Tuesday, 16 March 2010

Doomsday dollar scenarios

John Mangun
Outside the Box
Business Mirror
http://www.businessmirror.com.ph/index.php?option=com_content&view=article&id=23015:doomsday-dollar-scenarios&catid=28:opinion&Itemid=64

The policymakers and politicians lie about it because they are either too stupid to understand it or they fully comprehend and realize that the truth would cause rioting from Amsterdam to Zamboanga.

The media sugarcoat and camouflage it because their existence depends on a world of outward stability.

The people ignore it because, although they are convinced something is wrong, they do not know what to do about it.

Last week I wrote “The US is broke” because the debt obligations of the United States are so great the ultimate options are that the US default on its debt or print dollars to pay it. The first option has the potential of bringing down the global financial system and the second will destroy the value of the dollar and likewise destroy the concept of valueless paper currency.

A year ago it did not have to turn out this way. On July 16, 2009, US Vice President Joe Biden said, “We’re going to go bankrupt as a nation. Now, people, when I say that, look at me and say, ‘You’re telling me we have to go spend money to keep from going bankrupt?’ The answer is yes, that’s what I’m telling you.” Biden was thought a fool and made fun of for that statement. But he was absolutely correct.

Governments have the ability to spend themselves out of bankruptcy. The common term is “pump-priming.” Government can print money or borrow to stimulate the economy, creating enough economic growth to overcome the slowdown and also to pay for the “pump-priming.”

President Obama’s economic advisers knew this and Obama is intelligent enough to have followed that advice. But unfortunately, Obama is also incompetent.

The US government spent some $2 trillion and wasted it, creating nothing; no jobs, no economic growth, no stimulus. The money was wasted on temporary and overpriced government projects, not true stimulus for the economy.

Proper stimulus would have been setting up a large, quickly funded lending facility for small businesses. Obama bought and “saved” a dead car company, General Motors. Economic growth could have come from direct tax benefits to the people with jobs; Obama gave it to the failing banks and Wall Street brokers. The US needed a national infrastructure plan. The money instead went to the states for “green jobs.”

In 2010 the situation has deteriorated to nearly the point of no return.

Several large countries have defaulted on the debt obligations, notably Mexico in 1982 and Argentina in 2001. In these cases, there was somebody more financially stable to help them out. The World Bank, backed by the US, provided bridge funding until these countries could get their economies going again.

Imagine a Philippine megacompany like the Shoemart group becoming insolvent. That is not going to happen because SM is properly managed. But SM is so large there might not be enough local financing capacity to save it. The ripple effects through the economy would be a disaster. On the other hand, the Uniwide group has finally gone under. The losers with Uniwide are those companies and banks that extended Uniwide credit, but the effect to the economy is negligible.

If the US defaults on its debt, it would be a catastrophe to the global financial and economic system. Governments and financial institutions would, in turn, go bankrupt as the value of their assets denominated in US debt would be worthless. The Philippine government held approximately $11 billion of US treasury debt at the end of 2009. China holds nearly $1 trillion. It could happen if the time comes when the rest of the world cannot or no longer desires to fund the US debt.

An alternative to debt default is to monetize the US debt. That is a fancy term for printing enough dollars to pay the obligations. The potential for hyper-inflation in the US is real if people begin to perceive the dollar as worthless.

Hyperinflation happens when there is a loss of confidence in the future purchasing value of the currency, which leads to immediate purchases, creating instant inflation. It works something like this.

Suppose it was announced that the price of rice would be P200 a kilo tomorrow. Everyone would rush out today and buy rice, creating a shortage. Rice dealers would jack the price up, probably over P200. All other prices—pork, chicken, fish—would jump also because the price of these commodities in relation to rice would be too cheap.

If the US suddenly begins paying off its debt with newly printed currency, in the hundreds of billions, crude-oil prices will skyrocket, as also will gold and all other commodities. It can happen. It has happened.

There is an alternative to these two scenarios. The US could choose to revalue the dollar based on backing the currency with true value: gold.

The US is holding at today’s market price some $290 billion worth of gold. That is a drop in the ocean compared to the $2 trillion of actual currency and the $10 trillion in “public debt,” defined as all debt issued by the US Treasury held by institutions outside the US government itself.

If, and the likelihood is almost none, the US decided to back the dollar with gold, the price of gold would have to be somewhere between $5,000 and $10,000 per ounce. But it could happen as the other alternatives are really doomsday scenarios.

Countries that depend on shipping goods to the US could be wiped out as the prices they receive in local currency would be almost nothing. Countries holding vast mineral reserves like the Philippines would become wealthy overnight. All raw material commodities, not just minerals, would be similarly affected.

There is an interesting “karma” about all this. The wealth of the industrial nations in the 18th and 19th centuries was built on exploiting cheap raw materials from the now “Third World” countries. Maybe in the 21st century, those nations are finally going to get the price they deserve for their resources.



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