It's all about the dollar

National Inflation Association just produced an excellent video called "The Dollar Bubble." I'm listening it a second time as I write. It's 30 minutes but well worth the time.

The most compelling factoid I extracted was the fact that Cash for Clunkers was actually a Chinese program! (Mike Kim at 13:00; see video from 12:20) Repeated in the NIA's video was Peter Schiff's claim from a Philadelphia speech that the "Clunkers" had their engines destroyed by acid as a condition of their trade in.

Well, turns out the Chinese melted down on the vehicles. They'd been unwilling to accept our dollars--intrinsically worthless pieces of paper they are.

The Chinese aren't alone in their disdain for the dollar. The abandonment of the dollar has branched out into other countries. The Dollar Bubble video explains that Brazil no longer accepts US dollars for its rice.

It's worth mentioning that Brazil has aligned its currency to that of Russia and China, which are part of the Shanghai Cooperation Organization, a world order alternative to Anglo-American domination. This affiliation and coordinated action on dollar divestment indicates that there's a strong political agenda running alongside the economic imperatives traditionally associated with international finance, a consensus managed out of Washington and London.

The upstarts China and Russia, joined by Brazil and India into the BRIC consortium, intend to offer an alternative to the dollar's hegemony. These rising powers don't want to have to use dollars, not because they're riskier necessarily, but rather because having to execute their international transactions in dollars gives the US a big strategic advantage. The Indians recently converted billions in dollars to gold, which is historically (post-1913) a far steadier store of value.

The NIA video explains how the Chinese are promoting silver as a better store of value. The gold-silver exchange rate leans heavily in gold's favor, indicating that perhaps silver may have farther to go. Though I'm not an investment adviser, I have explained that I believe silver is a good investment. As a matter of fact, my meager portfolio contains mostly silver. (A diversified, long-term investment portfolio should contain no more than 10-15% precious metals.)

The idea is that precious metals are safer than dollars, but metals are volatile. As a matter of fact, they declined precipitously last fall. I'd be caught surprised by thinking that gold and silver would be considered safe havens, and that their value would at least stay steady. But gold and silver are really hedges against inflation. With no inflation on the radar at that point, the metals had no reason to rally--if anything the crisis created disinflation.

Tens of trillions in stock and home equity were crushed, meaning monetary deposits shrank in value. It's not printing up the money that represents inflation, but rather its velocity, how much it circulates. Since then, bank lending has dried up, decreasing the velocity of money.

From Yahoo/techticker comes the video interview of Mark Dow (Pharo hedge fund) summarized neatly that the supply of dollars in circulation has been actually falling. Banks have been content to sit atop their cash hordes and avoid risks associated with lending, particularly in a recession.

Hedge fund manager Dow explains that demand for dollars went up last fall. This was despite the large increases in supply as the Federal Reserve tried to stabilize the financial markets and flooded them with liquidity.

Much has been said about the impending hyperinflation caused by too much printing of dollars, but we've discovered how the dollars don't cause inflation if they're not spent. In the past, I've explained this by saying how petrodollars, typically sit in vaults, unspent and thus not contributing to inflation.

The monetary systems are flush with dollars, but the demand for dollars is low. People just don't want them. Now government spending might be a different story. The more money spent by government, the more our economy grows.

Blame the war mongers

Spending is the source of inflation, not just the act of printing money. Wars are incredibly expensive, and represent the biggest long-term contributor to inflation. As two historical examples, look to the post-World War I environment for Germany's inflation (caused by war reparations rather than direct war spending), then in the 1970s with the huge debt burden associated with the Vietnam War.

Now there's much debate about how government spending causes inflation. I ascribe to the simple belief that spending on military hardware and government-run programs typically produces the most inflation. Right-wingers would argue the entitlements do more to drive up prices. They may be right: Medicare costs have risen dramatically. But the so-called "discretionaries" only make up 1/6th of government spending (according to The Economist article below), so as a inflation multiplier, they can only do so much harm. Combined with military entitlements like VA health benefits, at as much as 1/2 our budget, total government spending on our wars past and present will cause far more inflation.

No matter how much social spending causes inflation, it's clear there the benefits of spending migrate down to the lowest income tiers, which serves a societal good. Not so true with military equipment, although Right-leaning economists (who are frequently ultra-nationalist/militarist) will argue that high-paying jobs associated with the Defense Establishment offer stability in employment.

In my opinion, there's little difference between a factory that relies on big government contracts and a company owned and run by government. It's the same hand--the taxpayers', or to be more accurate, future taxpayers'--that feeds both. In time, both the government-run bureaucracy and the corporate entity that subsists on government contracts will grow less efficient than private sector companies, which must compete.

Wars--and the inefficient contract system they support--are perhaps the best example of government bloat. I'd argue the military spending is a back-door entitlement for the wealthy who invest in the MIL-IND companies, in a quid pro quo with politicians to whom they donate campaign contributions.

Profiteering during war is typical. It motivates a continuance of hostilities. Militarism and apparently ceaseless adventurism will inevitably result in inflation.

The Right-wing is mollified with ultra-nationalist themes as the war machine and the State grow. In regard to military spending, Right-wingers are growing the size of government, a trend which they vociferously oppose when it comes to health care. Without wars' patriotic/ultranationalist accompaniment, those on the Right would question the economic benefits of increased government spending.

Article Spotlight

I just read a good piece on the falling dollar in Nov 21st issue of The Economist, titled "Dealing with America's fiscal hole."

The Economist article compares America's debt relative to its GDP. Currently publicly held federal debt constitutes 44% of GDP and will double in the next decade, according to the article. We're not alone--Japan's debt is bigger than ours relative to its GDP.

Rather than sound an alarm as so many Web-based sources seem prone to do, The Economist expresses concern, particularly over "uncertainty over how taxes may be raised to shrink deficits..." The English magazine advocates reducing the deficit. It makes the valid point that income is taxed heavily in the US, while consumption is not. The Europeans, among others, have adopted a VAT tax that makes goods more expensive.

If adopted in the US, a VAT would reduce demand. Up to now, traditional American economic policy emphasizes increased spending and consumption. By raising prices, a VAT would encourage the opposite. Worse, the VAT would be implemented alongside regular income taxes, meaning Americans would have to pay more to buy things, and thereby probably buy less, not necessarily a bad thing unless you have to work in one of the industries dependent on consumers' discretionary demand.

Historically, one of the worst taxes ever imposed was by George Bush Sr. on yachts and luxury goods back in 1990 or so. Turns out a good chunk of the American economy depends on the consumption patterns of the rich. The people building yachts weren't rich but felt the taxes' impact as fewer rich people bought yachts. Needless to say, the tax was later discarded, as was Bush I.

The Economist article acknowledges that a VAT "could too easily become a politically convenient way to vacuum up more money and expend government."

As we're not in an immediate crisis, it may be extremely tempting to relegate a solution to the growing deficits to a later point, especially considering the impact hasn't been felt. This procrastination is after all what's gotten us to the situation we're now in.

Representative Obey (D-Wis.) did suggest a war tax recently as a means to pay for all this. It would be nice to see the war expenditures manifest as a direct tax, to give war supporters an idea of how much their wars cost. I suspect much of the outward rah-rah/support for these wars would die down, at least among those who shouldered the burden, should a war tax be implemented.

One reason we haven't felt the grip of increased government borrowing is the fact interest rates are so low and thus interest payments not so hard to cover. Demand for US government-issued debt remains high despite the low rates, probably due to the risk associated with owning debt from other issuers, or holding equities. In this respect, the credit crisis of last year and ongoing instability serve the interest of government by making debt highly marketable on a risk-adjusted basis.

The Economist article brings up worries over rising interest rates, which could easily push the total amount of US government spending on interest alone to $700 billion a year by 2019, according to a Congressional Budget Office report.

The CBO report makes a point to compare Obama's budget and forecast revenues with CBO's. As you might expect, the differences between the two projections grow over time. The reason: politics often subject economic facts to a wide range of interpretation.

The source of the disparities isn't based on politics alone, despite politics' predilection for twisting data to serve specific political aims. If 99 economists were to look at the same numbers, there'd probably be 99 different conclusions drawn; that's the nature of economics--it's not nearly as exact as is thought.

Over the next ten years, the CBO anticipates the annual deficit to be two to three times higher than the President's projected budgets. Either our government will spend a lot more than Obama's people have projected, or revenues will be lower, or both.

Rather than dive into the numbers, I'm content with the conclusion that we will owe far more than we will be able to pay off. We'll have no choice but to let the dollar deflate. We do this by simply printing up what we owe--monetizing the debt. Holders of dollar-denominated debt will suffer, although in nominal terms the inflation will increase the amount of dollars they hold.

It's just like the analogy of $1 million dollar being air-dropped to every person in America. People would be overjoyed initially by the wads of hundreds that floated down from the skies like mana from heaven. Before the recipients could spend their money, stores would have jacked up their prices. And if you were one of the poor folks who'd invested and saved (behaviors our consumption-driven government has never rewarded), you'd be robbed since the new dollars would make the old dollars worth a heckuva lot less.

Showering people with government spending is hardly a solution. It might cause a immediate pop in the polls, but only because many people don't understand how inflation affects them. By the time a second or third shower of dollars came down, the money would be wallpaper.

Problems ahead

As much as we'd like to think the dollar's decline won't affect us, we can't escape the inevitable consequences of fiat money. Invariably such currencies decline in value. Our dollar buys now only 5 cents of what it could in 1913, the year the Federal Reserve began and debasement began in earnest.
Yet for as long as the government can borrow, it will. So understanding the macroeconomic environment is essential in determining the point at which the monetary system will break down. It's not too different from a huge Ponzi scheme--make it a point to withdraw your investment before the herd comes for theirs', which will have been spent.

In time, the government will enter into direct competition with the private sector. The rules of the game favor government--largely because it can simply print up what it owes. However one consequence of irresponsible fiscal management is that people will move to barter and alternative stores of value. In this regard government can't function in a vacuum; it must maintain the stability of the monetary base on which the private sector depends.

One area where the real economy can suffer is when the cost of borrowing rises. Crowding out is a phenomena where investors plow money into government debt instead of that issued by corporations. Right now, we don't have crowding out, but if foreign creditors demand more interest from our government, that wil mean private corporations will have a much harder time finding the money they need to grow. In a downward spiral, less growth in turn means fewer jobs, a weaker economy, and a lower tax base, which will force the government to borrow more, cut spending, or just print money.

Borrowing through the issuance of debt is easy to do now but as the financial stability of the United States government declines with growth in debt, creditors--largely foreign government sovereign wealth funds--will demand more interest.

It doesn't matter whether or not corporate debt is riskier at this point. Interest rates are relative. Government-issued debt is considered risk-free, though it really isn't: like any issuer of debt, governments are rated on their ability to repay. If tax receipts are rising, the government's ability to repay looks quite good. Therefore when an economy weakens, its fiscal strength weakens as tax receipts are down. The best example of this are local governments, many of whom have seen a dramatic decrease in tax revenues.

Unlike state and local governments, national ones can sell their debt based on the balance of payments--the net sum of exports of goods and services less imports. If a country exports a lot more than it imports, it will a mass a pile of currencies from the nations that purchase its exports.

China has massed a big pile of dollars. See this graph from mintlife, "Visualizing the US/China trade Relationship" to see how it works.

China can choose to hold or spend them on something like US government debt. Over time has done just this and over time assembled trillions of dollars in US Treasuries, in effect financing the US government's deficits.

Up 'til now, the Chinese appear to have been willing to receive nothing other than paper IOUs--which is what dollars essentially are--in exchange their investment. Then came the Cash for Clunkers, and the general migration away from dollar-denominated deposits. All of a sudden, the dollar wasn't good enough--we had to come up with something real, in this case vehicles for scrap steel.

By imposing payment demands on us, China is exercising an unprecedented level of clout. Chinese control over our national debt poses a threat to the independence of our foreign policy. If the Chinese think we should do something, they can pressure us by threatening to sell off our debt or simply not to buy more, which would force interest rates higher.

With the size of the Chinese dollar holdings, they'd be committing financial suicide to sell them, but they'd be hurting us as well. China couldn't sell off US bonds if it made its intentions to divest known. In a crisis, they'd be unable to sell dollar-denominated debt at all-no one would offer anything for them other than dollars. They could in the process decimate the value of US government-issued debt, although as the #1 hoarder of that debt, they'd suffer the most financial harm as a result.

The Chinese would also have to contend with rapid dollar devaluation, meaning they have to intervene massively, buying dollars, to prop up the fixed rate of exchange they have with it now. Rather than working at cross-purposes, selling dollar-denominated debt while buying the dollar, the Chinese would likely let their currency rise. This would greatly spike the price of Chinese imports, turning Wal-Mart into Tiffany's almost overnight.

Neither China nor the U.S. wants this kind of change. We're tied to each other at the hip. At the same time, the Chinese have made it clear that they're not willing to observe the status quo indefinitely.

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