The Economy's Next Move: 'Sugar High' Followed by Dollar Crash

When chess masters plan their next move, they look down all of the alternative paths as far as they can see to where they lead. Economic policy makers, on the other hand, only check out slight variations. When things are working, they avoid big mistakes. But when things aren't working, they get stuck down a failing path.

The current strategy is for the United States government to use its good credit rating to borrow from abroad while the Federal Reserve creates massive amounts of new dollars out of thin air. This borrowed or created money is then used for one expenditure after another. The goal being to reduce household savings (just 5% of disposable income in January) and increase fixed investment by America’s businesses. So far this strategy is not working.

World Bank President Robert Zoellick is the latest policy maker to look ahead, see that the world's current stimulus plans will fail, and recommend a slight variation. On March 21, he predicted that the world’s economy will contract by between 1 and 2% this year, despite worldwide government budget deficits. He added that the current stimulus packages will then produce a “sugar high,” a surge in economic activity that will be temporary. Being the world’s chief banker, his solution was that a greater proportion of the stimulus plans be given to the world’s bankers.

While Zoellick is to be commended for looking one move ahead, it is also possible to look two moves ahead. When Zoellick's "sugar high" hits, the Federal Reserve will be facing a very difficult choice between two bad alternatives:

1. High inflation. The Fed can let the expanded money supply cause high inflation.
2. High interest rates. The Fed can contract the U.S. money supply causing high interest rates, leading to economic stagnation in the United States accompanied by an upward spike in bankruptcies and U.S. debt payments to foreigners.

Either one will probably produce a dollar crash. The inflation would cause the crash immediately; the increasing debt payments as a percentage of our GDP would cause it eventually. Once the dollar crashes, here's how the events would unfold, as described on pages 188-9 of our 2008 book Trading Away Our Future:

Once the dollar starts to plunge, there would be such a rush to sell dollars on foreign exchange markets that the dollar would collapse in value. The United States would experience inflation. Interest rates would skyrocket. Trade would become balanced but at a severely reduced level of imports.

The skyrocketing oil prices and need to cut back on oil imports would force the United States to begin rationing gasoline, probably using an equitable electronic system like Martin Feldstein’s 2006 "Tradable Gasoline Rights" proposal.

If the Federal Reserve decides to inflate the money supply in order to pay off US debts with cheap dollars, we could experience runaway inflation. At the most extreme, the dollar might even be replaced with a new currency as has happened in Brazil multiple times. The Brazilian reis was replaced with the milreis, the milreis by the cruzeiro, the cruzeiro by the mil cruzeiro, the mil cruzeiro by the cruzado, the cruzado by the milcruzado, and finally the real.

There is an alternative path that is not being considered by American policy makers, the Program for a Strong America that we lay out in our book, Trading Away Our Future. Instead of fighting household savings, we should encourage them by replacing our current income taxes with the FairTax or a Value-Added Tax. Households would then provide more savings to local banks who would lend them to American businesses, making it entirely unnecessary for America to save the national banks or continue to run trade deficits by borrowing from abroad.

If we balance our trade at the same time through Warren Buffett’s Import Certificates plan, then the surge in investment by American and foreign businesses in new American factories would immediately pull the United States out of the great recession. Our plan would prevent the coming dollar crash, but would also work if enacted afterwards.

Comments

[Dave Wrixon]

Just be thankful if you get to the Sugar High first.

2009 Mar 23 05:26 AM

[ArkansasAngie]

Let's see ... Congress has already spent about 1.4 trillion in the last couple of months. Ben spent 1.3 trillion last week and Tim will spend another trillion (+/-) today. Then Congress, if it accepts Obama's budget, will spend another 3.75 trillion. Before you know it ... you're talking a lot of money.

The question is will the US be alone in spending and devaluing the dollar? A lower relative dollar will cause imports prices to rise. That says inflation.

Has anybody ever seen a guestimate for how non-competitive US manufacturers are in term of percentage costs? For example, Congress was throwing around a proposed tariff of 27.5% against China.

Is there a point that American manufacturers become competitive against China's here in the US? Entrepreneurs want to know.

2009 Mar 23 07:13 AM

[John Polomny]

Sugar high=commodities bubble. Buying gold and moving assets out of the dollar seems to be a prudent move if the US is going down the road to a banana republic.

2009 Mar 23 09:58 AM

[Paco6945]

A trade war would be disasterous -- for the US and the world economies. The best way to make US manufacturers more competitive is to pass the FairTax and eliminate corporate (and individual) income taxes along with productivity draining payroll taxes. Doing this would immediately make US exports significantly less expensive.

A byproduct would be foreign and US global companies relocating manufacturing operations to the US.

2009 Mar 23 04:58 PM