1.0. Coping Skills
1.1. The bottom line
1.2. Labor Deflation
1.3. Duck Diving The Wave
1.4. Embracing Stoic Paradoxes
1.5. When and How the System Will Fail
2.0. The Chessboard
2.1. The Soft War: China vs. the US
2.2. America As Visionary
2.3. China, Russia, and the Shanghai Six
2.4. Playing India vs. Pakistan
2.5. Preemption and Deterrence
2.6. Back to Iraq, Iran, and Saudi Arabia
2.7. Policy, immobile or movable?
3.0. The Trap
3.1. US Dollars as the Common Denominator
3.2. Currencies, Real Estate, and Easy Money
1.1 The Bottom Line
The global economic system has to be rebalanced. Beyond the symptomatic details, the world needs to figure out how much labor will be worth, where goods will flow, and to whom purchasing power will be allocated. It's more than likely that this major adjustment will be more noticeable starting in 2005 or 2006.
The next flourish of greed, trying to take formation now, will confirm that a major adjustment will shortly follow.
Note: Section 2.6 is a suitable place to start reading this forecast.
1.2. Labor Deflation
Many countries, resource rich and otherwise, believe erroneously that the strength of their domestic economies depends entirely upon their ability to supply the United States with a readily transportable supply of cheap labor value - labor value exported through the physical transfer of trade goods and the telecommunication of services which readily flow to the unflappable American consumer.
If resource rich countries were organized and confident, they could unilaterally set the market price for many commodities. These countries could also influence which "currency" will be accepted as a store of value.
But which paper currency has value?
Perhaps those things that we think of as real and tangible commodities are really currencies. Historically strong evidence exists to support this contention. In medieval Japan for example, "rice signaled wealth and also determined wealth through the use of a sho, a measure of rice. At various times rice was an instrument of trade, functioning as hard currency. Rice measured the wealth of the daimyo (lord) and provided payment for samurai (warriors)." Gold, oil, and food have the conceptual and historic potential to be used as measures of transferable value or currency. Therefore, as the United States dollar (USD) weakens, the subservience of the resource rich countries to the United States declines.
Over a long period of time, something happed to reduce the efficacy of the USD as a measuring tool of value. The United States ceased being able to build the kind of productivity it needs to offset the inflow of wealth that it imports. Instead the United States took advantage of the fact that it held a monopoly of currency designed to provide an advantage to global trade.
What broke this protectionist advantage down was the free flow of cheap global labor value. The United States cannot produce a return on investment because it cannot trim its labor value added costs. This means that debt levels and deficits have to increase.
Deficit spending has gone unnoticed by the majority because labor deflation temporarily offsets declining purchasing power. The global economic system has to be rebalanced.
With the dollar in the middle of every transaction and every livelihood, many blocking forces exist to keep the status quo in place.
If not in the United States, then where in the world do earnings and return on investment exist? It's true that Japan, Europe, and America have cutting edge technical, intellectual, and marketing expertise. The problem is that these advantages need to be continually renewed. Countries that have ownership of physical resources, and countries with the lowest labor costs (a good skill-to-cost curve) can provide added value and therefore a return on investment.
The true value of Canada, for example -- the future purchasing power of that nation -- derives entirely from the fact that it has few people and large amounts of untapped natural resources. The country has a large net present value relative to its internal demand for consumption. This holds true for several other resource rich countries.
It seems to me that Russia knows better how to manage its commodity wealth. Russia considers its oil and gold, its natural resource wealth, as its reserve currency. Russia will hoard its natural resources and will sell only to the highest or most amicable bidder. It will use oil as a strategic tool in courting China.
Russians know how to concentrate capital and will do so, with wild west bravado. The best use of a tax system resides in quashing political dissent and scaring away the vultures of international investing.
In another great misallocation, the Saudi royal family decided to concentrate wealth while entirely neglecting the needs of their internal economy. The great bugaboo of religious zealotry was an international weapon of mass distraction. As payback the Saudi royal family will have an internal reckoning day that cannot be too far in the future. As it stands, a high price will be extracted of the US for its connection with this thievery.
Closer to home, the Canadian government can take fallacious reasoning regarding labor value to the highest level of irony. Applying the same kind of nonsensical reasoning to China, the Canadian government envisions that it can provide labor value as a manufacturer-exporter of trains and planes. Costly Canadian labor cannot have intrinsic export value to China. Europeans too are fixated with the manufacture of airframes. But if the world becomes more regional, just where will these planes fly and what will they carry?
When China buys expensive items from Canada, Europe or the United States, they are doing no more than throwing a political bone. US trade figures that occasionally improve by three to five billion USD are sculpted by this facade.
China of course, and India as well, are at the nexus of global labor deflation. Both have well-trained labor pools willing to outbid any competitor. Information technology and inter-modal global transport facilitate the international flow of labor value. Again, the story of labor deflation masks the demise of American purchasing power. Beyond the details, the world needs to figure out how much labor will be worth, where goods will flow, and to whom purchasing power will be allocated.
1.3. Duck-Diving the Wave
Since starting in 2002, this newsletter has tried to describe the conditions of change which are occurring worldwide. The most challenging part of my educational process is to organize observations into a usable product. We are participating in a process that will ultimately allocate purchasing power, wealth, to those economies and peoples that can provide a value added return on investment.
Therefore, in this forecast I am not going to list a litany of symptoms. Instead I will try to concentrate on providing you with the basis of a future trend, a foundation on which to structure your investments.
To provide meaningful result, forecasts don't necessarily need to be one hundred percent correct. With this in mind I am satisfied with the quality of forecasting projections made to date. If you were reading carefully since 2002, you would have been buying Canadian dollars and gold near lows. You would have ignored the Dow entirely, sampled commodity funds, and focused on the most important investment objective of all: not losing your capital or purchasing power.
Some of the supposedly radical calls we have made, the ones which people most violently reacted to as impossible, are becoming grudgingly accepted by a growing number. Nevertheless we still hold a minority view because cognitive dissonance locks people into the familiar and prevents them from seeing the obvious.
From 2002 to 2004, when trends were working in our favor, we rode them. In contrast, in 2005 and 2006 we must be concerned not with riding waves forward but ducking under them in order not to be swept away. The waves we need to avoid are called economic "dislocation" and societal "realization."
1.4. Embracing Stoic Paradoxes
Before I get too deep into this forecast I will provide you with a method for absorbing and coping with the information presented.
Many people refuse to acknowledge facts when it is emotionally difficult to do so. In 1842, economist Charles MacKay made this observation: "Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one." In our analysis we are looking at the herd, and in contrast to them we have the confidence to point ourselves in another direction entirely.
Economic systems operate like a huge organism.
Systems are born, mature, decay, and die, only to be reborn. Therefore we need to participate in the changing economic landscape by knowing that we play a part in it. As one system falls so will another rise. Our goal resides in preserving our purchasing power through these transitions, so we are fully equipped to participate in growth phases of the newborn economy.
The reality of life is that the physical world does not change very much, even though economic systems do. Wise men are content in the face of events. We live in the physical world, thus we will participate in the rebirth of a new economic system. By being observant we ensure our prosperity.
Conventions of trade, finance, paper money, banking, and even economics are conceptual constructs that we use. Volatility and forecasts are nothing to get emotional about. Simply, we need to avoid the fatalism of the "dismal science." For us, happiness, contentment and harmony are possible and achievable under any and all circumstances.
1.5. When and how the system will fail
Economic systems die slow and painful deaths, and at the point of death, great drama usually occurs. History usually records the dramatic blindside as the cause of change. An example for this would be the stock market crash of 1929. Yet an entire global economic system was slowly failing long before that dramatic crash occurred. As reported in December's interim bulletin, volatility has been rising. This indicates that dramatically rough waters are ahead.
Denial and volatility will continue to expand in every way possible until these dynamics can no longer do so. Emotionally this may be frustrating because if everyone acknowledged that an economic system was aging, the birth of a new economy could occur swiftly.
In 2005 and 2006 I would avoid getting sucked into short term plays. Emotionally speaking, traders might find it difficult to ignore clear buy and sell signals on chart patterns, moving average crossovers, and the oversold-overbought technical oscillators. Therefore, they do not quantify the growing level of risk permeating the markets and the global economic system. They may care to remind themselves that trading tools are technical, not fundamental.
The right thing to do in my opinion is to hold unleveraged safe harbor positions in gold and, to a lesser extent, oil; and in select foreign currencies via cash or bonds. My rationale for this advice stems from the fact that I cannot tell when the drama of adjustment will occur, other than to say that it will happen somewhere within the span of this forecast.
Like you, I have not experienced the set of conditions and possibilities now unfolding worldwide. I look, and in almost every direction I see an economic and political system that has exhausted itself.
Within the United States both economics and politics were organized into participatory activities. In the ideal, the idea was to allow a large group of people access to activities that were once the purview of elites.
The cost, or entry ticket, to open and free participatory activities is informed consent. The informed part of the freedom equation has atrophied.
When I talk to highly educated people, it's surprising to find that they may be so highly specialized that they lack broad knowledge about sociology, history, economics, and politics. The majority of people don't have the time to become virtuous through knowledge. They cannot contribute to effective governance.
In 500BC, Confucius put the importance of investigative knowledge this way.
"Things being investigated, knowledge became complete. Their knowledge being complete, their thoughts were sincere. Their thoughts being sincere, their hearts were then rectified. Their hearts being rectified, their persons were cultivated. Their persons being cultivated, their families were regulated. Their families being regulated, their states were rightly governed. Their states being rightly governed, the whole kingdom was made tranquil and happy."
I mention Confucius because his and other ancient eastern philosophies are actively influencing the future of the world.
2.1. The Soft War: China vs. the US
China will solidify internal stability by procuring for its people higher amounts of societal, and small amounts of marginal (personal), purchasing power.
What of value does the United States provide China? The flow of capital and machine tools has already occurred. IBM has sold its personal computer license to Chinese interests. China is now bidding for natural resource companies in Canada. It was also alleged that a deal was struck between Russia and China regarding the future disposition of the oil reserved once owned by Yukos Oil. How can these absorptions benefit the strategic position of the United States? The answer is of course that they cannot.
The US cannot continue to provide value as a major consumer of Chinese goods. The Chinese majority lack the purchasing power to consume what they produce. Eventually, however, the Chinese people will be economically empowered to be better equipped consumers. Thus the flow of goods will shift.
Where possible, the Chinese will use soft power to achieve its objectives. It will do so with a long-term view, with pragmatism, and with the dynamism and depth of Asian philosophies.
By 'soft power,' I am trying to describe how China will design its policies to benefit much of the world that the United States has shunned. The United States works without subtlety, without consistency, and with an overly direct and confrontational approach.
In contrast, the term 'cooperative imperialism' might apply to the Chinese method. For example, China may fund improvements in Latin America that will result in it having access to a supply of resources it needs.
As a cooperative imperialist, China will convince its partners that they are working to mutual benefit. In fact, China will hold most of the negotiating power. The Chinese too will become imperialists. However, its satellites in a global sphere of influence might not recognize this to be fact.
China has also applied a cooperative imperialist ethos to its dealings with the United States. The Chinese know that US politicians will do anything possible to buttress US purchasing power through importation of cheap manufactured goods. The US intentionally subjected itself to Chinese labor deflation because it provided the illusion of domestic economic dynamism.
In the United States, "Hard power, the ability to coerce, grows out of a country's military and economic might. Soft power arises from the attractiveness of a country's culture, political ideals, and policies."
The United States proved that it can move aircraft carriers around. China will move its diplomats. Ultimately, the cost of this "war" to the United States will be the American Dream.
If bullets fly they will do so over the issue of Taiwan, the Spratley Islands, or to contain the possible re-emergence of Japanese military might. I would rank the probability of a Chinese military expedition in 2005 and 2006 as very remote.
US companies should not look upon China as a profit center. The capital now provided by these firms will be replaced with input from domestic sources.
Within the United States, "dramatic events" will eventually cause the loss of domestic tranquility. These events will adversely affect the Chinese economy, but any dislocation will be used to restructure that country towards assertion. The time frames of these two countries are entirely different.
I would expect the Chinese growth curve to be entirely different from the Japanese economic miracle that was the envy of the United States during the 1970s. The Chinese will build with permanent impermanence, by which I mean they will initiate impractical projects which speak more to the society's long-term capability than to permanently addressing a major need.
The Three Gorges Dam project would be a case in point. The Shanghai mag-lev train is another. These projects build international "face" by asserting that China will become the preeminent world power. Immediate practicality, and operable longevity, plays little part in these initiatives. Thus, they will be impermanent.
Make no mistake, however, that these initiatives are in fact pragmatic endeavors because these types of projects illustrate that a society has vision. A vision to grab hold in the future whereby a long term experience base can be built which will eventually justify and mainstream the seemingly impractical. The United States used to have this kind of vision.
2.2. America as Visionary
The failure of the Shuttle program was not isolated drama; it was instead illustrative of a systemic trend.
The US government dramatically lost its capability for manned spaceflight because it lost the vision to do so. The explosion of two space shuttles provided the drama, but the actual failure occurred long before those two instances.
A thematic connection exists between the space program and the declining dynamism of US policy. The main point being that as US policy became bombastic, the innovation and follow-on reformation occurred elsewhere.
A system for manned spaceflight will be reborn, and companies like Scaled Composites will provide the momentum. They will do so on a shoestring budget as well. Let's say that instead of a company filling a leadership vacuum, that in the geopolitical landscape a competing country, peoples, or region will do so.
The societal effects of visionary public policy initiatives are more participatory than are privately sponsored endeavors because they provide direct motivation and empowerment. They also build a foundation for a future filled with technological innovation. If all men are created equal, what would preclude China or India from having an inventory of the smartest scientists and engineers?
In the US, public policy initiatives can be created but cannot be abandoned or modified or updated. The result has been selective vision, a scatterbrained blurry kind of initiative, a condition ripe for a dramatic unfolding of events.
Arbitrarily government either gets out of the way of technological vision (because it cannot come to grips with change), or provides arbitrary barriers to it. Due to religious feudalism, the government has blocked initiatives into stem cell research. On the other hand, the Internet contains more religiously offensive pornography than the now politically correct 42nd street in NY ever did.
Don't get me wrong, the United States certainly has its corporate visionaries. Private initiatives are pursing technological opportunities in nano-technology, ceramics, and private space exploration.
Small companies are more flexible than brand name corporate behemoths. Therefore they are responsible for the lion's share of innovation. After any adjustment we will make it a point to invest in these types of companies. But presently, the stocks of these companies might be swept away with all the others in any downdraft.
The declining dynamism of US policy has become a pervasive theme. The September 11th attack did not produce more than a stopgap approach to problem solving. The event itself demonstrated a major lack of vision in a basic task of governance, namely societal defense. Costs have been incurred, governance has become rigid more oppressive and risky, little else has changed.
In contrast, it could be argued that the Tianenman Square uprising was a great enabling force for societal progress and economic ascendancy. To the astute, the drama of disaster brings with it some form of opportunity.
2.3. China, Russia, and the Shanghai Six - Kazakhstan, Kyrgyzatan, Tadzhikistan and Uzbekistan - and for good measure, let's add Georgia, Osettia and Chechnya.
The days whereby Henry Kissinger could play China against the Soviet Union are over. Historical considerations, issues of trust, and demographic incursions of territory aside, Russia (and the surrounding region) has the raw materials and China has the market.
Transportation systems will grow to meld common pragmatic economic and political interests together. In contrast, any supply chain that the United States might rely upon to transport oil away from these two behemoths will have the resilience of "two cups and a string."
Militarily, the two major players will continue to cooperate against a common enemy, namely ethnic and regional dissent. The Shanghai Cooperation Organization (SCO) puts it this way: "Security cooperation focuses on the fight against the evils of terrorism, separatism and extremism."
Of what use would the United States be to this growing relationship, other than an irritant and/or a blocking force?
The United States has a sophisticated asymmetric military presence in key cultural and geographic inflection points within the Chinese and Russian sphere of influence. The US has imposed itself as a splinter under the fingernail of an emerging regional block. I would not be surprised if, in a crisis, US forces were simply asked to leave.
The internal political story of both China and Russia can be summed up as follows: If you give someone something new, they will be happy. As long as the citizens of these countries see gradual improvement in their purchasing power and standard of living, they will generally ignore the political constraint of a dictatorial system of governance. The global rebalancing will occur west to east.
2.4. Playing India vs. Pakistan
Where does India fit in?
It was a reach in prior forecasts to suggest that India would work with Russia and China as to eventually fit into a complementary union. Instead China, and to a lesser extent Russia, may use the India-Pakistani situation to advantage by encouraging instability.
Pakistan will never be a useful international partner, but India will. Pakistan has had historic problems with self governance in that it has never since inception enjoyed stability of leadership.
Instability between these two players prevents the United States from pursuing a progressive policy in which it can become warmer towards India and intentionally more distant to Pakistan. China sees this.
Additionally, the US remains one Pakistani leader away from a disastrous situation. Dysfunctional countries, and countries with a weak internal leadership, see the atomic bomb, missile systems, and other aggressive technologies both as a poison pill and a nationalistic rallying point.
On a positive note, between 2001 and the present I underestimated the potential for the United States to contain and/or safeguard Pakistan's nuclear inventory. In the short term, the United States has been very effective in containing Pakistan's nuclear arsenal.
In terms of the nuclear card, the United States has been consistently able to build a winning hand from a position of weakness. It cannot afford to fail, not even once.
On the down side, America has lost credibility with the future that is India. It has had limited results in meeting its objectives against enemies lurking in the Pakistani badland, and it has failed to contain Pakistan's slippery grip on the export of nuclear technology. Popular (and frequently induced) hatred against the prosperity and policies of the United States provide the thematic twist to the story.
I am also certain that China asymmetrically asserted itself by selectively providing technical expertise to an expanded axis of evil. Dysfunctional countries can be partially but not completely contained. Therefore, nuclear technology will leak. Eventually an unstable nation, or peoples, will be impossible to deal with.
2.5. Preemption and Deterrence
A policy of preemption was a logical offshoot of this kind of bad-to-worse quandary. Preemption represents an action done and executed, not talked about. Roosevelt knew, and expressed in his corollary to the Monroe doctrine, that the worst thing a national leader could do in terms of credibility was to use "high sounding language" and fail to follow through.
Preemption has not occurred as regards Iran, North Korea, Pakistan and Saudi Arabia. The United States has not positioned itself to preempt against a large strategic threat. Instead it has used its reputation to skate along in the hope that time will solve the myriad of strategic concerns which are relentlessly mounting in number, potential impact, and scope.
The cost of preemption could be high in that it would radically upset the status quo in favor of the drama of an unpredictable situation -- a scenario to which the United States would have difficulty responding.
Economically, politically and culturally the United States cannot commit itself to the demands of a changed world. I am tired of asking year over year whether or not the United States is at war. Conventionally the United States lacks a draft and it still does not have a wartime economy or the capacity defend itself and/or mobilize.
It could be that a temporary and illusory situation now exists because deterrence, rather than preemption, has been effective. Many of the players in this global drama are small potentates, like Libya.
When the country is a person unto himself, intimidation and bluster can be very effective. These leaders see Iraq, and they know that they must kowtow because the tiger has most of its claws intact. If the tiger is wounded again, these leaders will assert themselves into weakness.
Drama can happen in many unpredictable ways. The United States can continue to be bogged down in Iraq, it could experience a market adjustment, be roiled by a third party regional conflict, or experience a terror event. It could suffer the dislocation of an economic event, have an interruption in oil supply, or participate in a conflict at a naval choke point. It could be branded by the world community as a rogue nation!
This list is no more than an incomplete litany of possibilities. Forget about the details; instead, qualify these potentialities as risk factors.
Who would place one hundred percent of their purchasing power into circumstances where the only certainty is a large overhang of risk? The answer, of course, is Americans whose money is trapped in US dollars.
2.6. Back to Iraq, Iran, and Saudi Arabia
Shortly after 9-11, a basic question was asked of some unfortunate four star general regarding the next logical steps to be taken in Middle East. We will call this fictionally illustrative individual General Stan D. Down, because he no longer has a job.
In response to this query about what to do, the fictional General Stand Down whipped out a non-fictional set of preexisting planning documents. Like the framework for the Homeland Security Department, academically envisioned wartime plans for the Middle East were on the shelf and ready to use!
In the rush of crisis, the President can make any of these plans national policy; however neither he nor the congress should be expected to read these plans prior to implementation.
As I have mentioned in previous newsletters, the Middle East war plan had its origin in the brainstorming that occurred during the oil crises of the 1970s. The general listened carefully to his peers, experts who sincerely believed at the time that nuclear suitcase bombs would shortly be detonated in a major US city or two.
General Stand Down clearly stated that, "Under these dire conditions, the first step to insure our national survival must be to capture the oil fields in Saudi Arabia. The initial operation to capture the fields will be a push over. Thereafter we need to mobilize the nation. All our lives depend on it."
Daniel Perle, one of the administration's "Vulcans" (I am not kidding!), chimed in: "Gentlemen, the Saudi oil fields are hanging out in the middle of nowhere, we have our troops and supplies prepositioned to do the job. We won't need to touch the Saudi cities, the Islamic political problem in the Middle East and elsewhere will become irrelevant to us. With Saudi oil, the war effort will not be a problem. Additionally, we can choose which of our allies to supply, therefore insuring our strategic and economic dominance." Perle was eventually authorized to float a trial balloon in this regard.
Major Quan Dary, the general's aide de camp and now an unemployed civilian, made his fatal political move with full and total sincerity. Major Quandary stated that, "As it stands, the armed forces don't have enough manpower or material for a protracted struggle. A quick takeover of Saudi Arabia would afford us the benefit of using the equipment that they purchased from us as interim supply."
General Stand Down chimed in: "In contrast to Saudi Arabia, we all know Iraq has no strategic importance. Once we touch Iraq it will be broken and our war games indicate that we will be in an uncomfortable situation. Per our planning documents, we will have little upside in terms of oil supply. Having to occupy large blocks of land and to manage large numbers of people will irrevocably erode our longterm strategic position. Of paramount concern is Iran's nuclear capability and its relationship with other nations undermining our interests. With our troops going into Afghanistan and a position in Saudi Arabia, we can attempt to isolate Iran."
At the following cabinet meeting, the now defunct secretary of the treasury, Paul O'Neill, had his say. "First of all, we don't have the domestic industrial capacity to wage the kind of war General Stand Down was talking about. Our military supply chain has been outsourced thus we will not be able to import the component parts needed for everything from radios to J-Dams. To have a future, we have to get our domestic house in order before we do anything."
At this point Donald Rumsfeld lost his cool, "Paul, unlike you, Dick and I have run some real kick ass companies, we are not old farts wasting away at Alcoa! First off, I am going to grab the generals by the nose and kick 'em in the tail, thus we will have this war delivered to the American people like a sloppy Joe hero packed in aluminum wrap."
Saving his political demise for a later day, Colin Powell stepped into the fray. "Guys, we need to talk to more people, and we need to build an international coalition."
Absorbing all this information, and having penny socials and business deals with the Saudi royal posse, the President made a bold decision. "Since we need to talk to more people, let's call Henry Kissinger."
History will record that with Kissinger, the confusion ended. Henry went on a media roadshow, ping-ponging between various television interviews. His policy pitch was slicker than snake oil, easy to understand, and would provide leadership where it was lacking.
Heralded to one and all, Henry stated that, "The problem for the United States is weapons of mass destruction. On this basis alone Iraq has to be dealt with. The Saudis on the other hand can be managed."
When Henry was asked by Charlie Rose if Iraq was a threat in regard to WMDs, his answer was that "They are if the President tells us that they are. The American people will believe him. Why wouldn't they?"
And they did, the American people believed the president and they reelected him. After months of angst and indecision the President of the United States was elated -- he finally had a policy.
Those that did not agree were shown the door. With a resisting world community, and Colin Powell in tow, the United States was moving towards an objective.
(As of December 2004, operatives, middle managers and top executives of the CIA have hit the exits along with a bevy of administration heavyweights, cabinet officials, civil servants and generals. Voting with their jobs and pensions, the best interests of many insiders reside in getting permission to go elsewhere. The administration reserves the right to moderate the flow from the floodgates.)
2.7. Policy, immobile or movable?
As a young manager I was once taken aback when my mentor, an officer of a major public corporation, told me that one of his jobs was to get the immobile moving. He was counting on me as his proxy in a half-dozen countries to convince, trick, treat, cajole, or bully his underlings into action. In the organization food chain, all the people I was trying to influence were much bigger fish than me. Like some stoic corporation, the United States too can become stuck in an immovable situation.
Another great surprise to me was that this executive really did not care whether or not the direction that things were moving was correct or not. He was more concerned that movement occurred simply because it extended the operational life of the corporation. This was many years ago, and the corporation in question will certainly fail within a year or two of this writing.
After September 11th, the United States had to do something or all would have been lost. Against the wishes of the international community, and with marginal domestic support, the managing executives of the United States got the nation moving. The direction taken was to go back to Iraq and into Afghanistan. The real issues and concerns (a nuclear-ICBM enabled Pakistan, Korea, Iran; and oil-rich Saudi Arabia as the true nexus of terror) would have to be set aside for another day. Organizations without vision, or without a sustainable future, have to move forward because doing so will provide more longevity than doing nothing.
3.1. US Dollars as the Common Denominator
Paper currencies are non-interest bearing, negotiable notes drawn on the good faith and credit of the country of issuance. In concept, the money in your pocket differs little from interest bearing treasury bills and notes. When central banks buy US dollars, they don't buy circulated paper currency. They buy bonds and bills. All currencies not being equal, ratings agencies go through all sorts of permutations and eventually a currency gets assigned a "Sovereign Credit Rating."
Ratings criteria include such factors as purchasing power parity, per capita GDP, inflation, growth rates, perceptions regarding legal stability-corruption, political risk factors, years since last default, imports versus exports, debt levels, and the list goes on. Once value and risk have been defined, a yield needs to be set to provide holders of these instruments with the incentive to hold them.
Currency can be readily transferred as an exchange of value, it has functional utility for that reason, thus as creditors we don't require paper money instruments to provide yield.
The world would become so reliant on the debt of a single nation that sovereign credit ratings and the risk reward curve are now ignored. In 1995 the Federal Reserve Bank of New York must have seen 2005 and 2006 coming when they stated that "sovereign ratings are assessments of the relative likelihood a borrower will default on its obligations." .... " Sovereign lending has historically been a risky business. A burst in sovereign lending in the 1920s-the closest precedent for the recent spiral in sovereign bond issuance-ended with a wave of defaults during the Great Depression. Twenty-one out of fifty-eight nations defaulted on their international bonds between 1930 and 1935; another four had already defaulted by 1929 (Suter 1992)." ... "Moody's was one of many parties taken by surprise by the extent of the sovereign default wave: a majority of the defaulting countries had investment grade ratings from this agency in 1929 (Moody's 1981)."
Today world currencies are so interconnected they use dollar holdings as a major store of collateral value. Were the sovereign rating of the United States to be downgraded, to realistically reflect fundamental value, or were the yield increased to reflect growing risk, the world would experience a wave of global default.
Entities buying or holding US dollars are creditors. Large creditors know that were they to sell even a small amount of their holdings, they would trigger a default. Therefore, the knee jerk reaction of creditor nations has been to support the value of the dollar. The creditors could also upset the market by failing to buy additional debt, evidence exists this has just occurred.
With USD 1.9 trillion in currencies changing hands every day, preserving a currency devoid of value becomes a very difficult thing to do. It becomes even harder to save a currency that grows debt faster than it can grow its future earnings potential.
In such circumstances monetary inflation occurs, the effects of which are to cause necessity commodities like energy and food to become expensive. The broad stroke of inflation also causes leveraged and derivative assets to become overly attractive. Debt multiplies gains and losses and the herd gets suckered into chasing yield without considering the fact that on the down side, their losses could exceed their working capital.
When this type of inflation fails to weaken the purchasing power of a currency, then debt default forces the issue and a severe adjustment occurs. When debt cannot be negotiated downward, default usually follows.
3.2. Currencies, Real Estate and Easy Money
In 2004, and before that, the ability to earn "easy money" abounded.
In its December 2004 report, The Bank of International Settlements identified the fact that large traders were selling US dollars (and the Swiss and Japanese currencies) to buy Australian and New Zealand dollars. In doing so they were enlarging the volume of the foreign exchange market.
Easy money could be found because the interest rate carrying costs of short-selling US Treasury bonds was less than the yield provided on Australian and New Zealand bonds. By selling something you don't have but which has a low carrying cost, selling short a borrowed US security, the money needed to buy another currency with a larger revenue stream was free. In fact, it provided a profit margin! With more buyers wanting Australian and New Zealand bonds, the value of those currencies increased against the USD, so amplifying profits.
Fundamentally, no reason exists to justify the type of capital flow that has occurred towards Australia and New Zealand, two tiny economies.
As a result of this inflow, asset valuations across the full spectrum of Australian and New Zealand assets have bubbled. Trade gaps, over leverage, and other symptoms speak to this fact.
Ironically, Australia has in my estimation the best central bankers in the world. Australia has consistently reduced its holding of US debt. Through its rate policy it tried to lead the United States and the world by example. Nobody was listening.
Interest rate differentials between currencies allow the Bank of Japan to make easy money. They sell yen to domestic savers via bank accounts, the revenue stream of these accounts depending on Japanese Treasury Bonds. Then the Bank of Japan buys US Treasury bonds because they provide a much higher return. Artificial demand for the dollar is a benefit of this policy, and intentionally so.
In September of 2004 the Japanese finally balked at purchasing still more dollars. To prevent a panic, the dollar received broad support from a spectrum of central banks, as described in my December 10 newsletter: "The injection of volatility can be construed as the input of artificially induced risk. So here we have it. The only way the US dollar can be preserved is to make it risky to sell it against the most popular and traded currencies, which are the Australian dollar (AUD), the New Zealand dollar (NZD), and the omnipresent euro."
The USD has been made risky to sell, but has also become more risky to hold! But most US investors don't know how to hold anything but dollars. Domestic US investors hold huge amounts of wealth in overvalued dollar-denominated real estate, dollar-denominated stocks and dollar-denominated bonds. The easy money structure of these assets provides merely an illusion of value.
For example, US domestic real estate has an easy money structure. Instead of selling one currency against another, mortgage lenders use differences in time and rate to their advantage. Here, too, a leveraged bubble has been created.
Banks and finance companies, tax services and car manufacturers are all addicted to easy money through arbitrage. Individual investors are addicted to the upside of leveraged investments.
In an adjustment, to occur and be visible by 2005 or 2006, these easy money positions have to blow up. An adjustment has to occur because everything has been mis-priced -- the majority of assets in the global economic community, in fact. Creditors (or their insurers) will have to absorb a loss. Savers, in their efforts to obtain a return, have unknowingly extended credit.
The solution resides in diversification to points outside the arbitrage equation, to those economies that are undervalued because of resources or purchasing power, and to those commodities which can function as a currency or which are indispensable essentials.
With the rules of economic gravity intact:
1) the yen and Singapore dollar (SGD) should strengthen against the USD;
2) the Canadian dollar (CAD) should be much stronger than it is versus the euro; (but don't bet on it)
3) gold should be getting stronger against the euro (EUR) JPY (yen), and the CAD.
The problem with this assessment is that the rules of economic gravity are not intact. Credit ratings are out of kilter, yields are out of alignment, and purchasing power parity valuations are qualitative.
My conclusion therefore resides in chasing zero yield, and finding the exits. The exists are those currencies and assets which are the most difficult to purchase. The SGD, a permanent position in gold as a currency, a straddled JPY position, liquidity-flexibility, and later I will consider whether or not to re-enter the Swiss franc. At some point I might want to be overweight to gold; it's too early to tell. I want to see gold in a clear uptrend against the EUR.
Gold should move up against the EUR. That currency has been bubbled on the expectations that it has the fundamentals to replace the USD as a reserve currency. It does not. Smart Europeans have, as discussed previously, been moving money to the Swiss franc.
At the start of this thesis I concluded that, "Beyond the symptomatic details, the world needs to figure out how much labor will be worth, where goods will flow, and to whom purchasing power will be allocated."
In 2005 and 2006, neither a borrower nor a lender be. The problem with that axiom being that currencies stored in a bank account, bond, stock, or in your pocket, are nothing more than credit! Gold, oil, rare materials and food stock are value storage alternates that come to mind.
Part Two »