See the faint jet plumes overhead? Once soaring
high through the celestial sphere of finance, the dollar is starting to lose
orbit – tugged by the drag of war.
But this time it's different. It's different because war is being waged in
a monetary climate that has no precedent: an inflationary fiat monetary system,
a derivatives bubble, a pesky PATRIOT Act, and a bulging trade deficit with
China. The confluence of the four spells trouble for the dollarized system,
a system that broke away from the gold-backed Bretton Woods arrangement in 1973.
The fiat monetary system, managed by a committee
called the Federal Reserve, is at the root of the growing trouble. As others
note, the Fed pumps
money into the system while declaring inflation tame. The Fed determines
inflation (not to be confused with the cost of living) from a narrow
measure called core CPI (Consumer Price Index). Core CPI excludes food and energy
and calculates housing prices based on a survey, asking, "At what price could
you rent your house?" Core CPI reveals no inflation because it tracks manufactured
goods that have cheapened over time, the result of the entrance of a billion
third world workers since 1990. These workers compete with Middle America and
give absolute dominion to global CEOs.
So, the Fed's ginned-up money supply (which must go somewhere) has flowed into
the housing, stock, bond, and commodities bubbles and larded the pay packets
of upper management and "brand-worthy" celebrities. Middle Americans that reside
in $160,000 dwellings and live paycheck to paycheck have been sidelined as the
rides the largest asset/pay wave in history. This suits the Fed fine; as a quasi-government
organization composed of private
member banks, its policy has helped the banking industry rake in record
profits. The U.S. government is also grateful because low bond yields (low yields
are caused by high bond prices – the result of inflated dollars chasing limited
investment returns) allow it to service its $8.8 trillion debt at a bargain
rate – a mere $406 billion last
year, instead of raising taxes.
The flip side of the money supply surge is the
astonishing growth of financial innovation that started with the changeover
to the fiat monetary system. This growth, commonly referred to as derivatives
trading, has had a profound impact on society in terms of wealth distribution,
leverage and debt levels. It is hotly debated among prominent financial gurus.
Derivatives, according to Allan Greenspan, help distribute risk; for Warren
Buffet they are financial "weapons of mass destruction."
Formally, derivatives are instruments "derived" from an underlying asset. Most
readers are familiar with gold or corn futures which are contracts to buy and
sell a standardized quantity of the metal or grain. But they probably don't
realize that their flexible mortgages, pocket full of credit cards and indexed
stock funds would not be possible without the "risk transfer" or "hedging" effect
of the financial side of these instruments. Risk transfer is largely beneficial
– it promotes competition and product choices among lenders and brokerage houses
and allows businesses to reduce their exposure to wild price gyrations in currencies,
interest rates, and commodities.
There is, however, a downside, which we're seeing now. Because lenders, drooling
over loan origination fees, could transfer mortgage risks to others, they signed
on all comers for "interest only" loans. Then they bundled up the mortgages
into "asset-backed securities" (or collateralized debt obligations – CDOs) and
sold them to other financial intermediaries, which in turn could hedge these
holdings with derivatives protection.
But "asset backed" is only as good as the asset. The highly leveraged housing
market has begun to turn south and is roiling
the subprime mortgage market (a trillion-dollar "poor man's" market),
and potentially millions
of American homes are heading for foreclosure. The disconnect between low wages
and high home prices is finally rippling through the credit market and is threatening
to prick holes in the rest of the financial froth. As Ludwig von Mises wrote
in The Causes of the Economic Crisis 80 years ago about the credit cycle,
"every boom one day must come to an end."
Derivatives numbers are staggering. The Bank
for International Settlements estimates that the notional amount of derivatives
traded on regulated exchanges topped a quadrillion dollars last year and that
the outstanding unregulated off-exchange (called over-the-counter – OTC) amount
stood at $370 trillion in June 2006. Because the OTC market is composed of endless
strings of bilateral transactions – the systemic risk is unknown. But that uncertainty
has engendered a whole new practice of layering new products over the old. Got
junk bonds? Buy a credit
derivatives default swap and wash your worries away. Buy
more junk and repeat.
This trend of layering protection over risky assets has resulted in a practically
boundless expansion of money and credit in the hands of hedge funds and private
equity (yesteryear's corporate raiders), which have a competitive advantage
over regulation-hobbled banks.
grows and record numbers of homeless pile
up in shelters, hedge funds and private equity huddle
together each week to leverage another multi-billion dollar takeover. The profits
from these deals exceed anything known in the history of capitalism – a double
shot of assets (2 percent) followed by a chaser (20 percent) on profits.
When Mises described credit financing, he explained that inflation would surface
in areas where credit was plied. If used for a new factory, the funds would
push up raw material prices and then wages. But deal financing today works in
the opposite direction – private equity partners acquire public companies using
cheap loans. Then they oust management, fire workers and, after a few years,
lavishly pay investment bankers to dress up the deal for relisting as a public
offering. Is this capitalism? It's a little like an old story of a taxi driver
staring at the dime tip from a dollar fare and the woman passenger asking "is
that correct?" And he says, "It may be correct, but it ain't right."
The innovative and opaque financing behind multi-billion dollar deal-making
has caused the Federal Reserve to discontinue its broadest measure of money
supply (M3); it has simply lost control over the numbers and the process. In
truth, no one knows what money means anymore as capital is becoming increasingly
"dark" and channeled into the hands of the mega-rich. Recent wanderers from
the current and past administrations – e.g., John
Snow, Paul O'Neill, Larry
Summers, and James
Baker – have found a new pew and are now devout hedge fund and private equity
The world has cracked into two orders – a swirling galaxy of exotic finance
and a trodden planet of labor. But the yawning gap between the two bodes ill
for the whole bargain. Extreme wealth of the very few has always depended upon
the continued hard
slog of the masses.
The PATRIOT Act
Meanwhile, the PATRIOT Act is doing its best to
make global business in dollars a thing of the past. (Sarbanes
Oxley – a piece of legislation intended to prevent future Enron scandals
– is another regulatory nuisance
to capital formation.) U.S. red tape has pushed London ahead of New York as
the premier issuer of initial public offerings (IPOs). Also, debt issuance (both
corporate and government) in euros
has exceeded that of dollars. And while the U.S. is gloating about the success
of placing sanctions on banks doing dollar business with Iran (success is measured
by the harm to the Iranian economy), some banks are simply switching
transactions to euros – reminiscent of the switch from British pounds
to dollars in 1956. Now that Iran has opened up bidding for 17
blocks of oil to the world, why shouldn't this switch accelerate?
The Dragon Makes a Hedge Fund
Enamored with its "successful" policy, the U.S.
could multiply it over the rest of the oil-rich instability arc, pushing the
dollar out of reserve status. Due to the massive dollar holdings of other countries
(the result of the record U.S. trade deficit), the fallout could be vicious.
Take China, a prime U.S. lender.
Where the dollar would end up if the gang
of three Xiaos decided to reduce its $700 billion-plus dollar
exposure by 20 or 30 percent by selling dollars and buying euros or Japanese
yen (the latter waking from its long slumber) is beyond this writer's guess.
The Chinese government, dissatisfied with the meager
returns on its U.S. Treasury debt, has recently announced the formation
of a new investment vehicle – promised to be the first trillion-dollar hedge
fund, working entirely in secret. Bush's third Treasury secretary, Hank Paulson,
who urges China to let the dollar slide against the yuan, says not to worry.
Money expansion is financing the U.S. warfront. Both the Fed's sleight
of hand and the credit creation of the derivatives industry have worked
magic for the government and the elite. However, the PATRIOT Act is making dollarized
business overseas a pain in the neck, and China has announced currency diversification.
The shaky housing and mortgage markets threaten to spark more panic
on Wall Street and pierce the credit bubble. The orbital ship of the dollar
may still be cruising, but through a dark space heretofore unknown.