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The Limited Shelf Life of Dollar Fruit
London, England
Wednesday, July 2, 2008

Today, we’ll keep it short and sweet.

The Dow managed only a piddling 32-point rise yesterday; still no recovery from last week’s big losses.

Oil rose another $1.30 – to close over $141. Gold jumped $16; it will now cost you $944 to buy an ounce.

“Caught between a fragile economy and banking system and rising inflation,” writes James Saft, “Bernanke and other Fed policy makers seem to have arrived on a strategy of jawboning the dollar higher and inflation lower.

“But talk is only effective if your audience judges that you have the means and willingness to follow through.”

Based on the last few days’ trading results, Team Bernanke might as well have kept their mouths shut. Gold and oil are acting as though they expect higher rates of inflation, not lower rates. And the dollar loses value daily – though it still has not collapsed completely.

The last part of that phrase might be worth a thought or two. The dollar has fallen against other major currencies. Against the euro, for example, it is worth barely half what it was at its high, which was reached shortly after the euro was launched 10 years ago. Against gold, it is worth only about a third of what it was worth 10 years ago. And against oil...the loss has been even greater – it’s down about 80%.

Yet, the dollar still hasn’t “collapsed.”

To give you an idea of what a collapse looks like, we look out the window. The English housing market seemed to defy the California trendsetters. As U.S. houses fell in value, U.K. prices stubbornly held up.

“It’s a small island,” explained the analysts. “We have a lot of immigration from overseas,” they went on. “We like owning our own houses,” was the verdict. Said a woman in the office when we enquired: “Housing always goes up in Britain.”

It goes up until it goes down. Now, it is going down, say the London papers. And the house builders are collapsing. Comes news this morning that the U.K.’s largest house-builder, Taylor Wimpey, was cut in half yesterday after it failed to raise the money it was looking for. This morning, the shares are still falling.

Another English builder has already collapsed. Its shares are selling for less than one times trailing earnings.

You want to see collapse? Just look at what has happened to Wall Street this year. In the last 6 months, Citigroup has lost 43% of its value. Merrill Lynch is down 40%. And Lehman Bros. has fallen 68%. The Wall Street Journal says banking stocks are beginning to look like the dotcoms in 2000. The big question is whether these are just temporary corrections – caused by panic over subprime losses and a credit crunch. Or whether it is a case of another dotcom-style bubble popping; if so, the Wall Street firms have further to fall and will not recover for many, many years.

But, back to the dollar.

In the vaults of various central banks around the world lies $4.8 trillion worth of foreign currency reserves – the fruit of selling oil and widgets, mainly to U.S. consumers. And like oranges or papayas...these dollars have a limited shelf life.

We have not been invited to peek into these vaults, but we have no doubt what we would find: huge stacks of green money, with the faces of dead U.S. presidents on the notes. Americans have been the world’s biggest spenders of the last 20 years. Naturally, it is their money that makes up the bulk of those foreign currency reserves. It is their money, too, that now poses the biggest problem – not only for the people who shipped it overseas, but also for those who have it in their vaults.

By our very rough calculation the total of these reserves will hit $5 trillion before the end of this calendar year. Then, we will be talking about real money. But that is the trouble; we are not really talking about real money at all, are we?

We should have said: $5 trillion is a lot of money; too bad it isn’t real. These are dollars, remember, the faith-based currency. The same dollars that have lost approximately 97% of their value over the last hundred years...and, according to the statisticians on the government payroll...now loses value at about 4% per year.

If we take the government’s number goons at their word, and presume that the entire $5 trillion were invested in 91-day U.S. Treasury bills, currently yielding 1.63%, the holders of all this dough are losing about $120 billion per year. The fruit is starting to smell a little rich, in other words.

But it could be a lot worse. If the euro, gold, oil, or commodities rise sharply, foreign dollar holders will feel like chumps. A few may give up on the dollar and dump it on the world market in large quantities. This could cause a sudden drop in the value of the greenback...leading other holders to rush for the exits. The dollar’s collapse would bring down the whole post-’71 monetary system...and pitch the world into a much more serious problem.

Already, many dollar holders are getting itchy. Many are looking to lighten up their loads. Some are trading dollars for food...

(“Hoarding nations drive food costs ever higher,” says the New York Times .)

A few have helped recapitalize the banks. And Abu Dhabi just traded $900 million for the Empire State Building. Only about $4.7 trillion left to go.

By comparison, the entire world’s stock of gold – above ground – is only worth about $4.2 trillion.

*** What the candidates will never tell you...

As we keep saying, democracy is fine, as long as you don’t take it seriously. The candidates for the White House job are eager to show voters that they are patriotic, religious and right-thinking men. What they don’t want to do is trouble the voters with real problems.

What kind of problems?

In our view, there are three major challenges facing the United States.

1) The country is going broke.
2) The military is out of control.
3) Standards of living are falling.

What? You haven’t heard the Democrats mention these things? How about the Republicans? Nope...?

As to the first, the country is going into a recession with its finances in the worst shape ever. In fact, if you believe Eli Broad, founder of Kaufman & Broad, the big building firm, this is the worst period in U.S. economic life since World War II. In his entire life, he says he’s never seen anything like it. And he’s 75 years old.

But here, we’re not talking about the economy itself. We do that every day. Here we’re referring to public finances.

Typically, in a recession, the government tries to “lean into the wind” to counterbalance the effect of an economic slowdown. Business stops investing so much. Consumers stop spending so much. The government – according to classic Keynesian economics – tries to take up the slack by spending more.

But where does it get the money? The feds already have a deficit of about $500 billion. And a “financing gap” of $57 trillion. In the coming recession, predicts Bill Gross of the PIMCO fund, the federal deficit will go to $1 trillion. Obama will likely be the next president. He’ll be tagged with the first TRILLION DOLLAR DEFICIT. But what can he do?

Obama says he’s going to cut spending. But every economist in the nation is going to tell him not to do it – not during a recession. It will only make the recession worse, they’ll say. Instead, they’ll urge him to spend more money. They’ll remind him that the Japanese used fiscal stimulus on a massive scale – equal to 10% of GDP – and it still wasn’t enough to light a fire under their economy. A similar fiscal stimulant in the United States would mean a deficit of $1.7 trillion!

Our old friend John Mauldin is sure we will “muddle through” somehow. “We always do,” he says. And it’s true; we muddle through most things. But a man does not muddle through a hanging; nor does an economy muddle through when its government goes broke.

More on these major problems tomorrow...