Boneheads, Iraq and the Artificial Dollar

By: John Mauldin | Sat, Mar 29, 2003
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The past two weeks I have had so many people email me an article by one Geoffrey Heard of Melbourne, Australia that I am going to comment on his nonsense. Because it is so wrong and yet his arguments seem so seductive, it offers an excellent opportunity for us to learn how world currency transactions really affect the price of gold and oil and other commodities. Warning: I am taking off my gloves in this letter. This is one of the more boneheaded pieces of conspiratorial economic garbage that I have read in quite some time. I normally don't respond to such ranting, but because it is seemingly being read and repeated in a lot of places, it deserves some attention.

Basically, his thesis is that the United States (and Bush) is invading Iraq to insure that they will still stop selling their oil for euros. Bush and the American elitists he represents are apparently afraid that all of OPEC will want to convert to euros. To quote:

"In 1999, Iraq, with the world's second-largest oil reserves, switched to trading its oil in euros....Iran started thinking about switching too; Venezuela... Russia...The greenback's grip on oil trading, and consequently on world trade in general, was under serious threat. If America did not stamp on this immediately, this economic brushfire could rapidly be fanned into a wildfire capable of consuming the U.S.'s economy and its dominance of world trade."

"It is the biggest grab for world power in modern times.... If America invades Iraq and takes over, it will hurl the EU and its euro back into the sea and make America's position as the dominant economic power in the world all but impregnable.... This debate is not about whether America would suffer from losing the US dollar monopoly on oil trading-that is a given-rather it is about exactly how hard the USA would be hit. The smart money seems to be saying the impact would be in the range from severe to catastrophic. The USA could collapse economically.... The key to it all is the fiat currency for trading oil... Under an OPEC agreement, all oil has been traded in US dollars since 1971 (after the dropping of the gold standard) which makes the US dollar the de facto major international trading currency. If other nations have to hoard dollars to buy oil, then they want to use that hoard for other trading too. This fact gives America a huge trading advantage and helps make it the dominant economy in the world."

Heard goes on to write about other US offenses, making clear that he understands the reasons for the vast conspiracy in which Bush and company are engaged. He clearly does not like the current US policy and looks to blame any and all world problems on Bush. Conspiracy Theorists of the World, Unite!

First, let's look at his first thesis: if OPEC began to sell oil for euros, it would doom the dollar and be a catastrophe for the US: "The USA could collapse economically."

You could make a case that in 1971 the oil for dollars deal was good for the US, but it was not some conspiracy or "deal." At the time, there was no other major currency with enough scope and supply to function as a major trading currency. The euro did not exist. The German mark and British pound did not simply have the supply of currency necessary without stretching the currency markets.

That was a period in which central banks had some measure of short and medium term control over the valuation of their currencies. By working together, they could establish a price range between currencies.

Then came 1992. The foreign currency markets had grown dramatically, and central banks were struggling to control their currencies. George Soros and the legions of traders who were investing/betting in the currency markets decided the pound, among other currencies, was over-valued, and were shorting the British pound.

Legend has it that a reporter came to him and asked him what he was going to do because the Bank of England was going to spend $30 billion pounds defending the value of the British pound. Supposedly his answer was, "What are they going to do in the 30 minutes after that?" $30 billion pounds was about 30 minutes of trading on the currency exchanges at that time.

The point was that central banks no longer had enough money to support a currency. To support a currency you have to have foreign deposits in order to buy your own currency. While the bank of England could print all the pounds they wanted to, they could not manufacture dollars or marks or yen. Those currencies had to come from actual trade surpluses, which England did not have at the time.

Central Banks Wave the White Flag
Within a few weeks, what I regard as one of the more remarkable and important op-ed pieces of the last half century appeared in the Wall Street Journal. It was an article by Walter Wriston, chairman of CiticCorp and the ultimate insider: Council on Foreign Relations, Tri-Lateral Commission and confidant of presidents and world leaders.

In it, he basically waved the white flag. We were in a brave new world where currencies were no longer controlled by central bankers but by currency traders. I remember reading it and recognizing the truth which it contained. I, for one, was happy.

In essence, the ability of central banks to manipulate their currencies for more than a short time was gone. Even acting in concert, central banks do not have the real ability to affect the markets for more than a few days. The most they can do is threaten, which keeps short term traders nervous, but currency trades back up like flood waters at a dam, eventually pouring over.

Today, Chuck Butler, currency trader at Everbank tells me the world currency markets trade $1.2 trillion a day. That is almost one half a quadrillion dollars a year. To provide some perspective, the entire US economy is "only" $12 trillion or so.

The total value of oil trades a day is a drop in the bucket compared to the currency markets. If OPEC wanted to be in euros all they have to do is convert to euros. You could price oil in terms of any currency, but those who sell must do something with the dollars or yen or yuan or pesos they get. After the money is in an OPEC bank account, they can do anything they want with it.

If OPEC decided they wanted to price oil in euros, it would make no difference to the US price in dollars. It is supply and demand, and currencies are extremely liquid.

Heard writes "If other nations have to hoard dollars to buy oil, then they want to use that hoard for other trading too." In light of the liquidity in the currency markets, this is a stupid statement. You could "hoard" any major currency (yen, pesos, euros, pounds, won, renminbi, etc.) and when you want to convert it into dollars to buy oil you can do so instantly and with almost no transaction cost. A country or business will keep its reserves in whatever currency it thinks is the best at the time and then convert for the sale. There is no "hoarding" of dollars, unless that is the currency the various central banks or businesses want to use.

As an example, let's look at gold. Gold is in a great bull market, right? On July 1, 2001 gold was 265, and today it is around $330. That is a $65 rise for about a 25% gain.

On that same day, the euro was $.8378 and today the euro is $1.07. The euro has risen almost 30%. Which is the bigger bull market?

Furthermore, if you live in Europe, there has been no gold bull market since July, 2001. Gold, in terms of euros, is actually down slightly, depending on what day you look at gold and currency prices. On July 1, 2001 you got 316 euros when you sold an ounce of gold. Today you only get 299 (at $1.07).

The same applies to oil. In the US, we have watched as oil prices go through the roof. Depending on what period you use, oil is up only slightly in Europe. Is that because OPEC loves the French? Of course not. It is entirely because the dollar has dropped against the euro.

If oil were priced in euros, the results would not be any different. The price would have risen in the US and been almost flat in Europe. The reasons for the drop in the dollar have nothing to do with Iraq or oil. We will discuss the real reasons a bit later.

Look at it this way: there is x amount of oil available for sale on any given day. It will go to the highest bidder. If someone from Europe wants to buy oil, in reality he is paying in euros. The conversion to dollars is transparent to him. In large amounts, it costs almost nothing to convert to dollars or pounds or any currency. Oil is no different than wheat or sugar or any other commodity. It is supply and demand that determines the price, and the currency used for the transaction has nothing to do with it, as long as it is liquid.

To claim, as Geoffrey Heard does, that the dollar would drop because of oil being priced in euros is absurd and shows a complete lack of understanding of how the currency markets work.

Further, to suggest that "If America invades Iraq and takes over, it will hurl the EU and its euro back into the sea" is equally absurd. What if America decided to invade Australia to take over its wheat crop? Would that hurl Canada and its dollar into the sea?

Heard's thesis is based upon the presumption that the US wants to maintain a strong dollar, when in fact the clear leaning, if not actual private preference, at both the Treasury Department and the Federal Reserve is to allow the dollar to drop. While the Bush administration gives lip service to a strong dollar, they have also made it clear that they do not intend to intervene to support it. "Let the market work" is the mantra. A falling dollar helps the Fed control deflation.

A gradually falling dollar works to our benefit by making our products cheaper on the world markets. It allows US producers to compete with foreign companies for the American consumer dollar. It helps stem the deflationary tide. And it helps lower the trade deficit, as it makes imports more costly and helps our exports.

Further, Heard's thesis assumes the US is capable of controlling the value of a dollar. It is not. The world currency markets are far bigger than the US Federal Reserve. The only unilateral power a central bank has is the ability to destroy its currency by printing too much of it.

Oh, I suppose the Federal Reserve could reduce the money supply and the supply of dollars and drive the dollar up. But classic economic theory says you can control the quantity of a product (in this case the dollar) or the price, but not both. Reducing the money supply would currently throw the US into a severe deflationary recession and possibly lead to a world-wide depression. That is not a policy that is likely to be pursued.

As the Dollar Churns
With that as background, let's look for a moment at some of the seismic changes which are happening in the world currency markets. I am going to suggest to you that one event leads to another which leads to another and the result is not what you are hearing in the mainstream press.

The first thing to notice is the huge US trade deficit, currently in excess of $500 billion. This is now close to 5% of GDP, and as noted this time last year, in every case in history when a country reaches a trade deficit of 5%, a serious currency correction follows.

As long time readers know, a 20-30% drop in the currency does not bother me. The US went through such in the 1980's, and life seemed to go on just fine, thank you.

The Artificial Dollar
The dollar is artificially high. By artificial, I mean the following things: first, the rest of the world, and especially Asia, is hooked on selling products to the American consumer. If prices were to rise 30%, we would buy less of their products and more of our own. If they sell less, their unemployment rises and profits drop.

For now, they are willing to take dollars because it keeps their factories going. They convert those dollars into local currency or other currencies.

Secondly, there are those who hold dollars because it is better than their local currency. Physical dollars are desired in many Latin American and African countries, and other parts of the developing world. The clear pattern is that the dollar is a better value than the local currencies.

Could the euro become as popular a currency? Sure, but then there would be two choices, not an abandonment of the dollar. Will it be more popular than the dollar? In some countries, yes, especially those closer to the Eurozone. But the primary driver for such holdings is not to get the best performing currency, the euro or the dollar, but to have a currency which is not their local currency, which their local governments continually inflate and debase.

Third, it is obvious that if we were not the reserve currency of the world, the dollar would not be as high. The dollar would have less buying power. Foreigners look at that buying power and are often jealous, seeing it is part of American hegemony.

But it cuts both ways. An artificially strong dollar has meant that our manufacturing base has slowly been eroding as more and more jobs leave the US for cheaper production climates. There is no free lunch.

As I noted one year ago, Morgan Stanley projected that a 20% drop in the dollar against the euro would knock 1% off of the GDP of Europe, and it looks like it is doing just that, as it hurts their sales to us and makes their goods and services more expensive to the rest of the world. If the dollar were to drop another 10% or go to $1.25 you will hear screams and moans throughout Europe, as business would have to compete against much cheaper production from not only Asia but from the US.

A rise to US$1.25 euro means the price of products made in Europe would have risen 50% in terms of dollars over a period of just a few years. This will give the US and Asia a huge advantage in selling products and services to Europe and a major competitive advantage in the rest of the world. If European businesses are already having problems (and the statistics suggest they are) then this would be even more devastating.

What could Europe do? They could ask for an increase in tariffs, but this would start a trade war which they would lose, and could possibly trigger a world-wide recession. It would also contravene a lot of treaties they have worked very hard to get signed, and also cause a major split within the European Union. This is not a likely scenario.

The more likely effort will be to get the Chinese to allow their currency to float against the dollar. Today it is pegged to the dollar, which means a fixed amount of Chinese currency always equal a dollar. If the "peg" is taken off, the Chinese currency will rise, thus making their products more expensive and European (and US) products relatively more competitive.

The rest of the Asian Tiger countries will be able to let their currencies rise along with the Chinese renminbi. None of these countries are against a stronger currency as long as they to do not lose competitive advantage against each other.

Foreign products will cost US consumers more, we will buy less and will be able to sell more of our products and the trade deficit goes down. (This whole process could take a decade or longer.)

The Competitive Currency Dance
Except. Except the Japanese get hurt in the process. They are clearly fighting deflation, and a rise in the value of their currency would be deflationary. They have government debt problems which dwarf those of the US. Their banks are bleeding and are in a true crisis. Dennis Gartman writes today that just the four largest banks are reporting losses approaching $3 trillion yen, or over 20 billion dollars. Analysis of Japanese business is bleak, and consumer demand there is decreasing as the population ages rapidly.

Japan is the third largest economy in the world. They have been a major source of lending in the world, and a weak Japan is good for no one. Can Japan afford to let its currency rise 20-30%? Can it keep it from happening without massive printing?

If Japan will not let its currency rise, can the other Asian countries? For instance, if the Korean won rose 20% against the yen that would make a Hyundai cost the same as a Toyota. The price advantage goes away, and Korea suffers. The variations to the currency dance are wide.

Until the rest of the world and especially Asia can wean themselves from dependence upon the American consumer, the dollar will remain artificially high. That is not to say it will not continue its decline. It will. It is just that it will take longer than it would without the artificial factors cited above.

(By the way, that also means that gold will increase in value as well. It means that the price of oil will rise in terms of dollars over time.)

One last lesson we can learn from Heard's piece: always be cautious when reading an essay from someone with an obvious ax to grind, especially when it borders on the conspiratorial. Such a writer has a single-minded purpose: to re-enforce his basic prejudice. Just as all the world is a hammer to the man who only has a hammer, all the problems of the world are the cause of whatever is the focus of the writer's animosity.

Heard will dismiss my writing as naive apologetic writings from an obvious proponent of American hegemony (which by the way, I am not). But it will keep him from having to deal with reality.

There may be good reasons to oppose the war. But they should be arguments founded in reality and philosophy and not conspiratorial hyper-ventilation or over-wrought emotions. I am quite properly suspicious of governments and the motives of politicians. But I do hope I let reality impinge on my analysis of their policies, either good or bad.

A Quick Look at the Economy
Housing starts are down. Initial unemployment claims are down, although still high and lay-off announcements seem to be falling off. Everything is slowing down, but nothing has stopped. The euphoria that greeted the start of the war is now fading, as investors realize it might be (gasp) weeks or months to mount and conclude one of the more ambitious military ventures in history. Thus uncertainty sets back in.

Charles Krauthammer notes: "By Monday the media were in full quagmire mode. Good grief. If there had been TV cameras not just at Normandy, but after Normandy, giving live coverage of firefights at every French village on the Allies' march to Berlin, the operation would have been judged a strategic miscalculation, if not a disaster. The fact is that after a single week we find ourselves at the gates of Baghdad, servicing the longest supply lines in American history, with combat losses astonishingly low by any standard."

We face an enemy which hangs a woman for waving at a coalition solider, shoots its own troops to get them to march and die, surrenders and then opens fire, shoots women and children who try to get food and water, hides behind women and in hospitals and literally sets a young girl on fire with the kerosene she was trying to smuggle to her home. This is not a climate where the Iraqi people feel free to welcome us or for the average soldier to surrender.

Yes, this might take longer, but the outcome is no less sure. However, the US economy seems once again focused on the uncertainty. The longer this war goes on, the more concern I have about an outright recession beginning later this year.

It is quite possible that oil will not come down as fast, even after Iraqi oil is back online. Nigeria is becoming a major problem, and 800,000 barrels per day have been pulled out of production, which is a huge number. Venezuela is still problematic. The combination puts world oil supplies in jeopardy. If it's not one thing it's another.

The US Senate has cut the President's tax cut in half, and as long time readers know I believe the stimulus from the tax cut will be needed to avoid or at least postpone a recession later this year. Given the problems in the economy, which I will address in detail in a future letter, this is not a good omen.

Thus, with the prospects for a longer war, an uncertain consumer, the "oil tax" from high oil prices not going away any time soon and the smaller tax cut stimulus, this was not a good week for the Muddle Through Economy. We will stay tuned.

One final note before I close: central banks no longer can control their currencies because of the massive liquidity of the world currency markets. This is a good thing. Further, any currency which does not have sufficient liquidity will be automatically under-valued, because there is increased risk in holding the currency. Liquidity, the ability to be able to sell on a seconds notice, helps take away the risk premium associated with illiquid investments.

Now some observers are calling for controls on hedge funds which can "short" the market. Shorting, they say, is one of the reasons for the bear market. "Hedge funds bad, bull markets good" is the simplistic reasoning. Much of the whining is from companies who cannot make a profit.

Hedge funds provide liquidity, pure and simple. If you take away the ability to short a stock, you will increase the risk premium on that stock because it will drive away investors and liquidity. If you want to induce a stock market crash, and I mean a real crash, not a slow drawn out secular bear market, then all you have to do is reduce the ability to short in this market. It will dry up liquidity faster than you can say 1987. If hedge funds cannot "hedge" their risks, they will simply withdraw from the market. That will take away liquidity and drive up the risk premium.

This may seem counter-intuitive, but hedge funds did not create the bubble and are not responsible for the bear. The writer we analyzed earlier decided falsely that the US reason for starting the Iraqi war was because we wanted to maintain a strong dollar. He looked for a reason to justify his beliefs about the US, and found a conspiracy.

Those who suggest that this bear market is the result of hedge funds who short stocks look for a scapegoat to blame their own failures to properly manage risk and invest or to manage their companies and make a profit.

The best antidote to someone shorting your stock is to make a profit and increase them every year. If you can't do that, then don't whine when your stock price goes down.

Making Progress
I did make some good progress this week on my book on investing in this secular bear market. I am increasingly focused on finishing, and will probably post a few chapters in the next few weeks, if my publisher gives me permission.

Have a great week, and I leave you with this thought which my wife sent me this morning. She has noted that I have been griping a great deal of late about a few events in my life which have caused a rise in my stomach acid levels, not to mentioned have robbed me of a great deal of time. But we all have to learn to relax and trust that God has things in control. I think it was my friend Richard Russell who noted that being calm and relaxed about life was one of the best things for a long and healthy life.

She sent me the following quote: "We must offer ourselves to God like a clean, smooth canvas and not worry ourselves about what God may choose to paint on it, but at each moment, feel only the stroke of His brush."--Jean Pierre de Caussade

Your not quite yet a relaxed sainted analyst,


John Mauldin

Author: John Mauldin

John Mauldin

John Mauldin

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