Faces of Death: The U.S. Dollar in Crisis

The US economy has been in crisis since 2008, and despite optimistic statements by officials and commentators, there are no fundamental signs that the crisis will end in the foreseeable future. The US economy has suffered a real estate collapse, a stock market crash, a banking crisis, a near systemic collapse on a global scale, a credit crisis, the worst economic downturn in the US since the Great Depression, and an unprecedented global recession.

Following two sequential economic bubbles, the dot-com bubble and the real estate bubble, no one has yet correctly called either the bottom for the US economy or the start of a US economic recovery. Nonetheless, each day, news reports, articles and statements by officials and commentators reveal new economic data and offer new analysis. Unfortunately, both the economic data and the interpretations offered by officials and commentators are contradictory.

It appears that both inflation and deflation are occurring at the same time; that the US gross domestic product and consumer spending are declining while stock prices are rising; that government spending is rising while tax revenues are falling; that consumers are deleveraging and that the flow of credit has slowed while the total of debts and liabilities in the US economy continues to rise; that the US dollar is falling while price inflation remains nominal; that interest rates are near zero for banks but rising for consumers. The seemingly contradictory facts indicate economic distortions and therefore developing systemic instabilities.

What ties all of the economic data together is the US dollar. Rather than considering what impact unsustainable economic distortions might eventually have on the US dollar, could the developing systemic instabilities instead be the symptoms of a currency crisis already in progress?

The debate over inflation versus deflation in the US economy tends to overlook the fact that both inflation and deflation are occurring at the same time but in different areas of the economy. The policies of the US government and Federal Reserve are inflationary but there are vast deflationary pressures with no relief in sight. The effects of inflation can always be seen in the long run in consumer prices, i.e., the dollar looses value as a function of monetary inflation thus prices tend to rise.

Faced with the imminent collapse of the US banking system in 2008, averting a deflationary depression, such as the Great Depression, was obviously desirable but whether the radical inflationary policies of Federal Reserve Chairman Ben Bernanke combined with US government bailouts can ultimately save US banks remains to be seen. However, a radically inflationary outcome and a corresponding fall in the value of the US dollar could ultimately be as destructive to the US economy as a deflationary collapse would have been. Monetary inflation in the financial system is a technical fix that does not address the deflation in the broad US economy. The broad US economy has continued to decline since 2008 despite having saved the banking system and despite massive deficit spending and stimulus programs.

The relationship between the banking system and the broad US economy hinges on the levels of debt in the economy. Since the mechanism of money creation is debt, the broad money supply cannot be inflated without increasing debt levels outside the banking system. Setting aside stock market crashes, it is debt defaults that create ongoing deflation via bank losses and failures.

According to the Federal Reserve Bank of St. Louis, the monetary base (MB) has approximately doubled in roughly the past 12 months. The increase appears to contradict the fact that deflationary pressures impacting US banks continued virtually unabated. Mortgage and credit card defaults have resulted in 170 US bank failures since 2007. A recent Bloomberg article indicated that the number of lenders that cannot collect on 20% or more of their loans hit an 18-year high, signaling more bank failures ahead.

The MB data reflect increases in bank reserves partly attributable to the Federal Reserve’s Term Asset-Backed Securities Loan Facility (TALF) program. Whether banks can successfully borrow their way past their losses depends not only on the magnitude of the losses relative to their revenues, reserves and balance sheets, but on future business performance. The strategy cannot work in the long run if the US economy continues to contract. While new money has flowed into banks, it cannot filter out into the broad US economy which continues to decline.

The dramatic increase in MB is not apparent in more broad measures of the money supply such as M3. M3 includes currency in circulation and all types of deposit and money market accounts as well as other liquid assets. Although the Federal Reserve ceased publication of the M3 monetary aggregate in March 2006, it is still calculated by John Williams of Shadow Government Statistics. M3 has been in a sharp decline since 2008, reflecting monetary deflation in the broad US economy.

Economic recovery cannot take place in a deflationary environment simply because money is less available to individuals and non financial businesses. In particular, small businesses provide roughly 2/3 of all jobs in the US economy and the flow of credit to small businesses has been sharply curtailed. The reduced availability of credit to consumers and non financial businesses has had a strong dampening effect on the broad US economy. Consumers are deleveraging (paying off debt) and non financial businesses, hesitant to borrow in the face of declining revenues and economic uncertainty, are cutting costs as well as jobs.

The effects of the credit crisis can be seen most clearly in the velocity of money (MZM) which shows that spending on the part of consumers and non financial businesses has slowed dramatically. MZM is the average frequency with which a unit of money is spent in a specific period of time. Saving and deleveraging on the part of consumers (as opposed to financing consumption via credit), reduced borrowing on the part of non financial businesses, and unemployment all contribute to falling MZM.

As deflation makes money more scarce (falling M3), consumer and business spending slows down (falling MZM) exacerbating falling business revenues, business failures, and unemployment, which in turn put additional stress on US banks. This is the short formula for a deflationary depression. Comparing the present situation to the Great Depression, the main difference is that deflation due to bank failures is being prevented, or at least slowed down.

Since inflation is the result of debt there must be an optimum or “healthy” level of debt for an economy relative to its gross domestic product (GDP). Since GDP growth is stimulated by inflation and inflation requires increased levels of debt, maintaining an optimum level of inflation requires debt levels not to increase disproportionately.

At a glance, it seems that US GDP, while in decline, remains near an all-time high in nominal terms. Interestingly, the GDP growth curve mirrors that of cumulative CPI, which is directly a function of inflation.

Looking at the percent change in GDP tells a different story. The way that the US government measures GDP has changed over time. John Williams of Shadow Government Statistics still measures GDP using the pre-Clinton era formula.

While the rate of decline in US GDP may be questioned, the fact of decline remains, i.e., the US economy is in recession. Whether nominal GDP indicates sustainable economic growth depends on the levels of inflation and debt in the economy. Specifically, if nominal GDP growth is accompanied by a disproportionate rise in debt, GDP growth is unsustainable at best and illusory at worst.

US unemployment data point to a further contraction of GDP. In an economy where GDP growth has been associated with rising debt levels and where consumer spending accounts for roughly 2/3 of GDP, unemployment cannot be considered a trailing economic indicator and might instead be seen as a leading indicator.

A further drop in consumer spending can be expected as a function of rising unemployment. The policy response of the US government has had little effect in terms of GDP or unemployment.

The key question with respect to US GDP is whether total debts and liabilities in the US economy are sustainable. If not, new borrowing on the part of consumers and non financial businesses cannot take place and deflationary pressures will persist in the broad US economy. Karl Denninger (The Market Ticker) has published a number of articles discussing debt levels in the US economy.

US mortgage and consumer debt levels, as well as asset values, have been in decline since 2008. At the same time, public debt has accelerated due to a dramatic increase in US government borrowing. Unfortunately, government spending on behalf of consumers and non financial businesses cannot offset deflation or halt the overall slowdown of the broad US economy.

Current debt levels in the US economy may not be sustainable. Federal and household debts and liabilities for the entire US economy, not including commercial debt, total $332,326 per citizen, or approximately $862,000 per household. While it may be interesting to conceptualize debt levels in terms of individual or household liability and to consider whether tax revenues will be sufficient to service a far larger public debt, what is most important is how debt levels relate to GDP.

Excessive debt levels point to excessive inflation in the past and suggest that GDP growth, having been over-stimulated, will contract more severely than expected. Similarly, bank balance sheets must contract for debt levels to return to sustainable levels. Consumer debt, however, is not the main problem. As unfunded liabilities come due, the US public debt will rise and servicing the public debt will grow significantly compared to tax revenues.

According to data from the Federal Reserve and the US government, the rise in debt levels has been pulling away from GDP growth at an accelerating rate since the mid 1990s. With GDP in decline, or in sharp decline as measured using pre-Clinton era methods, the ratio of total debts and liabilities in the US economy to GDP is unsustainable under any realistic GDP growth scenario.

Unsustainable debt levels are the root cause of ongoing deflationary pressures in the broad US economy. There are only two ways to eliminate excessive levels of debt: deflation and inflation.

The policy response of the US government and Federal Reserve has made clear that deflation will be prevented as far as it is possible to do so, i.e., to avoid a deflationary depression. The largest banks have been preserved under the “too big to fail” theory and the US government, as has been demonstrated in the past year, stands ready not only to borrow and spend whatever amount of money may be necessary without regard for the public debt or future tax or budgetary consequences, but also to take on virtually unlimited liabilities. The question is: will it work?

Although the US dollar rallied in 2008 as the global financial crisis brought world economies to a precipice, the US dollar in 2009 appears much less attractive.

Setting aside the US dollar inflation of past decades associated with the excessive levels of debt in the US economy today, a rapidly expanding Federal Reserve balance sheet and quantitative easing (“money printing”) are directly weakening the US dollar while foreign appetite for US debt is waning. On a global basis, there is a growing shift away from the US dollar both as a reserve currency and as an international medium of exchange, as well as a developing US dollar carry trade threatening to put additional pressure on the dollar.

The apparent choice between inflation and deflation may itself be illusory because both assume the US dollar can survive the developing systemic instabilities in the US economy and growing pressure on the dollar. Since monetary inflation is tied in lock-step to debt levels, an inflationary policy response might produce only unsustainable economic distortions. It is too late to put the inflation genie back in the bottle, thus there is no fundamental way to stop the slide of the US dollar in the long run.

Comments

[Roger Knights:]

"The apparent choice between inflation and deflation may itself be illusory because both assume the US dollar can survive the developing systemic instabilities in the US economy and growing pressure on the dollar."

That's the view from outside the box. Very good.

Oct 09 05:00 AM

[User 353732:]

The dollar is a symbol of America's global stature and competitive position. As America loses stature and erodes its competitive position because of the willed and willful policies of its Rulers, so the dollar declines. The investing world votes every day on America's relative global position. When the position is strong, the world has confidence in America's capacity to create wealth, defend liberty, honor promises and advance the values of a free civil society....and the dollar is accordingly strong.
When the world begins to lose confidence in America, it naturally loses confidence in the global symbol of America: the dollar and votes it down.

The Regime can and does lie successfully to the American people ------who are told every day that despite the evidence of their senses and their direct personal experiences, the economic recovery is underway; Big Govt is a great success; and more regulation, higher taxes, more liabilities and increasing mal-allocation of resources is the precise policy prescription for prosperity.

The rest of the world however, readily recognizes the lies for what they are and is telegraphing in the most efficient way it can what it thinks of those lies. The Regime is itself the Big Lie and it is turning the dollar into a fraud and an instrument of theft. The world is responding; the dollar is falling. The thieves and liars are being exposed to global investors.

Oct 09 06:57 AM

[CautiousInv...:]

To amplify on the above comment, the dollar is not only a symbol of the US but it also the de facto reserve currency of the world and the US has a fiduciary duty and responsibility to the rest of the world, a task that it has clearly failed to fulfill.

The actions of the Fed and the Treasury over the last ten to fifteen years have brought the world to what appears to be a tipping point, something that will finally precipitate a change in what has been a standing equilibrium. The widespread financial fraud perpetrated on foreign investors became apparent when Greenspan, congress and Treasury were not going to act in a manner that would promote a sustainable environment for the status quo.

In addition to abrogating our stewardship of the global reserve currrency and defrauding foreign investors creditors, a weak dollar cheats the US businesses and labor because a developed country cannot revert to a cheap currency to boost growth. In the 50's and 60's Britain tied it and quickly realized any advantages in international trade were quickly and disproportionately offset by a massive flight of capital; gain in export employment was more than offset job losses associated with capital flight.

To retain and attract capital we need to be less hostile to the interests of business and develop and implement policies to foster growth. A stable currency, less regulation, lower taxes, responsible fiscal policies and policies favorable to small businesses are all essential to fostering an environment needed to sustain economic growth.

Oct 09 08:01 AM

[zagrebzagreb:]

Not to muddy the waters with more information in an already complicated topic, but the US trade deficit is hugely significant in the value of the dollar and the desirability of US treasury debt... If we could - somehow - reach an equilibrium on what we import and export, or god forbid, even become a net-exporter, our dollar situation would be greatly eased.

As it is, our foriegn energy dependence alone contributes heavily to inflation, debt, and the simple exportation of wealth overseas... Throw in a couple of wars funded entirely on the national credit card, and you have a disaster in the making. Years ago, when the US dollar gained parity with the Canadian dollar, the writing on the wall was clear... Its amazing that we have to be struck with converging crisises before we pull our collective heads out of our asses.

Oct 09 11:27 AM

[ilc:]

"M3 has been in a sharp decline since 2008"... No. Your own graph shows M3 still GROWING at 4% YoY. It has only decelerated its continuing growth. And M2 growth has accelerated (now in the 7-10% range by your chart, where before it was in the 4-8% range).

"Economic recovery cannot take place in a deflationary environment"... Again - what deflationary environment? Perhaps you meant "a deleveraging environment"? Also, money is only a unit of account. Of course growth can take place under a stable or slightly deflating money supply; the U.S. did it throughout the 19th century. Economic freedom is the key, and what we unfortunately have less and less of in the U.S.

"As deflation makes money more scarce (falling M3), consumer and business spending slows down (falling MZM)"... Statements like these don't make sense. Again, M3 isn't falling (by your own chart). Also, MZM has been skyrocketing like M1. Perhaps you meant to say, "As deleveraging makes money grow less (decelerating M3), consumer and business spending slows down (falling MZM *velocity*)..."

"Since inflation is the result of debt..." - No. Inflation is the result of a growing monetary base (M0, working its way through MZM / M1 out to M2 and M3). It's a monetary phemenon, as the saying goes. I bet you're one of those people (and there are many) who think it's only about the end stage, CPI increases.

"if nominal GDP growth is accompanied by a disproportionate rise in debt, GDP growth is unsustainable" - "the US dollar in 2009 appears much less attractive" - At last, points where I can agree with you.

Thank you for the charts, they were interesting.

Oct 09 11:34 AM

[Angel Martin:]

From the article: "Economic recovery cannot take place in a deflationary environment simply because money is less available to individuals and non financial businesses. "

This is not correct. In fact, the entire 1920's boom occurred with a CPI lower than the peak in 1920.

www.bls.gov/CPI/#tables

There are many (in my view) flawed articles on SA based on the fallacy that economic recovery cannot happen if there is deflation (no matter how mild). If one realizes that there are many historical episodes of economic and financial assets boom simultaneous with dis-inflation or outright deflation (1920's, UK 1815-25 etc.) the strong market rally and low treasury yields start to make sense.

Oct 09 12:09 PM

[tom Andersen:]

There are of course those self - correcting measures that will help things out. For instance, when the Euro went from 75 cents to double that, combined with a real estate value decline of 60% or more in various places like Florida, all of a sudden a German could buy a Florida condo for less than 1/5 of the price he would have paid just two years ago. So they buy. Which helps the dollar, the real estate market, airlines, etc.
If the dollar drops even more, then the Asians will start buying. Not just real estate. At the end of it all, the US will not be the largest economy in the world, but everything will be ok. Sort of a 'we overspent and now we have to get back to real work' kind of an event, as opposed to a 'hyper inflationary end of the world' event.

Oct 09 12:36 PM

[carey_jim:]

It doesn't look to me as if there is any country or region on earth that is less corrupt, venal and inefficient than the United States.

Humanity itself is facing a huge crisis and since every individual sees everything from the perspective of his own family, social circle, region and finally country, we tend to blame our own country for everything.

In the 1930's, when the United States seemed to be falling into economic ruin, a very large percentage of Americans, including Joseph Kennedy, the Bush family, Henry Ford, Charles Lindbergh and many, many other prominent figures thought that Nazi Germany was the best hope of the world.

During that same period another very large percentage of Americans, including many other very prominent people, thought that Russian Communism was the best hope of the world.

We need to keep a little historical perspective, I think.

Oct 09 02:05 PM

[StockLurker:]

The US dollar is backed by nuclear weapons, the world's largest prison system, and the IRS.

Try paying your taxes in something other than the USD.

Oct 09 02:48 PM

[Contrary Le...:]

This a a great piece.

Responding to the last comment though;

The problem with the US Federal government (even if it does not become the biggest national socialist gov) us that it is the most efficient at killing people. I am going to stay far away thanks. I like it where the thugs can be bribed with a couple of bucks or a porno mag as opposed to a IRS audit or a raid by ICE or the ATF.

Oct 09 02:53 PM

[Rokjok777:]

Currencies are affected by two main factors, cross-border trade and investor risk appetite.
USD has had "home court advantage" on both of these for decades. First as the wordwide trade currency and secondly as a good, visible, safe, transparent, and popular place to invest, both for institutions and individuals. This home court advantage has saved the US tens of billions of dollars by allowing US interest rates to remain relatively low because there is a background demand for our currency.
But this "home court advantage" is slipping on both counts. Cross-border trade MAY increasingly be done in other currencies, but the shift will be slow. IMF says the USD share of trade transactions will fall from 60% to 52% in the next ten years.
The real effect IMO will be because of the second factor, investor appetite for USD assets. In the last 30 years, the American myth has been propagated throughout the world via Hollywood, mainstream media, and indeed, the US military. Everyone "knew" America was not only the strongest country but also the smartest, and also the best place to be an entrepreneur. America rescued the world from fascism and put a man on the moon. Most giant pools of investor assets are still controlled from NYC and London, and in most cases those investors didn't know anything about the rest of the world, didn't understand those locations, hadn't heard of their brands, didn't like their political instability and sketchy contract law. And let's face it, inherent racism also played a role: they didn't want to invest their money with someone with yellow or brown skin.
As giant pools of money are increasingly directed from places like Dubai and Beijing and Moscow and Rio and Norway and Singapore, however, many of those knee-jerk biases will be much less powerful. Yes America can and will create the next Google and Apple and Microsoft, but so will Brazil and China and India. And as America slips in things like education, taking care of its citizens, regulatory oversight (Bernie Madoff?) and replaces private capital formation with public entitlements, The USD will be less and less attractive to investors. It will be a generational change, kind of like sterling after WWI. IMO.

Oct 09 05:39 PM

[Zouk_man:]

"To amplify on the above comment, the dollar is not only a symbol of the US but it also the de facto reserve currency of the world and the US has a fiduciary duty and responsibility to the rest of the world, a task that it has clearly failed to fulfill."

The US Government has a fiduciary duty to its citizens. When we citizens decide we have finally had enough of this smoke and mirrors, then we can regain control of our government. Perhaps the US Dollar should crash and burn. Then we can pick up the pieces and start over.

I encourage all of you to pick one area in which you can make a difference, and put your money and time behind it in order to save this country. You are either part of the solution or part of the problem.

Oct 09 06:26 PM

[Ron Hera:]

To clarify, the article discusses monetary inflation and deflation which are different to rising or falling prices. The article contends that while the money supply is contracting (during the contraction) economic recovery is not possible because a shrinking money supply makes money progressively less available which in turn slows economic activity, e.g., consumer spending. The current contraction in the US appears to be a drawn out process with no definite end point due to the bank bailouts.

The article did not discuss price deflation and did not consider a future scenario where prices or the money supply are stable because I cannot yet foresee when that point will arrive. Current trends in US economic data, as discussed in the article, suggest growing systemic instability, e.g., rising equities and rising total debts and liabilities while GDP the broad money supply are simultaneously contracting.

The diverging trends in US economic data are important because they are not sustainable. One might ask if economic recovery will come before growing systemic instabilities bloom into a new crisis but it seems clear that economic recovery is being hampered (or prevented entirely) by the precise interventions that also are the cause of the unsustainable trends themselves.

Key differences between the current situation in the US and the depression of 1920 include the facts that the US government was much smaller in 1920 and actually cut expenses, whereas today's federal government represents an enormous share of GDP, is expanding very quickly, and is increasing spending dramatically. It seems possible that all three of the latter differences of today, having as their foundation the contracting and perhaps unstable US economy, are also unsustainable in economic terms.


On Oct 09 12:09 PM Angel Martin wrote:

> From the article: "Economic recovery cannot take place in a deflationary
> environment simply because money is less available to individuals
> and non financial businesses. "
>
> This is not correct. In fact, the entire 1920's boom occurred with
> a CPI lower than the peak in 1920.
>
> www.bls.gov/CPI/#tables
>
> There are many (in my view) flawed articles on SA based on the fallacy
> that economic recovery cannot happen if there is deflation (no matter
> how mild). If one realizes that there are many historical episodes
> of economic and financial assets boom simultaneous with dis-inflation
> or outright deflation (1920's, UK 1815-25 etc.) the strong market
> rally and low treasury yields start to make sense.

Oct 09 10:46 PM

[flow5:]

This country is experiencing stagflation, business stagnation accompanied by inflation. Disintermediation is responsible for the collapse of the non-banks (debt). Your money supply measures don't represent our means-of-payment money. The "monetary base" is not a base for the expansion of money & credit because it includes currency which has no expansion coefficient. Your velocity figures are contrived calculations. Your velocity figures have nothing to do with the real world. Debt cannot be measured to GDP. Debt has to be measured by the volume of savings offered in the market place. If you've studied exchange value of the dollar you would know that it is dependent upon several factors but the most important is our unstoppable trade deficit (not printing money). The FED cannot influence the dollar except for brief periods. YOur analysis is left begging.

Oct 10 08:41 PM