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Thursday, December 21, 2006

USD - 2007 A Final Year?

This article is going to discuss the growing world discontent with the USD. Previously, although the US fiscal and trade deficits were in danger territory, the US trade partners were willing to continue to accumulate USD foreign reserves as they sold masses of everything under the Sun to the US.

They benefited from massive economic growth, and let the USD hot money circulate in their economies as washed hot money (hot money comes in as USD and then is changed into local currency or lent out in local currency - this causes lending and asset bubbles locally, creating a seeming endless prosperity bubble until that comes to the inevitable end and they have massive inflation or asset bubble collapses). Ultimately this hot money issue will decide the USD fate anyway, but there are sinister looking issues, particularly with China, that may cause a USD crisis in 2007.

Effect of a serious USD drop on your savings

As far as the USD is concerned, there is a growing consensus that our trade partners are getting tired of accumulating the USD. If this becomes severe enough, the USD will experience a rapid fall in value on the order of over 30% in a year. The US stock and bond markets would collapse, and US interest rates rise into the teens at the least. The value of your 401k savings and other cash type accounts would drop 30% in USD terms based on the rising prices of everything, and another 30 to 50% in nominal USD value as well as the stock and bond markets collapsed. Net USD/real value of losses to your 401ks? Very possibly over 60% - in one year.

If the USD devalues heavily in 2007, we could be talking losses on the order of 60% net real value of USD financial assets. I get the impression that most people only think their dollar accounts would devalue modestly - perhaps 10% if the USD were to devalue heavily in 2007. They are mistaken. The value would drop more on the order of what I just calculated in real terms - in any case probably over 50%. The losses would be from a lower USD value combined with dropping stock and bond market values - things which every 401k and other retirement account is based on.

The US and every trade partner is hoping the USD could gradually devalue. They will work together for that end. That may happen. However, there is a serious level of risk the USD decline could get out of control. Central banks don't have all the cards. Markets can panic and outrun central bank efforts to stabilize things.

That exact same calculus is understood by our trade partners and will affect their USD holdings in the same exact way. The only reason why the USD has held up so far is because our trade partners do indeed understand this calculus, and have been so far able to stem any serious USD mini crises. The problem is, at some point there will be one mini crisis that is not stemmed, then we look over the edge of the precipice. It would not all happen in one fell swoop, but, at the end of a year, we could easily see a net 50% loss of real value of any USD holding.

The present USD situation with China and the US arguing over revaluing the Yuan has the potential to be the crisis that finally is the USD's undoing. Particularly since the US Congress is probably going to go ahead with US trade sanctions on China. China will threaten to retaliate by dumping the USD- a kind of economic doomsday weapon. Whether they actually do that, to their own great harm, is not clear. But the latest crisis is very revealing on the dynamics we are looking at going into 2007. China appears absolutely determined to stay the course, and not move much in the direction the US wants - they need millions of new jobs a year to deal with about 800 million poor and angry Chinese who have yet not benefited from their economic miracle. China considers their economic growth as central to resolving this. China is having 70,000 public demonstrations a year now. That number is rising as well.

Latest rumored USD mini crisis

Last week, there were meetings between Treasury Secretary Paulson and Fed Chair Bernanke, and other 'A' team US trade and banking representatives with China. This meeting resulted in a number of internet rumors and some verifiable comments that China is not giving in to US demands for a revalued Yuan/RMB. That is causing the US congress to get very mad, there are trade sanctions coming in 07. The Chinese evidently threatened to dump the USD - they have about a $Trillion. Then a very interesting development - Middle-East oil nations stated they will be severely harmed by a collapsing USD if China dumps it. They threatened to embargo oil to China should they dump the USD. All of this shows how high the stakes are going into 2007 for the USD - and how serious this USD situation is now. I think we can say, the USD situation is now at a crisis stage.

Formerly, the gold and other financial community has been tracking the financial mess the US has found itself in, with huge trade and fiscal deficits combined well over $1Trillion a year. There has been so much written about this that people probably are saying 'you guys have been talking about this for years - and not much has happened!'

Well, I can say that, having tracked this issue closely now for years, we are at a definite turning point. The once 'far off' end of the USD is now at hand or at least very much at risk of happening. The recipe is now in place, irreconcilable differences between China and the US over their undervalued Yuan, and pending US trade sanctions with a bold Democratic US congress.

From what I have heard, when the Chinese floated their idea (threatened) to go ahead and actually dump the USD this last week, first the EU told them they would not sell them enough Euros. Then, the Mid East Oil nations said they will not sell China oil if they dump the USD. China, however is not the type of nation to like being dictated to. They won't let the US dictate to them with trade sanction threats, and they won't take any EU interference in this situation well either, nor will they take Arab oil hostility well either. Also, the moderate Arabs are concerned that a paralyzed US would leave them wide open to a hostile domineering Iran.

The problem China has is it cannot give much ground on the Yuan (their view), or else something worse they fear will happen to them - an economic contraction and millions of rampaging peasants who already feel the economic largess has bypassed them.

These factors add up to a very good chance that China will retaliate against the USD anyway in 2007. I don't see them escaping from US trade sanctions this year, and the Chinese apparently believe they cannot do the things the US is demanding. SO, somehow, this year, the Chinese may pull the plug on the USD.

Who will blame whom?

I don't see this happening in the first part of the year. First, it will take time for sanctions to be voted on, then Bush will probably consider vetoing them. Then congress needs enough votes to override a veto. And so on. But, then, after a lot of hyperbolae, and ranting in the press, by June or July, we could see an attack on the USD as the rest of the world with USD holdings gets scared. Then, even a minor move by China could tip the whole thing into chaos. Then who could blame whom? We might even see a speculator front run on the USD that tips the whole mess downward.

Some financial alternatives in this situation and some pros and cons.

If I have already convinced you that the USD is in serious trouble in the coming year, then let us move to what-if scenarios about your savings.

Let us assume for the purpose of discussion that the USD devalued 30% in 2007. What would happen?

First, I would like to point out that the EU has done financial war games relating to this. They did simulations involving derivatives, and found that if one or two huge hedge funds went insolvent, there would be financial panics in their respective stock markets due to forced liquidations. The same EU bankers have also stated that a precipitous drop in the USD would cause financial flight out of world stock and bond markets. There would be a huge financial panic and flight to safety. I am not going to go into all the many aspects of this but:

  • Not only US stocks would crash, but likely most major stock markets due to financial flight and contagion. To see these as safe havens from a USD collapse is probably overblown.

  • There would likely be derivatives panics as the value of the USD and other currencies fluctuated wildly and caused huge losses on these incredibly leveraged positions.

  • There will be massive Foreign exchange volatility, chaos, and possibly restrictions.

Now, many of your USD accounts will have stocks, bonds and such. If the USD were to lose something on the order of 30% in a year, you will not only see prices of everything skyrocket but also see actual drops in the USD values of those stocks and bonds because investors will dump USD assets to escape the falling dollar. As I said, that will be a double hit on your USD accounts.

IF the USD were not to fall to zero, (I doubt it will in one year) then stock accounts for real type assets such as gold stocks and energy will have a two phase reaction.

First, many of these will initially drop due to forced liquidations of various investors. However, eventually a flight to financial safety will force these back up.

Possible foreign exchange controls

However, if the USD were to eventually completely collapse, many USD accounts will be frozen and there will be foreign exchange controls. Meaning you will be forced to ride whatever the outcome of the USD becomes. If the situation got really bad, I believe many mines will be nationalized world wide - that is already happening anyway. A gold stock is not as safe as a gold coin. Of course, these can be confiscated too, and they have been in the US once already in the Great Depression when US gold coin was recalled by the US government so they could run big deficits.

However, anything can be attached by the government in an emergency, so, in a way, this point is moot. It is not likely a paid off house would be so confiscated though, or apartment building or some other real thing. If you were to buy one now, just find one in a non bubble market. There are many areas in the US and Canada that would apply here.

Any protective movements of USD accounts will have to be done in advance of these coming USD drops. That means you would have to be willing to forego some of the coming stock gains that all the financial newsletters and media say are still coming for the US stock market, and not have as much in actual stock accounts and such, but be more in liquidated and protected mode.

Paid off real assets in your actual possession

Now, I have written before about how I prefer something like gold bullion or other paid off real assets, a non bubble house, apartment building or something like this. Paid off assets should survive a real USD devaluation. Some people like the idea of owing money on these things, to take advantage of a devalued USD, then to pay off these with depreciated dollars. The problem is, should you find your income reduced/frozen and unable to make the payments on the mortgages, then you are still subject to losing the asset until you actually pay the thing off. I think borrowing money hoping to pay off in devalued dollars is a dangerous way to have a real asset. Better to just have a smaller one paid off without a mortgage. You can always live in it if you have to.

One other consideration is that real estate will appreciate in value in a serious USD crisis and the taxes will go up, but, compare that to having some stock account collapse by over 50%, and paid in USD that are now worth 30% or more less. There are No perfect solutions that cover all aspects of a currency collapse. One has to make some trade offs. Besides, even if the USD stabilizes, any capital gains will be taxed on financial accounts.


OF course, other alternatives would be buying Euros, or other currencies. This can be a stop gap alternative. Personally, I think most of these are still inferior to paid off assets in a currency crisis. The problem is, people still need some cash to pay bills during such a crisis, so one can't put all of their cash into real assets necessarily. So, one needs to balance the idea of having all real assets- (gold or silver or other PMs , a house, or other real thing that you actually own and have possession of) and having some necessary cash type assets.


US bonds will do terribly if there is a serious USD crisis. Interest rates will skyrocket and bonds will tank. Also there will be the co debasement of the USD value of those bonds.

Other nation's bonds will initially do well, but if they raise interest rates to compete with the weakening USD then their bonds will also drop considerably. IF their economies fall into recession, their bonds will ultimately suffer as well. They could be a stop gap for the initial USD situation however.

Foreign stocks

The same goes for foreign stocks. Most foreign stocks are very dependent on the present status quo of the US/West centric economy. IF the US stock market crashes, eventually that will spill over into foreign stocks as well. Most foreign nations are not well situated to do well economically should the USD system take a big hit. Their economies will slow badly and so will their stock markets. SO these are not automatic havens from a serious USD crisis either.

And, resource stocks will be hit (perhaps except for PM stocks) because of declining economic demand for resources should there be a big economic slowdown in the US and consequently in the rest of the US trade partner world.

These are just some thoughts about what could happen if there is a serious USD crisis in 2007. I am not an investment advisor, but a gold commentator.

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December 20, 2006

Christopher Laird
Editor-in Chief

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