War Drags the Dollar Down

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.

Fiat Money

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 upper stratum 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.

Derivatives

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.

While poverty 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 practitioners.

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.