Submitted by Bud Conrad of Casey Research, first published in the July 2006 International Speculator, and worth a reread for anyone who has not seen it previously.
The Coming Currency Crisis
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.
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.
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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).
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.
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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.
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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%!
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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.
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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.
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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.
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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.
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.
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.