Fall Of The Dollar: Part-II

A Look Back

U.S. dominance occurred from the early 20^th century, when the country cemented its position as the dominant world political and economic power. The U.S. pursued an aggressive policy of expansionism, exerting its political and economic influence around the globe. After establishing herself as the world super-power, it employed all-out campaign to control everything-ranging from political, cultural, economic and monetary aspects. The whole world has been Americanized systematically.

Classic Gold Standard

Throughout the years gold has been accepted as money and the preferred currency or medium of exchange. The classic gold standard began to take shape in 1871 in Europe and elsewhere. From 1871 to the beginning of WWI, the currency of all the major trading countries of the world was pegged to gold. Gold coins circulated as medium of exchange daily. Gold was deposited in commercial banks and lent out. These commercial banks created credit by lending out more than the original amount of gold deposited. But they were always forced to keep sufficient reserves of gold on hand in order to meet demand of their depositors’ withdrawals.

The gold standard prevented imbalances in trade accounts between countries. Gold acted as an independent automatic adjustment mechanism. This prevented a country to drift away too far from the balance of trade (export/import).

The gold standard also stopped governments from acquiring large budget deficits. With a limited amount of credit available, government borrowing would drive up interest rates, making it more difficult for the private sector to borrow and invest. And if the private sector cannot borrow and invest profitably, the economy suffers. Government budget deficits spilled over into trade deficits leading to more gold flowing out; leading to eventual return to balanced trade.

The undesirable side effects of deficit spending made governments to strive to maintain balanced budgets.

Bretton Woods System

In July of 1944, delegates of 44 nations gathered at the United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire in USA. In that historic meeting, among other economic landmarks, came the Bretton Woods Agreement, which ESTABLISHED U.S. DOLLAR AS THE WORLD’S RESERVE CURRENCY. The Agreement pegged the dollar to gold at $35 per ounce and all other major currencies were pegged to the Dollar at fixed rates. The critical point here that, the value of dollar was BACKED BY GOLD RESERVES OF U.S. GOVERNMENT, and foreign governments were able to exchange $35 U.S. Dollar for an ounce of gold on demand.

Dollar As Reserve Currency Of The World

Thus US Dollar became the reserve currency of the world. This meant that the dollar became the currency used by other governments and institutions as part of their foreign exchange reserves and it also became the international pricing currency for products traded on the global markets, like OIL.

By virtue of using its own currency, the U.S. has run tremendous trade deficits without repercussions simply because the dollar is the reserve currency of the world. The truth is, between 1945 and the early 1960s, the world enjoyed relative monetary stability thanks to the Bretton Woods Agreement. However, the arrangements put in place in 1945 became strained in the second half of the ‘60s.

U.S. Dominance And Aftermath

During the 1960’s the U.S. became the undisputable world power by virtue of several factors,

• Military supremacy over all its rivals.
• Strength of the U.S. economy and the production method of America being far superior to any other nation. As told by Calvin Coolidge, 30^th President of the United States, “The Business of America is Business”.
• With the dollar now the global reserve currency, America had control over global financial markets.

At these times, the US governments implemented the GUNS AND BUTTER POLICIES. At one end, it operated its imperialistic ploy of controlling the strategic places of the earth, especially which have much holding of oil reserves. So it raged the war in Vietnam. At the same time in internal arena, it funded such mega schemes like Great Society Programs, fighting the War of Poverty and notably, Putting Man on the Moon. All these resulted in gigantic budget deficits, that were monetized (financed by in increase in money supply) by the Federal Reserve. All these put enormous pressure on dollar.

Other countries, beginning to realize that they were holding increasing amounts of US Dollars, began redeeming the dollar reserves for gold. At first there was not a lot of concern, because the amounts were relatively small. But, in the second half of sixties Washington became very worried.

By 1971, the trickle of gold leaving U.S. Treasury turned into flood. As a consequence, in August 1971, President Nixon decided not to exchange dollars for gold at the agreed upon rate.

Nixon Shock

Historically the governments have been incapable of maintaining the value of their currencies. Political leaders always face the dilemma of need for enormous funding to finance large schemes, at the same time pressure for keeping the taxation lower. Desperate to appease all the constituencies, they inevitably resort to “borrow to finance some new spending without raising taxes”.

Back to the context, President Nixon in 1971 decree repealed the Gold Standard i.e. keeping physical possession of gold against the physical currency (dollar); thus making the “real money” into “fiat currency”. This paved the way of unbridled expansion of dollar without any real asset behind it. This may be construed as the root of Fall of the Dollar.

Thus America truly entered the age of paper money: MONEY BACKED BY NOTHING! The Dollar was officially a “fiat” currency. By fiat currency, it means a common type of currency whose VALUE is based on issuing authority’s “guarantee”, not on any intrinsic worth or extrinsic backing.

The Dollar Tsunami

After President Nixon “closed the gold window”, the U.S. leadership worked feverishly to develop a new system of international monetary management. Due to super-heavy spending by U.S. government, such as in Vietnam War and Great Society Programs, the dollar was greatly overvalued. The American economy was also under serious inflationary pressure. The Nixon action effectively paved the way of monetary expansion,i.e. devaluation of dollar. The U.S. government then entered negotiations with its industrialzed allies to appreciate their own currencies, in response to this change. In December 1971, a meeting at the Smithsonian Institute by a group of 10 countries (G10), all industrialized, created the Smithsonian Agreement.

This Agreement effectively ended the fixed exchange rate system established under the Bretton Woods Agreement. This Agreement:

• Reestablished an international system of fixed exchange rates, without the backing of gold or silver.
• Allowed for the devaluation of the U.S. dollar; in other words appreciation of other currencies.
• Was the first time in which currency exchange rates were negotiated.

The Smithsonian Agreement, which President Nixon hailed as “the greatest monetary agreement in the history of the world”, led to an approximately 8% devaluation of the U.S. dollar and revised the price of gold from $35 to $38 per ounce. However, the Agreement failed to impose discipline on the U.S. government and with no other mechanism in place, the pressure against the dollar on gold continued. The result was, gold became a FLOATING ASSET. Towards the end of 1971, it reached $70.30/ounce of gold and has kept on rising.

This is when the industrialized nations of the world started to abandon the devalued peg against the dollar (BUT: it is still being done in case of Chinese currency, Renminbi, i.e. pegged with U.S. Dollar). By end of February 1973, all resemblance to the Bretton Woods currency exchange or the Smithsonian fixed rate of exchange system was closed. It was when the major currencies began to float against each other, as governments still had difficulties maintaining the exchange rates within +/-2% band, as stated in the agreement. It essentially brought into effect the FLOATING exchange rate system, which determined the exchange rates based on the market forces of supply and demand.

The Flood Gates Are Opened

When the U.S. abandoned the gold standard, it hampered an orderly economic policies that the entire world was bound to. This is very significant. All of the barriers to keep the U.S. in check just disappeared. The country was no longer required to pay for its imports with gold, or even dollars backed by gold. The U.S. could pay for its imports with dollars with no backing at all or with dollar-denominated debt instruments. America had the unlimited freedom to expand its monetary bases at own desire.

This created a surge in the central banks around the world holding U.S. dollars as reserve assets, due to the ever growing trade imbalances between the America and rest of the world.

Fall Of The Dollar: Part-I

Legacy of Jobs

Steve Jobs has become immortal upon his death. His wonderful creations, his passion and his uncanny drive- all have made him a superstar reigning in stratospheric heights.

Jobs showed an “unconventional” path to life. The urge to run by the heart, instead of the brain. Chase after what the heart desires, instead of conventional establishment. This is THE difference, the “Road Not Taken” approach of Jobs. In Job’s own words, “….Don’t be trapped by dogma-which is living with the results of other people’s thinking. Don’t let the noise of other’s opinions drown out your own inner voice. And most important, have the courage to follow your heart and intuition. They somehow already know what you truly want to become. Everything else in secondary.”

It takes radical determination, it takes hell of a courage to come out of comfort zone, come out of convention. It takes brimming tenacity of mind to pursue the inner-most urge and stick to it. You should be dead serious to stick to that hardcore urge. It’s like follow “What the Heart Says”, instead of what convention, or establishment tells you to. He was so radical, he made his own rules. He judged the world in binary terms. Products are “insanely great” or “shit”, one is facing death from cancer or “cured”, subordinates are geniuses or “bozos”, indispensable or no longer relevant. His outrageous comment about Microsoft, in the tele-documentary “Triumph of the Nerds”, was, “The only problem with Microsoft is they just have no taste……I have a problem with the fact that they just make really third-rate products”. This statement is quintessential Jobs: arrogant, frank, insightful and perhaps more than half right, though brutally overstated. One of NeXT executive commented, “Being around Steve is a reality distortion.” It is this Radical Mind that created the difference- in his own life and in his works.

His trademark is intensity, intuition-driven and radicalism. He had vision, he had the insight to exercise “think different” approach, which contributed to put Apple’s designs a head above the competition. He was intensely focused on his vision. In pursuing his heart’s urge, he was relentless. “….I’m convinced that the only thing that kept me going was that I loved what I did. You’ve got to find what you love….Your work is going to fill a large part of your life, and the only way to be truly satisfied is to do what you believe is great work. And the only way to do great work is to love what you do. If you haven’t found it yet, keep looking. Don’t settle. As with all matters of the heart, you’ll know when you find it.”

He had unconventional ideas. The thinking of death and get yourself done before you are gone-both are unconventional by western standards. The norm is to think of everything else other than death and get going as usual. The unusualness is evident in his behavior. He would park his Mercedes in handicapped spaces, didn’t put license plate on his car, offered stock options to his employees by backdating the option’s value.

He was visionary by the super-most standards. That’s how he became pioneer in his every endeavor. He is without a doubt top pioneer of computer generation. His uncanny creativity is obvious. He was the clear visionary to see technology to be designed and sold as consumer product, which was the revolutionary idea in early years of computers. His leadership in innovative products like Macintosh personal computer (the dominating Windows Operating System being modeled from Mac’s point-and-click system), computer animation (with Toy Story being the first fully computer-generated feature film by his company, Pixar) and series of wildly successful products of “simple elegance” like iMac, iPod, iPhone, iPad and other gadgets. Very few human souls invoked such immense repercussion in contemporary world like Jobs did. This “alternative” philosophy, this alternative approach to life, this intensity of heart’s passion, this mountain-like determination to materialize one’s own vision- are the true legacies of Jobs.

China Economy: Miracle or Bubble?

The problem with economic consequences is that, they are not visible before long long time. As we have seen the effects now unraveling in different parts of the globe, like the debt and demographic crisis in Japan, or the sovereign debt crisis in Europe or the Budget & Trade Deficit in the U.S., they occurred and impacted the economies within long span of time. There are also some symptoms that have evolved in China, which are just tantamount with Economic Bubbles.  Edwin Chancellor, a foremost authority on Economic Bubbles that occurred throughout history, has identified some classic symptoms of economic bubbles in case of China. Surely these have far-reaching consequences.

China has roared the most in the contemporary global economic arena. But its reputation as an unstoppable giant- as a country with an unending supply of cheap labor and limitless capacity for growth-masks some serious and worsening economic problems. China’s labor force is aging. Thanks to its brutally-enforced “one-child” policy, China’s population is actually set to decline in 2015, and its worker participation rate will peak this year- after which the numbers of people joining the work-force will fall off rapidly. If you would look at the real future of China, look at Japan, whose own aging population is the hidden cause of its continuing decline. Apart from that, its consumers save too much and spend too little. Its political and economic policy tools remain crude.

CLASSIC SYMPTOMS OF ECONOMIC BUBBLES IN CHINA

·         The biggest is the staggering dependence of its economy on government-fueled investments boom: No major economy has had investment as a percent of GDP at 50% for a sustained period. No country can be productive enough to take that proportion of GDP and re-invest it into new capital stock without eventually facing massive over-capacity and a staggering non-performing loan problem. In a free-market economy, investments fall during periods of uncertainty. Yet in 2009,Chinese investments in fixed assets jumped by 30%, rising to a record 58% of GDP. Roughly a quarter of this investment was state-directed, with many projects serving solely to meet local GDP growth targets. One commentator says, China is following the “Asian growth model on steroids”- i.e., the pattern of the Asian Tiger economies, boosting growth through ever-increasing investment, which led to the Asian Crisis in 1997-98.

Most likely, as per the wizard forecaster economist Nouriel Roubini (who first correctly predicted the American Housing Crisis), after 2013, China will suffer a hard landing. China needs to save less, reduce fixed investment, cut net exports as a share of GDP and boost consumption as a share of GDP. China is rife with over-investment in physical capital, infrastructure and property.

Roubini further added that the economy is overheating here and now, but in the medium term, China’s overinvestment will prove deflationary both domestically and globally. Once increasing fixed investment becomes impossible-most likely after 2013- China is poised for a sharp slowdown. Continuing down the investment-led growth path will worsen the visible glut of capacity in manufacturing, real estate and infrastructure.

Roubini says, “I was recently in Shanghai and I took their high-speed train to Hangzhou”, referring to the Maglev line that has cut travelling-time between the two cities to less than an hour from four hours previously.

“The brand new high-speed train is half-empty and the brand new station is three-quarters empty. Parallel to that train line, there is also a new highway that looked three-quarters empty. Next to the train-station, is also the new local airport of Shanghai and you can fly to Hangzhou” , he said. “There is no rationale for a country at that level of economic development to have not just duplication but triplication of those infrastructure projects.”

·         Lack of domestic demand: Too few people in China had the discretionary spending capability to support its economy domestically. Analysis has shown that it took a per-capital gross domestic product of about $5,000 to have meaningful discretionary spending power in China. About 110 million Chinese had that much or more, but they constituted only 8 percent of the population and accounted for just 35 percent of GDP in 2009, while exports accounted for 27 percent. In contrast, in advanced economies, about 70% of economic output is attributed to domestic consumption! Even China’s middle and upper classes had only 6 percent of Americans’ purchasing power.

·         Easy Money and Risky Lending: China today is keeping interest rates artificially low to promote investment and subsidize state-owned companies. For the past 40 years, the interest rate that major U.S. companies have borrowed at has been, on average, 1 percentage-point higher than the rate of GDP growth. In contrast, the Chinese prime borrowing rate has been on average 9 percentage-point below GDP growth over the past two decades!

What’s more, Beijing responded to the 2008 financial crisis and the resulting collapse in its exports by ordering its banks to lend.  In 2009, new bank lending grew by nearly 10 trillion renminbi ($1.5 trillion), or around 29% of the country’s GDP.

“The size of this credit expansion is worrying in itself”, obereves Edwin Chancellor. “It beggars belief that lending could have expanded so rapidly without some decline in underwriting standards”. Indeed, much recent bank lending in China resembles the lowered underwriting standards that led to America’s subprime-mortgage meltdown of 2007-08. For instance, up to half of 2009’s bank loans went to local government funding vehicles that appear to have little or no current cash flows. Instead, local governments are now depending on asset prices for revenue-much as they did in places like California during America’s housing bubble.

·         Real Estate Bubble: Chinese authorities are pursuing massive commercial and residential real estate construction despite lack of perceptible demand. Among the results: the newly constructed “ghost town” of Ordos in Inner Mongolia-with housing for a million, and virtually no residents. “Build it and they will come”- or maybe they won’t.

In addition, for Chinese households, artificially low rates of interest on their savings are also driving them into speculation in real estate-just as Americans did the years leading up to the 2008 crash. As a result, in China today, residential real estate is averaging between 20 and 40 times average household income-compared to roughly 10 to 12 times household income at the height of the U.S. housing bubble in the most overvalued neighborhoods. “This has to qualify as the most dramatically overvalued real-estate bubble in world history”, writes Steven Jon Kaplan of Truecontrarian.com.

·         A Surge in Corruption: “All great speculative manias have been accompanied by rising levels of fraud”, observes Edwin Chancellor- and it’s only after the bubble bursts that the Madoffs and Enrons come to light.

Here, of course, is where the closed nature of Chinese society is especially worrisome: China recently earned a dismal 3.5 (out of 10, for “very clean”) in Transparency International’s 2010 Corruption Perception Index, giving it a rank of 78…just below Tobago.

More worrisome: the real estate boom and infrastructure spending that are driving Chinese growth are especially susceptible to corruption. As evidence, the New York Times reports, half of all those luxury sales are estimated to be bribes.

·         A Fixed Currency: “Fixed currency regimes often produce inappropriately low interest rates, which are liable to feed booms and end in busts”, cautions Chancellor.

China’s currency, the renminbi, is pegged (fixed) to the U.S. dollar-leading to an undervalued exchange rate that boosts exports, keeps interest rates low, and encourages massive inflows of foreign capital.

And get this: The Bank of China is printing as much as $ 2 billion worth of renminbi per day in order to buy dollars and maintain the currency peg. The money supply skyrocketed 26% last year in China, creating an artificially booming economy that cannot last and will eventually cause a collapse.

CONSEQUENCE?

China avoided a hard landing during the global credit crunch but faces a downturn after 2013, as it will struggle to keep increasing fixed investments, Roubini said. He said, investment was already 50 percent of gross domestic product. Sixty years of data had shown that over-investment led to hard landings, citing the Soviet Uniion in the 1960s and 1970s, and East Asia before the 1997 financial crisis.

“A significant slow-down in China, or even negative growth, would likely reverberate throughout the world economy, including that of the United States”, warns Banning Garrett, Director of the Asia Program for the Atlantic Council of the United States. “The end of China’s role as an engine of growth would be a blow to global economic growth, affecting investors in China, purchasers of Chinese goods, and exporters to China”.

Bloomberg’s David Lynch agrees (1/26/11): “Any Chinese financial emergency would reverberate around the world. The  total value of the country’s exports and imports last year was $ 3 trillion, with about 13% of the trade between China and the U.S. As of November (2010), China also held $ 896 billion in U.S. Treasuries.

If China’s growth falls to less thn 5% in 2011 (from the targeted 8%), global commodity prices could plunge by as much as 20%, warns Fitch Ratings (11/30/10). Shares of U.S. and other Western commodities, steel, energy, manufacturing, automotive and chemical firms- which have come to rely on China as their biggest customer-would tumble if the country’s construction and capital-expenditure booms abruptly ended.

“A bursting China bubble would be a massive deflationary shock to the world economy”, says Chen Zhao, Chief Global Strategist and Managing Editor for Global Investment Strategy, BCA Research Group. “With China in growth recession, global saving excesses could surge and world aggregate-demand would be vastly deficient.  Bond Yields could move to new lows and stocks would drop, probably precipitously-in short, investors would face very bleak and frightening prospects.”

Like we have said at the beginning, it takes long for economic consequences to become visible. But, as symptoms often presage ominous outcome, this might be the case for the bubbles foaming in Chinese Economy over the years. And, if they burst, it will have far-reaching consequences.

Who Gains What- Out of Synthetic Debt Deal?

As suggested by us, the U.S. was able to cut- through a last minute Debt Deal on August 2 to avert possible default, after almost 2 months of haggling over the issue, and pressing over priorities of each other parties. Most of the proposed rise of debt ceiling ($900 billion in this year and subsequently $1.2 to 1.5 trillion) would be ploughed-back by deficit reduction of $2.4 trillion over the next 10 years.

The bill tilted heavily on the Republican agenda- not raising any new revenues by NOT incurring new taxes on American corporate, WITHOUT reducing any significant Defense budget. It only focuses on deficit reduction by cutting expenses. The common objective of achieving a balanced fiscal condition could not be met without instituting an increased revenue earning (by higher taxation mostly from rich corporates and individuals), vis a vis curtailing onerous budget spending. The cumulative deficit reduction of $2.4 trillion, proposed to be made within next 10 years, is less than the figure $4 trillion that bipartisan groups and political leaders had more or less agreed was necessary to put the debt on a meaningful downward path relative to GDP. It’s also the number that Standard’s and Poor, the credit rating agency, had suggested necessary for America to avoid a downgrade to its AAA credit rating.  Between American battle of conflicting priorities- maintaining fiscal balance as well as maintaining political and military supremacy - the latter clearly prevailed. The current reduction of defense budget proposal, in inflation adjusted dollars, kept Defense spending higher than it was at the height of the Cold War. Adjusted for inflation, the U.S. spent at most $580 billion a year on defense at the height of the Cold War. In the 2011 fiscal year, the Pentagon’s baseline budget is $549 billion, with another $159 billion allotted for the wars in Iraq and Afghanistan, for a total of $708 billion. That total figure drops slightly to $670 billion in the 2012 budget proposal.

The cloudy process of deficit reduction has lots of catches within it. The budget employs a BASELINE that automatically adds an upward adjustment for the rate of Inflation. And then, on top of this, the budget is automatically adjusted upward by another 7.5% each year! So, every year, the budget increases by 7.5% plus an adjustment for inflation!

So, the bottom-line is, the U.S. budget would be increasing by $10 trillion over the next 10 years. Now, if the planned deficit reduction materializes, the budget will only increase by $7.5 trillion! So, it’s no surprise that S & P on August 5 had downgraded America’s sovereign rating for the first time since the U.S. won the top ranking in 1917. This entails even higher costs on top of debt-behemoth that is on the economy’s shoulder, translating in higher interest rates. Projections are that the higher interest rates triggered by a downgrade could knock 0.4 percentage points off U.S. growth. That’s a big deal when the economy is growing at just 1.3 per cent (as per second quarter GDP data, annualized). And it’s worth noting that now that GDP is revised to be growing insignificant, debt is larger as a share of GDP (with gross debt ratio to be 96% of GDP, as of June 2011). This massive debt repayment program would have to be met by further monetary expansion.

Where will this extra money come from? Clearly, the Fed will continue its “money-pumping” program, by buying out massive amounts of Treasury Securities which are beyond purchase demand by investors. It will continue to erode perilously the value of money i.e. U.S. Dollar further and further.

So, if Republicans are the clear winner from this deal, the economy is the loser. An ideal deficit-reduction package would have coupled near-term stimulus with long-term consolidation, that at first stabilized and then reduced the debt as a share of GDP. As it transpires, this deal certainly doesn’t do the first and it’s unclear that it will do the second. So, in the final count- as political eventualities have shown- the fiscal chaos in the U.S. goes on. It’s like a spiral the continues unbroken. And, as mentioned, it does have monetary implications, which erode further the U.S. Dollar value.

After QE2, What’s Next?

In our last post about U.S. Quantitative Easing (QE) http://investmentsandbeyond.blogspot.com/2011/06/deadline-june-30th-end-of-quantitative.html, we discussed about the background and actual results of the QE program. We also mentioned about the possible outcomes that might emerge. As anticipated, the Federal Reserve is contemplating on injecting another bout of “money-pumping” program, as evident from Fed Chairman’s testimony to the Congress Financial Services Committee on July 13, “the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support”. Ironically, the same period coincides with crossing the full-limit of U.S. debt ceiling, which needs to be enhanced and pending repayments must be made by August 2.

We can surmise from careful reading of Ben Bernanke’s statement to the Congress that the Fed would somehow and someway (however they name it) come to the rescue of the flat economy with another trillion or so free dollar. The stalled debt talk would reach a synthetic conclusion at the 11^th hour, the U.S. debt would narrowly escape the default. Actually the US government and correspondingly the Fed have no alternative. As Bernanke himself testified before the Congress, “Any U.S. default would be a major crisis and would throw shockwaves through the entire global financial system”. The US economy is being cut by a double-edged sword, on one side, further indebtedness crushing the U.S. dollar further; on the other, the U.S. mandatorily has to borrow more (as the US default would permanently jeopardize the government’s credibility) to repay and to further expand the economy. This is imperative, as in the U.S., where consumer spending accounts for 70 percent of the GDP, without increased consumer spending, the economy would again be recession-bound. And the less people are out of work, the less they consume.

 So, we can fully expect another DILUTION of money. Through the haggling over “money”, by means of endless credit expansion, the government has put the “trust” in money (which acts as a legal tender provided by the state) in serious jeopardy.  Already the ratings agency Moody’s announced it is considering downgrading of U.S. debts. This would further increase the interest rates and the borrowing costs. The increased payment costs would just make the likelihood of pulling out of downward debt-spiral almost impossible.

Another aftershock of this attempt to crush the Dollar would be the fall of housing prices further. According to Gary Shilling, President of A. Gary Shilling and developer of S & P Case/Shiller  Housing Index, we can expect “another big leg-down in housing”, which might trigger serious problems for the economy in 2012. The Bottom Line is: Gary Shilling thinks house prices probably have another 20% to fall.  

The same story holds for European countries, where sovereign indebtedness for lot of countries has gone beyond their actual capacity (i.e. national economic output). For example, Italian Debt-GDP ratio is now 120%, for UK it is 77%. For Japan, it is the highest indebtedness rate of 225%! So, clearly we are heading for a global economic anarchy.

Thus we are witnessing the Dollar fall and inherent reciprocal rises of gold and oil. Bernanke, himself testified, “the rising prices of gold reflects global uncertainties…the reason that people hold gold is as a protection against what we call tail risks: really, really bad outcomes’. As the governments all over the world have become the source of systematic risks by abusing the powers they have been entrusted with: power to spend, borrow, tax and print money. We don’t see any possibility of respite from this vicious cycle in foreseeable future.  Amid these uncertainties, gold is poised to shoot further in price, with the value of $2000 knocking at the door.

Sovereign Debt Crisis: Where does it end?

The problem with debts is that once you open this Pandora’s Box, it becomes a vicious cycle. You take on more debts and so on. This spiral goes on, as if a powerful genie is pushing you through. If capitalism brings forth more freedom, sometimes this freedom becomes abusive. You create unlimited amount of debt capital for whatever purposes to satiate unending needs. The sovereign nations are victims of this vicious cycle and seem to be heading towards doom. They have gone extreme beyond their means.

European sovereign debt crisis nicknamed "the PIIGS" (after countries most affected like Portugal, Ireland, Italy, Greece and Spain) is worst hit.  At end of 2010, Portugal's public debt was 93% of its GDP; Ireland's  96%; Italy 119%; Greece 143%; Spain 60% (source:Wikipedia). Then comes the story of Japan, which crossed the national debt to GDP ratio of whooping 226%! The US indebtness is estimated at 93% of GDP. Economists Carmen Reinhart and Kenneth Rogoff have shown that a rise in government debt above 90% is associated with a decline in economic growth of roughly one percent point per year.

Prof. Reinhart warns, “These processes are not linear, you can increase debt for a while and nothing happens. Then you hit the wall, and—bang!—what seem to be minor shocks that the markets would shrug off in other circumstances suddenly become big.” That is the nature of debt bubbles; they keep expanding and expanding until the day that they inevitably burst. Governments around the world will issue somewhere in the neighborhood of $5 trillion more debt this year alone. Debt to GDP ratios all over the globe continue to rise at a frightening pace. Because the world is so interconnected today, the collapse of even one nation will devastate banks all over the planet. If even one domino is toppled, there is no telling where things may end.

We have seen the marathon round of bailouts being taken place in Europe. We have to keep in mind that all of these “bailouts” are just more loans. There is no way that the Greeks are ever going to be able to repay all of this money. But this is what happens when a nation lets debt get out of control. For years and years it can seem like all of that debt does not have any consequences, but then the day of reckoning comes and it is a complete and total nightmare.

So will these bailouts solve the problem?

No, giving Greece more loans is only going to kick the can down the road for a little while longer. The truth is that Greece is bankrupt. Unless huge amounts of Greek debt are forgiven, Greece is going to default sooner or later. When confidence in the finances of a nation is lost, borrowing costs can go up very quickly. Today, the yield on two year Greek bonds is up to 28.6%. When Lehman Brothers collapsed, it was leveraged 31 to 1. Today, German banks are leveraged 32 to 1. German banks are also holding a massive amount of Greek debt. That is why there is so much fear that the crisis in Greece could spread across the rest of Europe and start toppling dominoes. The severity of the crisis is evident.

The U.S. is rapidly approaching a day of reckoning like the one that Greece is going through. The U.S. government has piled up the biggest mountain of debt in the history of the world and faith in the U.S. dollar is dying. The whole world is watching the U.S. government run up record-setting budget deficits and they are watching the Federal Reserve print money like there is no tomorrow and they realize that the U.S. financial system is slowly imploding. Now President Obama is crying for a sustainable solution of budget deficit by reaching a deal as part of a trade-off in which Congress would agree to extend the nation’s debt limit (which has already crossed $14.3 trillion limit) by Aug. 2 to prevent a catastrophic government default on its bills. Right now, the Federal Reserve has been buying up most new U.S. government debt with dollars that it has created out of thin air. This is a giant Ponzi scheme, and it is a major contributing factor to the decline of faith in the U.S. dollar.

The world financial system is far more vulnerable today than it was back in 2008. Professor Sung Won Sohn at California State University warns that “The European debt crisis has the potential to have as big an impact as the subprime mortgage crisis did in the United States.” The next wave of the financial collapse is going to hit at some point, and when it does it is going to probably be even more painful than the last wave. The major risk involves is, this debt crisis destabilizes the very fabric of the society. It was evident from the wild protests that have been taking place in Greece. Today more and more Americans are losing their jobs and their houses, being forced to become outcasts. It portends sad unrest that may erupt elsewhere in the world also. So, are we heading to a complete financial collapse and pervasive civil unrest around the globe?

Deadline June 30th: End of Quantitative Easing?

To combat virulent recession, the Fed started Quantitative Easing in November-2008, by buying-out “toxic assets” and circulating money into the economy. The QE is an ad-hoc monetary policy used to stimulate the national economy when conventional monetary policy has become ineffective. Central banks utilize QE by purchasing financial assets from banks and other private sector businesses with new money that it creates electronically. This action increases excess reserves of the banks and also raises the prices of financial assets bought, which lowers their yield (price up, yield down). The whole process aims at reigning in lower interest rate regime, making it cheaper for businesses to raise capital. It is also an inflationary tool and can be used to ensure that inflation does not fall below target, thereby boosting economic activities.

At some point, cash emerge from bank reserves and flow faster into a larger economy. Private sector money would change hands more rapidly. The expectation is that hiring would rise; banks would lend; loans would be cheap and lots of people would buy houses.

After QE1 (starting from Nov-2008) added $1.75 trillion to federal debt with little positive impact, the Fed might have chosen to abandon quantitative easing. But in November-2010, the Fed again began injecting another $600 billion into the economy- this time QE2.

Almost closing the deadline June 30^th, the QE2 involves buying up long-term treasuries in order to depress long-term interest rates. The tactic could stimulate lending as mentioned above, but will boost inflation, which, due to the Fed’s money injections, is already poised to continue climbing. At the least, it is evident the desired results are far from visible. Ironically, it was also endorsed by the Fed Chief in a way, when Mr. Bernake admitted publicly last week that: “ Maybe some of the headwinds that are concerning us, like the weakness in the financial sector, problems in the housing sector-some may be stronger and more persistent than we thought.”

When the deadline comes to a close on Thursday June the 30^th, what might happen to the already depressing economic scenario? To bolster hope over economic recovery, may be plethora of QEs (QE3, QE4….) will continue to inject billions/trillions into the thin air. Meanwhile, the economy will continue to be in the doldrums. This shakiness was evident, as the U.S. stock market started to nosedive, at one point sending the DOW more than 200 points. Stocks continued to slide-the market finishing down for the seventh week out of the last eight. There is a potential of an ensuing market collapse. Correspondingly, we might expect a strong push in gold and silver prices, taking them to new heights.

Return to the Gold Standard?: Part-I

The unprecedented changes in global economy in last couple of years and its aftershock have evoked debates over several unique economic issues, one of them being the possibility of returning to the Gold Standard. This particular economic phenomenon is nothing new, as far as economic history is concerned. The classic gold standard was in place from last part of 19^th century till First World War.  This allowed a country to maintain a balance between its monetary reserves and its gold holdings. It also allowed an economy to limit the amount of credit it could create. In essence, it forced a country to maintain a balanced budget and prevented it to “go beyond its means”.

Under the Gold Standard, a government is limited-both legally and practically-as to how much paper money it can print. As recently as the Lyndon Johnson administration (1963-1968), the U.S. could print paper dollars equal only to four times the value of the nation’s gold reserves. Under this standard, governments that print too much paper money risk runs on their gold reserves. Runs occur as holders of the paper seek to convert to gold before the vaults are empty. A run on the dollar is what happened in the late 1960s, which culminated in President Richard Nixon “closing the gold window” in 1971.

The subsequent offshoot was the governments creating budget deficits to the unsustainable level. As at present (in May 2011), the US debts amount to $14.32 trillion, representing 98% of 2010 GDP of $14.66 trillion (source: Wikipedia). This undue expansion has had its consequences, with the dollar losing its value (in purchasing power) of over 80% in last 40 years, after the abandonment of gold standard. In this crucial junction of global economy, it is worthwhile to think of some drastic changes, at least there are some learning points from this particular issue of Gold Standard.

Fall of the Dollar:part-1

The primacy of US Dollar as global Means of Exchange as well as World Reserve Currency is in tatters, due to various geo-political and economic reasons. From the early 20th century, United States has enjoyed unprecedented economic and political clouts of global scale. This enabled Uncle Sam to exercise supreme control everywhere in the world. This also enabled the country to alter the traditionally established means of exchange and reserve currency, i.e-Gold Standard. For meeting its ever expanding fiscal deficit, it was forced to break the system of balancing its money with reserve (i.e. gold). So it was virtually free to expand its monetary base, without having to keep any corresponding reserve. By selling its own-currency-denominated debts like US Treasury Bills and Bonds, it has borrowed virtually indefinitely. Foreign countries, mostly the central banks, have hold mega amounts of US dollar reserves on their accounts, which in turn, don’t carry much value other than promise to pay. Dollar has also been established as means of exchange to trade oil, which is the “global fuel” for energy, for no real economic reasons. The costly wars that the US has been engaged with, starting from Vietnam War to recent Iraq & Afghanistan War, have caused gigantic pressure on its fiscal balance for long. The most powerful country on Earth, apart from its fiscal imbalance, is also entangled with its own economic crisis like real estate collapse and financial sector collapse. The seemingly indispensable Quantitative Easing policies will continue to shatter the US currency further. Time will say where it is heading to.

Investments- All About Growing Wealth

Investments is vital for life, just like education or healthcare. It deserves our attention and energy (and offcourse some of our money). Its about timing. When we spot an opportune time and take a small action, it gets a multiplied yield for us. Its about being aware of the present Market, following the events impacting it and making ripples (and waves). Taking those situations into consideration, identifying some directions and opportunities-are all the market-conscious investors do. There are some principles, which are almost as powerful as laws- act as dynamics and gives positive leverage to our invested money. All these things and concerns we will explore and cultivate on regular basis. These will lead us to growing our wealth.