Thursday, June 11, 2009

The Dollar Conundrum: Poison or Cure?

Either the dollar is defended with high interest rates or it will collapse under the tsunami of debt/money expansion. If it collapses then the cost of imports will skyrocket. Either way, the credit-addicted U.S. economy will implode.

The choice just ahead is stark: either passively watch the dollar collapse as the tsunami of money expansion and Federal borrowing slams it or start defending it with much higher interest rates. Either way, the credit-dependent U.S. economy will be unable to borrow freely at low cost from the rest of the world.

The blogosphere is chockful of reports documenting our trading partners' not-so-subtle stampede to the dollar exit--is there any mystery here? None whatsoever. Even a so-called reserve currency like the dollar responds to supply and demand: as the Fed pushes money expansion up by 100% (you've seen the hockey-stick charts by now) and the U.S. Treasury borrows trillions of dollars to fund a widening deficit and various trillion-dollar bailouts of failed and/or fraud-filled/looted industries, then this burgeoning supply overwhelms demand, pushing down the value.

There is a positive feedback loop strengthening here. The more the dollar falls in value against other currencies, oil and gold, the greater the pressure on non-U.S. holders of dollars to dump their bucks before they fall even lower in value. This selling further lowers the value of the dollar, triggering even more angst/panic/pressure to dump/sell dollars.

How low will this feedback loop push the dollar? There are various technical analysis-based guesses or projections, but I am guessing just on fundamental issues that a fall of 50% would be a good start to re-align the dollar with its fundamentals (lousy and getting worse).

So what happens to the cost of imports like oil when the dollar falls in half? They double. So even if oil remained at current levels when priced in yen, euros or gold, it could be $150 per barrel to those of us paid (or holding) dollars.

It doesn't take much imagination to reckon the damage that doubling would do to the energy-profligate U.S. economy. Just recall last summer when gasoline hit $4.50 and then go on from there.

It also doesn't take much to imagine what a doubling of import prices would do to the sales of imports. They would decline if for no other reason than fewer people could afford them. The loss of sales to those who depend on exports to the U.S. to generate surpluses in their own economies would be severely negative.

Now cheerleaders will note that such a staggering depreciation of the dollar would make U.S.-based manufacturing suddenly look attractive in comparison to suddenly-costly overseas production. But you can't just swap out factories and relocate entire supply chains; that takes time.

Such a pronounced decline in the dollar's value would devastate the bond and T-bill market as everyone fled the dollar; this would trigger a catastrophic drop in the value of every existing bond and basically evaporate the U.S. Treasury's ability to sell more debt or even roll over existing government debt. At that point the U.S. government would actually not only have to live within its means (spend no more than revenues) but it would have to pay off bonds as they came due--that is, spend considerably less than revenues.

The same of course would be true for corporate bonds, new home mortgages, etc. All U.S. debt would drop 50% in value and become increasingly illiquid as fewer and fewer investors will be willing to gamble on its future purchasing power.

For a credit/debt-based economy, the inability to float new debt and roll over old debt would be cataclysmic.

The only way out of the crisis (and indeed the only way to stave it off beforehand) would be to raise interest rates to such a high level that dollar-denominated debt would become attractive. This is not without historic precedent; buyers of long-term T-bills in late 1981 earned a 16% return.

What happens if the interest rate on T-bills and other debt jumps to 10%? Mortgage rates jump to 12%. And what would that do to real estate valuations? Since buyers can only afford X per month, then as interest costs doubles, the mortgage valuation (and the value of the underlying property) has to fall in half.

So right as standard-issue financial pundits (SIFPs) like the execrable Jim Cramer are announcing the bottom in housing, house prices could fall in half from current levels. Can't happen? Don't bet on it.

If interest rates doubled or tripled, that would eviscerate every sector of the economy which depends on credit--which means, well, all of them, but especially autos and real estate. With their collateral (house) worth half of its already diminished 2009 valuation, the average middle class household would be unable to support any new debt.

Oh, and let's not forget what happens to equity markets when interest rates double: they crash. Why take a chance on risky stocks when you can get 10% on a "safe" T-bill? And so there is another body-blow to household equity/collateral: everyone's 401K, IRA and other equity holdings will be smashed.

In the last bout of higher interest rates (for different reasons) in the 1970s, stocks (adjusted for inflation) lost fully 2/3 of their value. We would be foolish to expect anything less severe if the dollar crashes and interest rates double to defend what's left of the currency's purchasing power.

No economy can support stupendous imbalances in trade and capital flows forever. The book The Dollar Crisis: Causes, Consequences, Cures does a good job of explaining why.

So the choice is stark: either drink the poison of a dollar falling in half and the subsequent collapse of the bond and credit markets, or double interest rates and drink the poison of a collapse in the value of existing bonds and the strangulation of the housing market via high interest rates.

Either way, the value of existing bonds will be destroyed. Either way, the credit-dependent U.S. economy finds itself without the ability to palm off dollars on "marks" for absurdly low rates of return. The only question is: what end-state will we choose? One in which the dollar is essentially destroyed as a store of value, or one in which we face reality and start paying a high enough return to salvage what's left of its value?

Yes, that will destroy easy, low-cost credit, and every sector which depends on it. But at least savings, incomes and assets will be conserved and not destroyed along with the dollar. The first poison (complete destruction of the dollar) is fatal; the second (raising rates to defend the dollar) is painful and wrenching, but ultimately positive. For much higher rates would rid the economy of its multiple destructive imbalances and disincentives; it would be the equivalent of a chemotherapy treatment from which the patient (the U.S. economy) emerges stronger and healthier. As the book recommended above phrased it, a "cure" is available, and it's called much higher rates of return.

A few classics in case you missed them:

The Long Emergency: Surviving the End of Oil, Climate Change, and Other Converging Catastrophes of the Twenty-First Century James Howard Kunstler

The Future of Life E.O. Wilson

Globalization and Its Discontents Joseph Stiglitz

On Peak Oil:

Beyond Oil: The View from Hubbert's Peak

The Party's Over: Oil, War and the Fate of Industrial Societies

The End of Oil: On the Edge of a Perilous New World

Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy

On chemical/toxins overload:

Our Stolen Future: How We Are Threatening Our Fertility, Intelligence and Survival

On the demographic time bomb about to explode:

Fewer: How the New Demography of Depopulation Will Shape Our Future

The Coming Generational Storm: What You Need to Know about America's Economic Future

On collapse of advanced civilization:

Collapse: How Societies Choose to Fail or Succeed (Jared Diamond)

The Collapse of Complex Societies

A realistic appraisal of alternative energy:

Sustainable Energy - Without the Hot Air

Our previous lists of hot reading and viewing can be found at Books and Films.

Of Two Minds is now available via Kindle: Of Two Minds blog-Kindle

Of Two Minds reader forum (hosted offsite, reader moderated)

Thank you, Alberto R. ($20), for your continuing generosity to this site in money, ideas, and encouragement. I am greatly honored by your support and readership.

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