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Budget Follies Are a Warning Sign for the Dollar

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Superpowers decline and fall the same way: They rise to power, overexpand their reach in the world, spend too much domestically, then lose control of their finances and devalue their currency to nothing in order to pay for it.

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Everything is changing. People are taking their comedians seriously and the politicians as a joke.
-- Will Rogers

The recent budget fight (or discussion, or petty argument, or whatever you want to call it) has come to an end yet again. Just as most of us figured, US politicians decided to end to their argument at the eleventh hour to avoid a default.

Here are some observations:

1. The debt ceiling is flawed. If the ceiling was meant to keep politicians from borrowing and spending, and to keep debt at a certain level of GDP, it has failed -- it accomplishes neither. If the purpose was to cap the national debt (which now approaches $18 trillion), the system failed miserably. No other country in the world has such a system; the debt ceiling should be eliminated. In short, this is just a made-up crisis.

2. The politics are too partisan. When you are in a debt crisis, you need both revenue generation and spending cuts. Many Democrats do not want to touch Social Security or Medicare, which is an unrealistic position to take. Many Republicans do not want to increase revenues in the form of increasing taxes -- this is also unrealistic. You need a combination of spending cuts, rising taxes, and entitlement reform. And the bickering is embarrassing.

3. Much of the US's debt is owned by foreigners. There seems to be ingrained views on both sides. President Obama thinks he has the upper hand because he won the election. Winning an election does not make you dictator or king. You still must be flexible and work with your opposing side. The Tea Party is totally inflexible on the other side of the aisle. What Obama and the Tea Party both must remember is, to a certain extent, the US is not sovereign. Nearly 40% of its debt is owned by foreigners; it's critical to respect what the Chinese and Japanese think -- you don't bite the hand that feeds you. This is not Japan where 95% of the debt is domestically owned. Again, the fighting is embarrassing for these foreign owners. At some point they will get fed up.

4. The US is losing its influence in the world. China and India are now trying to create domestic demand in their economies. They have 2.6 billion people -- about eight times the population of the States. If they were to buy 1/12 of the goods and services that US consumers buy annually, they would be spending as much as US consumers in total dollars. Once this occurs (it will take years), they will not have as big a need for the US consumer and will not need to hold huge amounts of US debt. Much of this debate can happen because the US is the reserve currency of the world. However, if it loses influence....

As I noted in a recent article, Europe looks like it is about to break out and really begin to outperform. The Italian iShares MSCI Italy Index ETF (NYSEARCA:EWI) and Spanish iShares MSCI Spain Capped ETF (NYSEARCA:EWP) actually broke out of the recent market correction lows in the S&P 500 (INDEXSP:.INX). The euro is near multiple-year highs despite all the calls of doom and gloom in Europe. I believe past austerity measures are a big reason the euro has held up better than most expected.

I believe that the US dollar is in the midst of a long term decline and is losing its status as the world's reserve currency. Most superpowers decline and fall the same way: They rise to power, overexpand their reach in the world, spend too much domestically, then lose control of their finances and devalue their currency to nothing in order to pay for it. During the decline of Rome, it was bread and circuses; in the United States, we have food stamps and professional sports.

The national debt is $18 trillion; unfunded liabilities are estimated at $50 trillion and beyond. There are unlimited reasons to be negative on the dollar.

Finally, please remember this bull market is nearly five years in the making. A bear market and recession will occur within the next few years, and with no real reforms being made at the government spending level, that could be the downturn that leads to the demise of the currency.
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