The View From 1776

Storm Ahead?

The economic barometer has been falling for many months.  Analysts have, with greater frequency of late, expressed fears of a major dollar devaluation.

This is not a prediction of specific events or the timing thereof.  But you should become aware of the many economic warning signs that have become increasingly evident in recent years. 

Typical is the following quotation from the Wall Street Journal’s February 17, 2007, editorial How Expansions Die:

Thus does a virtuous circle caused by easy money turn vicious, and interest rates aren’t even all that high—at least not yet. The Fed’s concern over housing’s potential effect on the broader economy is no doubt one reason it has kept short-term rates at 5.25% for several months, despite signs that inflation risks remain. Notwithstanding yesterday’s monthly inflation statistics (a function mainly of energy prices), gold has climbed back up to $665 an ounce, the dollar is weak, and “core” inflation remains above the Fed’s 2% upper limit.

The underlying problem is too many dollars sloshing around the world, the result of the Federal government’s unsatisfiable desire for more spending, along with consumers’ imprudent willingness to go into debt, spending more than they make.  These two economic drivers are facilitated by the Federal Reserve’s role as creator of fiat money in limitless quantities.  The inevitable result is inflation, which by definition is devaluation of the currency.

While our fiat currency is steadily devalued via rising prices for daily necessities and payment of ever higher taxes, the international foreign exchange markets have not yet reacted as strongly as many economic analysts fear they will.  In a Wall Street Journal article dated February 5, 2007, Dan Molinski reported:

Although many of the latest U.S. economic reports have been positive, there has been a peppering of negative news. In addition, the Federal Reserve left its key interest rate on hold for the fifth straight meeting and expressed less concern about inflation. That revived near-dead talk of rate cuts, which could be a negative for the dollar.

“There’s been a sea change in sentiment, and it seems no one wants to be” betting on the dollar to gain, said Michael Woolfolk, senior currency strategist at the Bank of New York.

An accelerated and significant dollar devaluation, among other things, would likely raise interest rates.  Foreign central banks holding billions of dollars invested in U. S. Treasury securities would demand higher interest rates as compensation for the risk of further loss of value in those investments.  Higher interest rates increase business costs and reduce profits, leading to lower business activity and increasing unemployment.  At the same time, prices of imported goods, now a huge part of what consumers buy, would increase.

In our severe, Great-Society inflation of the 1960s and 70s, the stock market cratered and interest rates soared into the 20% range.  It was this which gave rise to the leveraged buy-out phenomenon, in which stock market operators could buy an entire company, at depressed stock prices, for less than the value of its assets, then dismember the company and sell some of its assets to repay the acquisition debt.

Without the automatic regulatory mechanism of a true gold standard, the Federal government is able to expand its deficit spending by having the Federal Reserve System create fiat money out of thin-air, a bookkeeping process accomplished simply by purchasing Treasury debt directly from the Treasury and on the open market.  Government spending pumps dollars into the market, in the case of entitlement spending on Social Security, Medicare, and Medicaid, with no offsetting production of goods and services that add to the productivity base of the economy.  They are merely transfer payments: taking from wage-earners and giving to non-earners, while adding to consumer spending and pushing prices upward. 

Open market purchases of Treasury debt from financial institutions create new lendable balances on the books of the financial institutions. Those new lendable balances have been employed in a flood of credit card lending and 1st and 2nd mortgage home loans, which bid up domestic prices and suck in huge volumes of imported goods, manufactured more cheaply overseas.

At the end of the chain are the central banks of exporting nations like Japan, China, and Germany.  Their exporters are paid in U. S. dollars, which are converted into their local currencies, the exchanged dollars going into the accounts of the central banks.  Those dollar exchange holdings are then invested by central banks primarily in U. S. Treasury debt.  The amounts are huge and potentially great trouble for the dollar exchange rate and for the U.S. economy.

As Wall Street Journal reporter Andrew Batson wrote in a February 15, 2007, article:

China’s central bank sits on a hoard of $1.07 trillion in foreign currencies and securities, making it one of the biggest investors in the world. Now, officials have agreed that the traditional approach to managing this massive rainy-day fund—keeping it safely invested in bonds issued by U.S. and European governments—is out of date.

Following the lead of countries like Singapore, South Korea and Norway, China is starting to look at new ways of managing its investments.

Together, these moves by central banks have ramifications for financial markets world-wide. The likely result: fewer steady purchases of investments like U.S. Treasury bonds .....

Even a slight shift of this type could have a significant impact in U.S. markets. China has long been one of the biggest buyers of Treasury notes, making it in effect a major lender to the U.S. government. China’s buying has helped keep interest rates low in the U.S.: The greater the demand for a country’s bonds, the lower the interest rates the country needs to offer.

Among other things, those huge dollar exchange holdings by China and Russia (the number three holder of exchange reserves) put foreign policy clubs into the hands of nations that do not want to see the United States remain the dominant world power. 

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