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Minyan Mailbag: How Dollar Debt Could Play Out

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The current credit bubble is by far the largest relative to GDP ever.

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Mr. Practical,

The global economy has been US-centric for a very long time and it is hard to think in terms of how financial and economic relationships will behave if and/or when the US-centric dynamic begins to transition.

In your latest article you talk about the consequence of a "socialistic" response to the problems that have been created through the massive debt that has built up in the US.

When foreign investment begins to repatriate… "This will cause further dramatic erosion in the dollar, higher U.S. interest rates, and a reduction in our standard of living."

It is here where I would appreciate your perspective. Many very savvy investors that I greatly respect are expecting a deflationary, dollar-strengthening spiral to take root and become irresistible. I understand that the weight of debt normally leads to an ultimate reduction in consumption and a tendency to pay down debt.

I understand the US paying down its debt, (less consumption and more production) would normally be dollar positive. However in the case of the US, (with warnings from the Comptroller General of the United States, a growing cost of interest on foreign debt, the current and ongoing need to continue borrowing from foreigners), it "seems" to me that a typical scenario of US citizens simply reducing consumption, increasing exports, reducing debts… leading to a stronger dollar is not a foregone conclusion.

Doesn't the fact of the US having restructured to a dominantly consumptive economy mean that a reduction in consumption which is fueling the debt problem will be a disproportionate negative as the domino effect ripples through the US economy? (Wal-Mart employees laid off and don't buy their Starbucks (SBUX), Starbucks employees laid off and don't get oil changes at Jiffy Lube, Jiffy Lube employees laid off don't shop as much at Wal-Mart (WMT)…) Isn't it possible that the effect of reduced consumption in a consumption dependent economy will be a far greater dollar negative than debt reduction positive? Particularly when there is no light at the end of the tunnel, (even with reduced consumption), as far as the need for continued US borrowing from foreigners?

I am anxious to hear your thoughts.

-Jeff


Minyan Jeff,

Unfortunately, we could very well experience both a stronger dollar for a time and then a much weaker one.

A force strengthening the dollar (relative to other currencies) is now coming from attempts to restructure and pay dollar-denominated debt back, simply because there is too much of it. Thus there is an increasing demand for cash right now, not coming from new projects that business wants to take a risk on because it looks good, but because banks and other financial institutions are attempting to refinance and restructure existing debt that has become unmanageable. Financial institutions are currently seeking to retire debt and reduce leverage; this process involves selling assets and is deflationary in nature.

This is why the Fed has lowered interest rates at the discount window (emergency room): private money is no longer willing to lend to banks holding crumbling and risky mortgage debt and the Fed and other central banks have become their only source of liquidity. Banks have little treasuries in inventory to exchange for new credit from the Fed; this is why the Fed is now accepting more and more risky collateral like mortgages and consumer loans. Ironically this may allow banks to not write down those assets to market prices: they exchange in REPO those assets at some artificially high price and the Fed carries it at that price through the term in the REPO.

If the REPOs are continually rolled, the banks may not have to take losses on those assets for some time. If this is so (I am investigating this), it is just another shell game to buy time. In trying to get normal longer term funding, I know of a sterling deal floated by a major European bank that failed; it pulled the deal and funded through Euro debt at egregious terms (imagine what that will do to its earnings). This tells us, by the way, that it is not just a dollar debt problem (although dollar debt is by far the largest), but a global debt problem.

A force weakening the dollar will be (may be acting now to a small extent) the final destruction of that debt manifested by foreclosures and prices of assets like land and houses (and yes, eventually, stocks) that act as collateral, falling domestically until foreign savings buys them at lower clearing exchange rate (this is likely to be much lower given the meager amount of world savings relative to dollar debt). It is when a significant portion of the dollar debt (I don't know the number) is destroyed (defaulted upon) that the forces working to strengthen the dollar are overwhelmed by the forces weakening the dollar. Remember, the dollar is not backed by real money, but by debt. When that debt is destroyed, the dollar becomes worth much less.

This is when gold will rise precipitously against the dollar and other currencies as well. Those currencies backed by real savings will do relatively better.

So your friends are right, for now, I think. While the global economy is still throwing off some income, albeit too low an income to avoid restructuring, and because most of the debt is in dollars, there is currently upward pressure on the dollar relative to other currencies. But imagine if economies, especially the U.S., begin to actually contract ( I believe that the U.S. is already in recession, but psychological factors like the whisper of Fed funds rate cuts and flawed thinking like the government will be able to manage the debt problem through bailouts, is keeping things at least together for now).

Income (GDP) will fall to levels that will turn restructuring into default (my belief due to the magnitude). This is when the dollar really begins to go down relative to other currencies, other currencies where there is some modicum of savings backing the domestic "money" supply. Global liquidity had been coming from yen savers exporting those savings and central banks levering (printing money against) it. In other words, yen savers had been willing to risk more for higher yield by taking currency risk. As they realize their folly and bring those funds back to yen-based yields (other Asian countries too), that liquidity availed to weaker currencies (those with no savings) like the U.S. has dried up.

Inside the U.S. we are not likely to see such a picture unless we look out globally. To us the dollar will be scarce and real interest rates will be stubbornly high (unlike the past several years when they have been stubbornly low). To foreigners, the dollar will be weak and prices in the U.S. will be going down precipitously. The Fed is aware of this scenario; that is why in one of their "solution" papers where they attempt to deal with "zero" bound interest rates, they worry about a flight of capital from the U.S. They identify a solution as creating a two-tiered dollar, one for U.S. citizens and one for foreigners.

Don't get me wrong: there is a lot of debt in Asian economies as well, but most of it is public debt. This is another problem.

As you can see it is a matter of timing. No one knows exactly how this plays out. Government plans, like watching a Republican president actually back a bail-out of Wall Street, are likely to get crazier and crazier in attempts to put this unwind of the debt bubble off. But someone is going to either pay this debt back or suffer even worse consequences like default. The best case is that it is our kids that do it, if you want to call that a best case.

But I don't think it lasts that long. It may not even last a few more months, given the immense size of this problem. The problem of course is U.S.-centric, although Asian countries have learned well over the last several years how to create debt and look good doing it.

Who is to blame? Jim Grant wrote a wonderful article in the NY Times op-ed section a week ago explaining 1) the magnitude of the debt problem and 2) that lenders will always lend too much and borrowers will always borrow too much. He explained that credit bubbles were created and went bust long before the Fed was ever created.

But the current credit bubble is by far the largest relative to GDP ever. Why? Part of the reason is derivatives have pushed lenders and borrowers to levels of risk taking unimaginable to our predecessors (due to the contingent nature of derivatives). But I do believe a large part of the reason as well is that central banks have created moral hazard, bailing out investors with artificial liquidity at every downturn.

Best Regards,
Mr. Practical

No positions in stocks mentioned.
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