Wednesday, February 16, 2011

Deficits, Credit Inflation, and the Dollar

Over the past decade, but especially over the last year or so, there has been a concern over when the “deficit sharks” are going to turn against the United States bonds and the United States dollar. This question has certainly arisen in the minds of many as the Eurozone has been attacked and the Chinese make moves to make their currency “more international.”

My answer to this is that the debt of the United States will not really come under attack until the United States dollar ceases to be the one reserve currency in the world. And, the United States dollar will continue to be the one reserve currency in the world for a relatively long time.

It has been the status of the United States dollar that has allowed the United States government to “get away” with its fiscal irresponsibility for the past fifty years and it is this status that will allow the United States government to “get away” with its fiscal irresponsibility for a while longer.

Since the United States debt can always be paid off with United States dollars people and nations will hold the American debt and will rush to it when there is a “flight–to-quality.” This is just what we have seen over the past fifty years, especially during the worldwide financial crisis 0f 2008 and 2009.

The United States government took on a new philosophy in the 1960s, a philosophy that allowed that it was alright to run fiscal deficits, not only in periods of recession but also in “good times” so as to achieve higher rates of economic growth and keep people employed. This philosophy was inaugurated by the Kennedy administration and was absorbed by the Nixon administration and became the backbone of the economic policies for both Republicans and Democrats continuing into the present.

This “philosophy” achieved the following results: a decline of 85% in the purchasing power of its currency; under-employment in the economy reaching at least twenty percent of the workforce; and an income distribution that is highly skewed to the wealthy.

The philosophy called for a “credit inflation” in the United States economy that would result in prices rising on a regular basis which would put people to work and with a special emphasis on home ownership for almost all Americans which provided these citizens with an asset that constantly rose in price and which became the “piggy bank” of middle classes.

The debt of the United States government has increased at a compound rate of about 7% since 1960 up through the beginning of the Great Recession.

Prices rose at rate just below 4%, as measured by the implicit price deflator of Gross Domestic Product, during the same time period.

The rate of growth of real Gross Domestic Product rose by slightly more than 3%.

During this time period the value of the United States dollar declined.

The period started off with the price of the United States dollar fixed according to the Bretton Woods rules for international finance. By the end of the 1960s, sufficient inflation had been created along with rapidly increasing capital flows throughout much of the world so that the fixed exchange rates could no longer hold. As a consequence, the United States dollar was floated on August 15, 1971 by Richard Nixon and the race was on.

Dollar indices have only been in place since about 1973 because the dollar only began floating in late 1971. But, since then the value of the United States dollar measured against major currencies has declined by about 25%. (Remember the other major countries inflated their economies as well. And, many had currency crisis as well during this time period.) Against a broader range of currencies the dollar has declined by closer to 70% over the same time period.

There is no question that the “rest of the world” believes that the economic policies of the United States government are flawed. Just look at what the market is telling us!

However, the United States dollar is the one reserve currency of the world. Thus, the United States can get away with a lot of “stuff” that other governments cannot get away with.

And, the United States government has constantly argued that it is for a “strong dollar.” And, by the United States government I mean both Republicans and Democrats.

The United States government has lived off of its privileged position of having the one reserve currency in the world. It continues to live off of this privilege because it is still going to be a while before the United States dollar loses its position as the one reserve currency in the world.

This privilege has meant that the United States government does not have to conduct a “disciplined” fiscal policy because any consequence of its lack of discipline is sufficiently far off in the future to not really matter.

I presented my response to the current budget proposal of the Obama administration and the Republican posturing in my blog post of February 15. See “The Obama Debt Machine,” ( My conclusion is that we will have more of the same…more credit inflation.

So, that is my forecast for the “alpha” investor: the economic philosophy of the United States government has not changed.

Oh, there will be interludes in which “prudence” is popular. These will be like the “Volcker interlude” in the late 1970s and early 1980s when monetary policy was used to try and stop inflation, and the “Clinton interlude” in the 1990s when the federal budget was brought into balance. But these were just temporary diversions from the trend.

Maybe Charles “Chuck” Prince, the former chairman and chief executive officer of Citigroup, will have the last laugh. Prince, who made the remark that captured the attitude of the early 2000s, stated that “as long as the music keeps playing, you’ve got to get up and dance.”

In periods of credit inflation, taking on more debt, taking on more risk, mismatching maturities, and aggressive financial innovation pays. As Prince admitted, Citigroup got up and danced.

Dancing pays during a credit inflation. However, you need to be agile enough to sit out the intermissions when the musicians take a break as they did during the Great Recession.

All indications point to the fact that the “music” will continue on. The name of the dance is “credit inflation” and this dance will continue, with some periods of intermission, until the United States dollar ceases to be the one reserve currency of the world. Until then there seems to be little or no way to discipline the United States government for its profligate budgetary ways.

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