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This essay
from the July 2006 International
Speculator captures the essence of Bud Conrad's forward-looking,
contrarian analysis… almost eerily so as we appear to be on the brink of
the economic precipice described herein.
By Bud Conrad, Casey
Research
Poor Ben Bernanke. The greatest financial train wreck
in history is going to happen on his watch, and it will be mostly his
predecessor’s doing. But not the work of Alan Greenspan alone. The
Washington elite and their compulsively clever counterparts around the world
have set the US (and global) economy up for a currency crisis of gargantuan
proportions.
When?
Soon.
To explain why this seems inevitable and unavoidable,
let’s look at the data. First, there are the deficits. They’re
big, and they’re three.
Deficit 1 – The Government’s
The lamest deficit excuse, a story left over from the
20th century, is that government can use borrowed money to
stimulate the economy. It can’t. While it’s true that government
can spend borrowed money to encourage particular favored activities (the ones
with the right political connections), the borrowing dampens the rest of the
economy by depriving it of capital.
What’s worse is that the favored activities are
usually of the wasteful, rat-hole variety: wars; regulatory agencies; fatter
subsidies for uneconomic farming; more complex Medicare programs; and bigger
budgets for public schools that don’t teach and for colleges that teach
whining. Meanwhile, commercial projects that add real wealth get cut off from
the capital they need or have to bear the added costs that come from the
government competing for investor funds. And so the government is left with
more debt to pay and a smaller economy for its tax collectors to feed on.
It’s not rocket science. Arithmetic is the same
for a government as for the guy driving a Mercedes on a Volkswagen budget:
Spending more than you make, let alone more than you will likely ever make,
leads to ruin. The only difference is that it takes governments longer to get
there.
And if we’re not there yet, we are getting very
close. The US government has run up a truly horrific debt of $8.2 trillion.
That’s $28,000 for every man, woman, and child in America. By itself,
the debt would be a serious but not catastrophic problem for the economy. But
unfortunately, it is not a stand-alone problem. It feeds other problems,
including – among others – inflation.
Debt and Inflation
Just how is the government’s budget deficit
inflationary? The answer is partly political and partly economic.
The political part is simple. Government debt makes inflation
attractive for politicians. Inflation is a slow-motion default – a
default on the installment plan – that reduces the real burden of
servicing the debt and leaves more resources for the politicians to play
with. Inflation is especially attractive for them when the debt is owed to
foreigners, who don’t get a vote. Politicians bemoaning inflation,
those responsible at any rate, cry on the outside while laughing on the
inside.
The economic part is more complex. Because the deficit
handicaps all the industries that aren’t being bottle-fed by government
spending, much of the economy will tend to languish – which is a signal
for the Federal Reserve to expand the money supply. It is the increase in the
money supply that directly causes inflation.
And there’s a second chapter. The government
finances its budget deficit by selling IOUs. In the case of the US, the IOUs
are primarily short term, especially US Treasury bills. From an
investor’s point of view, the T-bills are an interest-earning substitute
for cash. So a government deficit decreases the demand for dollars themselves
– and that reduction becomes a second, independent source of price
inflation.
If the US were alone in the world, that would be the
end of the story. All the T-bills (and T-bonds) would be sold to people in
the US, so that the government deficit would be offset by private saving. The
deficit would give the economy nothing worse than a low-grade fever –
chronic but unspectacular inflation accompanied by a stunted growth rate.
But the US isn’t alone in the world, and it
isn’t just another country, so there is more to the story. It is the
US’s singular role in the world economy that will turn US deficits into
global economic disaster.
The world functions on a dollar standard and has done
so since the end of World War II. The USD is accepted as cash in most
countries. Many millions of foreigners rely on it as a second currency and
use it as a store of value. And the US dollar is the world’s de facto
reserve currency: It is used by central banks to back their local currencies.
The volume of dollars and dollar-denominated assets accumulated by foreigners
during the reign of the dollar standard is staggering and without historical
precedent. Any move away from the dollar would be… well, problematic.
Deficit 2 – The Public’s
Americans used to be savers. Not any
more. Chart 1 shows a stark picture. As recently as 1990, Americans on
average saved about 7% of their income (which allowed them to buy up much of
the debt the government was issuing). But the savings rate fell over the 15
years that followed, hitting zero in 2005. Unlike in China, where the average
savings rate is said to be 20% (some unofficial reports have it as high as
40%), or even in some European countries where it is reported at 10%, the
savings rate in America is now negative.
The debt Americans have been building up isn’t just
a number that sits on a balance sheet. And it isn’t spread evenly
through the population and through the economy. It is concentrated in one
area, residential real estate. And it is concentrated in an unstable fashion
– thanks to the government’s efforts to stimulate the economy.
After the equities boom faltered and the US economy
showed signs of weakening in 2000-2001, the Fed started cutting interest
rates and worked its way almost to zero. Americans borrowed and spent as
never before. Anyone who didn’t own a house borrowed to buy,
increasingly with no money down or with interest-only loans. Those who
already owned a house borrowed against it to buy furniture, cars, boats,
yard-wide televisions, and trips to Hawaii. And the process didn’t stop
with just one round. Empowered by ultralow mortgage rates, people bid up the
prices of existing houses, allowing their owners to draw even more spendable
cash at the refinancing window – or to use their equity to bid on an
even more expensive house, or even second and third homes, in the process
taking on even bigger mortgage commitments and pushing home prices ever
higher.
So it’s not just the US government that is in
debt, but also individual Americans who have racked up $8.7 trillion in home
mortgages (many with adjustable rates that are now rising) and $2.2 trillion
in consumer credit ($36,333 per person).
Bub-Bub-Bubbling Along
We all know there’s been a housing bubble. But
with interest rates now rising – the Fed has hiked rates without a
break in the last 16 FOMC meetings – what comes next?
The housing boom is over. Prices have softened in many
areas and in others prices are beginning to decline. The reason? Interest
rates have risen to a point where mortgages no longer look like free money.
The refinancing market, which is a good barometer of how high or how low
rates “feel” to the public, shows this in emphatic fashion in
Chart 2. Borrowers have gone on strike, and without borrowing, the best the
US real estate market can do is to tread water.
Yes, the housing boom is over, but the story of the
housing boom isn’t. The mortgage debt is still there, saying
“FEED ME” every month. If interest rates keep going up…
1. Home buyers will cut back on what they are willing
to pay, so prices will decline.
2. Homeowners will see their equity shrink and then
disappear. Mortgage lenders will swallow huge losses as many home owners
default.
3. Homeowners with adjustable-rate mortgages will be
squeezed; and
3a. Many will
be forced to sell, so prices will decline; and
3b. The rest
will cut back on consumer spending in order to keep their houses and so will
push the economy toward recession.
The Federal Reserve has been letting interest rates
rise because it is concerned about the prospect of inflation. But the
unraveling of the real estate market, if interest rates keep rising from
here, is so automatic, so ugly, and so obvious that the Federal Reserve must
know what the consequences will be if they push rates much higher. The Fed
might choose to tolerate a little more inflation rather than risk a deep
recession. Too bad that’s not the only decision they face.
Deficit 3 – At the Water’s Edge
The US government is running a chronic deficit, going
deeper and deeper into debt. The US public is running a deficit, going deeper
and deeper into debt. So where is the credit coming from? The short answer is
that it’s coming from nearly everyone who isn’t an American and
isn’t dirt poor.
The longer answer is that the US has been able to tap
into a river of foreign credit by virtue of the third deficit: the trade
deficit. Foreigners, in the aggregate, sell about $2 billion per day more of
goods and services to Americans than they buy from Americans. The Americans,
in the aggregate, make up the difference by selling investments to
foreigners, most conspicuously US Treasury bills. Chart 3 illustrates this
two-way street and shows how rapidly the traffic has been growing.
Why This
Can’t Go On
If you have a very good credit rating, you may be
carrying credit cards with limits of $10,000, $20,000, or perhaps much more.
But however good you may look to lenders, there is a limit to how much they
are willing to lend. And however good the US may have looked to lenders in
the past, there always were limits to what it could borrow. The difference
between then and now is that today the US is straining those limits.
Two elements determine how far foreigners will go as
lenders to the US. The first is akin to a credit test. The second is a
portfolio consideration. It is becoming increasingly difficult for the US to
satisfy either of them.
Foreigners will accept T-bills and other dollar-denominated
IOUs only so long as they believe US borrowers can make good on their debts.
The concern is not primarily about explicit defaults. It is about the
likelihood of a slow-motion default via inflation. It is a concern about the
future value of the dollar. Confidence that the dollar will hold its value is
strained with every increase in the US budget deficit (which increases the US
government’s incentive to inflate) and with every increase in the
overall level of US debt to foreigners (which encourages the public’s
tolerance for inflation).
It would take a phenomenally slow person, say, a
central banker, to have much faith in Uncle Sam’s good credit when the
US can’t pay its current bills by a very wide margin – and has
trouble saying “no” to new spending plans. But even the faith of
a central banker must have its limits.
Perhaps the central bankers haven’t yet seen
Chart 4, showing the Government Accounting Office’s latest projections
of US federal government red ink. Based on straightforward assumptions that (i) regular income tax rates continue; (ii) the
alternative minimum tax is adjusted; and (iii) discretionary spending grows
with GDP, the projection for spending, and thus the budget deficit, flies off
the map. By 2040, the yearly deficit grows from the current 3% of GDP to 40%!
The second element in the calculations of foreign lenders
is a portfolio consideration. Owning too much of anything is worrisome. So
even if the risk of the dollar losing its value were modest (which it no
longer is), as foreign holdings of dollar-denominated securities grow, the
risk eventually becomes intolerable.
Chart 5 shows foreign holdings of US investments. The
numbers are enormous. Japan alone has bet over $1 trillion on the
dollar’s ability to hold its value. That’s enough to breed
uneasiness in any portfolio manager. And the numbers keep growing because the
US keeps importing goods by the boatload and paying with dollar-denominated
IOUs. The breaking point is getting closer at a rate of $2 billion per day.
Relying on
the Kindness of Foreigners… Who Hate Us?
The great irony is that the US is counting on
foreigners to invest $2 billion per day… at a time when we are not
winning many hearts and minds abroad. The counterproductive and unwinnable
war in Iraq is just the unhappiest part of the current picture. Among other
reasons why hatred for Americans is rising are:
- We maintain military bases that locals don’t
welcome, and not just in Islamic countries. Many Germans feel that their
country is still occupied after a war that ended before they were born.
The US keeps troops in over 130 countries, where most people are no
happier to see them than Americans would be to see Russian or Iraqi
soldiers shopping at their hometown WalMart.
- The US earnestly attempts to impose
government-issued “American values” on others. Bush says he
wants to democratize Iraq – with no regard for whether the Iraqis
want to be “democratized” or not and with no thought to what
actual practice will slither out of the slogan. We chastise others,
including China, about their human rights record, but our words now
appear hypocritical given the heavy-handed US occupation of Iraq and the
indefensible existence of the Guantanamo gulag.
- The US helps governments run by dictators and
murderers stay in power, and surviving victims remember. They
won’t forget that Saddam Hussein was once an ally. Iranians who
hate Americans don’t do so because they hate Calvin Klein
underwear, but because they felt oppressed by our former
protégé, the Shah. The same goes for many current US
allies in “the ‘stans,” the
most noticeable recent example being Vice President Cheney’s trip
to Kazakhstan to cozy up with that country’s ruling despot. The
pattern long held true in Latin America; the effectiveness of
anti-American political rhetoric for politicians like Chavez, Morales,
and their ilk should come as no surprise.
- We talk about freedom and free trade, but the
threat of massive violence seems to be the main tool of our diplomacy,
and US subsidies for farmers don’t provide much of a free-trade
lesson to Third-World farmers.
In short, the American global cop, far from harvesting
the gratitude of a world made safer, is perceived as a hypocritical and
plundering thug – hardly the sort of thing that makes foreigners line
up to invest in America.
US heavy-handedness abroad and the ill will it inspires
are dangerous for many reasons, including their effect on the US dollar. War
in Iraq and saber-rattling over Iran are driving the price of the oil and
other imports up in the US, which increases the trade deficit, which adds to
the pile of dollar-denominated IOUs held by foreigners. And the same
belligerence confirms in many Middle-Eastern minds that the US is driven by
an anti-Islamic agenda. It gives them a non-financial motive for embracing
alternatives to the dollar: the euro, the yen – anything not made in
the US. Other foreigners see the belligerence as more evidence that the US
government is a reckless spender and heedless of the consequences of its
growing debt.
When the Drums Stop
The foreigners who hold all those dollars are getting
restless. Chart 6 below shows recent changes in foreign holdings of US
Treasury securities. The pattern is shifting.
It is striking that, in keeping with its official
statements, Japan (the largest foreign holder of US Treasuries) has indeed
begun lightening its load of American paper. This is not an “if”
or a “maybe,” but a real and very significant shift… happening
now.
Other changes are happening, not major dollar dumping
yet, but rumbling. Look at the UK bar – it has more than made up for
Japan’s negative number in recent months. That’s interesting in
and of itself – why the UK?
The UK, like Luxembourg and the Cayman Islands, two
other major sources of US debt buying, is a financial way station for
international transactions – particularly from the Middle East. We
suspect that the spike in UK purchases reflects a desire by investors in the
Middle East to avoid dealing directly with the US – Arabs with a lot of
oil money who don’t want their US-based assets exposed to rising
anti-Muslim sentiment, for example – but who are not yet ready to dump
the dollar altogether. It’s an important sign. It indicates a shift in
the attitude of the most sophisticated elements of the Muslim world away from
thinking of the US as a financial safe haven.
And there’s more. Consider this statement from
Mr. Yu Yongding, an official of the People’s
Bank of China:
Regarding the need for China to reduce its holdings of
US dollar reserves: Firstly, in the first stage we must reduce accumulation, then later we should reduce our reserves… [China and
Asian countries] don’t need that large an amount, more than $2
trillion, of foreign exchange reserves… Then, all East Asian countries
have tremendous foreign exchange reserves and they all want to get rid of
them, but if you do this then you cause competitive devaluation, not of their
own currencies, but of the US dollar. So we should do this in an orderly
fashion. If Asian countries moved too fast, everyone would lose… It
would be utterly unfortunate if Japan sells a proportion [of their reserves]
that causes problems. Then China panics and China sells a proportion –
it would be very damaging.
Mr. Yu articulates the anxiety shared by other central
banks: a desire to unload excess, overvalued dollars that is checked by the
fear of triggering a cascading fall in the dollar. They won’t tolerate
life in this box forever. All it will take is for one central bank’s
governing body to get spooked, to decide that it had better get out of the
dollar before everyone else does. The stampede will be unstoppable, and the
dollar’s foreign exchange value will tumble.
Where will all that money go? The euro? The yuan? The ruble? The one thing that seems certain to us
is that a significant fraction will go into gold, not only as an investment
but as a means of wealth protection. Just a few days ago, Mr. Yu was quoted
in the press saying: “We need to use some of the reserves to buy other
assets such as gold and strategic resources such as oil.”
We don’t know which central bank will be the
first to tiptoe toward the exit or when it will try. The process may already
have begun. But we do know that important changes are already taking place
among US trading partners. The US government’s daydream of spending its
way to prosperity may not last the year.
The End of the Dollar Standard
Central banks won’t be the only players. The
millions of people around the world who use the dollar as their second
currency will join in. And for most of them, “the dollar” doesn’t
mean Treasury bills, it means $20 bills, $50 bills,
and $100 bills. The collapse in the foreign-exchange value of the dollar
sparked by foreign central banks unloading their excess holdings will
undermine everyone’s confidence in the dollar’s usefulness as a
store of value. Private foreign investors will flee the dollar, further
reducing its foreign-exchange value. And most of that privately held cash
will flow back to the US as more fuel for price inflation. The dollar
standard will be dead.
The consequences will be of historic proportions.
How “historic”? As you can see in Chart 7,
if the world’s central banks backed their currencies with gold, it
would send the price up (in current dollar equivalents) to many thousands of
dollars per ounce – easily $5,000 or more.
But wouldn’t central banks fight against such a
rise in gold? Wouldn’t they sell some of their tons of bullion to cash
in on higher prices or out of a desire to keep the price from rising further?
Our friends at GATA make a compelling case that the central banks
don’t actually have as much gold as they say they do. But even if
that’s not the case, all the gold holdings the central banks report
still are nowhere near enough to back their currencies. Note that, as a
percentage vs. paper, gold now makes up only .04% of total central bank
reserves.
Again, if the dollar proves to be unreliable as a
backing for other currencies, what are central banks going to replace it
with? Even if they move en masse to the euro, a global crisis is hardly a
time for central banks to sell off the one hard asset they have.
And, as discussed in previous editions of IS,
all modern currencies are empty promises. If the dollar is an “I Owe
You nothing,” the euro is a “Who Owes You nothing?” What
central bank would want to back its paper with more paper in the midst of
such a world-wracking crisis of faith in paper?
With the political uncertainties that surround the
other contenders – not to mention the object lesson of the spectacular
collapse of the USD, when it happens – we believe the world will
eventually stumble back onto a gold standard. That could happen in as little
as a decade. In the interim, they may flirt with the euro, the yen, or other
tissue papers, but not enthusiastically and not for long.
Virgins Are Safe This Time
Is there anything the US government can do to stop the
train wreck? Earlier governments tried sacrificing virgins to the gods to
ward off disaster, but the practice seldom worked and isn’t likely to
be revived. The Federal Reserve could try raising interest rates still
higher, high enough to convince foreign central banks to hold on to their
dollar investments, but that has about the same chances of working as tossing
gold-laden virgins into deep, water-filled sinkholes did. It might protect
the dollar standard for a while, but it would turn residential real estate
into a financial graveyard and trigger the depression the Fed is trying to
avoid. Of course, the Fed could fight a contraction in the economy… by
lowering interest rates. But that would bring on a flight from the dollar and
a more rapid end to the dollar standard. There is no way out.
Future Uncertain?
If we’re right about a coming monetary regime
change, it’s hard to imagine a future for the US that isn’t grim,
with plenty of harm splashed around on its trading partners: inflation…
currency crisis… dollar crash… government instability…
internal conflict for scarce resources… welfare system collapse…
skyrocketing unemployment… taxes raised on a population burdened with
an uncompetitive US economy… dollar down 40%… 60%…
80%?… emergence of competitive economic battles on too many fronts:
China, India, Japan, Russia – and on too many military fronts. End of
empire/Fall of Rome redux… the Greater
Depression.
We are already seeing extreme volatility in emerging
markets as the hedge funds beat a hasty retreat for liquidity. Get used to
it.
Remember, never before in history has the unbacked paper currency of a single country been used as
the de facto reserves of the world’s central banks. We are truly in Terra
Incognita, uncharted territory – and a hair trigger away from a
currency crisis that, once begun, will quickly spin out of control.
Gold Is the Past… and the Future
At our recent Chicago conference we polled the audience
to see if anyone of the 300 attendees could name the five natural reasons
that Aristotle gave as to why gold is money. Despite having regularly
mentioned those reasons in these pages – and offering a prize –
not a single attendee had enough confidence in his or her understanding to
stand up and recite the five reasons. So, here they are again: It has
intrinsic value (it’s valuable in many uses); it’s convenient
(houses are not easily portable); it’s divisible (the Mona Lisa
isn’t); it’s durable (wheat rots); and it’s consistent
(diamonds have different grades that are not always easy to see).
Even if the regime change we foresee takes decades to
come about, the softest “soft landing” imaginable will still be
very painful, with repeated flights from paper currencies. That is why we
have been saying that gold isn’t just going through the roof, it’s going to the moon. And given the signs
– particularly the housing bubble popping on the sharp point of higher
interest rates and the increasing moves on the part of foreigners to distance
or divest themselves of dollar-based assets – we believe the fireworks
are going to start sooner rather than later.
As to what speculators – what anyone –
should do, it doesn’t really matter whether the fall of the dollar
precipitates the level of crisis we expect. The steps we advocate are
reasonable for anyone who doesn’t want to get hurt by a currency
crisis: buying physical gold (and silver – both are still relatively
cheap in inflation-adjusted dollars); getting a useful portion of one’s
assets into a stable country outside of the US (preferably one with no
involvement in the “War On Terror/Islam”); and investing a
fraction of one’s portfolio in gold stocks.
That these moves are also the same as those you need to
make for realizing enormous profits is not a coincidence but a reflection on
our times.
One More Observation
Government deficits, trade deficits, and losses in the
dollar’s value tend to move together, a point made clear in Chart 8
which shows what happened after the US abandoned the gold standard.
[The past five years – since this
article was first published – have seen even more of a slide for the US
dollar and its economy. What’s worse is the D.C. politicians show no
sign of understanding what’s ahead, much less changing course. But you
can start to protect yourself and your portfolio today, by signing up for a free,
online video event that Casey Research will be hosting next week. The American Debt Crisis will
feature Doug Casey, Bud Conrad, and other Casey Research experts as well as special
guests – you don’t want to miss it. Register
now; the event will be held Wednesday September 14 at 2 p.m. EDT.]
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