Dealing With the Dollar

Dealing With the Dollar
by Dan Denning
The Daily Reckoning
London, England
Tuesday, May 30, 2006

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• The dollar is doomed to trade for the price of scrap paper...the Law of Limp...

• Flying into temptation - and then hobbling back to sanity...the ball and chain of private debt...

• One dedicated reader chases down a bus in Northern Virginia for us...why isn’t the Home Depot CEO back on paint mixing detail?...and more!

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Since we were born, right after World War II, the dollar has lost about 90% of its purchasing power. It will lose more value; the bias toward degeneration grows stronger.

Markets were closed yesterday. With nothing fresh in the news to entertain us, we entertain you with fresh tales of what occupies our mind these days - the decline and fall of the dollar.

Yesterday, we explained to you why this was inevitable. The Law of Limp, we said, shows that an institution invariably rushes into temptation on two strong legs, but hobbles back to prudence as though qualified for handicap parking.

This might seem to you, dear reader, a purely theoretical point. But it describes why the dollar is doomed to trade for the price of scrap paper, eventually.

The Fed is quick to loosen credit, and slow to tighten. Over time, this bias toward the quantity of paper money over the quality means that the dollar gradually weakens. The Law of Limp will make sure of it

The Law of Limp means that the government of the United States has a rendezvous - with destitution.

From a USA Today study of government debt:

"Americans' government obligations are five times what people owe for

mortgages, car loans, credit cards and other personal debt. The $57.8 trillion liability is the amount that government needs now, stashed away and earning interest, to generate enough cash to pay future obligations. The obligations are valued in today's dollars and come due as early as in a few days, when Treasury bills mature, to as long as 75 years for Social Security and Medicare.

“Like an unpaid credit card bill, the balance grows every year - about $25,000 per household annually.

“Taxpayer liabilities grew 20% in the past two years, 13% above the inflation rate.

“What's behind the increase:

“Medicare. The health care program for the elderly saw its long-term deficit grow $4.5 trillion from 2004. The causes: higher medical costs and an aging population. Not a factor: the new Medicare prescription drug benefit. It was included in the 2004 number.

“Social Security. The program's deficit for workers and beneficiaries already in the system grew $2.5 trillion over two years. Reason: Each generation gets benefits greater than the last, so the program automatically gets more out of balance every year.

“Government retirement benefits. Pension and retiree medical benefits for civil servants and military personnel are more generous than those for private-sector workers. But government has not set aside as much money as private companies to pay the costs.”

The Law of Limp tells us why debts are doomed to grow to such proportions. Like the Fed, the feds flew into temptation...and limped back to sanity only reluctantly, hesitantly and partially. They were quick to loosen the purse strings and slow to tighten them. Deficits were many; surpluses were few. The red numbers burgeoned; the black ones shrank. The feds ran over the budget to counteract the downturns in the business cycle, but they forgot to run under the budget to counteract the upturns. And so, the debt mounted up.

During the administration of George W. Bush alone, more debt has been added than during all the administrations put together since that of George Washington.

But wait a minute, you may be thinking, “Isn’t there a war on? Isn’t that the real reason debts have exploded? And doesn’t it make sense to pay the costs of fighting a war - no matter how great they may be - so that future generations may live in liberty?”

We have two answers to this: “no” and “it depends.”

But let us connect a few more dots before we answer so bluntly. An institution is a thing of nature. And like all creatures of nature, it ages...gracefully sometimes, comically and embarrassingly most of the time. As an institution ages, parasites, hustlers, and conmen cluster around it to take advantage - as if they were peddling magazine subscriptions door-to-door to old ladies.

One of the cons described above is the expansion of government spending in rough times. The theory was given to us by Keynes, an economist of surpassing intelligence and questionable sense. The practice of it is given to us by hack politicians. In theory, spending in bad times is offset by forbearance in good times. In practice, spending never stops, because there is no will to stop it, and because the programs, once put in place, persist out of sheer inertia.

As spending continues, the Law of Limp dictates that more and more people will develop infirmities. Government spending, designed to counteract a downturn in the private sector, results in more people employed by government and fewer by private business. Those people are not fired when the economy improves. No, they remain on the public payroll until the next downturn, when a new batch is added. In the private sector, meanwhile, a slump thins the ranks of productive citizens. In the public sector, it fattens them.

Of course, employees are not the only recipients of government gravy. Nor do they suddenly lose their appetites when the menu improves in the private sector. Medicare, Social Security, government pensions, government insurance programs, government contracts - all continue. Gradually, the economy accumulates more and more parasites, people who do not add to its productive output. As their numbers grows, so does the limp. That is to say, government becomes even more reluctant to cut spending, reduce subsidies, eliminate boondoggles or restrain mushrooming public debt. In Britain today, “44% of the electorate [are] either in the pay of or directly reliant on the state for their income,” reports the Fleet Street Letter. In Scotland, 51% of GDP is spent by the government. In Northern Ireland, the figure is 66%. We think of Britain as a dynamic, free-market country, but the recipients of government spending can control the outcome of every election. No wonder the nation limps.

But is America any better? According to the numbers from the Bureau of Economic Analysis, the government spends only about 20% of GDP in the United States. Unlike Britain and Europe, health and education expenses are counted as largely private in the United States and not included in the government budgets. But even they are heavily subsidized and regulated. Include all the spin-offs, contracts, and subsidies to businesses, and the numbers tell a different tale - the public is on the hook for an amount equal to four times GDP.

And Americans limp more than these numbers suggest. In addition to the public debt, they drag around the ball and chain of private debt. They might think they would prefer a stronger dollar and a balanced federal budget, but they can’t afford it. The Law of Limp guarantees that.

[Ed. Note: The falling dollar...soaring public and private debt...the demise of the American Empire - these subjects will all be central to the discussions at this year’s Agora Financial Wealth Symposium. You won’t want to miss this conference...taking place on July 25-28 in the Fairmont Hotel in Vancouver, B.C., we will have all of your favorite Agora Financial columnists - plus a few special guests! Save your spot today and you can still take advantage of the early bird discount. Click here for all the details:

Agora Financial Wealth Symposium - July 25-28, 2006 Vancouver, B.C. - Today is the Last Day for the Early Bird Discount!

And now, the news according to our currency counselor:

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Chuck Butler, reporting from the EverBank world-currency-trading desk in St. Louis...

“Could this be what Bush is looking for now? A change to the so-called strong-dollar policy? Only time will tell, but I can tell you this right here, right now: traders have long memories and have begun to trade the dollar.”

For the rest of this story, and for more insights into the currency markets, see today’s issue of

The Daily Pfennig

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Back to Bill Bonner...

*** One dear reader went to great lengths for us...

“I work in downtown D.C., and I always look forward to seeing your ads scattered throughout the District like gold specks in a sea of sludge,” he writes.

“However, it appears that Washington has been unable to contain your message within the city limits. Here's a shot of a bus at the Rosslyn Metro station in Virginia (gotta love cell phone cameras).

“Of course, the bus didn't stop in front of me, so I ended up chasing it a block down the street in order to get a decent snapshot. Initially I had some second thoughts, but after a few moments of hesitation, I decided to go for it. After all, at least I wasn't trying to park a U-Haul at the Capitol! So in addition to capturing a ‘priceless’ photo, I was also able to provide ad-hoc entertainment for my wife and several bystanders as I ran after the bus with outstretched phone in hand.

“Great job on the DR articles! You guys are living proof that concerned thinkers still exist in our society. The daily dose of sanity is a lifeline in a city where debt is wealth, lies are truth, and integrity is the lapdog of politics. Keep up the good work!

“P.S. Next time you're planning an excursion in downtown DC, give us readers more lead-time. I, for one, would certainly enjoy the opportunity to meet you guys and watch some of these escapades in person.”

[Ed. Note: To see this dedicated reader’s picture - and to learn about our journey to the “other side” last week, see here:

Welcome to Squanderville

*** Parasites, gamers, and swindlers - you find them all over the place in the degenerate phase - even at the head of major enterprises.

Somehow, Home Depot managed to miss the big upswing in the housing market. The New York Times reports that its share price has fallen 12% in the last five years, while its rival, Lowes, has gone up 173%. You’d think the board would have called in the CEO, Robert Nardelli, and kicked his derriere back to the paint department. Instead, his pals on the compensation committee decided he deserved to earn almost a quarter of a billion dollars over that five-year stretch.

*** Poor Joe Passarelli. The Palm Beach paper reports that he wakes up “anxious and sweaty” worrying about his real estate investments in Southern Florida. He’s knocked $55,000 off the asking price for his condo and still no takers.

“I was never much of an investor before this wild craze began, and somehow I backed into it,” he told a reporter. Now, he’s trying to figure out how to back out of it without getting burned.

But condo flipping isn’t as easy as it used to be. The places have gotten heavier. It’s harder to carry them...and harder to turn them over. Some subdivisions seem abandoned; there are so few residents. Many of the units are for sale. Many others are simply unoccupied, waiting for the next shoe to drop.

“For sale” signs are up everywhere. Real estate agents’ lock boxes are on many front doors.

“My sense is that people who bought an investment in 2005 are probably not going to make money,” said a local investor. “A lot of them, I think, will lose money.”

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The Daily Reckoning PRESENTS: Prices are on the rise everywhere, and unfortunately, the money in Americans’ wallets is nowhere near as good as gold - it’s just some pretty green paper. Dan Denning looks at what’s in store for the U.S. dollar. Read on...

DEALING WITH THE DOLLAR
by Dan Denning

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 kinds of financial assets I talked about in Chapter 1 - 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 you wouldn’t want to be in a situation where your cost of living doubled or, put another way, your money went half as far as it did the day before. In fact, I’d venture to say you’d do just about anything you could to avoid it. Once you are in that situation, you have few good choices. Prices are rising everywhere around you. The money in your wallet that you 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. I mentioned earlier that it happened to the British pound sterling in 1931. Everyone thought that currency was unsinkable, too - until it sank. It happened to the German reichsmark 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 U.S. 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 jewelry, 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 risk 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 U.S. dollar. Why is that? And, more important, what’s the solution?

In the years before the U.S. 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 U.S. 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 government has made big dollar promises in the Social Security and Medicare programs. It’s also made trillions of dollar promises in the form of U.S. 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 U.S. government has been considered such a low credit risk in the past (very little chance that Uncle Sam would default on his loans or go bankrupt), the interest rate on U.S. 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 U.S. government for it to honor its promises to pay.

But what if those investors stop buying U.S. bonds because they realize the U.S. 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 U.S. 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 U.S. 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 U.S. government. If the interest rate on U.S. bonds isn’t good enough to compensate for the dollar risk, investors will sell U.S. bonds and buy someone else’s.

If you could compare the interest rates on U.S. bonds to the interest rates on bonds that are considered risky, you’d have a good idea of just how risky the U.S. financial picture is and just how vulnerable the dollar is. In short, to measure dollar risk, 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, U.S. 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 risk by market participants. The 30-year U.S. bond currently yields about 4.67 percent. 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 risk - is a comparison between rates on U.S. 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 U.S. bonds and the interest rate on foreign bonds.

I should admit that the BEDspread is biased. As the world recognizes how weak the U.S. 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 risks between their bonds and American bonds narrow. In other words, American bonds will be recognized as risky. The dollar will fall.

Regards,

Dan Denning
for The Daily Reckoning

Editor's Note: Dan Denning, editor of Strategic Investments, is one of America's most respected "big picture" analysts working today. The above essay was adapted from his book, The Bull Hunter, that details how the collapse of the U.S. credit bubble will see Asia emerge as the No.1 market for profit-hungry investors over the next three to five years.

Daily Reckoning readers can order their copy of The Bull Hunter at a 35% discount, just click below for all the details:

The Bull Hunter - Now in Paperback!

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