Not all economists agree that currency empires, like the one the dollar has enjoyed since 1973, end with a great inflation. Some investors, whom I respect a great deal, such as Bob Prechter and Gary Shilling, believe we’re actually headed for deflation whereby cash will be king.
But I can’t think of any example from history in which a currency empire ended with the currency in question actually gaining in purchasing power. When currencies fall apart, it usually means inflation.
For the record, looking at the world as a bull hunter, I think we’ll have both inflation and deflation in the coming years. For the financial assets such as most stocks, bonds, and real estate – prices will fall.
People won’t want to own paper. They’ll want to own stuff. For other things, such as commodities or certain kinds of stocks or currencies, there will be a lot more demand.
People will trade an asset falling in value, the dollar, for something that retains value much better. The Chinese have been doing just this – trading paper for real assets for the last two years. I call this ‘The Great Resource Grab.’
It’s safe to assume that Americans wouldn’t want to be in a situation where their cost of living doubled or, put another way, their money went half as far as it did the day before. In fact, I’d venture to say they’d do just about anything you could to avoid it. Once in that situation, there are few good choices. Prices are rising everywhere. The money in Americans’ wallets that they once thought was, say, as good as gold, turns out to be nothing more than pretty green paper.
This kind of inflation – where it takes more and more money to buy simple things – is a lot more common than you might think. The history books are full of disgraced currencies. It happened to the British pound sterling in 1931. Everyone thought that currency was unsinkable, too – until it sank. It happened to the German Reich mark as well. You can spend a whole hour in the money exhibit at the British Museum looking at pictures of once-valuable currencies that inflated away into worthlessness.
The truth is, currencies come and go only a little less frequently than governments. Good governments do everything they can to create a sound currency. A good government doesn’t spend more than it takes in through tax revenues. A good government makes sure tax rates are reasonable enough that reasonable people pay them instead of finding ways to avoid paying them.
You could say that a currency is basically a referendum on the economic health of a country. A country with sound finances and a healthy economy tends to have a sound, or strong, currency. Foreign investors want to own the currency because its value is stable. You can consistently exchange it for goods and services and get real value. Your money has purchasing power.
But if currencies are like beauty pageant contestants, as my friend Dr Steve Sjuggerud says, then the dollar is currently a big, fat pig with bright red lipstick.
Investor Doug Casey calls the dollar “the unbacked liability of a bankrupt government.” Jim Rogers says that the dollar is a “deeply flawed currency.” All of them are referring to the monstrous debts run up by the US government.
By now, you’re certain to have heard and read many other bearish statements about the dollar. But the question is, what can you do about it? When Germany experienced hyperinflation in the 1920s, there was little the average German could do, unless he or she owned wealth in some other form – silver dinnerware, for example, or gold jewellery, or even livestock that could be traded for essentials.
Today, the danger to the currency in question (the dollar) is just as great. But here’s the good news: You have far more ways to reduce your dollar threat and make a profit than any other investors in the world have had at a similar economic crisis point.
Right now, one of the biggest problems in the world happens to be the US dollar. Why is that? And, more important, what’s the solution?
In the years before the US government entered dire financial straits, investors used to want to buy its bonds. In fact, some people – notably, Japanese and Chinese central bankers – still do. But more and more investors around the world are beginning to doubt that the US government can keep the trillions of dollars in promises it has made. Those ugly debts and deficits turn out to have real economic consequences. Deficits do matter.
The US government has made big dollar promises in the Social Security and Medicare programs (Medicare is the federal health insurance program for people age 65 and older and for individuals with disabilities). It’s also made trillions of dollar promises in the form of US bonds, Treasury bills, and Treasury notes held by investors all over the world. These bonds, bills, and notes pay an interest rate. Typically, because the US government has been considered such a low credit threat in the past (very little chance that Uncle Sam would default on his loans or go bankrupt), the interest rate on US government bonds has been lower than on the sovereign bonds issued by governments that are considered more risky.
Keep in mind that the bond is simply a loan you make to the government, which will be paid back with interest over a fixed period of time. As long as the government isn’t spending far more than it’s taking in through taxes, it doesn’t have to borrow too much. But when it makes big promises and spends more and more each year, it has to borrow more and more money. Another way of saying this is that investors have to lend the money to the US government for it to honour its promises to pay.
But what if those investors stop buying US bonds because they realize the US government can’t control its spending habits? What would happen to the dollar? More important, how would you know it was about to happen in time for you to do something about it?
The more I began to think about this question in the last three years, the more I realized I would have to have some way of knowing what investors thought about the quality of the US government’s debt. Did investors still think America’s Treasury bonds were the safest investment in the world? Or was news of America’s large deficits starting to give investors second thoughts? How could I measure what was going on?
To solve the problem, I invented a new indicator. It’s a trip wire of sorts. It tells me when the rest of the world is starting to get nervous about the credit quality of the US government. And here’s the important point: This is another way of telling me what the world thinks about the dollar.
The less investors like the dollar, the more they’re going to demand higher interest payments from the US government. If the interest rate on US bonds isn’t good enough to compensate for the dollar threat, investors will sell US bonds and buy someone else’s. If you could compare the interest rates on US bonds to the interest rates on bonds that are considered risky, you’d have a good idea of just how risky the US financial picture is and just how vulnerable the dollar is.
In short, to measure dollar threat, you’d need what I call a BEDspread. Once you had it, you’d know when to sell the dollar as it fell or buy it as it rallied.
As I mentioned earlier, US Treasury bonds are widely considered to be the safest investment in the world. The interest rate the government must pay on them reflects the perceived threat by market participants. The 30-year US bond currently yields about 4.67%. Uncle Sam is safe, so he doesn’t have to pay exorbitant rates of interest to borrow money from you, the government of Japan, or the central planners in Beijing.
On the other hand, so-called emerging market debt is perceived as much riskier. In this case, I’m talking about the government bonds of foreign countries like Mexico, Brazil, and Russia. Sometimes you’ll hear it called sovereign debt. Because
all of these governments have had trouble with both their economies and their currencies, they have to pay more to borrow. Their bonds pay investors a higher rate of interest.
The BEDspread – my invention for evaluating dollar threat – is a comparison between rates on US government debt and rates on emerging market debt. By the way, BED stands for ‘benchmark emerging market debt,’ which is a mouthful. I’ve called it BED for short and married it to spread, or the difference between the interest rate on US bonds and the interest rate on foreign bonds.
I should admit that the BEDspread is biased. As the world recognizes how weak the US government’s fiscal situation is, the BEDspread will converge. Uncle Sam will have to pay higher rates of interest to borrow.
Foreign governments will pay lower rates as the relative threats between their bonds and American bonds narrow.
In other words, American bonds will be recognized as risky.
The dollar will fall.
By Dan Denning for The Daily Reckoning.
Author of 2005’s best-selling The Bull Hunter (John Wiley & Sons), Dan Denning is the editor of Strategic Investment, one of the most respected ‘big-picture’ investment newsletters on the market. Dan is a former specialist in small-cap stocks, drawing on a network of global contacts. You can read more from Dan and many others at www.dailyreckoning.co.uk.
Category: Economics