Today’s lead headline on the Bloomberg Newswire reads, “Dollar Reaches 3-Year Low vs Euro as US Economy Sheds Jobs.” The dollar fell to $1.05 per euro this morning which is its weakest level since November 1999. The dollar was tagged again today when the Labor Department announced that the US economy lost 101,000 jobs in December, when economists were predicting that payrolls would rise by 20,000 jobs. As we move through 2003, these two issues should continue to dominate the headlines. In the end, 2003 will go down in the history books as a pivotal year for global currencies, especially the US dollar.
Inflation is not higher prices. Higher prices are the result of inflation. Inflation occurs when the supply of money is inflated. If you have a million dollars and a million widgets, each widget costs one dollar. If the supply of money is increased by $500,000, you now have $1.5 million and the same million widgets. Each widget will eventually cost $1.50, but it takes six to nine months for the new supply of money to trickle down through the system. In the meantime, the government created the new money and they get to spend it first, by buying widgets at $1.00 each. After the new money works its way through the system, it simply takes more money to buy the same goods.
I like to ask people a few simple questions. What is money? What is the best kind of money? Can anyone tell me what a dollar is? Can you define a dollar? First of all, they are not US dollars as defined by our forefathers. They are Federal Reserve Notes, which have no definition. There are two primary characteristics that money must fulfill. Money is used to facilitate the exchange of goods and services, and money should serve as a storehouse of value. Our money has worked well to facilitate trade, but it has done a horrible job in serving as a storehouse of value. Since its inception, the dollar has lost 95% of its purchasing power.
According to credit analyst Doug Noland, over the last two years the M-3 money supply has ballooned an historic $1.46 trillion, or almost 21%. That’s a huge number. As you can see from the graph above, the excess money creation over the last two years is now taking its toll on the purchasing power of the US dollar. How can it be that the money supply has grown by 21% but we keep hearing of inflation in the 1-3% range? Where is the rest of it going? The simplest explanation is that the Fed must create new money faster than money is being destroyed via debt defaults and stock market losses. If they don’t inflate we go into deflation and our current monetary system of fractional reserve banking will implode with deflation. In deflation there wouldn’t be enough money in circulation to pay all the outstanding debts.
Gold and The Dollar
Back in the sixties the government inflated the supply of money to finance the war in Vietnam. Through the late sixties the French recognized the monetary inflation of the United States and based on the Bretton Woods Agreement, they exchanged their dollars for gold at $35 per ounce. At Bretton Woods, we told the rest of the world that everyone could use the US dollar as the world’s reserve currency and that the US government would be responsible to not create more money than could be backed by gold. Per the Bretton Woods Agreement, the US had to either reduce the amount of dollars in circulation or break the ties from gold. After the French emptied half of Fort Knox, President Nixon decided to continue with the monetary inflation and break all ties to gold in 1971. The dollar went into a tailspin and before it was over, our policy makers had to raise interest rates above 20% to bring confidence back to the dollar. At the time, Americans were saving about ten percent of their income and debt levels were nothing compared to today. I shudder to think what 20% interest rates would do today. Shortly after that the world transitioned from a fixed exchange rate system to floating exchange rates between currencies.
Different Inflation Than The 1970’s
After the monetary inflation of the sixties, the excess money creation caused the price of consumer goods to go through the roof. That is what most people think of as inflation. This time around it is different. The excess money creation of the nineties (enormous by all historical standards) resulted in higher prices for financial assets. While Alan Greenspan warned of “irrational exuberance” he provided the necessary fuel to send the stock market into the blow-off phase. After three years of stock market declines, we are still witnessing the bust in financial assets subsequent to the credit induced boom. Wealth can not be created by borrowing and printing money. What concerns me now is the fact that we are trying to fix our economic problems with the very same tools that created the problems in the first place.
Here are a few graphs to ponder as we look to see the effects of a falling dollar. To the question above, “What is the best kind of money?” it sure looks like the euro has been a better money than the US dollar over the last year. How about gold? Is it money? While it is not used much to facilitate trade, it has done a much better job than the dollar as a storehouse of value.
CHART SHOULD BE HERE
Chart source: www.stockcharts.com
Remember that ALL fiat currencies (no exception) have failed and gone to zero value. We are now on our fourth currency here in the USA. It would not surprise me one bit if we are in fact on our way to a new US dollar (with pastel colored inks) sometime in the next year or two. We shall see if today’s financial engineering via derivatives is enough to save our current system. It sure is obvious to many observers that the markets are being propped-up with intervention. We see the “flagpole” rallies in the stock market, a floor on long bonds with Fed intervention to monetize keeping interest rates artificially low, and currency operations to keep the dollar from tumbling too fast too soon. Let’s see how long they can keep it alive.
Pimco’s Paul McCulley Says.. . Paul McCulley manages many, many billions of dollars for Pimco’s bond funds and is highly respected on the Street. Mr. McCulley explains it this way, “Over thirty years ago, America was forced to bust up the Bretton Woods arrangements, because America didn’t want to deflate sufficiently to keep gold from rising above $35 an ounce. Today, just the opposite problem exists: America needs to inflate the money stock, while devaluing it against gold, so as to keep private sector debt obligations from sinking into a deflationary abyss. And the world needs the same thing: a broad based, wholesale devaluation of all paper currencies versus a basket of globally-traded ‘stuff’.” It seems strange to hear one of our country’s biggest bond gurus calling for devaluation. Note that he is suggesting a broad based devaluation of all paper currencies. If all currencies are devalued proportionately, there is really no net difference.
The US needs to devalue to fix the trade deficit and the current account deficit. At the same time, Japan needs to devalue in order to jump-start their export driven economy. During the Holidays, Japanese Finance Minister Masajuro Shiokawa said that they would need the yen to weaken to 150 yen to the dollar (trading about 124 at the time). Instead of that happening, the yen recently strengthened to 119 yen per dollar. Ooops! Not good for Japan. On Tuesday this week Mr. Shiokawa said that a “stable” rate for the yen would be 125 per dollar, about 4% weaker than present. It sounds like someone got to Mr. Shiokawa and told him no way at 150 (We can’t fix U.S. trade balance at that level.), so now he’s happy to settle at 125. He is basically saying that if the yen strengthens against the dollar, then Japan is in big trouble. In the meantime, the European Union decided this week to keep their interest rates unchanged, which should continue to attract global capital to the Eurozone and keep the dollar under pressure.
Big Picture: Strategic Portfolio Adjustments
Last year the debate raged on as to whether we would see inflation or deflation. Over the last two years I have been using a highly sophisticated investment strategy—you can’t have your cake and eat it too. To translate, my asset allocation was roughly half to short the overall market and half to go long commodities and precious metals. I won on both ends, but I am now re-thinking the strategy. If inflation, the precious metals take off, if deflation, the market goes down. It has served me well, but it now looks like they will pull all the strings to inflate, inflate, and inflate more!! On November 13th Alan Greenspan said, “There’s virtually no meaningful limit to what we could inject into the system were that necessary.” After that Fed Governor Ben Bernanke offered his dissertation on the use of the printing press to fix our money problems.
I am shifting more of my allocation in favor of inflation. This gold bull market is for real. This is a global event. They can devalue all of the paper currencies, but how can they devalue gold? Gold will not go into default like paper instruments, it can’t!! If all currencies devalue around the globe, gold is going through the roof. Japanese investors have been all over it, China just legalized gold ownership for its citizens, the Arab world is working on the gold-backed Dinar, Russia has made gold coins available to their citizens as an alternative to US cash dollars, and the Europeans have been savvy gold investors for centuries. The gold bull is for real, and with a hard floor at $330 with the recent breakout, I don’t see a whole lot of risk in the current inflationary environment.
Let’s Subsidize Everything!
It is obvious that the economy is not as strong as the talking heads on Wall Street would like to think. If things were so good, why would President Bush go to such extremes with his economic package? I read it like this: The Federal Government gives tax money back to the consumer and says, be sure to spend it. Then they offer incentives to investors to help prop up an ailing stock market. Some economists estimate that the elimination of income tax on dividends would pop the stock market by about ten percent. The Fed will continue to support bond prices to keep interest rates low (call that monetization of the long bond). Now if consumers keep spending money they don’t have, investors keep stocks up with tax incentives, and the Feds keep the bond market up, I guess it will be up to foreigners to keep supporting the US dollar. It all sounds like a disaster is waiting to happen in the currency markets. Indeed, 2003 will be the “Year of the Global Currency Wars.”
There is already enough fear out there in Investmentland, I don’t want to be reckless in pushing the fear button. I am optimistic because the portfolios are diversified for protection. I can only think of one way to end this gracefully, and specifically with regard to what is happening to our economy and the US dollar: “The prudent see danger and take refuge, but the simple keep going and suffer for it.” (Proverbs 27:12)
