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Competitive Devaluation

Everyone and his brother thinks that the US$ is going down. When so many people are in one side of the trade, it's important to examine the case for the other side. This is especially true for silver investors, as the Dollar is the global accounting unit for precious metals and commodities.

When one discusses the Dollar's stance, it's important to remember: "with respect to what?" For Example, is Dollar in a bearish stance with respect to gold, silver, Yen, Euro, or oil, etc.?

There are at least several reasons why US$ may rise against other fiat currencies.

First, the Dollar Index level at 80, a 20-year low support level, is strong enough such that it won't be significantly crossed without a serious fight. (Long-term Dollar Index chart, DecisionPoint format is available in Brian Bloom's most recent article, "Paranioa." Richard Russell also showed the same chart in his mid-November Dow Theory Letter issue.) Markets are mischievous. The Dollar may actually go down below 80 a bit only to claim the largest possible number of speculative shorts before turning around for a rally.

Moreover, trade deficits may not have as large an impact on the Dollar as many economists believed. Consider the following alternative theory… The US manufactures produce the highest margin products. The trade deficit is a measure of revenue not profit margin. Economists have thus far tend to discard the measure of profit margin among the macro variables. Therefore, while the US runs a large trade deficits to its trading partners, the US runs a large profit margin surplus to other countries. This theory is courtesy of Andy Kessler, and explained extensively in his book Running Money.

OK. If you don't like that, at least one has to agree with Kessler that in the short-term (and possibly medium-term), his theory is maybe right. The problem is in the long-run. This "long-run" basically means that other countries have caught up with the US in the technological lead. It means that other countries have so much R&D and intellectual property that they can manufacture products or provide services with profit margins that exceed the US. And excel the US in many high-tech products and services, not just a few. The "long-run" may take quite a few years and possibly even decades.

And lastly (also the most important) the demographically-driven debt problem, in the long-run, maybe worse in many other countries than the US. Consider the following two sets of data supplied by Professor Laurence Kotlikoff and Scott Burns' book, The Coming Generational Storm (highly recommended):

The Aging World and Population Decline (population in millions)

Country or area 2000 2025 2050 % older than 60 in 2050
United States 283.2 346.8 397.1 26.9
More developed regions 1191.4 1218.8 1181.1 33.5
Europe 727.3 683.5 603.3 36.6
  France 59.2 62.7 61.8 32.7
  Germany 82 78.9 70.8 38.1
  Italy 57.5 52.4 43 42.3
Russia 145.5 125.7 104.3 37.2
Japan 127.1 123.8 109.2 42.3
China 1275.1 1470.8 1462.1 29.9

And

The Decrepit Quarter

High Life expectancy (76.9), low birth (1.5) Most of Europe, Japan, China

Panglossian Balance

High life expectancy (73.4), low birthrate (2.1) United States

Postmodern Malthusian Hell

Low life expectancy (58.0), low birthrate (1.4) Russia, most states of former Soviet Union

Traditional Malthusian Hell

Low life expectancy (52.3), high birthrate (4.9) Most of Africa, other undeveloped nations

So, Panglossian Balance. The US is actually one of the bests among a bad lot!

Competitive Devaluation

The purpose of this article is not to advise you to go long the US Dollar. Rather, it's to argue that the Dollar's decline relative to other paper fiat currencies maybe over.

However, the last point mentioned above, the demographically-drive debt problem, is very real and severe for many countries in the world on an absolute scale; even though US is in relatively better shape than other industrialized nations. There are three possible ways for political leaders (and central bankers) to "manage" away this debt problem: increase taxes, cut benefits, and seigniorage (or the inflation tax through currency debasement). An honest politician would probably tell, or attempt to tell, the truths. An honest politician would probably attempt to raise taxes and/or cut benefits. An honest politician would also probably try to avoid seigniorage as much as possible since such process, unlike the more transparent tax increases and benefit cuts, is a bit like stealing.

Have you ever met an honest politician? I know a few. And they soon convert from honest to dishonest politician. Power corrupts.

So given the political reality, the best managerial strategy is to postpone the inevitable debt problem as far into the future as possible. Preferably until the politicians have retired. Having this goal in mind, inflation is the best way to go; and, hence, the most likely outcome.

One country after another rushing to collect seigniorage through currency debasement results in competitive devaluation.

One more point. While trade deficits don't matter, trade issues matter. Drums of protectionism may grow louder as the industrial nations' economies remain in the doldrums. China's Yuan-peg is needed for China to economically develop itself out of a third world nation's condition. In the same time, China's peg is inviting trade criticism from the US and Europe. And other Asian nations, competing against the Chinese on export basis, cannot afford too much currency appreciation. As US Dollar depreciates, it puts further pressure on Europe to talk down Euro.

Given the existence of WTO and the possibility that events may not play out exactly as the history, competitive devaluation may materialize as a venting venue of global protectionism sentiment. This is in contrast to the ‘Thirties. Back then, countries were raising tariffs one after another.

Conclusion

We are likely entering a period of competitive devaluation, practiced by the global central bankers and politicians, with the following long-term implications for investors:

  • Gold and silver are likely to continue their long-term bull markets as they are "natural" currencies that cannot be debased.

  • Commodities, due to their intrinsic values, can keep going up in the long-term as well.

  • Paper fiats will likely enter a volatile period, with "commodities-based currencies" more capable of holding value. Thus, Australian, New Zealand, and Canadian Dollars are likely to rise in the long-run.

  • The long-term relative performance of stocks, bonds, and cash are likely to be ugly, uglier, and ugliest respectively.

So 2005 maybe the first year that we are seeing precious metals and commodities prices divorcing from the paper fiats.

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