What the dollar decline means to you…
- Nov 27, 2006
- admin
- Investing
PAUL VOLKER SOUNDED very upset.
Apparently, a group of economists, using the same techniques as those used on the set of “Jurassic Park” (as opposed to those used on the set of the movie “Sleeper”), recently thawed the former Chairman of the Federal Reserve from his amber-induced deep sleep.
After they finished splashing water on his face they gave him the news: We’ve flashed back to the 1970’s: the United States government is running large budget deficits, there’s been extremely loose monetary policy and we’re fighting a war with open-ended costs. And just like the 1970’s, Washington is behind the Eight Ball. But it’s not a dream. It’s the year 2006.
Upon processing the information, Mr. Volker boldly predicted there would be a “75 percent chance of a currency crisis within the United States during the next five years.”
Unfortunately for us this isn’t a movie. And, history tells us that Mr. Volker’s recent predictions are based on some pretty strong evidence.
During the past six months, a growing chorus of leading domestic and international economists have begun to sing the same tune.
And now that the dollar is beginning to collapse, I think it’s time we listened.
The Calm before the Storm?
Why are these leading economists and thinkers beginning to see a currency crisis on the horizon? It’s certainly not based on the surface of the economic waters that look troubling. In fact, recent economic news has been rather promising: the economy has been growing nicely, signs of inflation have abated and of course the unemployment rate stays encouragingly low.
And who can forget about the stock market. Ever since it seemed likely that the Dems would win the midterm elections, the S & P 500 Index has been hitting new highs seemingly every day.
While there is no question that Wall Street was happy to see good, old-fashioned Washington gridlock, the markets sharp rise suggests a belief that the fundamentals are beginning to look more promising (as well as a belief that recently approved Treasury Secretary Paulson actually knows more about international finance then Mr. Snow knew about bushy eyebrows).
But Wall Street is a place where two types of big money co-exist: “smart money” and the “smarter money”.
“Smart money” invests in the stock market. “Smarter money” invests in bonds and currencies.
“Smart money” tries to capitalize on stock prices in relation to long-term interest rates.
“Smarter money” sets long-term interest rates.
It’s the “Smarter money” that’s beginning to get nervous folks.
What Lies Beneath?
If you look beneath the surface of the positive news coming from the “smart money” on Wall Street, you will see that our economy indeed faces some big, possibly painful adjustments over the next year.
And these “adjustments” could have major implications for your portfolio.
By far the most striking has been the degree that the dollar has fallen since the mid-term elections. Since then, the greenback has dropped in heavy trading and this week hit new lows against the euro and several Asian currencies. It seems that foreign investors have had enough.
And rightfully so. Our current-account deficit, the net amount we borrow from foreign lenders each year, inched its way up to 6% of GDP last year – a level never seen in the U.S. before and reflective of third world nations in financial crisis.
But that’s not all.
The broadest measure of the amount the United States owes the rest of the world – the net international investment position or NIIP – has gone from negative $360 billion in 1997 to an astounding negative $2.65 trillion recently.
What’s really surprising is that this has never happened before. Our current-account deficit is in uncharted territory, both as a share of the economy and in terms of the share of foreign savings it soaks up.
Most economists have long argued that this imbalance must, at some point, be corrected.
It seems that the time is now upon us.
How Did We Get Here?
Cut out all the clutter and its simple really: The United States has been spending more than it can afford to.
To spend the money, we borrow from foreign governments. The borrowing largely comes in the form of United States Treasury Bonds that we issue each month.
During the past several years the largest buyers of our bonds (investors lending us money), have been the leading governments in Asia.
They’ve been lending us between $1.5 – $2 billion per day.
To date, the large (and rapidly growing) amount of external debt has not yet been much of a burden on our economy. We’ve had no problem borrowing more money and interest rates haven’t been much of a burden to this point.
That’s likely to change though.
Recent economic weakness in the U.S. suggests that the Federal Reserve will not only stop raising interest rates, but will actually be inclined to lower them some time next year.
Think about that for a moment: if the U.S. lowers interest rates, the foreign governments who have been buying our bonds will begin to buy bonds from other countries such as Germany or England or France where their interest rates will likely be higher.
Why? Because like any of us, foreign governments hunt the globe for the highest returns they can find also. And if they can invest $100 billion in Germany at 6% versus $100 billion in the U.S. at 3%, where do you think they’re going to go?
Danger’s My Middle Name….
On the monetary side danger looks like this:
If foreign governments stop purchasing our bonds the bond prices will decline; if bond prices decline interest rates will rise.
Rising interest rates are never good for an economy; especially one that looks like it’s going to slow down next year – just ask somebody who has lived through the stagflation of the 1970’
On the fiscal side the picture looks equally bleak:
If foreign governments decide to stop lending us money by purchasing our bonds, the U.S. government has to find an alternative way to finance our deficit.
There are three primary options the government has:
The first option would be for the U.S. government to cut the amount we borrow. But to cut the amount we borrow means we have to cut our fiscal spending. Just a casual glance at the morons on both sides of the aisle in Washington shows how unlikely that prospect is.
The second option would be for consumers to spend less, thus increasing the savings rate. This could happen if the Fed were to aggressively raise the interest rates or if consumers bought fewer goods from foreign countries (yes, this means you).
But as always the Fed is walking a delicate balancing act with interest rates. If it raises them too quickly, it may stunt the already inconsistent growth of our economy.
And consumers buying fewer goods? Alas, look deep into your own heart for the truth. Getting 250 million Americans to spend less would be like herding a roomful of cats – a nearly impossible task.
The “Third Rail” Option
On the fiscal side (I’m on a roll here folks), the third and final option is would be for the U.S. to “default” on its debt….
Not default in the way you and I understand it.
Default in a way that only the most powerful government in the world could.
Let me explain. When we issue bonds we borrow in our own currency. Therefore, by letting the dollar drop, trillions of dollars would be wiped off of the value of our lenders assets.
In other words, we would owe the foreign governments who lent us the money, trillions of dollars less than the amount we actually borrowed.
To put this in perspective, if the U.S. dollar falls by 40 percent in value, this would amount to the biggest “stealth default” in world history.
And you know it’s going to keep on falling because it’s the easiest way out (for the U.S.) to begin to rectify its imbalanced finance-based economy.
Back to the Future
That brings us back to Mr. Volker and the 1970’s.
As you can see, the real question is not whether the dollar will fall, but how drastic the economic effects of its fall will be. In the mid-1980s, the greenback’s trade-weighted value declined by 40% with few ill-effects noted in America. The world economy absorbed the shock reasonably well.
Unfortunately, many economists like Mr. Volker see more parallels today with the dollar’s collapse in the 1970s, when the Bretton Woods system broke down. As I mentioned before, the 1970’s was a time of large budget deficits, loose monetary policy and high oil prices, and America faced open-ended costs to pay for a war.
We’re facing the same situation today, but in addition, the combined costs of fighting in Iraq and maintaining security at home could easily match the cumulative 12% of GDP that the Vietnam war cost.
There is therefore a risk that the global economic consequences might be as severe as those which followed the demise of Bretton Woods, with the ultimate consequence being “stagflation” – stagnant economic growth + inflation.
Some of my more popular contemporaries believe that the only way that this would happen would be if the buyers of government bonds to began selling them in a panic-style rush.
I think they’re missing the whole point.
The problem isn’t that foreigners are going to rush to sell the dollar denominated assets. The problem, as Mr. Greenspan himself recently pointed out, is that “foreign lenders will eventually resist lending more money to the United States, causing the dollar to drop further.”
Mr. Greenspan is right – they’re simply going to stop lending us money.
And for them (or anybody else for that matter) to begin to start lending us money again they’re going to have to get a lot more in return.
In other words, they won’t buy bonds unless they’re getting paid an interest rate to match their risk.
Let’s hope that rising interest rates are the only result of the current economic situation. Because if the dollar happens to decline more rapidly than we would like, and if interest rates shoot up faster than we would like, our economy will, at best, be in for a very hard landing.
At worst, it could be a case of déjà vu all over again….
–Dylan Jovine