Americas falling dollar and mounting international debt are the inevitable products of dysfunctional international financial arrangements. This system appears likely to come crashing down with alarming implications for the the economy.

Few of the overseas investors who found the dollar so attractive in the 80’s and 90’s were concerned that their investments in the US might move us into a non-sustainable international financial position –a position that would ultimately lead, among other things, to significant losses in the domestic value of their US dollar securities. But that is precisely what is happening.

The US today is in a position similar to that of Mexico in 1980, Norway in 1987 and Thailand and Mexico in the 90’s. These countries paid the interest on their international indebtedness with some of the funds received from the inflow of new foreign investments. The US is now doing the same thing. It is engaging in Ponzi finance, and the game will soon be up.

By the end of 2004, the US’s net international indebtedness had increased by some $500 billion for the year, reaching $3 trillion. It’s international indebtedness has been increasing at an annual rate of 16 percent, while its GDP has been growing at a six percent rate. In the long run, international indebtedness simply cannot increase more rapidly than GDP. If it did, foreigners would, in theory, eventually end up owning all the assets and securities in the US. As a practical mater, policy adjustments or the market will ensure that this does not happen.

Predicting the timing and pace of the unavoidable transition to a sustainable situation is hazardous. Yet such a transition is inevitable. The needed adjustments in the US and other countries could occur without significant effects on employment and inflation or major disruptions in the foreign exchange market, but the likelihood of such a “soft landing” is small.

The primary variable that must change is the US trade deficit. It must decline to between $100 billion and $200 billion a year from its current level of around $600 billion. The purpose of paring back the trade deficit is to reduce the growth rate of our foreign indebtedness. The target value for the trade balance is determined by the difference between the maximum sustainable growth rate of GDP and US net payments of investment income to foreign creditors. Back-of-the-envelope calculations suggest that the necessary reduction of the trade deficit amounts to between $350 billion and $450 billion, a significant drop from todays level of $600 billion. Because our net external liabilities increase year after year, the longer the delay before the trade deficit is reduced, the larger the needed reduction.

The decline in the trade deficit must be matched by a comparable increase in annual savings and therefore slower growth in Americans consumption and in US production of tradeable goods. While the longer term results will be positive, the process of achieving them may be extremely painful, including rising rates of inflation, interest, and unemployment and possibly a severe economic recession.

Global consistency requires that the trade and current account surpluses of the countries that now have such surpluses must decline by $400 billion. The problem is that it is hard to find a country that believes its trade surplus is too large or that its holdings of international reserve assets are too large. The implication of the slower growth that lies in store for China and other countries like Brasil is that their demand for US dollar securities will increase and so will the US trade deficit. But that can’t happen, because the capacity of the US to adjust to the excesses in foreign countries is nearly exhausted. There is great potential for more conflict between the US and its trading partners.

The key to achieving a soft landing is a steady decline in foreign demand for US dollar securities of about $100 billion a year for the next three or four years. IF the decline is too rapid, the value of the dollar could plummet, while inflation and interest rates on the Dollar bonds surge.

Although the value of the dollar has been declining in the foreign exchange market for the last three years, that decline has not yet reduced either the flow of foreign savings to the US or the growth rate of our net international indebtedness. A modest increase in the pace of dollar depreciation might lead to a soft landing. But there are a multitude of other scenarios. For example, an initial modest depreciation of the dollar could seem to hedge fund managers and momentum traders like a clarion call to “short” the dollar, by betting on further declines. The central banks in Asia and Europe would then find themselves between a rock and a hard place. They would feel tremendous pressure from their politicians to buy dollars to prevent the value of their own currencies from rising quickly and thus hurting exports and domestic employment. But the banks would also recognize the risk in the course: The more Treasury bonds and other US securities they held, the more they would stand to lose as the dollar dropped in value. If this fear were to rule, the dollar could fall far and quickly, inflicting heavy damage on the US economy and other as well.

MM-
It's considered inappropriate to crib material from other sources and not provide a citation. This material comes directly from Aliber's Jan. 2005 essay in the Wilson Quarterly. See:
http://www.austinlemoine.com/images/File19.pdf

It's a pretty frightening and well-reasoned article.

(Message edited by Branquinho on May 29, 2007)

I wonder if there is anywhere where the dollar is rising?

mia culpa. received from coleague. thought it to be topical but didn't investigate further. checked your source and verify it's cribed. Still find it enlightening in reguards to current $ deval against other world currencies.

No prob. Bust your colleague's chops...

DR. In '02 DOP was 17/usd. Today it's 88% higher at 32/usd. 5yr high: 55/usd in '03.

It does little good to compare the exchange rate between various years without also looking at changes in pricing and inflation. When I first went to Brazil the exchange rate was $1 to R$1, and now it is $1 to R$2, so the rate is better now, right? Wrong, because then a piece of ass at Help cost R$80-R$100 (or $80-$100). Now it costs R$250-R$350 (or $125-$175). Then factor in inflation and it means that if you bargain and get her for R$250 then you're paying close to the same as you might have in 1996 or so, but if you're paying R$350 or more, the pussy you've purchased is higher priced than would have been the case 10 years ago.

I do miss the days when it was $1 to R$3.50 and you could get three girls from Karlas for 2 hours each for under $100!!!

I have a question:

Exactly WHY are precious metals 'precious'? Gold? Platinum? In this supposedly enlightened age of humans, are we still worshiping shiny objects? They don't have any intrinsic value other than their worth in structural engineering?

It is because people believe it is.

You can buy gold with carefully printed pieces of high quality paper and or numbers that are cleverly generated on computer screens. Anything and everything representing "value" other than perhaps food and water is all perception.

If a few Billion Chinese and or other people think Gold the most valuable thing on the planet...... it IS the most valuable thing on the planet.

I think Gold is the ultimate investment.... up until a series of good economic reports rolls in. Politics aside. Recessions tend to be cyclical after all. Even really bad ones run their course sooner or later. And when data turns positive. People will be less interested in Gold.

Good point re: believing in paper with numbers on it.

We could all become Bill Gates if we could convince people that the aroma of horseshit could prevent cancer or something.

Exter's Pyramid is an organization of asset classes in terms of risk and size. Gold is just another asset class. http://en.wikipedia.org/wiki/John_Exter

Actually it is a bunch of bullshit....just like the recent stock market drops because of the debt crises in Europe of perfectly fine companies doing quite well. One day their stock is down, a few days later the stock is up....again, a bunch of bullshit!