Thursday, June 11, 2009

Game Over

There's just no weaseling out of this one.

Charles Hugh Smith:

The choice just ahead is stark: either passively watch the dollar collapse as the tsunami of money expansion and Federal borrowing slams it or start defending it with much higher interest rates. Either way, the credit-dependent U.S. economy will be unable to borrow freely at low cost from the rest of the world.

The blogosphere is chockful of reports documenting our trading partners' not-so-subtle stampede to the dollar exit--is there any mystery here? None whatsoever. Even a so-called reserve currency like the dollar responds to supply and demand: as the Fed pushes money expansion up by 100% (you've seen the hockey-stick charts by now) and the U.S. Treasury borrows trillions of dollars to fund a widening deficit and various trillion-dollar bailouts of failed and/or fraud-filled/looted industries, then this burgeoning supply overwhelms demand, pushing down the value.


Such a pronounced decline in the dollar's value would devastate the bond and T-bill market as everyone fled the dollar; this would trigger a catastrophic drop in the value of every existing bond and basically evaporate the U.S. Treasury's ability to sell more debt or even roll over existing government debt. At that point the U.S. government would actually not only have to live within its means (spend no more than revenues) but it would have to pay off bonds as they came due--that is, spend considerably less than revenues.

The same of course would be true for corporate bonds, new home mortgages, etc. All U.S. debt would drop 50% in value and become increasingly illiquid as fewer and fewer investors will be willing to gamble on its future purchasing power.

For a credit/debt-based economy, the inability to float new debt and roll over old debt would be cataclysmic.

The only way out of the crisis (and indeed the only way to stave it off beforehand) would be to raise interest rates to such a high level that dollar-denominated debt would become attractive. This is not without historic precedent; buyers of long-term T-bills in late 1981 earned a 16% return.

What happens if the interest rate on T-bills and other debt jumps to 10%? Mortgage rates jump to 12%. And what would that do to real estate valuations? Since buyers can only afford X per month, then as interest costs doubles, the mortgage valuation (and the value of the underlying property) has to fall in half.

So right as standard-issue financial pundits (SIFPs) like the execrable Jim Cramer are announcing the bottom in housing, house prices could fall in half from current levels. Can't happen? Don't bet on it.

If interest rates doubled or tripled, that would eviscerate every sector of the economy which depends on credit--which means, well, all of them, but especially autos and real estate. With their collateral (house) worth half of its already diminished 2009 valuation, the average middle class household would be unable to support any new debt.

Oh, and let's not forget what happens to equity markets when interest rates double: they crash. Why take a chance on risky stocks when you can get 10% on a "safe" T-bill? And so there is another body-blow to household equity/collateral: everyone's 401K, IRA and other equity holdings will be smashed.

In the last bout of higher interest rates (for different reasons) in the 1970s, stocks (adjusted for inflation) lost fully 2/3 of their value. We would be foolish to expect anything less severe if the dollar crashes and interest rates double to defend what's left of the currency's purchasing power.


So the choice is stark: either drink the poison of a dollar falling in half and the subsequent collapse of the bond and credit markets, or double interest rates and drink the poison of a collapse in the value of existing bonds and the strangulation of the housing market via high interest rates.

Either way, the value of existing bonds will be destroyed. Either way, the credit-dependent U.S. economy finds itself without the ability to palm off dollars on "marks" for absurdly low rates of return. The only question is: what end-state will we choose? One in which the dollar is essentially destroyed as a store of value, or one in which we face reality and start paying a high enough return to salvage what's left of its value?

Yes, that will destroy easy, low-cost credit, and every sector which depends on it. But at least savings, incomes and assets will be conserved and not destroyed along with the dollar. The first poison (complete destruction of the dollar) is fatal; the second (raising rates to defend the dollar) is painful and wrenching, but ultimately positive. For much higher rates would rid the economy of its multiple destructive imbalances and disincentives; it would be the equivalent of a chemotherapy treatment from which the patient (the U.S. economy) emerges stronger and healthier. As the book recommended above phrased it, a "cure" is available, and it's called much higher rates of return.

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