The Forgotten Benefits of the Gold Standard
One of the benefits of the gold standard, long forgotten, was that it acted to regulate imbalances in trade. Under the gold standard, trade imbalances between countries were unsustainable because they would self correct over time. Here is an example of how that worked: When a country would export more than it imported, it would accumulated more gold. That is because it could take the surplus foreign currency received in trade and convert it to gold.
As you have learned, when gold entered a country from outside its borders, it always caused inflation. That is because the surplus of gold (money) relative to the goods and services available for purchase always bids up those prices. When a country's goods become more expensive, they also become less attractive to its trading partners. As a result, the country cannot export as much as it once could.
Back in the days of the gold standard, more gold would then flow out of the country than would come in, because imports would exceed exports. Because of less gold in the country, prices would eventually decline to where they had been originally.
World War I began in 1914, although the United States did not enter the war until 1917. In the early years of the war, England and France depended heavily on the United States to provide them with arms. As a result, gold flowed into the Unites States, while arms flowed out. The incoming gold allowed the banks to loan more money, causing the money supply in the U.S. to increase by nearly 50 percent during the period 1914 -1917.
When the U.S. entered the war in 1917, England and France had all but exhausted their supplies of gold. As a favor to England and France, the U.S. suspended the gold standard and began providing armaments on credit. Additionally, the U.S. printed money to provide for its own troops. During the next three years, the money supply again increased by almost 50 percent. When the war was over, the Allies looted Germany. With the spoils, England and France paid back their loans to the United States. As a result, even more gold flowed into the United States.
The doubling of the money supply during the war years was the source of the boom in America that occurred in the 1920s. A bubble economy ensued, which set the stage for the stock market crash in 1929. The country had made a grave mistake by taking gold in and creating excessive credit. The inflated money supply led to over investment, and finally, over capacity.
After the war, the gold standard was reestablished and remained in effect until World War II. Having learned from their mistakes after World War I, at the end of World War II, all governments wanted to assure a smooth return to a peacetime economy. A summit took place with representatives of the world's major nations in attendance. The resulting accord was called the Bretton Woods Agreement.
The new system modified the original gold standard into the gold exchange standard. Under the new system, the dollar/gold ratio fixed the price of gold at 35 dollars an ounce. Foreign governments (but not the public) could exchange one ounce of gold for 35 dollars and, more importantly, could exchange thirty-five dollars for one ounce of gold. The government backed the dollars with gold reserves held in U.S. vaults. Recognizing that individual countries could gain unfair advantages in trade simply by devaluing their currencies, the world's nations agreed to peg their individual currencies to the dollar at fixed rates of exchange. The system worked well for more than twenty years. Because of the ultimate peg of every currency to gold, sustained trade imbalances could not occur – that is, if every country kept its promise to redeem their currencies with gold.
The Window Closes In the 1960s, dollars poured out of America. A great deal of money went to a small country in Asia, where we had no business being. Additionally, large U.S. corporations (soon to be known as multi-nationals) began opening up operations in other countries, taking our dollars and spending them outside the country. In both cases, had we simply stayed at home and minded our own business, we would not be facing a financial catastrophe today.
As the expenditures in Vietnam mounted and our major corporations expanded abroad, foreign countries found themselves with a growing amount of dollars. After a while, they began wanting to exchange a portion of these dollars for gold. Soon, the United States began running out of gold reserves. As a result, in 1971, Richard Nixon declared that the United States would no longer exchange its gold for foreign currencies. All bets were off, so to speak. In 1973, with the gold window closed, all countries agreed to let their countries' currencies "float" freely against one another. Henceforth, supply and demand would determine the value of a country's currency.
It is interesting to note how often administrations, confronted by unprecedented economic circumstances, have often acted capriciously, with little understanding or regard for the longer term consequences of their policies. This theme repeats throughout history. We have learned how decisions to arm the Allies inadvertently led to the Great Depression more than a decade later. Later in this chapter, we will come to appreciate how the Vietnam War and Nixon's subsequent decision to close the gold window may yet give rise to enormous global hardship thirty-five years after the fact.
Shopping at the World Mall Before delving further into the world of foreign exchange, let us first gain a working knowledge of two important terms that economists employ in this field.
Balance of payments is the difference between the amount paid by a national government to other countries and the amount it receives from them. The
current account is nothing more than a checking account that records the value of a government's imports and exports. When a country exports more to the rest of the world than it imports, its current account shows a surplus because it received more money than was spent. Conversely, when a country imports more than it exports, its current account shows a deficit because it spent more than it received.
Trade surplus and trade deficit are lay terms that mean the same as
current account surplus and
current account deficit. Like budget surpluses and deficits, current account surpluses and deficits can accumulate over many years.
Subsequent to the dissolution of the Bretton Woods system, which had mandated the convertibility of all currencies to gold, the United States found itself free to import as much as it wanted. For the first time in history, it could shop with impunity, possessing what amounted to a credit card with no limit. The United States could pay for foreign goods with dollars (backed by nothing but the good faith of the U.S. government) or with debt instruments (IOUs). Given that license, the U.S. ran current account deficits year in and year out. The cumulative account deficit (the total we owe the rest of the world) is now over four trillion dollars.
For the past thirty-odd years, despite the enormous balance owed on our account, until very recently we were never called on the carpet or forced to tighten our belt. Why? Because for some time we have been the big bully on the block. The United States is the world's biggest customer, and that is the primary reason we generally manage to get away with dictating to the rest of the world. Our currency, the dollar, has become the de facto global currency. For that honor, we can thank OPEC, who made the decision to price their oil in dollars rather than some other currency. Now, every country needs dollars to buy oil.
It is important to realize that this new system, which allows currencies to float freely, is a rather recent experiment, especially when observed from a longer-term historical perspective. No planning took place, nor were econometric models constructed that might have revealed potential future problems. For years, the United States has willfully purchased goods from the rest of the world without any money to pay for them. These shortsighted policies will very soon produce dire economic consequences. The chickens are about to come home to roost.
Too Much of a Good Thing Since abandoning the gold standard, we have learned that sustained trade imbalances set off a chain reaction of economic events. When a country runs a large current account surplus, money flows into the country. The quantity of money entering the banking system is "high-powered money."The term refers to the fact that, because banks are only required to hold a small portion of their currency on reserve, the money deposited multiplies. For example, for every $10 deposited in a bank gives the bank the right to lend out $100.
As you might imagine, the extra money in circulation –- often initially lent to businesses -– produces investment in capital projects. Businesses build new factories and produce more widgets. However, if the supply and demand for widgets were already in balance, the additional supply produced by the new factories would overwhelm demand. The business would possess extra plant capacity, but also additional expenses, including interest on the new loan. With sales no higher than before, the business's net profits would decline. In the case of a larger company, lower earnings would eventually result in lower share prices.
In light of what we have just learned, let us now reexamine the Great Crash. From 1914 to 1917, gold flowed into the United States to pay for arms sold to England and France. The money received from the sales was high-powered money. Banks were able to lend a multiple of that amount to businesses. As a result, within seven years, the industrial capacity of the United States doubled. In 1921, the Federal Reserve attempted to soak up some of the excess liquidity by raising interest rates. GNP declined by almost nine percent and the country began to slip into recession. The Fed reversed course, added liquidity, and the economy stabilized. Unknown at the time, the economy, in fact, was still gaining steam from money supply increases years earlier.
By 1926, overcapacity had become a problem. It was no longer profitable to invest in plant and equipment. The stock market continued higher because the country's mood was still good and credit was easy. Before long, corporate profits began to decline, but the public did not seem to notice. In hindsight, it was one more period of irrational exuberance. In 1929, it became clear to even the average person that corporate profits were in a tailspin. Once the market crashed, bankruptcies followed. Banks failed and deflation set in. The same sequence of events has played out repeatedly throughout the world – in South America in the 1970s, in Japan in the 1980s, and in Asia in the 1990s. While the source of the inflow differed in each instance, the very act of receiving additional money from outside the country always upsets the country's fragile economic balance. Before looking at further examples, however, we first need to learn a little more about balance of payments.
A Crucial Concept As we learned earlier, balance of payments is the difference between the amount paid by a national government to other countries and the amount it receives from them. This number is comprised of two components. The first component, which we learned about, is called the current account. The current account measures the trade in goods and services between countries. If Israel wanted to buy Apache helicopters from us, the money they sent us would show up on our current account as a surplus and on their current account as a deficit. Conversely, if we buy 10,000 Sony TVs from Japan, the money sent to them shows up as a deficit on our current account, while Japan's current account records a surplus.
The second component of balance of payments, called the financial account or capital account, measures the flow of capital into and out of a country. For example, if Sony were to buy an American movie studio, our financial account would record a surplus (we received money). Japan's financial account would show a debit (they spent money). The same would occur if the Japanese government or any of their large corporations were to buy stocks or bonds in our country. You may wonder, in this hypothetical case, if Japan is credited somewhere for owning our stocks, bonds, and an American movie studio. The answer is yes. Another account, reserve assets, contains that information. Reserve assets include all balances of payments, as well as all assets held or controlled outside the country.
An understanding of reserve assets is crucial to understanding our current dilemma. The reserve assets account adds the current account and financial account together. Thus, by looking at the reserve asset account, we can get a good idea of how much money is either flowing into or out of the country. One more point: the reserve assets account is cumulative.
Trade Induced Bubbles After the stock market bubble in the United States occurred in the 1920s, the gold standard kept trade balances in check for a number of decades. After the United Sates abandoned the gold standard in 1971, South America became the first region to suffer the consequences of trade imbalances. While the genesis for the bubbles that occurred in Brazil, Argentina, and Mexico began with trade imbalances, oddly enough they were not theirs.
During the 1970s, the United States ran huge deficits with the OPEC countries. Much of the money the American consumers spent to power their mini-vans, eventually found its way back to the United States as the OPEC countries made large investments. America's largest banks, flush with cash and looking for a new place to loan money, found their opportunity in South America.
Brazil and Argentina, in particular, were rich in resources, but required better infrastructure and further industrialization in order to profit from them. American banks were happy to oblige, and lent billions of dollars to the developing countries. The additional money flooded the economies of those countries, resulting first in economic booms, followed shortly thereafter by rampant inflations. Decades later, those countries remain on the critical list economically.
After World War II, Japan did an amazing job of rebuilding their economy. Their citizens embodied a strong work ethic and their savings rate was among the highest in the world. Japanese factories were highly efficient and, by the 1960s, their products were rivaling American products in quality. Exports increased each year. From 1969 to 1972, their reserve account grew five fold. Their economic ascendance might have continued unabated were it not for OPEC. Unlike the United States, Japan is completely dependent on outside sources for its supply of oil. Therefore, the oil price shocks of the 1970s significantly impacted Japan's economy. By 1977, however, the country was back on track and its reserve account showed a new high balance.
During the 1980s, Japan dominated the foreign exchange market and, economically speaking, was the envy of the world. The billions of dollars entering the country would have driven the Yen too high if they had converted all the dollars to their own currency. That would have made their exports more expensive and ruined their business. Instead, the Japanese invested the dollars back in the United States. It bought our corporate bonds, our treasury bonds, our stocks, businesses, and even real estate. Even with its voracious appetite for foreign investments, far more money flowed into the country than left. From 1982 through 1988, its reserve account again grew five-fold and approached 100 billion dollars. As the high-powered money entered the banking system, it generated even more credit in the economy.
In a replay of what occurred in the United States during the 1920's, the excessive credit caused a boom first in capital spending on plants and equipment, and then later in stocks and real estate. Just as in America, the overcapacity in industrial capacity led to decreased corporate profits, which in turn led to a slowing economy and stock market crash. Japan then entered a severe deflationary recession, which has lasted more than a decade
While Japan struggled in the 1990s, the rest of Asia was quick to pick up the ball and run with it. Interestingly, the seeds had been planted as early as the mid-eighties, and Japan planted the seeds. You will remember that, just when Japan's economic growth seemed unstoppable, the U.S. and other industrialized powers teamed up to lessen its advantage by driving the Yen higher against the dollar. While Japan's exports fell, the country was, nonetheless, still flush with money. Japan then embarked on a practice of outsourcing its manufacturing to other Asian countries where labor was cheaper. Korea, Thailand, Malaysia, and Indonesia were all big beneficiaries.
As money poured into these countries' banking systems from direct investment, a wave of credit creation followed. Their stock markets caught fire and it was off to the races. Thailand's share prices quadrupled between 1988 and 1993, while property prices rose by as much as 1000 percent. It is important to point out that, while Japan's original surpluses entered their current account via exports, the surpluses in Asian countries such as Thailand entered their financial accounts because of direct investment. There is no difference. Once money enters a country's banking system, it produces the same ultimate effect: the money supply expands. To reiterate, it is not necessary for a government to print money for their money supply to expand. A country's money supply can expand simply by accepting money from outside its borders. This can occur either in their current account, the result of higher exports relative to imports, or into their financial account by way of direct foreign investment in companies, either through loans or purchases of stock.
While Japan was responsible for providing the majority of capital to Asia, other foreign investors followed suit, buying stocks or loaning money. The excess credit, once again, fostered huge overcapacity and overbuilding. Having spent time in Bangkok in the early nineties, I can testify to seeing hundreds of vacant skyscrapers and abandoned tower cranes as far as the eye could see. Office space in Bangkok had more than quadrupled during the boom, but it was mostly vacant.
The Asian boom began in 1986 and lasted until 1995. The high current account deficit, which Japan ran with the United States in the 1980s, was the genesis of the Asian bubble. When the stock market crashed in Thailand, it lost 95 percent of its value. Thailand's currency, the baht, fell more than 50 percent against the dollar, provoking devaluation. The repercussions of the Asian crisis reverberated around the world. Even a decade later, excess capacity remains, and the commercial vacancy rate is extremely high. Eerily, the exact sequence of events, which occurred a decade earlier in Japan, played out again in Asia.
The U.S. Predicament The United States current account balance has deteriorated since 1992. The trend may not stop until the dollar has collapsed, making foreign imports more costly. The most powerful force exerting pressure on our current account balance is the low cost of imports available from overseas. The trend of outsourcing our manufacturing to countries that possess an abundance of low cost labor only exacerbates the problem. Of course, the U.S. government could ban the practice or impose high tariffs on goods from overseas. High tariffs would raise prices on imported goods, making domestically produced goods more competitive.
In all likelihood, the U.S government will not implement such policies. We have come a long way from protectionism and the trend has been steadily toward increased trade liberalization for the last twenty years. Additionally, the world's largest companies, multinationals, exert a great deal of influence on our politicians. Adding to the evidence that protectionism is unlikely is the fact that the U.S. is currently seeking to establish a free trade zone with all of South America.
By building manufacturing plants in developing countries, companies benefit from both state-of-the-art, new facilities and low-cost labor. The leading countries that are prime candidates for manufacturing are Vietnam, India, Indonesia, China, the Philippines, Thailand, Malaysia, Mexico, and Korea. Three billion people live in these countries –- ten times the number in the entire United States. Additionally, the population is much younger, with the largest number of workers just now entering the work force. Without question, labor will never be a problem for the world's huge multi-national companies. Furthermore, domestic companies who do not relocate plants to the low-wage areas will find it increasingly difficult to compete with those that do.
The wage difference between the United States and developing countries is enormous. In China, hundreds of millions of workers make only five percent of the wages earned by their American counterparts. As the century progresses, new manufacturing jobs will go to these willing workers. On the other hand, you can expect blue-collar workers in the United States to continue to struggle. For two decades now, they have made no progress. Adjusted for inflation, blue-collar workers make less now than twenty years ago. Their plight can only worsen as the trend toward increased imports combines with the trend of offshore relocation of manufacturing to cause a decrease in manufacturing jobs in the U.S.
During the 1990s, the strong U.S. economy played havoc with the current account deficit. The strong economy greatly benefited the dollar, thus making foreign imports cheaper, while hurting exports. Americans, awash in cash and credit, embarked on a worldwide shopping spree.
One could argue, however, that the worsening current account deficit actually benefited our economy. From the perspective of politicians, whose timeframe for measuring the consequences of economic policy is generally short, the argument might be valid. Without question, the low price of imported goods benefited the American consumer. More importantly, the low cost of goods that flooded into the country dampened inflationary pressures. With inflation at bay, both businesses and consumers were able to borrow at favorable rates of interest. While all that is true, it is also true that -- just like in America during the 1920s, South America during the 1970s, Japan during the 1980s, and Asia during the early 1990s -- the United States also experienced an economic bubble in the latter part of the 1990s. The consequences of that bubble were a stock market crash in 2000 and a real estate bubble, which began shortly after the stock market crash.
You may wonder what caused the U.S. bubbles in first the stock market, and later, real estate. At first blush, based on the current account, the idea might seem contradictory. We learned that current account surpluses cause bubbles we witnessed that phenomenon in Japan. But how does a current account deficit cause a bubble? That situation is unique to the United States and here is how it works. Since the early 1980s, we have imported consumer goods and sent money overseas in payment. Almost all the money we sent overseas came right back to us. Please read the next paragraph very carefully because the concept explained is critical in understanding the current economic dilemma facing our country.
When a foreign country receives billions of dollars from us in payment for their exports, they have only two choices as to what to do with the money. The first option is to convert the dollars to their own currency and spend the money in their own country. For any country that relies on their exports to make money, however, that option is economic suicide. If they were to do that, the price of their currency would rise against the dollar, making their exports more expensive and less desirable to America and other countries. Their second option is to take the billions of dollars and invest it back in the United States. By doing so, their reserve assets increase – i.e. they become richer without endangering their trade competitiveness.
While the U.S. current account worsened during the 1990s, the financial account grew by nearly a similar amount each year. You will remember that the financial account measures the money invested in a country each year. Since 1983, the financial account has grown to over four trillion dollars. To state it another way, because of all the money we spent on foreign products, foreign nations have been able to buy four trillion dollars of our country by investing those dollars into our stock and bond markets. You could say that, in return for obsolete beta maxes, cabbage patch dolls, and thousands of other pieces of junk with Taiwan stamped on the bottom, America gave up a great deal of its country.
Show me the money Foreigners mock our moral fiber and claim that we have become a nonproductive society that primarily values consumption and luxuries. Are they right? It would be difficult to argue the point. In 1950, we produced more than half of the world's goods now we only produce about one-quarter. We have run current account deficits for thirty years in a row and now owe the rest of the world over four trillion dollars. We are, of course, the world's largest debtor by far.
If you believe that debt is only a government problem, you would be mistaken. Regarding debt, there is enough blame to go around. Of all the total outstanding debts, government is responsible for about one-quarter and businesses are responsible for about one-third. John Q public owes the largest portion of debt. In fact, public debt has risen by more than a third in just the last three years. Mortgage debt has risen over 40 percent during that same period, and consumer credit has risen about 20 percent. While I would like to "show you the money," I am afraid I can only "show you the debt."
The other side of borrowing is saving. As a group, we do not tend to save much anymore. Our national savings rate is rapidly approaching zero.
Instead, we have developed a nasty habit of borrowing money to pay for our little luxuries. The consumer's borrowing record is even worse than the Federal government's.
The Household Debt Service Ratio shows how much American families spend each month on interest just to service their debt.
Small businesses have been going deeper in the hole as well.
Big business slowed their borrowing somewhat after the stock market crash, but their overall amount of debt is still increasing.
State and local governments have shown the most accelerated increase in debt.
Clinton pared the Federal debt mountain back for a few years, but Bush pushed it up to a new all time high.
A Reckoning Awaits It is time now to try to make sense of what we know, and to consider what implications may lay ahead. The first thing we know is that the United States imports more than it exports. That trend is likely to continue. Because of much higher labor costs, the United States will never be able to manufacture most products as cheaply as it can buy them from overseas manufacturers. The following balance of payments graph makes the trend abundantly clear.
The next thing we know is that most of our trading partners would lose export share if they converted the dollars that we sent them to their own currency. To do that, they would need to sell their dollars and buy their own currency. Rather than reduce their advantage, they send the majority of the dollars received in export trade back to the United States. With these dollars, they buy stocks, corporate and government bonds, and sometimes make direct investments in companies and real estate.
We also know that we cannot depend on foreign governments to finance our spending habits forever. Foreign governments are very much aware of the potential risks they face. The larger our overall debt grows, the less likely we will be able to pay it back. If we do not have enough money to pay our debts--which include ongoing interest payments, principal repayments as notes and bonds mature, and guaranteed entitlement payments--we may have no other choice but to print money. If we print money, inflation will rise and the value of the dollar will fall. Foreign investors thus risk repayment in depreciated dollars.
When U.S. dollars come back into the United States from foreign investors, those dollars generally find their way into the banking system. Because banks can lend a multiple of what they hold in reserve, the inflow of dollars provides an ongoing dose of credit to our economy, which shows up in the money supply. This trend, beginning in the early 1980s, accelerated in the early 1990s and spawned the stock market boom. In the last few years, foreign buying of government agency bonds from Fannie Mae and Freddie Mac has created the real estate boom. The following graph shows a sharp increase in recent years in the amount of dollars foreign countries have loaned back to us. You may notice how they pulled back some recently. That is because they have grown more cautious about buying our foreign debt and, instead, have begun using the dollars we send them to invest in natural resources throughout the world.
The next graph shows the corresponding cumulative growth in money supply.
The data is clear that the money coming in from foreign dollars is not going to productive investment. The government is using the money to pay interest on prior debts, while households are spending the money on current consumption. That is clearly not a good sign.
Going forward, we must ask ourselves what possible scenarios could result if foreign lenders decide to take their dollar holdings elsewhere. Let me propose a hypothetical scenario. Assume Japan decides not to invest in our treasury and agency debt. Instead, it buys Eurodollars. The dollar would fall against the Euro. Because oil is priced in dollars, OPEC would either raise their price to compensate for their foreign exchange losses (it has already done this once) or re-price oil in Euros. In either case, much higher oil prices would occur, with attendant inflationary pressures.
Because all commodities are priced in dollars, commodity prices would rise as well. Rising commodity prices, we learned, leads to cost-push inflation. A lower dollar would cause bondholders to sell, rather than risk payback in depreciated dollars. When the bond market declines, long-term interest rates rise as they maintain an inverse relationship. When corporations must pay more to borrow, they must also raise prices to protect their profit margins. That is also inflationary.
The Fed Fights Back If this scenario were to occur, the U.S. economy would begin to slide into a severe recession. While businesses may attempt to raise prices to compensate for their increased borrowing costs, the demand will not exist. They will begin slashing prices and reducing overhead by eliminating workers. Prices could then succumb to the worldwide deflation that will eventually take the upper hand. However, the United States government will not go down without a fight. While deflationists make a very strong case, the fact of the matter is that the Federal Reserve will simply not allow deflation, which would lead to depression. They have made that perfectly clear. In 2002, the Board of Governors circulated the following paper entitled, "Preventing Deflation: Lessons from Japan's Experience in the 1990s."
"This paper examines Japan's experience in the first half of the 1990s to shed some light on several issues that arise as inflation declines towards zero. Is it possible to recognize when an economy is moving into a phase of sustained deflation? How quickly should monetary policy respond to sharp declines in inflation? Are there factors that inhibit the monetary transmission mechanism as interest rates approach zero? What is the role for fiscal policy in warding off a deflationary episode? We conclude that Japan's sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities' failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the general lesson from Japan's experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus – both monetary and fiscal – should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity."
According to this paper, the Board of Governors is well aware of the potential economic implications of a sustained deflationary slump and wants to avoid that at all costs. They believe that it was the Japanese's "failure to provide sufficient stimulus to maintain growth and positive inflation" that resulted in Japan's depression. They further state that once inflation and short-term interest rates approach the zero-lower-bound, both monetary and fiscal policy should go beyond conventional levels. I take that to mean that the government is prepared to fight deflation by any means possible, which would likely include both fiscal stimulus (government spending programs) and monetary stimulus (printing money).
What effects would fiscal and monetary policy have on the economy? As we have seen, when additional money comes into an economy, it always has an inflationary effect, with a lag that can sometimes be as much as two years. Therefore, it would behoove us to monitor the economic results whenever the Fed cuts interest rates. If we observe that the economy is not recovering, we can anticipate that the Fed will then apply fiscal and monetary stimulus – i.e. inject money directly into the system.
Since World War II, interest rate manipulation has cured every recession on record in the United States. As of late, however, that conventional monetary tool has not been very effective. If the economy does not revive this time from continuous interest rates cuts, we should be concerned. It would mean that neither businesses nor the consumer took the bait. When the government offers businesses the opportunity to borrow money at ridiculously low rates of interest and they fail to do so, it is because they cannot find a productive place to put the money. The fact that factories are operating far below capacity indicates that current public demand is insufficient to warrant further expansion. While low interest rates might allow the average consumer to save thirty dollars a month on new car payments, if he is concerned about job security he will not risk buying a new car.
Housing has been the primary beneficiary of low interest rates. First time buyers have found it easier to qualify for homes that they might not have otherwise been able to afford. Current homeowners have benefited from lower interest rates by refinancing their homes, thus freeing up additional equity. The home improvement business has profited from homeowners redoing outdated kitchens and baths, adding decks, and generally upgrading their homes. Despite rapidly escalating home prices, however, the average homeowner has even less equity in his house now than before the refinancing boom. Homeowners frequently used monies from refinancing to pay off higher interest rate loans on credit cards and automobiles. That explains why the household debt service ratio has retreated fractionally, while the overall debt burden of households has increased.
Without a doubt, the real estate sector has kept the economy afloat recently, but just barely. How much longer can refinancing continue? For first time buyers wanting to buy homes, a drop in the rate on a thirty-year mortgage from six percent to five percent would lower their payments considerably – all things being equal. However, if the average price of homes in the neighborhood where they had hoped to live increased from $250,000 to $290,000, their payments will not be any lower, nor will their ability to qualify have improved. As to current homeowners, their payments are about what they were before, but the amount of money they owe is greater. They converted their equity gains to cash by refinancing and quickly spent the money. At some point, as interest rates reach their lower limit, further refinancing will no longer be possible. The billions of dollars in consumer hands, which resulted from the refinancing boom, kept the consumer above water. In doing so, it acted as a crutch for the economy. When that process ends, the economy will falter. The next step by the Fed will be outright fiscal and monetary stimulus.
Historically, the Fed has typically acted too soon or too late. On the one hand, they fear inflation and are reticent to stimulate the economy if they believe it would revive on its own. By acting too soon, their stimulus would combine with the nascent normal upswing and result in an overheated economy. By acting too late, they risk a period of recession given that the effects of monetary stimulus are not generally visible for six months to two years. I would presume that deflation is by far the more serious threat to the Fed, because deflation is recessionary, while inflation is not. Therefore, they are likely to act sooner rather than later. As investors, we need to guesstimate the consequences of the expected stimulus.
We have a great deal of evidence that the economy will not revive, as the Fed expects. It is likely that the Fed bases its optimism on historical precedents. The benefits of monetary stimulus, however, are no longer relevant in today's economy. First, let me explain why, and then you will see that the proof already exists.
The Hard Truth Our economy is structurally much different from those days when previous recessions could be ended with a wave of the monetary wand. Our economy's problems are structural. The economy is no longer capable of dancing to the tune of monetary stimulus. The United States is not the productive country that it once was we have become a nation of consumers rather than producers. We now let other countries make our clothes, our shoes, our gadgets, and even program our computers. Meanwhile, three million American workers lose their jobs. Their families join the working poor or exist on welfare. Those Americans who have money spend it on designer jeans, DSL, DVD players and GPS systems for the SUV, subzero refrigerators, granite countertops, and ever bigger patio grills. Those that do not have money borrow it, and buy pretty much the same stuff. That sums up the typical American consumer.
The government, meanwhile, spends money it does not have on programs that it cannot afford. Going forward, inflation-adjusted entitlement programs alone are destined to bankrupt the country. Meanwhile, politicians dole out promises of benefits to the electorate in order to gain votes. Our government's overspending has alarmed the world community, who are all too cognizant of the fact that a depression in America would bring the rest of the world down with it. Still, the government records deficits each year. As the total debt grows, interest payments take a larger share of GDP. It does not take a genius to see that America has lost its way. Even to the casual observer, it would seem clear that the country is locked on course to self-destruct.
A small dose of monetary stimulus, the most likely first strike the Fed will take, will not be enough to turn the ship around. Here is why. In a normal economy, businesses would use that money to expand their plants and modernize their equipment, thereby increasing productivity and output. As discussed earlier, however, because of overcapacity (the result of manufacturers leaving the country in droves), businesses are unlikely to expand. Instead, expect businesses to use any extra money they can find to pay down their debt load.
In days past, consumers would take the extra dollars injected into the system and buy products from U.S. factories. In today's economy, however, consumers are more likely to pay down debt. Even the money they spend will, percentage wise, not go to American factories as it did in the past. Instead, consumer demand will translate into more imports, which will worsen the current account deficit. Once again, the money that the Fed pumps into the economy will find its way to foreign countries.
Earlier, I told you that I would explain why the monetary stimulus would not work and I have. I also told you that I would show you proof. Look again at the charts titled "Balance of Payments" and "Foreign Official Assets in the U.S." and it will be abundantly clear. We have already received monetary stimulus. It came from foreigners who took the dollars we gave them for imports and invested them back into our country. The money went into banks and fostered credit creation. That is no different from the Fed creating credit creation by printing money or using any of its other tools to stimulate the economy. If you take another look at the chart titled "Foreign Official Assets in the U.S.," you can see that every year the line is above zero, foreign capital flowed into the country. The chart on M3 shows the expansion in money supply that resulted.
When the Fed does implement its initial stimulus package, it will be interesting to see what asset classes will benefit. Will the real estate bubble continue? Will commodities and precious metals enter strong bull markets? Will natural resources gain? Will the dollar fall? Will yield spreads widen still further as the specter of inflation looms imminent?
After the initial stimulus fails to bring the desired result, a second, even stronger monetary or fiscal stimulus package could be required. It is unlikely that the Fed will just sit back and allow the economy to falter. It is more likely they will point to some benefits gained from the first stimulus package as justification for a second. Depending on the size of the stimulus package, inflation should be off to the races with future consequences too frightening to consider.
Structural imbalances, now built into the economy, will soon cause a weakening of the economy. The government will respond using either fiscal or monetary stimulus, or both. The huge injection of money into the economy will create tremendous dislocation in markets, possibly creating asset bubbles and pronounced strong trends in physical commodities and tangibles. This financial storm will make some people richer and others poorer. I hope you will be among the former camp. The time to make money will be short, however. Your best course of action will be to learn how to use various investment vehicles and take action. If you make money, the battle will be half won. History has shown that those who actually are able to keep the money they have made during speculative bubbles (witness the NASDAQ bubble) are a small minority. Therefore, you must be ever vigilant and not allow your financial successes to swell your ego or cause you to become greedy.
You should welcome any window of opportunity you may have to eliminate all debt, build a war chest for a rainy day, improve your health, and become more self-sufficient. We must recognize that a small portion of the blame for the coming economic train wreck lies with each of us. We have been wasteful, overindulgent, spendthrifts for far too long. It is time we reexamined our own values and taught our children new ones. Our parents knew the value of a dollar and the dangers of debt. We have forgotten what they knew, but those who forget the lessons of the past are destined to relearn them. We are no different.
MORE INFORMATION ABOUT THE COMING INFLATION CRISIS AND HOW TO PROFIT FROM IT IS AVAILABLE AT: WWW.CURTISARNOLDREPORT.COM
Copyright 2005
Curtis Arnold is the country's leading authority on inflation and a best-selling financial author. His latest book, HONEY, WHO SHRUNK OUR MONEY? is due out in 2006. Please visit www.curtisarnoldreport.com for continuing coverage of the perfect financial storm and investment updates. The author is also available for speaking engagements. Contact: curtisarnold@hotmail.com.
