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May 12, 2006

Dollars on the Wing, Which Bubble are You On? How About Bubble Number 3?

Few Americans are aware that the dollar has lost about 8% of its value in terms of the euro or yen in just the last couple of weeks. Most seem conditioned to think about these kinds of movements as little more significant than blips on a control-tower radar screen.  Needless to say, that's not the way we see it in dymaxia.  Here, with a little background is why our metaphorical instrument of choice would be the seismograph.

The US, through a post World War II treaty signed at Breton Woods and later revised by the Nixon Administration,  was granted a special role in the world economy.  It manages the only fiat (paper-backed) currency in the globe that is considered by the world's central bankers as a "reserve currency"; that is,  giving it a status once limited to gold or silver.  For most of the last 50 years the system has, with a few noticeable strains, worked out pretty well, especially for the US which gets to spend money that ends up sitting in Central Bank coffers rather than returned for redemption. In addition, and this has nothing to do directly with Bretton Woods, the US has gotten a further lift through the pricing mechanism for petroleum, which is quoted and traded in dollars.

For most of these decades of the world paper dollar economy a number of factors have weighed in the favor of the mechanism. The US has provided a degree of political stability rare in recent world history and its economy has up to this day --with some major mutations, the how of which we'll talk about-- remained a major driving force in world economic growth.

But in recent years there have been a number of cracks.  Two factors that have changed the most radically on the US side are the trade balance of goods and services and official US internal attitudes towards domestic personal and government debt --at the time of Bretton Woods, the US was running the largest trade surplus in the world and neither political party would be taken seriously if it advocated breaking the link between spending and the taxpayers; from grade school on, Americans were urged to save as a patriotic duty.  After all, it was the Savings Bond campaign that was used to finance World War II.

Today this all would sound pretty darn quaint... if it weren't so serious! In the last four years even as American families were urged to pile on more personal debt, the government has borrowed more than in all its prior history. According to the Treasury Department, America's first 42 Presidents (from George Washington to Bill Clinton) borrowed a combined total of $1.01 trillion from 1789 to 2000, Between 2000 and 2005, President George W. Bush has borrowed $1.05 trillion - and he's got a few more years left to go. As a result every child born in the country today comes into the world with a debt of nearly $400,000. For the rest of the world, we have witnessed the rapid economic growth in China and some parts of the Indian economy as Americans outsource more and more of their manufacturing and professional services. US trade debt with China alone has now reached over 250 billion a year and climbing. For the world, in total, the US is expected to buy nearly a $trillion this year more than it brings in by 2007.

Ironically US domestic deficit spending and its emphasis on subsidizing capital has been the driver of this growth. It has also kept the overall US economy moving along, at least in terms of corporate profits.  US global corporations, acting as financial and infrastructure masters have been able to capitalize on their superior logistical role as intermediaries in this new system. For working Americans who have suffered flat wages since the 1980's and seen their competitively paid jobs exported in ever greater slices to the emerging centers of labor surplus, the picture has not been so good. What helped many put off the pain was first a tech bubble that lured them into the investor class and then, a just-in-time, Fed-induced housing bubble, into the refinancing class.  Americans may not have earned more but they have been able to borrow more against plastic or, if they owned one, their homes, as historically low interest rates and easy lending practices fueled a housing boom that rose right out of the embers of the collapsing tech stock bubble. But even increased mortgage debt and interest only loans didn't quite match their appetites for more goods, bigger houses and bigger cars.  During the same period per family, non-mortgage household debt (plastic) also rose to historical levels (presently $37k per family).

Grocking that even the Chinese, Japanese and Saudis, dedicated to desperately keeping the golden lamb around for one more fleecing, could no longer absorb all these over-leveraged dollars and that inflation was imminent, the Fed has recently moved into Plan C, or Bubble 3. After tightening interest rates steadily over the last year and a half, this week  they made that move again for the 18th straight time. But, for the economists and the MSM flacks who blithely cheerlead the debt economy, insisting the house of cards is "solid", rising rates have collided with another critical reality, oil prices.

By some time in 2007, as we said, the US will probably buy a trillion dollars a year more than it sells to the rest of the world. In world economic history, the US and the rest of world for that matter, since we are all linked by the same printing press, are already far out into uncharted territory.

Geology, of course, is not just a metaphorical part of the economy.  The latest fissure is reflected in the price of both yellow and black gold. Both of these commodities have moved from low price ranges to historically high prices in little over the last couple of years. Gold has always been in short supply.  The developed world, on the other hand, has experienced an unprecedented rush in economic development thanks primarily to the open tap of cheap, plentiful energy, something it took the natural world eons to deposit.

Since prehistory, gold, though treated as a primitive relic by many modern economists, has proved time and time again to be a reliable, universal store of value. In times of fiat money, it tends to recede into the background as the influx of newly leveraged money fuels growth only to return to prominence when the inevitable bust occurs. In the last few centuries the importance of gold has been in direct ratio to the number of years a paper or fiat currency has remained in circulation.  Historically, every government that has managed a fiat currency has succumbed to the temptation of printing more than the world can handle and after there is an initial surge in economic activity as more money rushes from pocketbook to  pocketbook, prices start to climb out of control. Twentieth century central banking was founded on the principal that economies needed a referee able to step in when things swing too far out of balance. The major tool of central bankers has been their ability to tighten and loosen credit primarily through interest rates but sometimes through regulation and external currency manipulation. For Japan Inc., the exchange value of the yen is never underestimated.  The hand of the Bank of Japan is never far from the currency trading floor.

Like the next big quake somewhere on the Pacific rim, no one knows exactly how much force has to build up before there's the violent shock. In the case of today's overhang, the friction that is keeping this enormous shelf from moving too fast is the counter effort being made by China, Japan the Saudis to relieve the pressure on the dollar. These countries are the major beneficiaries of America's insatiable appetite for things big and small, fast and slow. They are the global Atlases of the currency world but always with the caveat, only for as long as they are willing. In effect, they have become America's bankers of last resort. As the major dollar holders and purveyors, they stand to suffer enormous losses should things suddenly slide into a trough..

 When Bush pronounced that the US was addicted to petroleum it was like a drug dealer blaming his clients for his job choice.  What Bush didn't say is that the US public is addicted to spending borrowed money. The Fed it might be added has, through the housing bubble, been the money pusher of last resort but even it has no control over the flow of oil or dollars for that matter.  Proven oil reserves, can like dollars, be printed on paper but sooner or later they have to matched by actual deposits.

The Fly in the Desert

Oil as we said, is also priced in dollars but unlike the Chinese, of late the oil producers have refused to completely go along with the game, possibly because of something only they know for sure. The amount of proven reserves of oil in Saudi Arabia, the world's largest source, is a state secret. In the last few years Shell, the second biggest oil company in the world has regularly reduced its estimates of how much oil it holds in "proven" reserve. An ever growing number of geologists believe that we have reached a point in history, that has been dubbed Peak Oil. Peak oil occurs when the amount we extract going forward is less than the amount of new oil we discover.  For the US, for example, although it was long denied, this event occurred sometime around 1970 

The Fed, of course, knows that these major tectonic problems can't wait for the politicians.  Any number of them have proposed using coercion to urge the Chinese to raise the value of their yuan against the dollar, as if that alone would help. Unfortunately for them, the US no longer makes most of things it buys from the Chinese; the global corporations that run those businesses and technologies have moved manufacturing permanently abroad. No one could seriously think they will move their furniture making facilities, say, back to North Carolina.  Any move at all,  would likely be to someplace like Vietnam where labor costs are even cheaper than in China.  A higher yuan, on the other hand, coupled with rising oil  prices might just be the tremor that sends the whole edifice tumbling. In any case, as you'll see below, we are likely to find out fairly soon.

The US has, in fact, become addicted to bubbles. In the 1990's during the tech bubble stocks of a publicly traded Texas fish oil company that changed its name to dot com, doubled its capital value overnight and companies that never brought a product to market or ever would, were valued in the billions as more and more investors threw their money into the game. Win or lose, most Americans --already accustomed it seems to the odds in Las Vegas, agreed it was a load of fun. Even after that bubble burst and the blood was still being swabbed off the exchange floors, the public began hankering for the next one.

It's precisely at this moment that The Fed, saw its role change from banker of last resort, and master of soft landings, to owner of its own bubble blowing machine and thus, master of soft soars and soft bottoms.. By pushing down interest rates and, more importantly, minimum loan requirements, to historical lows, before long the public was busily refinancing their homes and speculating in condo's..  It was a no brainer. Not only could you lower your monthly payment by periodically refinancing in a rising market, but you could pull cash you had paid in back out.  Once again, just like in the days, we had "money for nothin' and our kicks for free". For big investors money could be borrowed in the US and relent somewhere else where rates were higher. The hedge funds got fat and so did the loan writers.

 For the Fed it became time to slow the housing bubble down before it too ended in disaster. With mortgage payments going up, gasoline prices hitting new highs, and the stock market rising, the public mood was turning sour. The virtuosi at the Fed, it seems, already had their next move in sight. They knew that the only thing keeping the dollar from dropping was the draw of higher interest rates in the US than in Japan or Europe. Short term investors could move money into the US for a couple of extra points at a fast enough pace to keep the dollar firm for a while. All the Fed had to do was begin to hint that it might stop raising interest rates for the dollar to begin to slide. The Fed was now on its way to creating Bubble # 3, we'll call it the "cheap dollar bubble", coming to a pleasure palace near you soon. What all central bankers like most, is gradual.  So when the dollar moved almost all the way back to its historical low against the euro last week, the Fed added the word "yet" to its pronouncement on interest rates. Here's what the meaning of yet is: "we want a cheap dollar but we want it to play out over months, not days or weeks."

 Check out the price of copper, or scrap metal, or oil, or gold or just about any other commodity.  In the face of these upward inflationary pressures the Fed should be pushing rates up further.  The only thing other than the combined wills of the Chinese, Japanese and Saudi national corporations that has kept the dollar up against these overwhelming deficit numbers has been, as we said, the lure of relatively high US interest rates. Whether its this month or next, the Fed is going to "pause' in its course to raise rates. When they pause, private money, the majority portion not controlled by the central bankers around the world, anticipating a falling dollar will have to look around for better deals. 

After all, countries can lend money at a loss to meet larger national goals but private foreign money won't stand for, say, 10-20% depreciation on T-paper paying 5%.  Smart money in the US will also start looking abroad for shelters against a falling dollar further pushing the dollar down. The Fed won't intervene because cheaper dollars will automatically lower in real terms US debt while triggering yet another bubble of financial and trade activities for bankers, hedge funds and investors. Once again global corporations with ties in London, New York and Tokyo will be able to straddle the gaps pulling value wherever it can be best leveraged. Foreign profits will look particularly good on balance sheets as they get calculated back into cheap dollars. Corporations like Cargil, ADM, Boeing, John Deere will benefit from the competitive edge they get from the cheap dollar. The US stock markets will anticipate these paper profits and not fall too quickly, thinks the Fed.

Look for a cheap dollar bubble in a market near you. Expect ever higher commodity prices and eventually a budge in the price of Chinese goods upwards. It won't be a good time to travel abroad and we may see hoards of foreign tourists ready to take advantage of the bargains over here. Energy is going to go up, maybe close to the breaking point.  But even there, the Fed can't really mind.  After all, the public would never stand for a raise in taxes to discourage petroleum consumption but they can always blame the Saudis and Chavez for $4 a gallon petrol, or if that fails, all the politicians.

Posted by dymaxion at 06:00 PM

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