Home > The Merk Perspective > Merk Insights > October 7th 2003

3rd Quarter - Global Warming

Axel Merk, October 7th 2003
This article was written by Merk Investments before the Merk Hard Currency Fund was launched.


Merk Insights provide the Merk Perspective on currencies, global imbalances, the trade deficit, the socio-economic impact of the U.S. administration's policies and more.

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The rising US trade and current account deficits are the dollar’s equivalent to global warming. Most people do not pay attention anymore to these “twin deficits” because they have been incomprehensibly large for some time.

The world is addicted to the US consumer and the entire world – with the exception of hesitant Europe – wants to sell their goods cheaply to the US by keeping their currencies weak. The weak currencies cause a boom in Asian local economies that are at risk should their currencies strengthen. To help to keep the currencies weak, Asian central banks purchase US Treasuries at an alarming pace. In simplified terms, the foreign buying of US Treasuries is not very different than if the Federal Reserve Bank purchased the Treasuries from US banks: a result is increased liquidity at US banks as they receive cash that they can lend to businesses and consumers.

In other words, everybody seems to win with a weak dollar – the world can sell to the US consumer, and the US economy gets a boost. Unfortunately, there is no such thing as a free lunch. This artificial boom may cause capital misallocations because Asian investments may take place that are only profitable because of the weak exchange rates. Such misallocations (“bubbles”) make recessions that follow at some point down the road more severe. For now, the imminent concerns of keeping the Asian economies running are greater. China is interested, at any cost, in generating employment for a growing population migrating to the cities.

This competitive devaluation game of non-US currencies will continue until and unless the trust in the dollar is shaken. The main side effect is that huge amounts of US dollars are accumulated. The central bankers around the world are worried that once somebody starts selling their dollars, it may cause an avalanche. There is only a relatively small crowd that predicts a collapse of the dollar, largely because just about everyone in the world has an interest in keeping the US consumer going who may buy less should prices rise.

The problem that the US consumer has is that he (or she) is responsible for 70% of US GDP, up from about 50% in 1990; the consumer did not have a recession; and is lured to spending with 0% financing campaigns. The US consumer has massive debt, but again, few people take notice because the US consumer has a long history of carrying a lot of debt. Most ignore that as a percentage of disposable household income, the US consumer has, thanks to a downward trend in interest rates, kept a relatively constant ratio allocated to debt service payments. The grave concern is that a rise in interest rates may dampen US consumer spending. The Fed has indicated that it will try to control not only short-term interest rates, but also longer-term borrowing rates; it is questionable whether it can successfully fight market forces.

The most recent experience to a serious dollar devaluation dates back to 1971 when the US abandoned the gold standard on August 15. There are parallels to the events at the time. When the 1944 gold standard (Bretton Woods agreement) was put in place, the US dollar quickly became the world’s preferred reserve currency, as it was not only the only currency convertible into gold (at $35 an ounce), but – unlike gold – it also paid interest. In the second half of the 1960s, LB Johnson increased government spending in a booming economy with full employment causing major imbalances. LBJ was more interested in re- election than in taming the economy. As a result, more dollars were printed and foreigners started to exchange their US dollars for gold. By 1970, only 55% of the US dollar was backed by gold; by 1971, that ratio had fallen to 22%. To support the dollar, the German Bundesbank (Buba) purchased US$4bn in April 1971. On May 4, 1971, the Buba purchased US$1bn in 1 day, and on May 5, 1971, the Buba purchased US$1bn in the first hour of trading, after which intervention was given up and currencies were allowed to float freely. A severe devaluation of the dollar ensued.

Let’s fast forward to 2003: Gold still pays no interest, but US real interest rates are close to zero if not negative; yet gold has kept its purchasing power over 5000 years. Japan and China purchase 70% of debt recently issued by the US government. From January until July this year, the Bank of Japan (BoJ) purchased $81bn in US Treasuries. In the four weeks ending September 26, the BoJ purchased $40bn. And in a recent trading day, the BoJ purchased $3.5bn in a single day. The BoJ is desparate to keep the Yen weak, but seems to fail in its efforts. Indeed, this afternoon, 7 October 2003, the dollar bought 109.89 Yen, sharply less than just a few days ago when the BoJ heavily intervened to keep the yen at 112. It didn’t help that outgoing European Central Bank (ECB) president Wim Duisenberg commented on the dollar’s decline last Sunday: “We hope and pray that this adjustment, which is unavoidable, will be slow and gradual. We will do everything in our power to make it slow and gradual.” If Greenspan had said this, the dollar would have collapsed. Duisenberg is on his way out, and he wants to leave a legacy that he failed to build earlier.

While most would argue that the US has had a tough time, by some accounts, the recession after the bursting of the technology bubble is the one that “never happened.” GDP kept up relatively well because the US consumer continued to spend. However, with consumer and government debt reaching new peaks, it’s the foreign buying of Treasuries that keeps this economy going. In addition, we have very strong stimuli from tax cuts and lower interest rates. Theoretically, the high debt should lead to higher long-term interest rates. Foreign and possibly Federal Reserve Bank buying of US Treasuries have kept interest rates low, further stimulating the US and global economy.

The recent surge in intervention and continued escalation of government spending combined with a recovery that has failed so far to generate jobs, is very concerning. It is quite possible that the Fed will succeed in strengthening the US and world economies through its aggressive policies, but the risks of a devaluation of the dollar have never been greater. The Fed does not care about the savings of Americans; it only cares about GDP growth and employment. Because most Americans are focused on their domestic economy, few may notice or complain if the dollar was devalued. Indeed, it’s almost patriotic to favor a weaker dollar to increase US exports. This is the latest coup of the Bush administration in the name of patriotism.

We feel obliged to take unusual steps to protect our portfolios. We have further increased the exposure of our US portfolios to the price of gold. We have taken steps to protect some of these portfolios against a fall in Treasury prices (i.e. rising interest rates). We continue to reduce our exposure to the US consumer in both US and European equity portfolios. To the extend that it is compatible with client requirements, we try to replace a portion of US bonds with European bonds in bond portfolios to better preserve their long term purchasing power (traditionally, one wants to exclude the exchange rate risk at a bond portfolio, but in this case, we feel that avoiding the exchange rate risk is the greater risk).

It is quite possible that companies serving the US consumer will do very well, and it is quite possible that a stronger US economy will cause the dollar to strengthen. However, we are not traders, but investors. We believe that time has come to take substantial precautionary measures. We believe that innovative US companies will continue to do well, and we believe that Europe will have a recovery. But we are ever more selective in the choice of our investments. This may lead to concentrations, such as an emphasis on German tourism, one of the areas that benefits from a strong Euro.

Last May, the ECB indicated it may pursue a more aggressive policy, but has since backed down. While incoming ECB president Trichet may change this path, it would not surprise us if the ECB sees the current turmoil in the currency markets as an opportunity to establish the Euro as a prime competitor to the dollar as a reserve currency. If played wisely, being a reserve currency is a tremendous asset as the US has proven.

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