Dollar Pessimism

People wonder why I am so pessimistic about the fate of the dollar. One person recently told me that currencies fluctuate, and the dollar was overvalued anyway before this latest slide. I plan to studiously avoid being very technical in this blog, but I’ll quickly lay out some of the basic reasons.

The US dollar is the world’s reserve currency. A lot of the demand for dollars is based on this fact. Foreign central banks hold dollars as part of their reserves. Five years ago, central banks held 67% of their currency reserves in dollars. Today it’s 37%. China, Russia, Switzerland, India, and others have even announced that they are moving out of dollars, “because we need to diversify, and that has always been our strategy.” I guess that “always” started this year.

China and others have actually called to replace the dollar as the reserve currency; they have been making moves to do it. They are now trading with some major partners in their own yuan instead of dollars, allow some import/export to be done by private companies in yuan, etc. In all, so far they have made nine moves this year to get themselves out of the dollar (slowly), and replace the dollar as the reserve currency. They are even encouraging their citizens to put their savings into gold or silver instead of dollars. Since half of all dollars are held outside the US, should other countries decide not to keep them, demand for them will plummet, as will the value.

Obama is actually working on a plan with the International Monetary Fund to slowly replace the dollar as the reserve currency. They have worked together to construct a system of Special Drawing Rights (so far half a trillion dollars), that is a fake currency based on a “basket” of various currencies. It will take time, and at the moment the SDR’s are only used for loans (more like gifts) to poor countries, but my point is that our government is cooperating with it.

Oil sales are denominated in US dollars. OPEC has plans to replace the dollar by 2018, but many experts think it may be much sooner. As the dollar slides downward, it causes the dollar price of oil to climb to levels that hurt demand. Remember last year when oil hit $147 a barrel, but then demand dropped 5.8% and the price collapsed to thirty-something? That was quite a blow to some petro-dictators who are propped up by oil revenues. They can’t have that happening again because the dollar is weak. They plan to also go with a basket of currencies.

Ultimately, the strength of the dollar depends on strong demand either because of attractive interest rates being paid on dollar investments, very solid fundamentals of the US economy that make it seem trustworthy, or both. Interest rates on dollar investments are expected to “remain very low for an extended period of time.”

And the fundamentals? Ouch. US debt is now so out of control that there is no combination of taxes and spending cuts that could pay off this debt. At the moment, our government is borrowing half of the money it’s spending, and that is with rates very low. When it has to raise interest rates, the interest on the debt alone each year will cost far more than both wars currently do. The debt is projected to go through the roof even with the administration’s rosy projections, and that’s without factoring in their mountain of new debt from coming up with new trillion dollar programs every fifteen minutes. That also doesn’t factor in the suffocating effect of bills like cap and trade (intended to send 2.5 million jobs overseas per year before settling down to “only” a million jobs lost per year), card check (which is an attempt to aggressively re-unionize America at great cost), or alien amnesty (When we don’t have nearly enough jobs, adding millions of people will help, right?).

Quite a lot of experts will tell you right now that when the country is in a hole it can’t dig out of, it should stop digging at ninety miles an hour, and that if it doesn’t, there are only three realistic options: 1.) We can try this Keynesian model of throwing money at the problem until we have lost 20 years like Japan has. (I will probably write later about the insanity of trying to fix a “balance sheet recession” with a Keynesian money tsunami.) 2.) The US government can just default on its debt by not paying, or actually repudiate its debt. That’s game over. 3.) It can debase its currency until its worth so little that a mountain of debt doesn’t look too bad. What’s a trillion dollar debt if a loaf of bread costs a billion dollars? Yes, that’s possible. In 1923 Germany was making five billion Deutschmark postage stamps.

Any of these options is bad for the dollar. Option one, with the economy on the floor in a fetal position for twenty years, will give people no confidence in the dollar. Option two, default or repudiation obviously will kill any confidence in the dollar. And option three clearly is bad for the dollar, if we’re wheelbarrowing money down to the corner store to buy milk.

What about the recovery, you say. Won’t we begin a steep climb out of this hole and there will be plenty of money for paying down debt? I plan to write about the phantom recovery, the Viagra recovery. For now, suffice it to say that almost one hundred percent of the fundamentals of the economy are still heading downwards, many of them about to go off a cliff, and the few sparks of life we’re seeing are absurdly little considering that the Fed is drowning the country in money. Think about it. The various bailouts alone were enough money to completely pay off every mortgage in America, with a warehouse full of money left over. And you’re encouraged that manufacturing is up one percent?

Right now there is a steady large flow of money out of dollars. I believe that what strength the dollar has is based not even in confidence in the dollar, considering that foreign leaders have called Obama’s and Bernanke’s monetary and fiscal policies “reckless,” “irresponsible,” and “endangering the world economy.” That doesn’t sound like confidence. I believe that it is only confidence in China’s confidence in the dollar that is propping up the dollar at all. I would characterize what is happening now as a brisk walk on the dollar.

Confidence is a fragile thing, as we saw last September. In an era when the only way the government can pay for itself is to loan itself money because the usual buyers don’t want to, it may not take much for a walk to turn into a “run” on the dollar, with countries and investors scrambling to get rid of dollars before they’re valueless. The reason I took our money out of US dollar denominated assets is not because I think by the end of the year a dollar will be worth a penny, but because everything is in place for that to happen, and right now ther is not much to stop it.