This is the second article in a series called “Globalization – where is it taking America?” The first article was “Nine percent is now full employment in America.”
Globalization has created a large, new financial structure, which no one controls or regulates but which itself controls currency rates and, indirectly, most economies. It’s highly probable that it will soon produce a large dollar decline leading to a world crisis. We think this article explains why gold should be considered a very logical and rational investment, not a "fear" trade. We believe some stages of the crisis are predictable and present investment ideas for them. Both the “crisis” and “confusion” stages should occur over the next three to five years, maybe slightly longer. This article is about “how” and “why.”
The journey begins with first understanding what factors control currency rates and how globalization has slowly change their importance.
Two Vital Statements About Trade and the Dollar
There are two fundamental facts about the dollar and foreign trade that must be known. Following where they lead opens the door.
- Every year the sum of “everything” we import and everything “we export” always balances.
- The sole purpose of the dollar is to make sure #1 happens. Like a cork on water the dollar is constantly finding what level of exchange equalizes “total imports” and “total exports.” In the parlance of traders, it’s finding the price that “clears the trade.”
To most this sounds like a financial fairy tale; like theoretical statements never found in real life. Everyone knows there is a huge trade deficit where imports don’t equal exports, so what does the dollar balance? Nevertheless, these statements are true. Few know there is a third category of trade, and when it’s included, “total trade” is balanced. This third category is the importing and exporting of “financial assets”, i.e. stocks and bonds and things like that.
”Total Trade” = Goods + Services + Financial Assets
I know purchasing another country’s stocks or bonds is not normally considered an import or export but that’s just wording; the government accountants treat financial transactions as a third category of trade, equal in footing to goods and services. Whether it’s the Chinese government buying Treasury bonds, or you and I moving our 401K into foreign stocks, for all intents and purposes, these acts are identical to exporting an American car or importing a barrel of oil. And so are their effects on the U.S. dollar.
Holding this “view” is rather important because it’s “how” we view and integrate this third category that determines how clear the global picture becomes. While the government treats all three categories the same, ninety five percent of the time it separates them in reports. Goods and services are reported in the “current account” while financial transactions are reported in the “financial account.” This is unfortunate because it's only when you present the three together does a unified picture emerge. In fact, only when I saw one report that did integrate them did the dollar and trade picture clarify for me.
click to enlarge images
“Total Trade” Is Always Balanced
The graph above shows that for ten years, total trade has always balanced. The dark red and green bars are yearly America exports – red is goods and services, green is financials. The light red and green are American Imports. The scale is in trillions. Any slight difference is what the government calls a “discrepancy factor” and results simply because things are just too complicated for them to get exact. The reason everything is balanced is because the dollar makes it happen as expressed in #2. The graph also includes a chart of the different values of the dollar that maintained this balance every year.
How does this balance occur? Unfortunately, this graph hides the magic - they show everything in dollars but we know only exports are priced in dollars, most imports are priced in foreign currencies. For display they convert imports into dollars after the dollar has found the price that equalizes the two sides. The dollar exchange rate is the conversion rate that takes everything we export (priced in dollars) and makes it equal to everything we import (priced in foreign currencies). If imports suddenly increased, the dollar would move lower to rebalance it with exports. If exports suddenly increased, it would move higher to rebalance the two. More imports equals lower dollar; more exports equals higher dollar
When Americans Buy Foreign Stocks It Pushes Dollar Lower
Few are aware that when Americans buy foreign stocks, it acts to raise imports and pressures the dollar lower. This is true even if the purchase is through an American mutual fund or ETF. When foreign governments purchases our T bonds it’s an export and tends to move the dollar higher. It’s important to note that trade in “financial assets” is just as large as trade in goods and services and also varies more. If there was ever an event that caused both Americans to buy foreign assets and foreigners to sell American assets, it could crash the dollar attempting to rebalance the huge imbalance it would create.
If “Total Trade” Is Balanced, What About the Trade Deficit?
If “total trade” is always balanced, what happened to the trade deficit problem? It’s still there; it just changed. The problem is no longer “an imbalance”; it’s “how” it balances. Looking at how it balances shows Americans import more of the red stuff and foreigners more of the green stuff. The red things, however, are wasting assets; they need yearly replenishment. The green stuff doesn’t waste; instead it accumulates and piles up. As this continues, over time, foreigners acquire a larger pile of green than we do.
The New Global Financial Structure
Every year the U.S government reports “end of the year” values on what has accumulated in the two financial piles. The latest report shows that foreigners (governments, people or corporations) now own 21.12 trillion dollars of American assets and we own 18.38 trillion of theirs. This size is truly staggering considering that just twenty years ago it was only two trillion dollars.
One large category of assets is called “direct investments.” These are factories and lands that corporations own in the foreign country and are really equity type investments. The “claims” and “liabilities” numbers are primarily “cash equivalents” denominated either in dollars or foreign currencies.
The most worrisome category is “financial derivatives”, a category they only started reporting three years ago. It shows Americans own 3.51 trillion in foreign financial derivatives while foreigners own 3.38 trillion in American derivatives. These are OTC based (not exchange based) credit default swaps, and currency and interest rate swaps. We do not know how much discloser or regulation there is, how much capital is set aside to secure them, and if something similar to how AIG brought down our entire system is possible here.
The pie charts show that in general Americans own more equity type investments and foreigners more fixed income.
This is the new global financial structure that globalization has created which sits outside any country's control or regulation. Yet, through size and rapid changes, it's able to control currency exchange rates and indirectly, the major economies.
For example, the 11.8 trillion dollars foreigners are holding in cash equivalents and Amercian corporate and treasury bonds are now only yielding between 1/4% to 2%. This makes little sense investment wise. A small 5% decline in the dollar can wipe out two years of interest. If foreigners begin to sell it will cause a large drop in the dollar.
Why Does This Global Financial Structure Have So Much Power?
The reason these accumulated piles of wealth can and probably will cause a dollar crisis is rooted in something we haven’t discussed yet. It’s the one feature that makes trade in financial assets different from trade in goods and services. Financial assets can be sold back to (imported back into) the home country. They therefore reenter the import-export trade equation and pressure the dollar– this is something that boxes of shirts or barrels of oil can’t do. It’s this feature, plus the accumulated size of this global system, that makes it possible for this structure - which is completely unregulated or controlled - to overwhelm the trade equation on one side requiring a massive dollar change to rebalance.
Why Does This New Financial Structure Point Toward a Global Crisis?
Globalization, which integrates the countries of the world into one interlaced economy, was entered into without any plan or blueprint. Without oversight or a method that controls its speed, the sheer power of the process for major change almost guarantees it will produce a world crisis in its latter stages. By its very nature it’s a cycle that starts out good but ends bad. It’s only a question of “how bad.”
It starts out good because developed countries use cheap foreign labor and their strong currencies to import inexpensive life necessities leaving more money for a service economy. The developing countries get jobs and begin to acquire some wealth. But this isn’t static; it’s the start of the long slow process economists call “normalization” which is a narrowing of country standards of living.
The great equalizer of economies in the world is achieved through currency exchange rates. Normalization can only occur if forces eventually lower the dollar and increase other developing currencies. This can be forestalled for awhile by foreign countries buying our financial assets but it must eventually end. It’s the end that brings the bad part.
The U.S. Dollar Creates a Basic Instability
Using the U.S. dollar as a reserve currency and a foundation of Globalization is not the best idea. A world or reserve currency should be stable and hold its value. Using the U.S. dollar, which people know has to decline because of “normalization”, doesn’t make sense. It creates an inherent instability in the structure of the global financial system.
This instability is what will lead up to a world crisis. A crisis is the event that will transition the system from the US dollar to something more stable.
An Outline of the Crisis
This chart outline the five basic stages of the globalization cycle transitioning from an unstable one country currency to something more stable for a state of “country normalization” and global economy. The transition includes a crisis period followed by a confusion period before a more stable currency is developed.
A high dollar, which ultimately has to decline because of “normalization”, can only be forestalled so long. The trade deficit in goods and services can only be offset so long by continuous financial purchases by foreigners. Eventually the forces in the new financial structure become large enough to overwhelm any effort to keep it from adjusting. Eventually the situation just gives way.
For example, the 11.8 trillion dollars foreigners are holding in cash equivalents and Amercian corporate and Treasury bonds, yielding between 1/4% to 2%, could easily begin a selling wave that will cause a large drop in the dollar and begin a crash.
The Summary of Table of Transactions and the Dollar shows what would cause a dollar crash. It occurs when, along with the huge imports of goods that America needs, more imports of “financial assets” from the global financial structure overwhelms the import side of the trade equation causing such a huge imbalance that the dollar must decline 50% or more to rebalance it.
Crisis markets, like a dollar crash, are not based on economics but are usually driven by positive feedback forces and sometimes, in extreme cases, they hinge on some important but unknown factor that surfaces late in the crisis. The positive feedback loop that could cause the above situation is this:
As the dollar moves lower, foreign investment in dollar assets are valued lower while American investments in foreign assets are valued higher. This causes foreigners to sell American assets (to stop the bleeding) and Americans to buy more foreign assets (chasing the gains). These trade actions, as we showed in the table, drive the dollar even lower continuing and reinforcing the cycle.
It is almost always impossible to know if a crisis will go “extreme” driven by some unknown hidden factor. Two years ago it came when it was suddenly revealed that, after six months of decline, that banks’ net worth and that the entire system was bankrupt, since it all hinged on credit default swaps that AIG couldn’t possibly pay. Something similar to that might happen and it could also originate out of the derivatives both sides have in the new global financial structure.
A period of wide economic confusion will follow a dollar crash as fear and uncertainty of what hold's value occurs.
Investing for the Crisis
We appear to be rather far along into the dark cloud period. Throughout this period and into the crisis period investors should avoid almost all dollar based Investments. They should focus on hard assets (GLD and SLV) and natural resources and commodities including energy (OIL, UNG), plus countries whose economies are not based on trade with America like Australia (NYSEARCA:EWA) and Brazil (NYSEARCA:EWZ).
However, at some point early in the “crisis” period, all stock investments should be moved to hard asset investments since all countries will be swept up into the economic crisis that a dollar crash would cause. It might only be hard assets that would probably avoid the entire crisis period.
This global cycle explains why gold and other essential commodities have been rising for some time – many investors have long been aware of these the issues. Even though there might be a large decline in these investments before the crisis, it should recover and these type assets should not make a final top until late in the “crisis” period. I believe these periods are from three to five years away.
At some point, however, between the crisis and confusion period it will be best to move back into dollar based American assets as the dollar decline will overshoot and carry too deep presenting tremendous values.