After the Dollar: What Comes Next?

By Peter Schiff

My readers are familiar with my forecast that the US dollar is in terminal decline. America is tragically bankrupt, unable to pay its lenders without printing the dollars to do so, and enmeshed in an economic depression. The clock is ticking until the dollar faces a crisis of confidence like every other bubble before it. The key difference between this collapse and, say, the bursting of the housing bubble is that the US dollar is the backbone of the global economy. Its conflagration will leave a vacuum that needs to be filled.

Mainstream commentators often discuss three main contenders for the role: the euro, the yen, or China’s RMB (known colloquially as the “yuan”). These other currencies, however, each suffer from a critical flaw that makes them unready to carry the reserve currency role in time for the dollar’s collapse. When it comes to fiat alternatives, it appears the world would be going out of the frying pan and into the fire.

Stimulus Wears Off

Michael Pento’s Market Commentary

The artificially engineered U.S. recovery is already starting to falter as a continuous procession of disappointing data continues to confirm the sad truth. Recent numbers on GDP, durable goods, housing, regional manufacturing, initial unemployment claims and leading economic indicators all indicate a sharp slowdown in GDP growth. Just today the ADP Employment report showed that the private sector added a paltry 38,000 jobs in May, down from 177,000 jobs in April, significantly below expectations, and the weakest number since September 2010. Just yesterday Case Shiller announced that the U.S. housing market had officially achieved a “double dip,” in that national home prices have given up the entire 5% bounce that they had achieved after the May 2009 lows. These signs of continuing malaise comes at a time when the government is contemplating ways to dramatically cut spending. But given the economic weakness, is America really ready to accept the short term consequences that a government spending cut would cause?

Free market disciples (like me) believe that government intervention is anathema to a healthy economy. In contrast, we believe genuine government stimulus comes from low taxes, stable prices, reduced regulation and low debt. Our economic policy makers have scrupulously avoided such remedies. However, in the short term, it is possible for government central-planning to artificially boost GDP. But as the short term has come and gone, Washington’s heavy hand is now inflicting lasting demand on the economy.

When a country spends in order to stimulate growth it gets the money from three sources: taxing its citizens; borrowing from the existing pool of capital, or borrowing newly created money from its central bank. All three options are economically poisonous.

The act of taxing one sector of the economy in order to redistribute wealth to another is not a net economic benefit. To think that taking money from Citizen A and giving it to Citizen B improves the outlook for both assumes that the government knows the best way to allocate resources. But everything I have ever seen tells me that this is not so.

A government could instead distribute money borrowed from the private sector’s existing pool of capital into targeted areas of the economy. But this type of “stimulus” is simply a deferred tax with interest. Any money borrowed by government could have been utilized by the private sector to expand business and grow the economy. Instead, money spent by government makes no lasting economic impact.

Some liberal economists argue that funds left in the private sector would likely be saved, rather than spent, during an economic downturn—thus exacerbating the recession. This may be true, but necessity, in the form of weak balance sheets, is the factor that usually drives the private sector to save. Any interference with that deleveraging process can have dire consequences in the long term. Government borrowing only delays the eventual pain because a significant tax increase will eventually be needed to pay down the added debt. If the private sector is prevented from paying down debt, the debts will simply be transferred, with interest, to the public ledger.

Finally, a government can acquire spending power from outside the existing domestic savings pool by borrowing newly printed money that enters the economy in the form of deficit spending. However, the inflation created by the central bank printing has its downside. At first, the economy experiences a combination of higher prices and growth. Producers raise prices as the domestic currency loses its value, while others are deceived into believing the value of money has remained unchanged; and so they increase their production and expand real GDP. However, the more the central bank prints, the less real growth and the more inflation the economy will experience.

This is precisely the recipe that we are currently following. Between 2008 and 2010, the Federal government borrowed over $3.1 trillion. It is expected to run-up another $1.5 trillion in debt this fiscal year. Meanwhile, the Federal Reserve has increased their balance sheet by nearly $2 trillion in order to accommodate the massive increase in public sector borrowing.

By borrowing printed money, the government has been able to perpetuate our consumption driven economy, while simultaneously raising most asset prices—even home prices have been prevented from falling to a level that can be supported by the free market. The Fed’s desire to create inflation and support prices has at last driven up industrial commodity prices like copper to all-time nominal highs. But once oil prices crashed through the $100 per barrel level, the Fed was forced to ratchet down its inflationary rhetoric. The question now is whether actions will follow.

The Fed and the Administration have now reached the point of diminishing returns. Whatever anemic and temporary growth that was generated by borrowing and spending printed money is now being superseded by rising prices. Any further monetary stimulation will only send aggregate price levels surging, even as GDP growth falls.

The government’s window to artificially drive real GDP growth by borrowing and spending has closed. The U.S. economy now faces another recession head-on, as the private sector deleveraging process resumes and the public sector deleveraging process begins. Alternatively, the Fed can keep expanding its balance sheet and send the economy deeper into stagflation. The only question for investors is whether the next recession will be accompanied by inflation or deflation. But only Mr. Bernanke can answer that.

Training Wheels Off, Crash Helmets On

Michael Pento’s Market Commentary

Based on many pronouncements by economic policy makers, reams of articles by the top financial journalists and near continuous discussion on the financial news channels, it appears that the quantitative easing juggernaut that has steamed the high seas of macroeconomics for the last three years is finally pulling into port…supposedly for the last time. According to the dominant narrative, QEI and QEII helped stabilize the economy during the Great Recession and now the Federal Reserve is ready to take the training wheels off. If so, the economy may need a helmet because there is virtually no chance that it can avoid major contractions without central banking support.

It is ironic, but there is no doubt that the proposed removal of artificial stimulus would be the best thing for the country in the long term. But very few observers understand how it will inflict short term pain. So confident is the Fed that earlier this week, St. Louis Fed President James Bullard indicated that any notion of additional quantitative easing is off the table. In fact, he said the central bank may tighten policy in 2011 by allowing its balance sheet to shrink. Investors would do well to remember that Bullard was the first Fed official to support the second round of bond purchases now known as QEII. It is likely that he will make a similar reversal if the economy shows any signs of weakening in the months ahead.

Fed policy makers like Bullard are guilty of reckless optimism if they believe the economy has truly healed. The evidence of a pending slowdown is abundant. The Empire State’s business conditions index decreased 10 points from April to just 11.9 in May. Meanwhile, the prices paid index rose sharply, with about 70% of respondents reporting price increases for inputs, and none reporting price reductions. That inflation index advanced 12 points to 69.9, its highest level since mid-2008. And things are even worse in Philadelphia. The Federal Reserve Bank of Philadelphia’s general economic index fell to 3.9 in May from 18.5 a month earlier.

Turning to the labor front, the four week moving average of initial jobless claims rose to 439,000 last week, from 437,750 in the week prior. Of course, the real estate market continues in its malaise. According to the National Association of Realtors, April existing home sales dropped to an annual rate of just 5.05 million. Prices continue to set new post crash lows, with prices down 5% YOY. Despite the fact that the government still accounts for nearly the entire mortgage market and the Fed has rates near zero percent, inventory of existing homes jumped from 3.52 to 3.87 million units and the months’ supply climbed from 8.3 to 9.2. Does it sound like the economy is ready to get up on its own two feet?

But the Fed is under pressure to do something about the growing inflation threat. Year over year increases of CPI, PPI and Import prices are 3.2%, 6.8% and 11.1%, respectively. As price increases hit middle class consumers, the Fed is facing intense pressure to push down inflation by draining the balance sheet and raising interest rates. It’s a dangerous game.

In its simplest terms quantitative easing is nothing more than the government’s attempt to boost consumption by borrowing trillions of dollars. Over the long haul this is no way to run an economy, and a sustainable recovery will be impossible as long as such borrowing continues. But in the short term, a cessation of government borrowing will lift the veil on our artificial economy, and reveal how dependent we have become. U.S. fiscal and monetary austerity will cause GDP to fall as the deleveraging process that was interrupted in 2009 returns with a vengeance. I do not believe the Fed or the Administration has the intestinal fortitude to let that happen.

A bona fide Fed exit from interest rate manipulation means that both nominal and real interest rates would rise significantly. The ten year note yield is less than half its average over the past 40 years. Normalization of rates would provide a serious headwind to markets and the economy.

The high leverage that brought on the Great Recession has not been addressed in the slightest. U.S. household, corporate and government debt as a percentage of GDP has never been greater. So, if interest rates were to rise, why should we expect a different result from what occurred in 2008?

Whether or not the Fed is bluffing has dramatic implications for investors and the country. Mr. Bernanke will eventually have to choose whether he wants another depression or more of the inflation the Fed is so adept at causing and then denying.

Raising the Roof on Debt

By Peter Schiff

Today the U.S. government officially borrowed beyond its $14.29 trillion statutory debt limit. And even though the Obama administration has assured us that accounting gimmickry will allow the government to borrow for another few months, the breach has given seeming urgency to Congressional negotiations to raise the debt ceiling. Republicans are making a great show of acting tough by linking their “yes” votes with promises for future budget cuts (that could even slow the rate of debt increases at some uncertain point in the future). But as we go through the process, many novice observers may wonder why we have a debt ceiling at all when our government has never shown the slightest inclination to respect its prior self-imposed limits.

The ceiling was first imposed in 1917 as part of a deal that passed the Liberty Bond Act that funded America’s entry into the First World War. To make it easy for the Treasury to sell those bonds, Congress also amended the Federal Reserve Act to allow the Fed to hold government bonds as collateral. But given the potential for unchecked Federal deficits, Congress sought to limit taxpayer exposure to $11.5 billion.

The problem was that Congress never passed a law to prevent future Congresses from raising the ceiling. And even if it had, that law could have been rewritten by future legislation. Sure enough, when the Second World War rolled around the debt limit was raised frantically, leaving it at $300 billion by 1945. But believe it or not, after the War ended, the limit was actually reduced to $275 billion.

Despite the costs associated with the Korean War, the next increase did not come until 1954. And over the ensuing eight years, the ceiling was raised seven times and reduced twice, finally getting back to $300 billion in 1962. Since then, Congress has voted to raise the ceiling 74 times without a single reduction.

Practically speaking, a ceiling that is raised automatically is no ceiling at all. Given that, why not dispense with the pretense? The reason is politics. No Congressman wants to be on the record voting for unlimited debt, yet most are willing to rail against fiscal recklessness while raising the ceiling every time it’s reached. Any Congressman who gives lip service to a balanced budget Amendment but votes to raise the debt ceiling is a hypocrite. No one needs constitutional help to hold the line on the debt right now!

But epic levels of Federal red ink and the approach of the 2012 elections have raised the stakes. Despite the newfound urgency, nearly all Democrats and a very large chunk of Republicans argue that failure to raise the ceiling will be tantamount to economic suicide. They argue that such a rash move will cause the U.S. to default on outstanding debt obligations, thereby sending interest rates sharply higher across the board. Higher interest rates they argue would cripple the economy and permanently increase debt service costs. As a result, they predict capping debt now will precipitate a far deeper economic contraction than what we have already seen in the last few years.

Few see the inherent absurdity in the notion that taking on more debt improves the economic health and creditworthiness of the United States. I would argue for the much simpler idea that more debt weakens a nation’s financial position. More importantly, capping U.S. debt at current levels means bringing a future crisis into the present where it can be dealt with in practical terms. This is something that nobody in Washington actually wants.

If we do today what we have failed to do in the past, we very may well default on a portion of our debt. No doubt our creditors will suffer. But such near term pain will lead to a quicker and healthier recovery. Out of control Federal spending will have to be dealt with now. A downgraded credit rating will make it harder for the United States to continue borrowing, and as a result should be viewed as a blessing in disguise.

A reduction in debt levels is good economics. Remember, taxpayers will have to repay with interest anything the government borrows now. The more the government borrows, the larger it grows, and the larger it grows, the weaker the economy becomes. The less money the government borrows, the more that is available for the private sector to borrow to increase production and create jobs.

Failing to raise the debt ceiling will force Congress and the President to tell the truth to Social Security and Medicare beneficiaries who have been promised more than taxpayers can deliver. They will have to concede that so-called government “trust funds” are mere accounting gimmicks, and that benefits will need to be cut if the programs are to be solvent. They will have to tell the truth to our creditors that the U.S government has borrowed beyond the ability of its citizens to repay. And lastly, the stark reality will force the government to tell the truth to Federal employees whose salaries and benefits are unsupportable given our fiscal weakness.

But, on the other hand, if we raise the debt ceiling, we can postpone the crisis into an indefinite future. All of these tough choices could be avoided. Government pay and benefits will flow unabated, and our creditors will continue to get their interest payments now. But in the future, the value of principal repayments and government benefits and paychecks will lose purchasing power. That’s because if we keep raising the ceiling indefinitely, we risk destroying our currency. But the long slow death of a currency and the ebbing of a nation’s economic vitality doesn’t make for huge headlines.

It is for that reason I am 100% confident that Congress will do the wrong thing and raise the debt ceiling for the 75th time in 50 years. In the end there will be some kind of phony compromise with each side claiming victory. But while the politicians celebrate another dodged bullet, the U.S. economy will continue to be shot full of holes.

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The Institutional Gold Rush

By Peter Schiff

I have worked on Wall Street my entire life, and one thing I’ve learned is that large institutional investors, like pension funds and endowments, rarely veer from the herd. They manage too much of other people’s money to stick their necks out alone – if their investments go bad, at least they can point to everyone else who fared just as poorly.

For this reason, these funds are often lagging in their perception of crucial market changes – changes such as a doomed currency. While many of us are buying precious metals to hedge against the collapse of the dollar, gold and silver have been taboo investments on Wall Street for years. Fund managers are taught that gold is a “barbarous relic” – much better to stick with government bonds and blue-chip stocks. That’s what everyone else is doing.

But there are early signs that the herd is changing direction.

Inflation Destroys Real Wages

Michael Pento’s Market Commentary

In the same vein as medieval physicians believed bloodletting would cure illness, modern snake-oil economists still perilously cling to their claim that rising wages and salaries are the cause of inflation. With my recent debates with these mainstream economists, I’ve heard the following: “without rising wages, where does the money come from to push prices higher?” I was tempted to respond, “where do the employers get the money to pay those higher wages?” But economists tend to get a little nasty when you make them feel stupid.

It is actually the predominant belief that wages and salaries rise before aggregate price levels in the economy and thus during periods of rising inflation, real wages are always increasing. However, economic history has proven over and over again that real wages actually decrease during periods of rising inflation. Nominal incomes do increase, but this is merely a response to the inflation that has already been created.

The essence of this folly is that modern economists don’t have a firm grasp on the mechanics of inflation. At the most basic level, inflation comes from too much money chasing too few goods. The battle against rapidly rising inflation always has its genesis from a central bank that prints money in order to monetize the nation’s debt.

And because the central bank typically only gives this new money to the nation’s creditors—half of which aren’t Americans–the money created is never evenly distributed into the wages and salaries of the people. It goes first into the hands of those bondholders who receive interest and principal payments. In addition, the rapid expansion of the money supply causes the currency to lose value against hard assets and foreign currencies. Nominal wages and salaries eventually respond to soaring commodity prices and a crumbling currency, but always with a lag that causes their purchasing power to fall relative to other asset classes. Have you ever tried to ask your boss for a raise simply because living expenses cost 10% more than a year prior? As you are laughed out of the office, you can see the wage lag in action.

Recent economic data provides clear proof that the “wage-price spiral” alleged by Keynesian economists is plainly wrong.

The Consumer Price Index (CPI) has now increased for nine consecutive months. It increased by 0.5% in March from February and is up 2.7% year-over-year. The YOY increase in the prior month was 2.1%. It appears the increase in consumer prices is accelerating—and quickly. Meanwhile, in the last 12 months, the US Dollar Index has lost 8% of its value against a basket of our 6 largest trading partners. The dollar has also lost 29% of its value since April 2010 when measured against the 19 commodities contained in the CRB Index. If you needed more evidence of the dollar devaluation, producer prices are up 5.8% and import prices surged 9.7% YOY.

So there’s your inflation. But was it caused by rising wages and full employment? The unemployment rate has dropped a bit from 10.1% to 8.8% – but this is mostly due to discouraged workers dropping out of the labor force altogether. However, even if the decrease came from legitimate employment gains, it would be hard to argue that an 8.8% unemployment rate would put upward pressure on wages. And, in fact, it hasn’t. Real average hourly earnings dropped 0.6% in March, the most since June 2009, after falling 0.5% the prior month. Over the past 12 months they were down 1%, the biggest annual drop since September 2008!

The conclusion is clear: rising wages cannot be the cause of inflation.

Alas, there is a predictable path for newly created money as it snakes its way through an economy. It is always reflected first in the falling purchasing power of a currency and in the rising prices of hard assets. That’s because debt holders move their newly minted proceeds into commodities to protect against the general rise in price levels and as an alternate store of wealth. Food and energy prices have a higher negative correlation to the falling dollar than the items that exist in the core rate. They are the first warning bell in an inflationary period, which may be exactly why they are left out of the headline measure.

Nominal wages and salaries eventually rise but always slower than the rate of inflation, causing real wages to fall. If rising wages increased faster than aggregate prices, inflation would always lead to a rise in living standards. Is that what we’ve seen in Peron’s Argentina or Weimar Germany? The reason why the unemployment rate soars and the economy falls into a depression is precisely because the middle class has their discretionary purchasing power stolen from them.

Mark my words: if the Fed and Obama Administration place their faith in stagnant incomes to contain inflation, they will sit idly by while the country collapses in front of their eyes. Because of their medieval understanding of economics, these central planners are going to bring us right back to the Dark Ages.