Dollar's fate written in history

.....

John Lee
Jun 4, 2009 - Asia Times
 
.....

Debt-based monetary systems are inherently unstable. Money is created out of thin air by the banks and lent to government, consumers and businesses. In order to service and repay those debts, the borrowers take on more debts. Asset prices are inflated, and the vicious cycle continues until the debtors are unable to borrow or the banks are unwilling to lend.

At that point the system snaps, everything is sold off, and we have a financial crisis at hand. Here, we examine what happens to equity and currency markets in the aftermath of financial crisis and deduce what will be the likely outcome for the United States as it emerges from the present crisis.

1998: Russia

Declining productivity, an artificially high fixed exchange rate between the rouble and foreign currencies to avoid public turmoil, and a chronic fiscal deficit were the background to Russia's financial meltdown in 1998. The estimated US$5.5 billion economic cost of the first war in Chechnya was also a cause.

Prior to the culmination of the economic crisis, the government-issued GKO bonds in a policy that has been described as similar to a Ponzi scheme, with the interest on matured obligations being paid off using the proceeds of newly issued obligations.

Two external shocks, the Asian financial crisis that had begun in 1997 and the following declines in demand for (and thus price of) crude oil and nonferrous metals, had a negative impact on Russian foreign exchange reserves. A political crisis came to a head in March when Russian president Boris Yeltsin dismissed prime minister Viktor Chernomyrdin and his entire cabinet in March.

The Asian crisis and related political events rattled investor confidence, caused foreign investors to sell off Russian stocks, bonds, and get out of roubles.

The amount of money involved in GKO bonds, at some $150 billion, was not a cause of concern for a $1 trillion economy. But with more than 30% of GKO bonds owned by foreigners, the foreign selloff caused havoc in equities, bonds and the rouble. The Russian broad equity index crashed by more than 90% from late 1997 to October 1998, and the rouble went from five roubles per US dollar to 30 per dollar in June 1999.

After the equity panic bottom was pressed in October 1998, the Russian equity index, measured in roubles, rebounded strongly in part thanks to the depreciating national currency. However, measured in US dollars, Russian stocks didn't make a full recovery until some five years later.

2001: Argentina

In 1998, Argentina officially entered a recession that lasted for three years and ended in a collapse as fears of the devaluation of the peso led to bank runs. This led to heightened protests and violence affecting many people and companies, causing several deaths.

In 2001, Argentina had $100 billion of national debt, which was about 40% of its gross domestic product. While the amount was containable relative to its GDP, the Argentineans made a mistake of denominating its debt in US dollars. With a shrinking current account surplus, the country wasn't able to raise dollars to pay debt principal and interest in 2001 and eventually repudiated on the foreign debts. The fixed exchange rate was removed and the peso was quickly devalued. The exchange rate was then left to float, causing further devaluation. The peso went from parity with the US dollar to four per dollar in early 2002.

The Argentine equity index plummeted 60% in 2001, and although it recovered fully in 2002 in nominal terms, it wasn't until 2004 that stocks come back to their pre-crisis level in US dollar terms.

Today: USA

The US has just experienced the biggest debt blowup known to man. Mortgages debts worth more than $1 trillion had to be bailed out. Lehman Brothers, Merrill Lynch, Bear Stearns, Countrywide, Fannie Mae and Freddie Mac have all become history. Even the iconic Citibank was brought to its knees and a stock price of $1 before the government bailout. The S&P 500 index halved in 12 months.

The US is privileged to have its dollars serving as the world's reserve currency. America's debt is denominated in dollars, which can be printed at will by the Federal Reserve - and print is what the Fed did, and continues to do, creating more than $1.5 trillion to bail out various groups.

The S&P 500 responded positively to monetary easing, rising 40% since March in nominal terms. It shouldn't be surprising to see the index recover to its pre-crisis level. Equities have to rise as in the cases of Russia and Argentina, when currencies had been massively devalued.

In real terms, however, when S&P 500 is measured in gold terms, it will likely take many years before the index recovers.

Where does the dollar go from here? When foreign investors took flight from Russian rubles and Argentine pesos, the dollar was the beneficiary. When global investors take flight from the dollar, which currency benefits?

Gold is the ultimate antithesis to the dollar. Gold is liquid, universally recognized and limited in quantity. Just like Russians and Argentines trying to anchor their currencies to the dollar, the US government devised various ways to slow down the rise of gold prices to maintain the dollar's soundness. However the massive money printing by the Fed and fast-eroding confidence in the dollar by international investors might just be the key to drive gold past the ellusive $1,000 per ounce level and not look back.

As we saw in the past crises in Russia and Argentina, and also in Thailand and Brazil, equity markets eventually do return to former levels while the devalued currency never regains its former strength. The US case will be no different.

A further rebound by the equity market in nominal terms can be seen albeit with extreme volatility, and we will likely witness a four-digit gold price this year. As the Chinese saying goes, crisis is spelled "danger" and "opportunity". There is still time to diversify out of dollars before the world recognizes the currency's permanent debasement and demotion of status.

.....

John Lee is the founder and principal of Mau Capital Management and the portfolio manager of a mining equity hedge fund. He is a CFA charter holder and has degrees in economics and engineering from Rice University. Lee has a keen interest in the history of money and economics, and has previously studied under James Turk, a renowned authority on the gold market.