Mike Whitney Uruknet 6/2/06

The great dollar sell-off has begun in earnest, although to a large extent, it is being concealed from the public.

That’s okay. After all, wary currency traders have been expecting a dollar-slide for months but were nervous about the prospects of widespread panic. Everyone from Bill Gates to Paul Volcker has predicted that the current trade deficit of $800 billion (7% of GDP) is unsustainable and would result in a weaker dollar. So, it is only natural that China, Japan and other foreign nations that normally load up on greenbacks would begin to cut back on their purchases. The danger to the United States, however, is extreme. If the transition is not carried out skillfully, it could precipitate a run on the dollar and trigger economic pandemonium. No one wants to see the global-economic giant pirouetting through the ether in flames. By the same token, no one wants to be the last man holding onto stockpiles of scrip that are diminishing in value.

The delicacy of the situation explains the sudden appointment of Henry Paulson as Treasury Secretary. Paulson is a brainy insider who has the bone-fides to manage a very tricky “retreat” from the dollar. America’s economic future will depend heavily on his ability to steer the ship of state through troubled waters.

As we already noted, there was no doubt that China, Japan and others would eventually reduce their dollar-holdings as America’s debt continued to mount. What is surprising though, is that a sell off did not occur earlier when Bush enshrined his reckless tax cuts and profligate spending as “permanent”. The administration’s commitment to live beyond its means has never been in doubt. The greenback will pay a heavy price for Bush’s lack of discipline.

Of course, Bush is not the main scoundrel in this morality play. The Federal Reserve has seriously undermined the currency by engineering one monetary-coup after another. Greenspan’s “cheap money” policy has produced massive equity bubbles that naturally appear whenever interest rates are absurdly low. When the stock market bubble crashed in the late 90s, millions of working class people lost their retirement and life savings overnight, while wealthy insiders walked away unscathed. Undaunted by the economic carnage he produced, Greenspan again lowered interest rates to a ridiculous 1% in 2001 which created a $9 trillion housing bubble, “the largest equity bubble of all time” (says “The Economist”). Now, as interest rates inch higher, the housing industry is lumbering towards the power-lines and certain death. The effects on the world economy are incalculable.

Under Greenspan, the money supply expanded at an unbelievable rate. “From 1982 to 1992, it went from a “modest” 8% year-on-year expansion. However, from 1992 to 2002 it moved into overdrive with the deregulation of global markets with a year-on-year expansion of more than 12%. Since the 2002 post 9/11 crash, the money supply has been expanding at greater than 15%”; more than doubling in less than a decade. (“Fiat and Credit” Nigel Maund)

Now there are signs that foreign lenders have had enough of the weakening currency and are reducing their stockpiles of greenbacks and dollar-denominated securities. The Gold Forecaster reports in its recent article “The US Dollar and its Prospects”:

“Last month saw the U.K. and Caribbean Banks buy a disproportionately large amount of U.S. Treasury assets. It appears that this is part of an international dollar liquidity management program. If this is correct the two centers will buy even more from now on, as other foreigners reduce their purchases of the U.S.dollar.”

This means that China and Japan have begun to reduce their purchases of US Treasuries but, surprisingly, some mysterious third party has begun to pick up the slack?

And, who would that be? Who is crazy enough to increase their dollar-holdings when everyone expects the dollar will decrease in value?

What appears to be taking place is the Bush administration or the Federal Reserve is actually purchasing its own debt to control the rate at which the dollar declines. It’s a good strategy, but it can’t last forever.

If the dollar began to nosedive, then central banks around the world will quickly ditch the dollar and ignite a global-economic firestorm. By purchasing its own debt, the US hopes to engineer a “soft landing” and maintain its status as the world’s “reserve currency”.

As the world’s reserve currency, the Federal Reserve can simply print money which the rest of the world accepts as payment for goods and resources. There’s no better business on earth. As one admiring currency-trader said, “It’s like having a mint in your own backyard.”

The system was put in place after the vast devastation of World War 2 and has made the Federal Reserve the de-facto steward of the global economic system. Nearly 70% of the reserves in foreign central banks are either dollars or dollar-denominated securities. This is as close to a monopoly as possible.

We are seeing the greatest fiat-money experiment in history. The awesome power of the greenback extends to all markets, and yet, is completely disconnected from the traditional means of measuring value, like the gold standard.

It’s clear that the Bush administration believes that the dollar will maintain its lofty perch if they are able to control the vast oil resources in the Middle East. Then, foreign countries would be forced to use the dollar, (despite its $8.4 trillion in debt) to purchase their oil. We should anticipate that the dollar’s value will be increasingly linked to oil, and that its future will depend to a large extent on the military’s success in pacifying Iraq. (and Iran) Needless to say, the results are far from certain.

But, even if the administration’s plans in the Middle East succeed, there’re stormy times ahead for the greenback. The US has reached an unsustainable level of debt in government, business and personal finances. Gigantic mortgages and credit card debt are nearly as striking as the nation’s mammoth trade deficits. The entire country is mired in swamp of red ink for which there is no easy remedy.

James Shepherd, President of JAS MTS Inc. puts it this way:

“A perfect storm is developing and much of this danger has to do with debt. …When a saturation point of debt and leverage is reached, even a minor dislocation can cause a dramatic collapse….Debtors are always punished more severely in a declining economy because, as activity subsides, they are less able to service their debt and the value of the assets that have collateralized are also falling. Once those that own real estate realize that their neighbors cannot service their mortgages and are forced to sell at almost any price, thereby driving down the perceived value of their own property, the conditions necessary for a full-fledged debt-driven meltdown will be in place… a severe recession – is about to sweep over the landscape and blow away those who are not prepared.”

The predictions of Warren Buffett, Chairman of Berkshire Hathaway, are equally sobering:

“There are deep-rooted structural problems that will cause America to continue to run a huge current-account deficit unless trade policies either change materially or the dollar declines by a degree that could prove unsettling to financial markets. Indeed, without policy changes, currency markets could become disorderly and generate spill-over effects, both political and financial.” (Quotes form Dudley Baker, “Ominous Warnings and Dire Predictions of World’s Financial Experts”)

“Could the falling dollar lead to “political turmoil”, as Buffet suggests?

The Organization for Economic Cooperation (O.E.C.D.) has joined skeptics at the IMF in predicting that the dollar will fall by 35% to 50% in order to balance current account deficits. These are modest predictions given the enormous amount of debt the US has accumulated in just the last 6 years. ($3 trillion) Consider how life for the average American will change when gas is $6 per gallon rather than $3; when groceries skyrocket to twice their normal price, and when life-savings are cut in half overnight.

The greenback is now facing its greatest challenge due to its massive account imbalances, reckless mismanagement, and erosion in confidence. The only way the dollar can slow its downward slide is by maintaining its stranglehold on the oil trade. Currently, oil is sold exclusively in dollars which allows the US to float trillions of greenbacks through the system without fear of them being cashed in the short term. Unfortunately, there’s rebellion among the vassals. Iran (5.4% daily world oil output) Venezuela (5.2% daily world oil output) and Russia (15.3% daily world oil output) are all threatening to abandon the dollar in their oil transactions which would send hundreds of billions of dollars back to the US and plunge the country headlong into a deep recession. If this mutiny succeeds, the dollar will vanish in a poof of black smoke.

No More M-3

The Bush administration and their co-conspirators at the Federal Reserve have added to the suspicion surrounding the dollar by removing all the reliable data on its value. In late March, 2006 the Fed ceased publishing the M-3, the indicator of how many dollars are in circulation. That doesn’t mean they stopped calculating it for themselves; only that the public is prevented from knowing what is going on. Eventually this lack of transparency will be disastrous for the dollar, as the use of money is predicated on confidence. By making their activities as opaque as possible, the Federal Reserve is just adding to the nervousness in the markets and a loss of faith in the economy. America’s biggest lenders in Europe and Asia are now expected to calculate the real value of the dollar for themselves, because the statistical information they need has been purposely removed from the public record.

That does not inspire confidence.

How long will countries loan money to a nation that takes a “trust me” attitude, especially since no US government has ever been more widely distrusted than the Bush administration. The removal of the M-3 may seem like a clever, short-term idea to disguise the machinations of the Fed, but over time it will be seen as a costly mistake.

Paulson to the Rescue

Newly-appointed Treasury Secretary Henry Paulson has been given the impossible task of closing ranks with the Federal Reserve and micro-managing an “orderly devaluation” of the dollar. The fear is that a “sudden disorderly adjustment” will precipitate a run on the dollar; leaving markets in a swoon and sending the dollar through the floor. Regrettably, there are no easy choices; the dollar is going down. The accumulated weight of unfunded tax cuts, extravagant military expenditures, personal debt, and global trade imbalances have taken a wrecking-ball to the greenback and left little room for hope. Paulson’s job is to turn the dollar’s demise into a “controlled demolition” rather than a full-system meltdown.