Twenty Thousand Leagues under an Ocean of Debt
We all remember the dot com craze of the late 1990's, as well as the aftermath. Regrettably, for many people some recollections are more painful than others.
While that craze died a quick death with the NASDAQ market crash of 2000, the bubble psychology that steered it did not, having been masterfully re-routed to the housing market, courtesy of the US Federal Reserve's deflation fearing generational low interest rate policies. Getting a loan became too easy, as did the profits from liquidity driven real estate speculation. The enormous liquidity and low rates were a shot in the arm to the savings and income short American consumer, who was now able to tap into low-rate induced rising home equity values, and spend the money on consumer goods. This ATM cash withdrawal machine of sorts, and the consumer spending it helped generate, is what arguably kept the economy from tipping into recession.
But there was no silver lining in this cloud for the US dollar. Its value took one on the chin as rates fell, declining against most currencies as well as tangible assets like oil, gold and other commodities. Deflationary fears, having been drowned out by the oceans of liquidity, quickly gave way to inflationary concerns. In 2004 the Fed reversed course and started raising interest rates, citing these inflationary concerns as well as a falling dollar. By doing so, they disturbed a delicate balance when it came to the consumer. Relaxed in his warm bubble bath, the consumer watched nervously as the Fed turned the cold water tap on. By 2005, the warm comfort was replaced by pneumonia, as many consumers were facing loan defaults and bankruptcies hit records.
The issue of course is how and why did we get to this point? Why would the Fed lower rates to generational lows spurring a housing and mortgage bubble, only to squeeze loan holders - a large number of whom had taken out short-term variable rate loans - shortly thereafter with rising interest rates? The quick and easy answer would be myopia; but its astonishing level begs for an analysis in order to do it justice.
It is argued that the US dollar is America's most valuable export. I would not disagree with that assessment. Ever since the days when the US was the dominant player in world oil production sales of oil, particularly after the 1944 Bretton Woods agreement, were exclusively denominated in dollars. The Bretton Woods conference also established the IMF and World Bank and adopted a new gold-linked dollar as the currency for international transactions, effectively bestowing upon the US dollar the status of world reserve currency. This multi-dimensional demand for US dollars would keep dollar denominated asset values strong, as the entire world needed to accumulate US dollar based reserves for the purpose of securing current and future oil purchases.
However the US went off the gold standard in 1971, breaking the Bretton Woods gold link. Money and debt creation became the norm at that point as the US, removed from the shackles of the gold anchor, started to lose its status as a creditor nation. Cutting off that gold linkage however created a confidence issue amongst its trading partners, jeopardizing the world reserve status of the dollar. Needing to find a way to maintain dollar supremacy, the US struck deals with Saudi Arabia and others which ensured that the most valuable commodity of all would continue to be priced in US dollars alone.
Some thirty years later, the US is the world record holder in debt accumulation; although much to the chagrin of the US's reportedly dwindling gold reserves, not a record for which gold medals are awarded. Debt levels under the current administration have reached such dizzying heights that nerves are being stretched thin. Several news sources report that countries have been diversifying out of dollars and dollar assets. Braver countries are, once again, talking about pricing oil in other currencies; a move that would further reduce dependence on US assets and US government policies. Gold and commodity markets have also taken notice, suggesting that a world consensus might be forming; one that views the US as abusing its world reserve currency privilege, to the detriment of other nations.
The bullish view is that the US experienced a similar set of geopolitical problems in those troublesome 1970's as well, only to come away unharmed, roaring into the 1980's. The inference of course being that those in this camp worry too much, or are too negative. A critical difference between then and now however, as noted above, is that in the 1970's the US was a creditor nation, whereas today it is a debtor nation. Furthermore, in the 1970's there were depressed asset values in both the stock and real estate markets, such that the tight monetary policy and higher inflation fighting interest rates that followed, although troublesome, did not significantly impact already depressed asset markets.
The same would not hold true today however, where massive debt levels, whether consumer or government, would buckle under the weight of continued interest rate increases. The need to raise interest rates to keep a floor under the dollar must therefore be balanced against the need to keep rates low so as to not destroy the economy and the consumer. While the jury may still be out on the end game the Fed will pursue, there is no doubt in my mind as to what their only option will be. The intertwined nature of interest rates, exchange rates, debt levels and policy errors of the past leave the Fed stuck between a rock and a harder rock, with little choice but to choose inflation. In the end, this course of action will destroy the same dollar the US has in the past fought so mightily to preserve.
When this cold reality finally dawns on people, there will be a crisis in world financial markets where, much like a bully on steroids, the only question will be what degree of damage we sustain, rather than whether any damage will be inflicted. Of course, there is no way to know when the unraveling will begin. Like the late night hockey playoff game that runs into overtime, a viewer would have a hard time predicting in advance the exact moment a goal may be scored. However, there should be no doubt in his mind that he will have this information when he awakens the next day.
Lastly, for the sake of thoroughness, and well aware that to avoid a crisis new buyers of US assets must be found, perhaps this journey deep into the debt ocean is a calculated effort, seeing as how we might run out of buyers for US currency and bonds here on dry land. Like Captain Nemo's thirst for new discoveries in the brilliant novel by Jules Verne, or others exploring the deep sea for advanced life forms, are we, as my broker likes to ask, searching for intelligent life elsewhere in the hope that we could sell themsome US dollar assets? High hopes in that respect would certainly explain our full steam ahead in continued debt creation. If we somehow discover intelligent life actually willing to purchase US dollar assets, a rather miraculous accomplishment in itself, let us hope they are a god fearing species. At the very least, they could always turn to prayer when all hell breaks loose.