Whither the dollar and gold? To answer that long-awaited inquiry – which will take some time to cover in full – let's start by getting a handle on “exploding debt dynamics.” Cartoonish as it sounds, it's a real term that IMF economists use.
If, like me, the phrase gives you visions of Wile E. Coyote blowing himself up with a box of ACME brand dynamite, you aren't too far off.
The technical meaning refers to the fallout from an ever-expanding debt-to-GDP ratio. Beyond a certain tipping point, a country's debt burden becomes “explosive” as interest rates shoot higher, hope of payment recedes, and investors stampede for the exits.
To further clarify, just imagine a man with a $50,000 a year income and a $70,000 a year lifestyle. Now imagine the man's “income-lifestyle gap” is financed by credit cards.
This can work for a while, but not forever. As more and more credit card debt piles up, the possibility of paying off the cards becomes ever more remote. Eventually the guy's credit rating goes into the toilet, his interest rates skyrocket, and the whole mess turns “explosive.”
This kind of thing can happen to whole countries, just like it does to people. Right now it's happening to Argentina for the second time within a decade. In due time it could happen to the United States.
Buenos Aires and Queen Cristina
It's a shame, really... Argentina is just such a wonderful country in so many ways.
The capital, Buenos Aires, is widely known as “the Paris of Latin America.” Having spent time in both cities, the comparison strikes me as a fair one. Paris is a good deal older of course – Buenos Aires wasn't founded until 1536 – but the architectural similarities are striking.
I was last in Buenos Aires a year ago this month. Below is a photo (taken by yours truly) of the street on which I stayed in the Retiro Barrio. (You can see the Paris influence, no?)
October 2007 (the month of my visit) was an eventful time for Argentina. On the 28th of that month, Cristina Fernández de Kirchner, wife of the outgoing President, Nestor, was elected to take his place.
Election fever was in full swing for the length of my stay. When she finally took the prize, the country went crazy. “CRISTINA! CRISTINA! CRISTINA!” the headlines chanted. Thanks to a winning combination of glamour and common touch, “Cristina's” popularity was immense... The Economist reckoned it more the coronation of a queen than the electing of a new president.
And Then Things Exploded
Those happy days are long gone now. Sadly, Cristina turned out to be a much better campaigner than leader. After taking the reins she made bad decision after bad decision, with a run of bad luck (in the form of falling commodity export revenues) making things even worse.
And so now, in 2008, “exploding debt dynamics” have once again sucked Argentina into the vortex – much as they did in 2001. Argentine stocks saw their biggest two-day drop in 18 years earlier this week. Interest rates on dollar-denominated Argentine bonds shot above 30%... higher than the penalty rates on a delinquent Visa or MasterCard.
The panic trigger this time around was Cristina's decision to raid the country's $29 billion worth of private pension funds. Out of the blue, the government decided this pension money was necessary to pay bills. (There is socialism, and then there is socialism .) The move was seen as so brazen, so desperate, that it's just a matter of time before Argentina defaults on its debts once again.
It Can Happen Here
The similarities are not exactly comforting. Debt-fueled as they are, Argentina's troubles have always hit a little too close to home.
The United States, too, labors under a heavy and growing debt burden. Both the U.S. and Europe are fighting the credit crisis with a tidal wave of capital injections and liquidity guarantees.
And so, with the Western World busy bailing itself out to the tune of trillions, no one has really answered the question, “Who's going to pay for all this?” The hope is that the printing presses can get the job done in the short term, with no one really noticing (or at least not balking too loudly) in the longer term.
Small countries like Iceland are allowed to implode. Argentina, too, is not a large enough player to pull itself clear of the vortex. But in this new era of big failures and even bigger bailouts, the question must be asked: What about Uncle Sam – the biggest debtor of them all?
The Greenback's Saving Grace (For Now)
As you've likely heard or read, printing presses around the world are chugging like mad. As the International Herald Tribune reports, “central banks everywhere have moved to an emphasis on supporting economic growth from a focus on inflation.”
America, meanwhile, is the epicenter of the toxic subprime crisis. We've done a great job of exporting the problem to banks around the globe... but the U.S. is still ground zero for this mess.
Why, then, has the U.S. dollar been so strong?
I see a few key reasons for the dollar's uncanny strength:
• U.S. Treasuries – and by extension the U.S. dollar – are still knee-jerk havens in times of crisis.
• Most other currencies (excepting the Yen) are looking just as bad.
• The dollar still has clout as the world's reserve currency.
• With the world “leveraging down,” U.S. investor capital deployed overseas is coming back home.
When things get really bad, investors and central bankers flee to what they know. Based on twenty-plus years of hindsight, the U.S. dollar and U.S. treasuries are two of the first things that come to mind in times of turmoil. (As does gold... but you can't shovel hundreds of millions to billions into gold without major dislocations.)
If you think about it, it doesn't make much sense to load up on U.S. paper and debt when Uncle Sam is printing away like mad. It's a bit like rushing to buy up shares in a company where new shares are flooding onto the market at an astonishing rate. From a long-term logic standpoint, it's just plain goofy.
But long-term logic doesn't apply in this case. Almost by definition, “panic” is about knee-jerk responses to pressing urgencies of the here and now. Consequently, the panicky investors piling into U.S. paper aren't thinking about inflation, or the long-term implications of stimulus gone wild. They're just looking for a port in a storm... going with what they know.
On that front, the dollar has been further aided by its world reserve currency status. Indebted as he may be, Uncle Sam is the only one who can issue large quantities of debt denominated in his own currency. America alone has this privelege, and it's a damn attractive one in times like these.
Can't Last Forever
A wise man whose name escapes me once said, “That which can't go on forever must stop.” I believe that truth applies to the dollar in spades.
What we have now is a crisis situation in which nearly all fiat currencies look terrible. The dollar reigns – like a one-eyed king in the land of the blind – because of its reserve status, its historical role as a haven, and the lack of sufficiently liquid alternatives for “parking” large sums of money. (There are few markets in the world as broad and deep as the one for U.S. treasuries.)
I submit that one of two things will happen from here. Things will get markedly better, or they will take a sharp turn for the worse. Either way, the crisis-mode thinking that fueled the dollar's rise will be replaced by something else.
If things get better, investors will start to wonder anew why they wanted to own big piles of U.S. treasuries at god-awful yields (and in some cases no yields at all) in the first place.
And as thinking shifts from here-and-now panic to a slightly longer term perspective, something of a revelation will creep in: Gee... do we really want to put our “full faith and credit” – not to mention our dough – in the promises of the biggest debtor in the history of the planet?
What's more, when credit markets unfreeze, panic dissipates, and the world starts growing again, capital will flow to the powerfully cheap asset classes that were once left for dead.
When the fever breaks, in other words, the relative appeal of various asset classes will shift. Treasuries and the dollar will be slowly (or perhaps not so slowly) abandoned on multiple counts... especially when it becomes clear that deflation has been vanquished and “managed” inflation is back in vogue.
That's what happens if things get better from here.
If things get much worse , on the other hand, we'll have a much more volatile and violent scenario to contend with... but still one in which the dollar resembles a man climbing a very tall high-dive ladder.
Next time I write, we'll talk about the potential for the dollar's “Zimbabwe moment,” cover various reasons why it hasn't happened yet, and make further headway towards tying it all in with gold.
By Justice Litle
Copyright © 2008, Angel Publishing LLC and Justice Litle
Justice Litle is the editor and founder of Consilient Investor. Consilient Investor is a broad ranging collection of articles ( written by yours truly) on markets, trading and investing... and big ideas related to such. It is also home to the Consilient Circle, a unique trading and investing service.