A Currency at Risk

It’s the day after Christmas, and I’m watching the dollar continue to fall against currencies like the Euro and the Yen. The New York Times did a piece today on how China’s willingness to take U.S. government debt – an unfortunate saving grace for us – and supply us with cheap manufactured goods added to our simple expectation that, with a little credit card and real estate debt, we could live the good life and have the “things” we so desired. We did ourselves in, but we took the world with us. But focusing on our expectations and the risks we may see in the future when it comes to the value of our currency are worthy of exploration. Look at the signs.

People and companies are buying U.S. Treasury bills that today yield approximately a zero rate of return (even slightly less for an instant in time) just to have an asset that won’t collapse in value. This clearly “deflationary” evidence is normally associated with something worse than a recession; some folks call what’s going on a “managed depression,” what the Great Depression of 1929 might have looked like with some government intervention. The demand for this zero interest paper is soaring, but there are also signs that the markets are beginning to worry about a different risk, the one associated with high government borrowings, failed stimulus packages and over dependence on this financial instrument… the rapid decline of what is currently a solid dollar as compared to other currencies around the world.

Although I think that this scenario is unlikely at least until we have hit bottom and begin to surface again, there are some who look to that “default insurance” instrument – the nasty derivative called a “credit default swap,” that floats in the international marketplace at a volume that is six to seven times our entire national debt, for answers. You see the pricing of these default instruments is based on risk analysis, and the solidity of risk has usually been measured against the creditworthiness of the U.S. government. The December 11 theDeal.com noted: “[I]f the credit default swap market is to be believed, as the cost of contracts protecting against an American default have topped 60 basis points [that’s 0.6% equivalent interest rate], indicating the U.S. is a bigger risk than Japan, Germany or Campbell Soup Co.” But what’s the worst that can happen if this scenario accelerates?

TheDeal.com continued: “FT Alphaville quotes one view from Monument Securities: ‘Though a Treasuries bubble might appear unproblematic, however, its bursting could turn out to be more dangerous than the collapse of any other kind of bubble. If confidence eventually returned to other markets, investors would shun the low yields on Treasuries. The Fed would then face the choice of monetizing most or all of the Treasuries market, as funds fled to higher-return investments, or else of allowing Treasuries yields to race higher. Because foreign holdings represent a significant proportion of the stock of Treasuries outstanding, a collapse in Treasuries prices might soon be reflected in a collapse of the US dollar, with the accompanying threat of hyper-inflation in the USA and depression elsewhere. At that point, many investors might wish they still enjoyed the comparative calm of the 'credit crunch'.' ”

Let me address this issue another way. When the world begins to recover economically, I suspect that currencies will be revalued based on a complex analysis of how much we have borrowed reduced by how much more productive we are at the time. If we don’t continue spending on training and education, you can pretty much guess what the productivity portion will look like. Clearly, education is the best hedge we have against this debacle. We already know that as a nation, we will have borrowed significantly more than any other major nation on earth. As the currency falls, the price of our exports (but we don’t export much in the way of manufactured goods anymore) will become more competitive, but the cost of globally priced products and commodities (oil, copper, foreign manufactures, etc.) will rise, spiking inflation.

The Federal Reserve typically counters inflation by cooling down the economy by raising interest rates. High interest rates slow real estate and consumer purchases, corporate expansion… well, you can guess the rest. Funny that multinational corporations, those whose trade is not necessarily primarily governed by American consumer activity, can actual weather this currency devaluation the best, sometimes even growing and prospering during the process.

The problem with playing with monetary and fiscal policies – which is most certainly a necessary evil when you a battling the demon of super-recessionary times – is that there are always unintended consequences. The other problem is that you won’t really know until the problem appears, and the measures you take to defeat that could also cause those secondary unintended consequences. And you thought theme park rides were exciting.

I’m Peter Dekom, and I thought you might be interested.