foreign currencies will both decrease. As the result stock prices will fall and the value of Dollar will rise. If FED loosens the monetary condition, the opposite, that is, lower Dollar and higher stock prices, will take place. It should be noted that the correlations between higher Dollar and lower stock prices, and lower Dollar and higher stock prices, as discussed here, are opposite to the widely held belief of many market participants. However, such correlations does not imply that the currency movements have caused stock prices to move since both movements are just the result of one cause, the monetary action of FED. When Dollar falls sharply, stock prices tend to drop in tandem for a while. Such moves are due to psychological shocks on investors and are not based on any fundamental connection between the dollar pool and the investment pool. As the proof, such stock price moves are often short lived and are reversed soon through oversold conditions. There is indeed a long term and indirect cause and causality relation between the currency movement and stock prices. That is, a long term trend change in the exchange rates of Dollar will affect US trade deficits, and the change of trends in trade deficits, as discussed in the previous paragraph, is a potent force to move stock markets, especially at the time when US trade deficits have become so large. For example, the drastic devaluation of Dollar vs. Japanese Yen in 1985 resulted in the stagnation and then fall of US trade deficit in 1987, and the crash of stock prices of 1987 followed. Again, when Dollar fell sharply against Yen in the middle of 1998, in the middle to late 2000 US trade deficit stagnated and US stock prices started to fall from its peak. Investors who sold their stock holdings at the middle of 1998 when Dollar tumbled against Yen would have missed the best part of the stock market rally of late 1990's. On the other hand those who ignored the warning of the 1998 Dollar crash and held on to stocks pass the middle of 2000 would have suffered severe losses. It is interesting to observe that though strong expansions of trade deficits tend to support stock rallies, the beginning of the long-term rise of stock prices are not well coordinated with the start of a new phase of trade deficit expansion. This is due to the fact that at the nadir of trade deficit, the amount of trade deficit becomes relatively small so it does not become a potent force in shaping the size of investment pool; rather other factors like FED easing becomes the dominant factor in determining the size of the investment pool. However, at the peak of trade deficits, its influence on the size of investment pool is significant, and any stagnation or shrinkage of trade deficits has measurable effects on stock prices.

 

 

By Dan Denning

 

 

As a child, I remember seeing my dad stand in the door-frame and slowly, in an eerily controlled manner, punch the door frame repeatedly. It impressed me and, I admit, scared me a little too.

 

But in a big Catholic family of twelve children, there are probably plenty of good reasons to unleash what left-over energy you have on a solid wood door frame, rather than, say, on your youngest child and seventh son (your editor.) We have no idea what the old man was hoping to accomplish. He usually ended up with bruised and bloodied knuckles. But afterwards, he was always a lot more relaxed...

 

The U.S. dollar is our proverbial door-frame. We occasionally bash our neural knuckles against the buck, trying to punch through the splintered remains of its abstract existence. We search articles and data to get at what really matters about the greenback and why it demands our attention. And then we read on a blog somewhere about the sock puppet of Pets.com and it all begins to make sense.

 

The dollar, this blog post suggested (we can't remember where we found it) is like an Internet stock circa 1999. Specifically it's like Pets.com. Pets.com was one of the last Internet concept stocks to go public before the Internet bubble burst in 2000. Its concept was to sell pet things to pet owners...on the Internet. It was a pretty simple business model, made famous by its sock puppet spokesman...er...spokespuppet. But some concepts are better left on the drawing board...or back in the sock drawer.

 

“Why buy pet supplies on line?” the company’s advertisement asked. "Because pets can't drive!" Flush with IPO cash, the company shelled out $1.2 million for an ad during the Super Bowl of 2000. But less than one year later, Pets.com lost its listing on Nasdaq and the company went out of business.

 

Once Pets.com started to unravel, very few investors managed to exit the stock without incurring substantial losses. And here is how Pets.Com of yesteryear is like the U.S. dollar today: Almost anyone who held a large position in Pets.com would have been reluctant to be the first to sell.

 

First of all, by selling, you admit that what you own deserves to be sold. Second, your selling might cause other people to sell, triggering a rush for the exits. Once the absurd spell which induced investors to buy too much of a stupid thing is broken, all hell breaks loose and panicked, undisciplined, disorderly, deeply de-stabilizing selling begins.

 

If the dollar is like Pets.com, the sell-off that's coming is going to make the dot.com bust look like a day at Disneyland. Everyone in the world who owns dollar-denominated assets owns a drawer full of dollars. In fact, so many individuals, institutions and central banks own dollars that the “overhang” of frightened sellers could be enormous, if a rapid selloff were to begin for any reason.

 

What might that reason be?

 

Will the Chinese Central Bank spark a mass exodus from the dollar? We don’t rule out the possibility. “The Chinese central bank warned that international holders of US dollar assets may start to adjust their foreign exchange holdings to reduce risk,” Forbes magazine reports. “If the US current account deficit growth continues to be higher than GDP growth, the investment value of US assets will be questioned by global investors, and the willingness of investors to continue holding and buying US financial products may weaken, the central bank said.’”

 

The Chinese own a lot of dollars. And perhaps that fact is beginning to make them nervous, as nervous as a long-tailed cat in a room full of rocking chairs, as the Southern saying goes. "China has been cautious in its statements about the dollar,” Forbes continues. “It now has over one trillion dollars in foreign exchange reserves, the world's biggest, and about 70% of that is believed to be held in dollar-denominated assets."

 

The Chinese have every reason, therefore, to avoid causing a dollar panic. But in today's Moscow Times comes a sober analysis of what we may witness in 2007. A political crisis in China could spell the end of the dollar, muses Alexei Bayer, "So far, China has avoided the kind of financial crises and political upheavals that have repeatedly blindsided smaller exporting nations around the Pacific Rim over the past two decades. The Beijing government has used carrots and sticks to keep its vast and rapidly changing society quiescent.

 

“Past success, however, does not mean that China will be able to keep the lid on this cauldron forever. Economic growth has unleashed tremendous energy and creativity in the Chinese population. But it has also created severe pressures - social, political, economic and demographic. Hundreds of millions of peasants have abandoned their centuries-old way of life and migrated to urban centers. The gap between the rich and the poor has widened...These pressures -- or other problems that cannot be currently predicted -- could plunge China into a crisis that could be quite severe.

 

“China has emerged as probably the only nation in the world that can single-handedly undermine the U.S. economy,” Bayer continues. “If China suffers an economic or political crisis, the United States will likely be plunged into a severe recession -- if not an outright depression.

 

“This scenario is ominously similar to that of the Great Depression of the 1930s, which was largely a U.S. crisis taking place after a decade of breakneck economic growth,” Bayer concludes. “The stock market crash occurred on Wall Street, but its shockwaves promptly spread around the world. Ultimately, the Depression marked the demise of British economic dominance and the end of the pound as a global currency. While the next global economic crisis is likely to originate in China, it will almost certainly mark the end of the dollar as the linchpin of the global financial system and a substantial diminution of the central role of the United States.”

 

So far, very few investors dare – or bother – to imagine the dire consequences of a forced Chinese dollar liquidation, and what it might mean for stocks (very bad) and for gold (very good.) But according to a recent New York Times article, the wisdom of individual investors is beginning to trickle up to the boardrooms of the world's central banks.

 

“Central banks will eventually take the same cue...if they continue to see the value of their dollar-denominated reserves plummet,” says Professor Richard Portes, who teaches economics at the London School of Business. “People say central banks don't care if they lose money. That's just not true. I've talked to central bankers who have said, 'I'm not going to be the last one out of this room if a fire breaks out.’”

 

No one wanted to be the last one out of Pets.com either. But the biggest problem wasn't deciding when to get out. The problem was being “in” in the first place. Such is the problem for today's dollar-based financial world. And the bigger problem is that there really is no "out" in the sense of escaping dollar risk entirely. Gold, presumably, would rally as the dollar’s value tumbled. But most other financial assets would tumble right along with the dollar. Neither stocks, nor bonds, nor even foreign currencies would offer certain protection against a dollar debacle. Almost certainly, a dollar debacle would become a worldwide financial market debacle.

 

Buying gold sometimes feels like smashing knuckles into a door – it’s painful and counter-productive. But this is not one of those times. As 2007 unfolds, we expect to find the world’s dollar-holders wincing in pain, not the owners of gold.

 

 

 

 

It is a modern enigma. The U.S. dollar -the world's "reserve" currency -is weakening, shrinking, falling. It has been since the inception of the Federal Reserve, the very institution assigned with the task of maintaining its value; but it has accelerated at an alarming rate of late.

 

"The dollar has slumped to new lows against other currencies," has been a refrain in the financial press for several years now. From 2000 to 2004 we scribbled out our financial insights from an office in Paris. During one 18-month period beginning in late 2002 the cost of living for those expats among us-who were paid in dollars but spent money in euros-saw their cost of living go up by almost half. Still, most Americans don't ever leave the homeland, so why should we care if the dollar falls in value? Well, the answer is relatively simple. Everything-milk, eggs, gas, construction supplies, you name it-now costs more.

 

But what a bizarre time we live in. Economists look at the same sign and explain, "No, it doesn't cost more. They're just charging higher prices." This is what is happening in our economy, and it is happening rapidly and all around us. American economists seem to not understand it (or don't want to admit it), but we're in trouble. They need to be reminded that wet sidewalks are not the cause of rain.

 

We have always thought of the United States as the world's leading economic engine. If by "leading" we mean buying up goods and consuming them, the United States is no longer in the lead, and that ultimately affects our entire economy and the value of the dollar. Now-and in the near future-we will see a shift away from U.S. dominance in the economy of the world, as China becomes the new global economic engine. China buys up goods from other countries, and its rate of buying is growing by leaps and bounds. Its purchases of goods from abroad surged 41 percent in 2003, passing Japan as the world's third-largest importer, behind only the United States and Germany. U.S. imports grew at the same time by just $10 billion, a mere 3 percent.

 

 

 

Economists like to talk about recoveries in terms of jobs, consumer spending, and trade with other countries. But a lot of this is just talk. What is really happening is alarming if we look at how and where we spend money. The best way to take the temperature of the economy is by measuring what we manufacture, what we spend, what we invest, and what we buy and sell. Collectively, this is referred to as the gross domestic product (GDP).

 

A problem, however, is that GDP is an amalgam of different things, some of which contradict one another. So looking at GDP in total doesn't tell us what is really going on. We have to look at the trends in the different pieces that make up GDP to really understand just how dire the situation has become.

You can see how difficult it is to gain anything when you look at the usual GDP formula:

GDP = Consumption + Business investment + What the government spends + Exports - Imports

 

When you hear that "GDP has grown in recent years," is that good news? Not necessarily; it depends on how the components of GDP have evolved. The change in GDP through 2003, for example, was skewed. While this was called a recovery, it didn't look at all like traditional recoveries we have seen in the past.

If we depend on the government to give us the information we rely on, it would be nice to get realistic information and not just answers they think we want to hear. The latest recovery isn't really a recovery at all, for example-in spite of what we are told by those in power.

 

The pattern of the latest recovery lacked any real momentum.

Economists also like to point out surges , those signs that the recovery is strong. For example, we were told that in the third quarter of 2003, GDP surged 8.2 percent-proof of a strong recovery. But it wasn't really a surge at all, only a one-time burst in consumer spending driven by tax rebates and the mortgage refinancing bubble.

 

While economists like momentum and surges, they hate bubbles. These are fake trends, false surges, and aberrations that don't have any momentum at all. So when we recognize that the growth in GDP was caused by an obvious bubble, it destroys the argument. Maybe GDP didn't really surge at all. Maybe it fell when we take reality into account.

 

We have gone through a strange period where several conditions were combined: Record-low interest rates, an exploding budget deficit, record-high consumer debt, and the housing and mortgage refinancing bubble. And at the same time (and for good reason) we experienced America's slowest economic recovery ever after a recession. This affects the value of our dollar because, in the big scheme of things, the fact that we import far more than we export -the trade deficit-is a huge problem that will ultimately destroy the U.S. dollar and its spending power. Combined with the government budget deficit, we are faced with a double-play threat to the dollar's value. The huge trade and budget deficits (known in economic circles as "current account deficit") are the real indicators we should be watching, and not the net GDP:

 

Regarding the risk of a disorderly adjustment [of the U.S. trade deficit], it should be emphasized that any excessive current account deficit will need to adjust eventually. What cannot last will not last. The crucial issue is whether the adjustment will be orderly or involve a large and disruptive change in key economic variables. Such a disorderly adjustment would affect not only the rest of the world but, in particular, the deficit country itself. There are a number of factors which may increase the risk of a disorderly adjustment.

In spite of the misplaced boasts to the contrary, we need to evaluate economic news from a realistic point of view. In order to judge whether something is good or bad, it needs a reasonable measure. The way American statisticians measure the economy deludes us about the extent of America's dollar problem.

 

The U.S. recession of 2001 was the mildest in postwar history. Normally, in a downturn in the economy people take stock of their personal balance sheets, pare back, pay off a little debt, and get their ducks in a row. Not so in 2001. In fact, Americans pulled out their credit cards and continued to spend their way right through the recession -so much so that the real work that generally takes place in a recession never happened. Debts didn't get paid off. Bad loans didn't get written off. The recession, rather than simply being the mildest in the postwar period, never really happened.

 

But we have kept ourselves in the dark, convinced that the economic recovery is strong because "they" have told us so. But realistically, we remain in the dark. Real GDP declined just 0.6 percent, well below the average 2 percent decline of previous postwar recessions. The great question, of course, is, what actually made this recession so mild? Quoting the chairman of the Federal Reserve, Alan Greenspan: "The mildness and brevity of the downturn are a testament to the notable improvement in the resilience and flexibility of the U.S. economy."

 

This position-that the U.S. economy is resilient or flexible -is a widespread view among American economists. It needs drastic revision because, well, the assumption itself is absolutely false. The 2001 recession was unusually mild, but this positive sign was more than offset by exceptionally weak economic growth in the two years following the recession-and they don't like to talk about that.

 

In economics, everything is compared. We measure good and bad compared to how good or bad the averages have been. This is reasonable, or else we wouldn't know what to think about 2 percent, 8 percent, or 194 percent. In the case of the elusive and misleading (but favorite) indicator, the GDP, the decline in all postwar recessions has averaged 2 percent. But this average loss has always been followed by vigorous recoveries. On average, over the three years of recession and recovery, there is typically an average net GDP growth of 8.2 percent. Now let's compare: Over the three years 2001-2003, covering recession and recovery, real GDP grew only 5.7 percent. So any boast about a particularly mild recession, not to mention our economy's extraordinary resilience and flexibility, is an exaggeration.

 

This talk about the economy's resilience and flexibility is inaccurate for still another reason. Recessions were always periods of sharply slower debt growth and repayment, reflecting retrenchment in spending. The 2001 recession, in contrast, was a period when debt growth accelerated, and that is precisely what the Greenspan Fed wanted to achieve. In a speech on March 4, 2003, in Orlando, Florida, Greenspan bragged about the fact that consumers had extracted huge amounts of previously built-up equities from owner-occupied homes. For the economy, such equity extraction was financed by debt .

 

The problem has only worsened since 2001. Consumer borrowing has been growing at record annual rates. As of the end of 2004, total consumer debt ended up over $2.1 trillion, a 23 percent increase over four years. (See Figure 1.1.)

 

Annual consumer spending and borrowing continue to rage higher at an annual rate of $480.3 billion. Even so, Greenspan has pointed to consumer trends as positive indicators. That strengthening trend, however, has come from inflating stock and house prices. Debt is soaring, and that is the problem. It would be different if that spending was going into a savings and retirement account or, in the case of business, into factory machinery. But it is not. The GDP growth involves spending money and borrowing the money rather than using earnings. That's where the problems lie, and that's where the demise of the dollar is going to occur. At some point in the near future, our country is simply going to run out of credit. We're going to max out our monetary credit card.

 

It is the debt itself, out of control and getting worse, that is going to cause the loss of the dollar's spending power. The higher our consumer debt and our government debt, the weaker the dollar becomes. And that means your savings and retirement account and your Social Security check are going to be worth less and less. This currency crisis is augmented by the fact that China is taking over in the world economy: it is becoming the leading importer, manufacturer, and producer in the world.

 

 

 

Before the demise of the dollar can be arrested, the causes-runaway debt and U.S. government policy-must be addressed. As a personal investor there's not much you can do but understand the trends in place and position your portfolio for success. You need to understand why prior structural flaws have gotten us to this point. Several things have contributed to this problem, including not only excess credit, but also the lack of savings and investment among American consumers.

 

A recession is a retreat, a decline in GDP, employment, and trade. Not surprisingly, most people think of such economic forces in terms of lost jobs, which is only one aspect of the bigger picture. But just as recession has an expanded meaning, so does recovery.

 

In the past, U.S. recessions resulted from tight money and credit. This translates to difficulty in getting loans (especially for homeowners and small businesses). It used to be a symptom of recession that people would say, "Money is tight."

 

We rarely hear that anymore. Why? Because money isn't ever tight these days; it's just worth less and less. The old-style recession and its accompanying tight money forced consumers and businesses to cut back on borrowing and spending excesses-belt tightening. This change in behavior eventually brought the economy and the financial system back into balance. Cutting back on credit when recession occurs is a form of "economic dieting." We have to slim down to get away from tight money, so that the economy can get back into those tight jeans it wore last summer. Most of us know exactly what that is like, and what it means.

Something has changed in the United States. Our economy is fast becoming morbidly obese and we have long abandoned the desire to slim down. We just keep buying bigger and bigger expectations. We've been living in the bubble.

 

It has become official economic policy, under Alan Greenspan's tenure with the Fed, to not only accept but to actually encourage borrowing and spending excesses. This occurs under the respectable label of "wealth-driven" spending.

 

When we speak at conferences and talk to people around the country we're consistently surprised at how little people actually know about the money they pack away in their wallets. Since 1913, and the passage of the Federal Reserve Act, the federal government has ceded the power over money expressly given to it by the Constitution to private interests. Article I of our Constitution gives Congress the power to coin money and to regulate its value. But that power has been delegated to the Fed, which is essentially a banking cartel and not part of Congress. This isn't just politics or stuffy economics. By allowing the Fed to have this power, we have no direct voice in how monetary policy is set, not that it would do much good anyway. The loss of sound money-money backed by a tangible asset, rather than a government process-is the root imbalance that's plaguing the dollar.

 

To give you an idea of how the recession and recovery trend has changed, look at the historical numbers-the real numbers and not the political/economic numbers we are being fed. (See Table 1.1.) The peak-to-trough changes shown in past recessions make the point: We're not gaining and losing economic weight and returning to previous health in the same way; something has changed drastically and, like a Florida sinkhole, we're slowly going under.

 

That's why the dollar crisis is invisible. We really don't want to think about it, and the Fed enables us to ignore it by telling us that all is well. As long as credit card companies keep giving us more cards and increasing our credit limits, why worry? And that, in a nutshell, defines the economic problem behind the demise.

 

An economist would shrug off these changes as cyclical or simply as signs that in the latest recovery a bias toward consumption is affecting outcome. But what does that mean? If, in fact, we are no longer willing to accept tight money as a reality in the down part of the economic cycle, how can we sustain economic growth? How much is going to be enough? And what will happen when seemingly infinite credit and debt excesses finally catch up with us?