Reading time: 10 – 17 minutes

For the last twenty-five years, the Fed flow of funds accounts reveal two dominant forces supporting US stock and bond markets.

Million mark bills used as a notepad (Germany 1923)

• Stocks: Stocks have been driven upwards by corporate executives and mutual fund managers who have backed stock-buybacks/executive option schemes to mutual advantage. As described in the article, “The quarter-century buyback era draws to an end”, this game is over and equities will now have to seek a new course.
• Bonds: The US bond market has been sustained by a huge and ever-growing pool of dollar financial assets held by foreigners as a result of the persistent US trade deficit. For a generation, the trade-deficit/bond market linkage has been a virtuous circle to the mutual advantage of foreign exporters and the US population seeking to spend today, pay tomorrow.

The supremacy of the US dollar is not yet dead, but portents of a fatal cancer — inflation — are there for all to see.

Two myths that confound understanding

For a long, long time, many people have been seriously concerned about the US trade deficit and about Americans owing vast sums to foreigners.

However, by citing the wrong linkages between supply and demand, while forecasting unlikely outcomes, these arguments have clouded, rather than clarified the issue.

The US trade deficit and dollar supremacy does have a definite down side, as we are now seeing, but two persistent myths continue to confuse policy decisions:

The “inability to pay” myth:

Some suggest that the bill to foreigners will someday come due and the US will not be able to pay the debt, enslaving future generations to debt bondage. See: “Warren Buffett Fears Foreign Ownership”. The problem with this argument is that since the debt is in dollars, the US Treasury can always pay it off by turning the printing press. After inflation, there will be no debt to pay.

The “competitive interest rate myth”:

Others understand the source of foreign investment in US bonds as being “foreign investors” and “central banks”. This is true enough, and somewhat obvious — the immediate buyers are indeed investors and central banks, but the ultimate source of the money — where it all comes from — are foreign exporters and foreign governments bent on raising domestic employment and keeping local factories busy.

It’s not as if there are foreign investors saying, “Oh gee, look at US interest rates compared to rates in Japan. Lets all buy dollars!”

No, what happens is that foreigners find themselves holding dollars for one reason or the other and can’t get rid of them by selling to other foreigners.

As a group, foreign holders of dollar financial assets only have two options: buy US bonds (or other securities), or buy US non-financial assets (direct investment, real estate, or export goods).

Employment and the trade deficit

Governments that hope to survive for long, other than by brute force, are interested in keeping domestic employment as high as possible.

The US trade deficit was been sustained for a generation by the fact that it has been good for employment, both in the US and abroad:

US full employment

Vast sums of ready credit for the US population originating from the trade deficit, has kept employment high.

Wall Street and the financial industry has been in a sustained boom for longer than most of those employed there now can remember.

Industries such as home building, home appliances, and automobiles have benefited from easy credit.

Everyone now has a credit card and it has been easy to buy merchandise imported from China, while keeping millions in the supply chain in business.

Barney Frank and Chris Dodd could not have spurred the sub-prime mortgage business without the trade deficit to provide the funds that employed many in building houses that many, otherwise, could not afford.

Foreign industrialization

While the US has been hell-bent towards becoming a “service economy”, developing countries, including China, have been going the other way towards industrialization.

Once you build a factory, you have to keep it busy, or plants will close and workers will be unemployed.

This means supporting foreign trade at all cost and not worrying too much about the quality of the foreign currencies being accumulated.

It also means adopting a neo-mercantilist attitude, favoring exports over imports.

A lack of responsible fiduciaries

The fatal flaw in this pretty picture of perpetual employment financed by a growing US trade deficit was the assumption that those employed as financial intermediaries would be responsible fiduciaries, concerned about only lending money to those who were likely to repay.

It assumed that bankers knew what they were doing and couldn’t sleep nights unless their customers’ money was safe.

It also assumed that financial market regulators were on the side of investors and would be able to stop a Ponzi scheme as vast as that of Bernard Madoff well before even the billion dollar mark was reached.

These assumptions have not only turned out to be false, but to a degree than no one had even imagined or predicted — not even me and I have been really pessimistic about the skills and ethics of financial intermediaries for a long time.

Not only has financial intermediation been broken, but there is a serious doubt as to whether it can be fixed in time to save the dollar.

The burden of monetary supremacy

Any country that harbors the world reserve currency must take seriously the responsibility to safeguard its financial markets from irresponsible hands.

However, the larger the pile of foreign financial assets, the greater the temptation for politicians to use this “easy money” in inappropriate ways.

Barney Frank and Chris Dodd boosted Fannie Mae, Freddie Mac, and sub-prime mortgages for the same reason that Bill Clinton molested Monica Lewinsky: because they could.

Without the trade deficit, government sponsored agencies could not have engaged in orgies of stupid sub-prime lending.

The wheels almost came off Citibank in the 1970s when the bank tried to “recycle” petrodollars by lending to third world countries.

However, the pile of dollars accumulated in the foreign trade accounts by 2008, was far, far greater than funds from the oil crisis of the Carter years, and Wall Street had grown less cautious and dumber in the interim.

The world’s central banker?

In order for a country to serve as central banker to the world, the people and the politicians representing them must understand what this involves and be willing to accept the responsibility of keeping the money of the rest of the world safe.

This might be feasible in a small country like Switzerland, but in a nation the size of the United States, such long-term commitment is extremely unlikely.

Americans never voted to defend the US dollar as the world reserve currency.

There was never any debate on the issue.

No presidential candidate or political party ever put the idea of the dollar being the world’s reserve currency on the platform.

Central banker by accident

Most of the population doesn’t understand the concept or have any idea where money that finances their credit cards comes from.

Dennis Kucinich, a Democrat candidate for president and representative from Ohio, has ranted in Congress that “Banks Are Loaning Our Money To Foreign Countries Instead Of Americans!”

Hysteria about foreigners getting there hands on “US taxpayers’ money” is at a high level.

America became central banker to the world by accident.

If fact, by mis-managing US finances during President Johnson’s “War of Poverty” and the Vietnam War, inflationary conditions were created that eventually forced President Nixon to abandon the gold-dollar standard, creating conditions for the dollar to become the world reserve currency by default — an unintended consequence on which the American people never had any say or understanding of what this entailed.

Withdrawal pains from dollar supremacy?

The possible abdication of the US dollar as “world currency” is associated with expectations of inflation and resulting consequences.

Among the American electorate, there is no explicit movement either for or against the idea of US acting as the world’s central banker.

Most of the population can’t even understand the concept. It simply is not an issue.

President Obama is not President Reagan, stirred by fervent fires of super-patriotism, suggesting US supremacy as the “City on the Hill” and promising “Morning in America”.

Instead, President Obama seems intent on not exercising world leadership, but rather on joining the United Nations and extending the “hand of friendship” to other countries, without pre-conditions.

He has picked a Treasury Secretary whose primary world experience is with the International Monetary Fund.

Wall Street itself has “gone international”, with the New York Stock Exchange merging with Euronext, NASDAQ linking up with the OMX Group, and with all major banks active in the international markets.

Tears over the demise of General Motors as an “American industry” are found mainly among unionized workers — most people realize that Mercedes Benz is now as “American” as “Ford Motors”.

The primary concern of Congress and the administration is to support domestic employment no matter what this might entail — including substantial risk of wild inflation.

If the dollar collapses in the process, so much the better for “US industry”.

Except for policy wonks, who don’t carry much weight in the polling booths, no one really cares about the US role as central banker to the world.

So, without political support, the question remains: will the world’s withdrawal from the dollar be painful or orderly?

The demise of the dollar: step by step

The first step in killing the dollar as the world reserve currency is to threaten foreign holders of dollars with inflation that scares their pants off and gets them hunting for safer assets.

Obama and the Democrat-controlled Congress have already managed to do this.

The next step is to transfer dollars from foreign hands to US residents, before it is too late.

Foreigners can’t get rid of dollars by selling them to other foreigners — they have to trade them with US residents for non-financial assets, like real estate, US companies, or export goods. Since foreigners, as a group, are the only ones with excess dollars to spend in the current depressed economy, and since US residents are hard up for cash, with banks not lending as readily as before, bargains will be available.

The removal of dollars from the accumulated trade deficit pool will suck money out of the US bond market. Interest rates will soar further.

With banks de-leveraging, companies will be forced to follow.

With a shrinking bond market, the only alternatives are to sell the company to those who still have money (such as holders of financial assets in the trade deficit pool), to raise money by selling stock (in a depressed market), or going out of business. Unemployment will get worse.

The final blow will come when President Obama’s and Speaker Pelosi’s grandiose “spending is stimulus” plans finally come to pass, requiring money from some source.

Taxes won’t do, because the country is in deep recession.

Cutting government spending is politically unpalatable to those who got elected on promises of such spending.

So its up to the monetary authorities to print money and cover the short fall.

The end result is inflation at a level Americans have never seen, are unprepared for, and that will devastate the elderly, the poor, and most in between.

By the time the final blow has landed, the world will have come up with some alternative scheme for international currency, probably sponsored by Secretary Geithner’s ex-employer, the International Monetary Fund.

Living in a post-dollar world

In a post-dollar world, Americans will no longer be able to live off the pool of easy money generated by the trade deficit.

In the post-Obama world, now that Americans (those that have managed to stay employed) have paid off mortgages and credit cards with debased currency, there will be renewed interest in sound currency.

However, trips abroad will now be frightfully expensive, as will be imported goods.

With American industry having been sent overseas during the years of dollar hegemony, it will indeed be “Morning in America” as brand new, super-efficient factories are built (without labor unions, which have been discredited after the General Motors debacle), and a much, much smaller Wall Street will now be staffed with boring, stuffy bankers, like in the old days, more concerned about depositor’s money and getting repaid than in their own year end bonuses.

Excuse me if I’ve gone a bit too far. It may be time to lie down.

I don’t know what is going to happen anymore than you do.

These seem to be times of momentous change and it is sometimes useful to try to see what might be coming — so as not to be blind-sided.

What do you think?