The Strong Dollar Illusion and the Coming Dollar Panic

Is the dollar’s recent strength a sign of returning economic health, or something very different?
 

It has gained in relation to the once mighty euro and the Swiss franc. It has humbled the British pound, the Canadian dollar, and the Russian ruble. It has made the Asian tigers look like pussycats.

Surprising as it may be, the above sentences refer to the U.S. dollar. The greenback just experienced its best week of gains in 16 years against the currencies of six major U.S. trading partners. Against the sterling, the dollar had its strongest week since 1992 when investor George Soros was credited with breaking the pound. Among the significant currencies, only the Japanese yen is powering higher, reaching a 13-year high against the dollar.

Once again, the greenback appears to be everyone’s favorite currency. But is it a sign of the end of the economic crisis and the return of U.S. economic health as one might be led to believe?

Typically the value of the dollar is a good barometer as to the health of the underlying economy. Over the past several years, the dollar has fallen, accurately indicating the overall deterioration in U.S. economic health.

Today, America’s biggest financial institutions are insolvent and failing. The government is spending billions propping up everything from banks and insurance companies to auto manufacturers. Commercial real estate is following residential real estate down the sinkhole, consumer spending is drying up, and the global economy, led by America, is on the verge of stalling. Yet, against that backdrop of negative indicators, the dollar is soaring. What gives?

Over the past seven years, the dollar has fallen drastically against other currencies like the euro and pound. It now appears to be temporarily bouncing. When currencies fall so dramatically, they often reach a point where for the time being, there are no more sellers. At that point, currency valuations can “bounce.” After the pronounced downturn that the dollar has experienced, especially over the last two years, investors may have decided the dollar may have reached a temporary low. Other sickly currencies are now under attack.

It has now become evident the developing world may be falling apart even faster than the United States. This has led to the collapse of what is termed the carry trade. The carry trade is the process by which investors borrow money in low-yielding, weak currencies, such as the yen and U.S. dollar, and invest in high-yielding currencies that will hopefully appreciate in value. The carry trade has been very profitable over the past few years as the dollar and yen tumbled. But now that emerging markets are facing collapse, investors are trying to move their investments out of reals, forints, won and pesos, and back into America (and also Japan). This results in investors selling foreign currencies and buying dollars, driving up dollar demand and thus the value of the dollar.

Another factor now driving up the dollar is that markets are plummeting. When people dump stocks and commodities, money has to be put elsewhere; the dollar is gaining by default. Additionally, cascading share prices mean that stock investors are covering their speculative investments as margin calls threaten. This has created a demand for dollars as they are forced to sell and pay back the loaned money.

And as the global banking crisis/credit crunch has unfolded, it has also created a scramble for dollars as banks have reined in lending, cut credit lines, and desperately tried to raise reserves.

All these factors have created the perfect environment to send the dollar soaring. In essence, the severity of the crisis spooked people back into the most liquid, easily tradable asset available: the U.S. dollar—despite the fact that the U.S has a compromised economy and dying financial system.

But as analyst Adrian Ash, writing for BullionVault, notes, a strong dollar resulting from market panic, as opposed to economic fundamentals, is a recipe for disaster. “How could a strong dollar possibly be in the best interest of the U.S. or global economies if it comes thanks to anything other than a reduction in America’s trade and budget deficits? What good can a strong dollar do if it appears instead thanks to a run on over-geared investment worldwide?”

The artificially high dollar is actually hurting the economy.

A spiking dollar means that all of a sudden, American consumers and businesses can purchase foreign-made goods on the cheap. Conversely, it is much more expensive for foreigners to purchase U.S.-made goods. U.S. exporters are about to get doubly hammered by a slowing global economy and volatile exchange rates. And on the national scale, the trade deficit will shoot up, and hundreds of billions of dollars per year will leave the country through trade.

This is a situation the U.S. government will not be happy with. Too many manufacturing jobs have already left the country, and unemployment is on the rise.

For fiat currencies in a globalized economy, it is a race to the bottom. Don’t be fooled by any “strong dollar” policy talk. As the Cato Journal notes, “a strong-dollar policy is the yeti of economies. Despite occasional sightings, most … scientific evidence indicates that no such species exists.” Governments can’t long stand the pressure of rising currencies.

So what will be the government’s solution?

Each time America has been faced with an economic crisis in the recent past—September 11, the dot-com bust, the Long Term Capital Management failure—it has inflated its way out by goosing the money supply and devaluing the currency.

If history is a guide, this dollar spike may be a golden opportunity for foreign investors to get out of their dollar holdings and to put their dollars to work, purchasing real assets, building infrastructure, etc., before the dollar regains its downward spiral.

And this time, the government’s incentive to create inflation (thereby eroding the dollar’s value) is far greater than in times past. The debts incurred by Americans during the run-up of the housing bubble are larger than ever experienced. America’s pension, Social Security, Medicare and Medicade liabilities absolutely dwarf the economy’s ability to finance them. And the multitrillion-dollar speculative derivatives tower destroying Wall Street may be a threat several times greater.

The only option available to the government, other than completely scrapping the system and starting over, is to create the money necessary to keep things functioning and pay all the bills.

For instance, the stimulus plans proposed by both candidates are nothing more than Zimbabwe policies. America is broke. As Peter Schiff of Euro Pacific Capital says, “[G]overnment either borrows more money from abroad, or gets it from the Fed, which simply creates it out of thin air. Either way, we undermine our economy with additional debt or inflation.” And since borrowed money eventually needs to be repaid, creating money may be seen by politicians as the only realistic way to pay for all America’s liabilities.

And in the meantime, cnnMoney.com is reporting that the Federal Reserve is expected to cut interest rates again this month in a further attempt to boost the money supply and stimulate the economy. Rates have already been slashed to 1.5 percent, and some investors now say the Fed will for the first time in its history slash rates to beneath 1 percent. “Everyone at the Fed has pretty much told you they’re going to cut,” said Rich Yamarone, director of economic research at Argus Research. “They’re in a kitchen sink mode right now. Rate cut, fiscal stimulus, bailouts—they’re throwing everything they can at this right now.”

cnnMoney.com says that even a rate cut to nearly 0 percent, as in Japan during the 1990s, is no longer out of the question. “There’s a hesitation to do it because it looks like desperation,” says David Wyss, chief economist with Standard & Poor’s. “But they’re getting desperate.”

Think about what it means when a currency can be borrowed at rates near 0 percent. Do you know why the average Joe is not allowed to borrow at those rates? Because then everybody would realize what a sham the world’s monetary system is. Everyone would be borrowing if they could get loans at 0 percent. Everyone would have access to as much money as they wanted. But, then the true value of the dollar would be exposed. The value, or purchasing power, of any money that can be created by the click of the mouse, and then lent out, will always eventually approach zero.

But for now, the world continues to panic into dollars—mostly for lack of a better option (although a truly unified European power bloc will soon provide an alternative).

The dollar’s strength will prove very temporary, however. Eventually, all the money being created by the government to prop up the system, and now being hoarded by ailing financial institutions, will pour its way out into the real economy. When that happens, inflation will strike with a vengeance, and the economic fundamentals will quickly reassert themselves, crushing what remains of the dollar’s purchasing power in the process.

Just as investors have panicked into the dollar, people will just as quickly panic out.

The only question is: How soon?