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The US$ Short Position

Below is an extract from a commentary posted at www.speculative-investor.com on25th April 2004.

We've recently received several e-mails from subscribers asking for our take on the idea that the huge amount of debt in the US represents a massive US$ short position. The idea, which is explained in detail by George Paulos and Sol Palha in their article at http://www.financialsense.com/fsu/editorials/2004/contrarian/April15.html, is that the US$ has the potential to move sharply higher at some point in the not-too-distant future as US$ debtors -- primarily those with large home mortgages -- scramble for dollars in order to meet the obligations to their creditors.

The aforementioned article is well thought-out and its central theme deserves consideration. Furthermore, one of the conclusions of the article meshes with something we've been emphasising over the past few months -- that now is a good time to be 'cashed up'. However, if US household debt represents a short position on the US$ it is a short position that will never be covered. And nor will there ever be a serious attempt to cover. That's because the SURVIVAL of the current monetary system relies on the continuing expansion of credit, that is, it relies on the continuing EXPANSION of the US$ short position.

Why the above is so can be gleaned by looking at a few figures. Total US debt (private + public) is presently about US$32 trillion, but the total supply of US dollars is only about $9 trillion. This means that if every US dollar in existence was put towards the repayment of debt the average creditor would only receive about 28c on the dollar. Also, if we assume an average interest rate of 6% on the $32T of debt then the annual interest bill is about US$1,900 billion. However, the increase in the total US money supply over the past 12 months was 'only' $420 billion. In a nutshell: there is nowhere near enough money in existence to pay-off the current debt and there is nowhere near enough new money created each year to even pay the interest on the debt.

But isn't the above an argument for massive deflation?

No, in a world in which there are no constraints on the amount of new money that can be created 'out of thin air' it's an argument for inflation as far as the eye can see. The crux of the matter is this: when you create a "Ponzi scheme" -- any scheme where money coming in from new investors is needed in order to meet the commitments made to current investors -- the scheme can't continue to function unless the new money keeps coming in at a fast enough rate. Once the rate of in-flow slows the scheme doesn't just experience a hiccup, it collapses. This is because the first failure to fulfill a promised return exposes the true nature of the scheme.

The current monetary system is effectively a Ponzi scheme whose survival relies on the total supply of credit and money -- the so-called US$ short position -- continuing to expand (the way the system is designed there can never be enough money to pay-off existing debts). So, don't expect that the major stakeholders in the system (the US Government, the Fed, the commercial banks, the GSEs, the money-market funds, the Wall St financial houses) will decide to just hunker down and weather a brief period of deflation. That's really not an option for them.

But if US consumers decide to stop increasing their debt loads or, heaven forbid, decide to start REDUCING their debt loads, what could be done to prevent a contraction in the total supply of credit?

At this stage there is no evidence that the credit expansion is about to go into reverse, but if a slowdown in credit growth did begin to become an issue then the Fed could follow through on its promise to push down long-term interest rates via the large-scale buying of bonds. The Fed would not necessarily limit itself to US Government bonds but might, if it perceived that the situation warranted more drastic action, also buy large quantities of agency debt and asset-backed securities. The likely SHORT-term effects of such action on the part of the Fed would be a) a reduction in the interest burden of US consumers, b) another mortgage re-financing binge, c) a monetary injection into the economy, d) higher inflation expectations, and e) a weaker dollar.

There are other ways to ensure a continuation of the inflation trend in the event that genuine deflation becomes a real threat, but the Fed's ability to monetise unlimited quantities of debt is by far the most potent inflationary weapon in the arsenal. A central bank that takes the 'printing press route' never has any trouble devaluing the currency. Instead, the problem they always end up having is figuring out how to prevent inflation expectations from spiraling out of control.

Something else that needs to be considered is that there is no precedent throughout history of a country at war experiencing deflation. The US is presently at war, the only difference being that this war is not being fought against a specific enemy. Rather, it is being fought against a methodology (terrorism). The nature of this war most likely prevents it from being won by military means, but this detail isn't stopping the US from TRYING to win it by military means.

One final comment: the financial-market and economic conditions during the second and third quarters of this year are likely to bring about the return of deflation as a 'hot topic'. This is what we warned about in our 22nd March commentary. However, a 20%-25% drop in the copper price following a 100% rally is not a sign of deflation, it's just a routine bull-market correction. A sharp decline in a drastically over-priced stock market is not a sign of deflation, it's just part of the natural process of reverting to the mean. A pullback in the gold price and a bounce in the US$ are not signs of deflation, they are just consequences of the fact that markets never get where they are going in a straight line. A slowdown in the reported economic growth rate is not a sign of deflation, it's just 'par for the course' because there wasn't much real growth to begin with.

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