* WHAT TO DO NOW: Learn where money problems really start. Politicians may complain about other governments’ economic policies, but the truth is that all money problems start at home. The original causes of all monetary distortions are supply and demand, either too much or too little money. In the past four decades there has always been too much money. See what that means below.
* EZ CURRENCY DIVERSIFICATION: Put bonds in your portfolio. This is an income producing protection against currency turmoil. See page seven to learn how to use bonds to hold currencies abroad.
* EZ PROFIT: Watch for hidden imported inflation that creates stagflation. The Fed made a move in 1994 that may create stagflation. See why in the case study on page nine.
See another plush, deeply-carpeted room. The curtains are drawn. Traffic sounds are muffled, distant and everything is calm behind thick, solid walls. Turmoil is far away and the atmosphere is of commanding authority and privileged wealth.
Let’s return our imagination to important offices, this time the U.S. Treasury. Picture executives gathered at one end of a long wooden table constructed from a single enormous piece of polished cherry. See them speaking in hushed tones. Word has come down through the Secretary, directly from the Presidency that the government needs money: sell long term bonds. The value of the dollar is plummeting. The government wants to pay interest and principal in cheaper currency over thirty years.
But what would happen if the thirty-year bonds offered by the U.S. government don’t sell? What if they were offered to the public, just as bonds had been for decades, but no one bought? What if one of the country’s largest insurance companies, which normally snatched a large percentage of the bonds for its accounts, was the first to sound the alarm. “We’re not buying any more long term U.S. government bonds. The government is doing nothing to strengthen the dollar. We’re not about to risk being paid back in a much weaker currency 30 years from now.”
That insurance company would have been sending a wake-up call: stop the printing presses, strengthen the dollar or we’re not buying.
And so the Treasury officials would huddle, speaking in hushed tones, as though unconsciously not wanting anyone outside the room (the public in particular) to know their thinking. After much discussion, they might agree to reduce the term (or length) of the bonds to twenty years. “Would twenty-year bonds be attractive?” They would ask the bellwethers of the investing public (such as the officials at the insurance company).
What then if the answer came back within hours. “Twenty years is too long!” The Treasury officials would have another meeting, make another plan. “How about ten years?” they would ask. But what if they again received another quick reply. “Ten years is still too long.” Within days, those Treasury officials would lower their terms for the bonds to three years.
Fiction and Fact
Does this sound like fiction? It certainly reads like a futuristic novel. But such a scenario has already been played out, almost exactly as described. The only difference is that it did not happen with the U.S. government, but in Canada. In early 1994, Ontario Hydro, one of Canada’s major utilities, issued 30-year bonds. One of Canada’s largest insurance companies flatly declared that they would not buy more worthless bonds. Ontario got rid of the bonds by reducing the term from thirty to three years, something they clearly did not want to do. They wanted to be able, as the Canadian dollar fell, to pay back the bonds in a weakened, cheaper currency years later.
One of the most frightening aspects of this is that Ontario Hydro’s bonds were rated AA- by Standard and Poor’s rating service! This is the higher ratings a bond can have. Strangely enough, these bonds are still rated AA-, which shows how little you can trust any rating system today.
Important Point to Remember: During times of currency turmoil the more trusted institutions can no longer be trusted. All things living- plants, animals, nations, institutions, even worlds all move through three cycles: growth, inertia and decay. Large financial institutions are built in the growth period of a nation or economic cycle, based upon a service they can provide during steady social and economic conditions. These large companies become fat, rigid and fixed in their ways. They are least capable of surviving the decay period of a nation, currency or economic cycle. The Ontario Hydro example above is proof of this, as are the huge losses in Orange County and the bankruptcy of Barings Bank. Institutions in decay are always replaced by institutions that are in their growth phase. The new institutions are the ones that will be healthy in and after turmoil.
Last lesson we began to explore the internal factors that destroy currencies and how this affects purchasing power within a country. Then we looked at the relationships between currencies in countries and how the internal factors of currency decay affect currency parities between countries.
Currency decay always starts internally within a country, so let’s look at the internal indications of a weak currency. Only after a currency is suffering serious internal problems does the weakness spill into its parity value versus other currencies. The term used to describe this currency decay is inflation. You will learn below that there are many kinds of inflation. Each inflation type differs but all rise from bad social and economic habits.
There are different types of inflation. Open inflation means simply that prices are rising on consumer goods and services. Price changes are measured in the U.S. by the Consumer Price Index and the Wholesale Price Index, both compiled by the Bureau of Labor Statistics for the U.S. Department of Labor. These, along with wage levels, are measures used to indicate the purchasing power of the dollar.
Suppressed inflation means that a situation exists in which prices would rise — if government regulations did not establish artificial limits on prices, wages, etc.
Perhaps the most classic example of suppressed inflation occured during the years 1968-1971. There was a tremendous pent-up price demand for gold. During that time, gold was pegged at $35 an ounce to the U.S. dollar. Inflation was accelerating. The United States was churning dollar bills off the printing presses, disregarding the tie to gold. When President Nixon finally announced, what the economic world had known for quite some time, that the dollar would be freed from its peg to gold, the price of gold shot upward, reaching a high of $860 an ounce within five or six years.
In this sense, prices are like steam. They can be contained for short periods, but as they expand exponentially, they must break free.
Important Point to Remember: Don’t be fooled by suppressed or artificial prices.
Today the dollar, which has vast inherent weaknesses, is being supported from time to time by organized international buying. In other words, its price is being artificially held. Governments around the world (the U.S. included) find that occasionally they need to buy dollars to keep the price from free-falling. These buying binges accomplish two things: they temporarily keep the dollar afloat (until the next crisis), and they mask the extent of the dollar’s weakness to investors who ignore fundamentals and do not look beneath the surface.
Open inflation has different forms. The following academic terms describe some of the forms inflation can take.
Gross Inflation: This occurs when rising prices are encouraging an increase in output and are bringing about fuller utilization of the work force and production capacities. People always want to take advantage of rising prices by making more articles that can be sold at higher, more profitable prices. Therefore, rising prices tend to bring factories to fuller capacity, because the factory owners see increased profit potential from selling their goods.
Gross inflation occurs when prices are inflating at a high enough rate over a long enough period of time. These figures vary, depending on the economic climate. There are many variables to consider. For instance, if prices were rising, say, 10% a year, production capacities would surely rev up to take advantage of future higher prices.
But inflation at that rate means that prices will double approximately every 7 years. (Use the rule of 72 to determine how long it takes a figure to double. Divide the interest rate into 72 — the answer gives you the number of years it will take for the principal, or in this case, prices, to double.) With prices doubling every 7 years, it’s hard for wages to keep pace. People with fixed incomes will find their purchasing power cut in half every 7 years. Eventually, products and services will become too expensive for people to purchase, and consumer sales will fall. As a result, companies will tend to produce less, workers will be laid off, and the economy will stall. This scenario has been played out countless times around the world. Inflation rates of 10%, 15%, 20% or more have eventually stalled an economy.
Pure Inflation: This occurs when prices rise after the work force and production capacities are increased to the fullest extent. This, clearly, is not in the best interest of the country. Pure inflation comes after gross inflation. As discussed in the previous example, ongoing price increases eventually are the undoing of an economy, destroying the economic and social fabric of a country.
Creeping Inflation: This occurs when prices rise gradually, over long periods of time. This is the type of inflation seen in the U.S. today. Creeping inflation (2%-3%) per year is tolerated as a means of keeping productivity and employment levels high. People see that prices are rising steadily, so they are encouraged to increase production of goods to sell them at more profitable prices. This encourages factories to move toward higher levels of output, increasing employment. Creeping inflation, however, does not encourage such rapid industrial output that commercial loans increase dramatically, (remember how the Fed and banks can make money out of thin air through loans) with the inevitable sharp rise in prices (because there is too large a supply of money). Wages keep up with prices more easily, and individuals on fixed incomes can more easily adjust on a yearly basis to increasing prices of goods and services.
Hyperinflation: This occurs when prices rise uncontrollably, threatening to destroy a currency by decreasing its value and making it worthless. Germany, Brazil, Mexico, among countless other countries through history, have experienced hyperinflation and the resulting social chaos.
Between WWI and WWII, the German mark inflated so rapidly that workers had to leave work at the moment they were paid so they could cash their checks and purchase food. If they waited even until the end of their workday, prices would have inflated so much in those few hours that their checks would have been worthless. The resulting social unrest laid the foundation for Hitler’s socialistic Nazi Party to work its way into power.
Stagflation. This is a period of simultaneous economic inflation and business recession. A classic example of stagflation gripped the U.S. from approximately 1979-1981. OPEC had strengthened, reducing shipments of oil and increasing prices. Nonetheless, the United States continued importing oil in high quantities. In 1978, the U.S. imported 8 million barrels of oil a year. In 1979, that figure fell to 7.9 billion per year, then 6.4 billion in 1980 and 5.4 billion in 1981. But the cost of oil skyrocketed, and the total cost of imported oil doubled from 1978- 1980 ($44.7 billion in 1978, $82.9 billion in 1980).
Understanding stagflation is important because many of the same factors were in play in mid 1995. Only history will tell if these factors lead again to stagflation, but we will examine this possibility after the case study later in this lesson.
War and Inflation
Major wars almost always result in inflation. Governments either simply print money or borrow heavily to meet increased expenditures. Yet, even if governments try to maintain a prudent fiscal policy during wartime, inflation is inevitably built into the economic climate of starting and waging a war.
Why? Because as a country goes to war, the work force shifts from production of consumer articles to production of wartime articles (guns, bullets, etc.) Civilian goods decrease in output, yet government expenditure for the war effort tends to increase total wages paid, especially if a high level of unemployment existed prior to the war. Thus, the output of consumer articles is reduced, but total consumer income is increased. In addition, war materials are essentially totally non- productive products. Since most war materials are destructive, the war products that are created (and paid for) cannot be offered back into the community where the money was earned to create them.
Inflation is simply too much money and too few products. In an inflationary state, people are willing to offer more money for less product or service. Thus, if a third of a population is paid to produce products (such as guns and bullets) that are not used in the economy then all the money they earn will be competing for the fewer civil products that are still available.
In effect, there is suddenly more money available to buy fewer goods, which is the classic definition of inflation. Governments often establish wartime price levels and rationing, but these can have only limited effect. Inevitably, the prices of goods rise.
Inflationary spirals often result from the increasing prices of consumer goods. This, in turn, generates pressure for wage increases to offset the price increases. An ongoing spiral results, with prices rising and rising.
During the Vietnam War years, the U.S. government played all ends against the middle. It printed money and borrowed heavily to pay for war materials and operations. At the same time, it printed money and borrowed heavily to finance and underwrite the world’s largest-ever increase in government-sponsored domestic growth. Roads and schools were built, public welfare funding shot up, and businesses were subsidized. If you think there was a lot of debate about the U.S.’s involvement in Vietnam, think how hot things would have gotten if the American people hadn’t been receiving all that government funding during President Lyndon Johnson’s “Great Society” efforts.
The U.S. government kept a lot of the people happy, but it also started the process toward federal bankruptcy with its “Guns and Butter” policies during this period.
The Effects of Inflation
Inflation hits people differently, depending upon their financial situation. Some types of incomes rise more slowly than even 2-3% inflation, and are thus always falling behind (meaning that purchasing power declines). These include pension and welfare incomes, rental incomes, government employees (teachers, schools, etc.), and bond incomes. During times of inflation, people dependent on these types of incomes lose purchasing power.
For example, if prices rise an average of, say, 5% a year, in five years prices will have risen 27.6%. (The reason the price increase is more than 25% is because inflation compounds annually.) A loaf of bread that once cost $1.00 now costs $1.28. A car that once cost $20,000 now costs $25,525. A home that once cost $50,000 now costs $63,814. At this rate of inflation (which has not been uncommon since WWII in the United States), people on fixed incomes will find their purchasing power declining yearly.
Say an older person living on a company pension finds his or her income rising 1/2% a year, while inflation is rising at 5% a year. The person will find, in short order, that his or her purchasing power has declined. Subtracting the person’s 1/2% yearly increase from the 5% annual inflation, the person essentially has 4.5% less purchasing power every year. Over a five year period that will reduce a person’s spending power by 21%! What once cost $1.00 now costs $1.28 — but the person on fixed income has increased his or her spending power to only $1.03. Thus $0.25 out of every dollar has been lost, just from inflation.
The same is true of a person living on bond income. A bond might pay 6%, but if inflation runs at 5%, the real rate of return is 6% less 5%, or 1%. And that’s not accounting for taxes, which eat up a percentage of that remaining 1%.
How Inflation Affects Bond Prices
This is why bond prices fall when interest rates rise. A bond paying 5% will not be as attractive when comparable newer bonds are issued paying 8%. In such an instance, bonds paying 5% could be sold only by offering a discount to the face value of the bond.
Likewise, bond prices rise when interest rates fall. A bond paying 5% will be very attractive when comparable newer bonds are issued at 3%. In such instances, the bond paying 5% can be sold at a premium to its face value.
For example, assume you are an investor who buys a German mark bond with a yield of 7.5%. A year later, if bonds are yielding only 5.5%, you could sell your bond at a premium. But what premium? The way to calculate this is divide the original yield by the new yield. In this example, you would divide 7.5 by 5.5, with the result of 1.3636. That means you could sell the bond for 36.36% more than you bought it — DM13,636. Why? Because a DM13,636 bond yielding 5.5% returns the same interest as a DM10,000 bond yielding 7.5%.
If the interest rates rise, the prices of bonds fall because investors will not be as interested in buying bonds that have lower yields. To find the price of a bond should interest rates fall, divide the new yield by the original yield. If you held a bond that paid 7.5%, and a year later new bonds were selling at 8.5%, to find how much your bond was worth, divide 7.5 by 8.5 = .88235. Thus, a DM10,000 bond yielding 7.5% would be worth DM8,824 when new bonds are selling for 8.5%. This is so because a DM8,824 bond at 8.5% yields the same as a new DM10,000 bond at 8.5%.
This is a very inexact way to calculate bond prices. Many other factors affect the supply and demand of bonds, and these ultimately affect the real yield. Expectations of inflation, demand for money, new issues, stock market prices, political and military events, economic events etc., all these would enter into the actual price offered on an outstanding bond. Supply and demand ultimately determine the prices of bonds, but from these examples we can see that the best time to buy bonds is when interest rates are expected to fall. The best time to sell bonds is when interest rates are expected to rise.
Any person living on a fixed income will experience loss of purchasing power from inflation — unless the person’s income has a built-in mechanism that raises income according to inflation rates. The inflation rate, however, is often a highly-debated figure among politicians and economists.
Some types of incomes increase more rapidly than the rate of inflation (meaning that purchasing power increases). These include stockholders and owners of businesses who benefit from increased prices, who also benefit from the naturally slower rise of costs (utilities, wages, etc.)
Rising prices always mean decreasing purchasing power for currency, so people with long term fixed debt benefit from inflation. If you owe $100,000 that comes due in ten years, and during that ten-year period inflation cuts the value of currency in half, you will be able to pay back the $100,000 in cheaper currency.
Who is Hurt and Who Benefits from Inflation?
Who benefits most from inflation? People or organizations with long term fixed debt and incomes that increase faster than the Consumer Price Index. These include many retail and industrial organizations that can raise prices as they see inflation driving the Consumer Price Index upward.
Who is hurt most by inflation? People on fixed incomes (older individuals and welfare recipients). These individuals cannot readily increase their incomes, and often are at the mercy of large, inflexible organizations (the government or company pension plans).
The U.S. today supports policies of creeping inflation (2-3% per year). Anything less tends to increase business production and bring inflation, because lower rates of interest tend to stimulate consumer buying and business activity, raising prices. Anything more leads to increased unemployment, a slowing economy, and falling prices (recession). Creeping inflation seems to keep the most people happy, so governments play with interest rates, money supplies, and government expenditures to keep inflation in this middle ground of acceptability.
Ways to Hold a Global Portfolio
Having looked at how inflation can create weakness in the value of long term bonds, we should also look at the benefits of this type of investment. First, they are safer than equities. Second, they give a known (if albeit fixed) return. Third, bonds are often oversold in anticipation of inflation and can provide better income and capital gains if properly purchased. One way to hold a multicurrency portfolio is to invest in medium (3-7 years) and long term bonds.
There are several ways to invest in bonds. One way is to have an overseas bank or stockbroker buy bonds for you. Listed on the next page is a sample bond portfolio that was offered by the Swiss bank, Banque SCS Alliance in May 1995.
An actual portfolio would certainly depend upon your own personal financial position and current economic trends, but we can learn much from looking at this sample because it was part of a total portfolio of US$1,000,000, which consisted of 29.4% straight bonds, 23.3% convertible bonds, 24.3% equities and 21.8% cash. The straight bonds are listed next page.
Banque SCS Alliance, 11 Route de Florissant, 1211 Geneva 3, Switzerland. Tel: 011-41-223-46-12-81. Fax: 011-41-223-46-15-30. This Swiss bank (which also has a branch in the Bahamas) specializes in global portfolio management with an emphasis on straight and convertible bonds.
How to Understand Bonds
Listed below is the sample bond portfolio. The bonds are shown first by currency of denomination. For example, the first bond shown (I have marked it in bold text) is a Deutsche Bank bond issue in French francs. Second, the nominal amount held is shown. In the example below, the amount of Deutsche Bank bonds held is 250,000 French francs. Third, is the coupon yield or the guaranteed annual amount that will be paid assuming that an investor paid full price for the bond (8.750% in the Deutsche Bank example). Next is shown when the maturity date, (which means when the loan will be paid back-August 22nd, 1996-in the Deutsche example). Then the Market Price is shown. The market price shows the discount or premium that one pays for the bond. For example, the Deutsche Bank French franc issue here is selling for a 1.25% premium. This means that one must pay FRF1,012.50 for each FRF1,000 worth of bonds. At this premium, the real yield of the Deutsche Bank French franc issue bond for an investor will not be the 8.750% coupon but 7.65% which is the YTM (real yield to maturity). Here is the sample portfolio:
Name Currency Coupon Maturity Market Yield To Date Price Maturity Deutsche Bank FRF 8.750% 22-Aug-1996 101.25% 7.65% S.N.C.F. FRF 9.000% 02-Apr-2002 106.25% 7.90% Deutsche Bundespost DEM 6.750% 01-Apr-2004 96.65% 7.27% E.I.B. Can$ 10.125% 10-Mar-1998 104.88% 8.12% Canada Can$ 10.000% 01-Mar-2002 109.59% 8.15% France ECU 8.250% 25-Apr-2022 95.72% 8.66% CIE bancaire ECU 6.500% 17-Sep-1999 94.33% 8.07% United Kingdom ECU 9.125% 21-Feb-2001 105.16% 7.97%
The portfolio above is typical of the type portfolio that a bank or broker might choose for an investor. It mixes currencies, issuers and maturity dates, but seeks to obtain the highest possible real yield. We will look at how to estimate real yield in later chapters.
Another way to invest in multicurrency bonds is through bond mutual funds. Listed below are fund managers that offer multicurrency and single currency bond funds.
AXA Equity & Law IFM Total Pound Bond Fund, Victory House, Prospect Hill, Douglas, Isle of Man, Britain. Tel: 011-44-1624-677-877. Fax: 011-44-1624-683684.
Baer Multibond German Mark Bond Fund, Bahnhofstrasse 36, CH-8010, Zurich, Switzerland. Tel: 011-41-1-2285111. Fax: 011-41-1-2112560.
Bank Brussels Lambert, BBL Renta Fund Italian Lire, 24 Avenue Marnix, 1050 Brussels, Belgium. Tel: 011-322-547-2744. Fax: 011-322-547-8018.
BIL Belgian Franc Bond Fund, 2 Boulevard Royal, L-2953, Luxembourg. Tel: 011-352-45901. Fax: 011-352-4590-2010.
CMI GNF Swiss Bond Fund, Clerical Medical House, Victoria Road, Douglas, Isle of Man, Britain. Tel: 011-44-1624-625599. Fax: 011-44-1624-677020.
CS ECU Bond Fund, 58 Grand Rue, L-1660, Luxembourg. Tel: 011-352-4600111. Fax: 011-352-745541.
CU PP Peseta Bond ACC, Centre Mercure, 41 Avenue de la Gare, L-1611, Luxembourg. Tel: 011-352-4028-20261. Fax: 011-352-4028-20221.
Parvest Obli Dutch Gulder Bond Fund, Banque Paribas, 10a Blvd Royal, L-2093, Luxembourg. Tel: 011-352-46461. Fax: 011-352-46464141.
Pacific Australian Dollar Bond Fund, PO Box 45, Port Vila, Vanuatu, South Pacific. Tel: 011-678-24106. Fax: 011-678-23405.
Rorento Global Bond Fund, Case Postale 114, CH-1215, Geneva 15, Switzerland. Tel: 011-41-223-41-1392. Fax: 011-41-22939-0111.
SBC Bond Portfolio Can Dollar B Fund, 26 route d’Arlon, L-1140, Luxembourg. Tel: 011-352-4520301. Fax: 011-352-452 030700.
Templeton GS Emerging Market Bond Fund, Centre Newberg, 30 Grand-rue, BP.169, L-2011, Luxembourg. Tel: 011-352-4666671. Fax: 011-352-4666760.
What to do now? Write to the fund managers. Look for their bond investing philosophy. Do they hold long or short bonds? Do they attempt to obtain income and growth or just income? Look at their performance over one year and three. Find out their philosophy for safety and ask to see a sample portfolio.
Ask yourself, if you want to hold bonds in many currencies, do you want to have your own portfolio of bonds or do you want several single currency bond funds? Will your needs be filled by a global bond fund where the manager chooses which bonds to hold?
For this case study, we return to the U.S. Federal Reserve Bank. The year is 1994. The Fed spent the year anxiously raising interest rates to fend off looming inflation, but the economy did not slow down. On November 13, 1994, the Fed raised the discount rate .75%, the largest increase since 1981, when it was in a desperate fight against double- digit inflation. Even with these rate hikes, prices remained strong and a definite tendency towards inflation continued. The stock market continued to rise, because each interest rate hike calmed inflation fears. Most analysts feared, however, that the higher interest rates would make the economy sluggish. The Fed then felt that the rates had risen to uncomfortable levels and halted future interest rate hikes, opening a window for long-term inflation.
The tactic worked for the Fed in that the economy did not crash in 1995, though it did begin to slow. However, the price was paid for keeping the dollar rate low. The value of the U.S. dollar crashed versus the Japanese yen and many of the hard European currencies.
This shows how internal politics and currency distortions have an external effect on a currency. In this case the Fed said, “For internal economic reasons, we want to keep interest rates low.” The rest of the world disagreed. The rest of the world, speaking through currency prices essentially said, “We think that your low interest rate will cause inflation in the future. We will, therefore, only accept U.S. dollars at a lowered parity versus the yen, etc.”
From this case study we can see how a country’s interest rate, and rising consumer and production prices (inflation) can affect a currency’s value.
Other Reasons Why Currencies Move
There are other reasons why currencies become weak or strong. Unemployment levels are an important factor.
Low unemployment is viewed as inflationary. If there are not many workers available in the workplace, the view is that business will have to pay more to attract or keep workers. Higher wages start an inflationary cycle. Once inflation starts, then a currency’s internal purchasing power falls, plus the currency will weaken versus currencies in countries where there is not inflation.
When a country’s money supply increases faster than the country’s GNP, inflation will occur and the currency may weaken. Trade balances and current trade accounts affect a currency’s value.
A country’s government debt and deficits affect the currency’s value as do tax rates, and the nature of a country’s debt (whether it is long term or short term and whether it is domestic or foreign debt). These indicators are reviewed indepth for many different countries in later lessons but in this lesson, let’s return to our study of inflation and look at more economic history.
The Middle and Late 1990s — Undercurrents of Inflation
The U.S. government may be trying to rein in inflationary tendencies, but today there is a vast undercurrent moving the U.S. economy toward pure inflation, hyperinflation, or stagflation (a situation in which prices inflate, the value of the dollar falls worldwide, and unemployment increases as industrial output falls).
Stagflation is a likely scenario as the dollar continues to fall in strength. As will be explained in detail shortly, as the value of the dollar falls, everything produced out of the country becomes more expensive for U.S. citizens — cars, computers, wine, furniture, etc. Since almost every product today is at least partially made out of the country, prices will rise as long as the dollar falls.
This trend is called Imported Inflation.
Imported inflation could cause stagflation again. We learned on page four of this lesson how a sudden rise in the price of oil in the 1980s caused stagflation then. This could happen again because of the enormous sudden fall of the U.S. dollar in 1994 and 1995.
The lower dollar means that prices will rise in the U.S., but wages will not follow. Consumers will purchase less because of the rising prices, and as a result producers will cut back. With production and consumption down, consumers and producers will tend to borrow less from banks. Banks make profit by lending money, but with demand for loans down, banks will need to lower interest rates to attract borrowers. However, with the dollar weakening on the foreign exchange markets, the Fed will be caught again between a rock and a hard place.
Because of the weakening dollar, the Fed will have to actually raise interest rates on Treasuries (and the discount rate) to attract investors. If the Fed doesn’t raise rates, the dollar will keep falling. But the rising interest rates will further slow the country’s internal economy.
This stagflation scenario could lead to spiraling inflation and slowing production as the dollar becomes weaker. Employment falls as businesses lay off workers. Inevitably, stagflation would attract government intervention. Prices would be frozen, along with wages, and it could even happen that the Federal government would decree it illegal for businesses to lay off employees, or to do so only after receiving permission.
The unemployment would create enormous social problems, added welfare costs, etc. and make it harder for the government to reduce its deficit. The enormous national debt quite likely could push the U.S. toward a stagflation-like economy. It is estimated that if the U.S. debt continues increasing at its current rate, interest payments on the debt will exceed tax revenues by the year 2010. Certain government agencies have already estimated that there will not be enough money in the system to fund social security or welfare entitlements even after 1995. At that point, the U.S. government will, in effect, be bankrupt. A scenario could exist in which government security issues could go unbought. The government would need money desperately and have no place to get it.
When the Game Runs Out
If this scenario in the U.S. were to unfold (we will look at reasons why it may not) well before interest payments on the U.S. national debt would overtake tax revenues, Treasury securities would become very hard to sell. This could create enormous instability in many countries including the U.S.! Many governments may have to take drastic measures to protect themselves from ensuing bankruptcy. They may have to raise taxes, most likely require all pension funds to be invested in government bonds and prohibit all funds from leaving the country. Some may decree, by law, that individuals and organizations with assets overseas and offshore (trusts, bank accounts, and investments of all sorts) draw their funds back into the U.S. or face losing the funds altogether. They may even prohibit individuals from owning precious metals. They may even nationalize some large corporations, restructuring the financing of the corporate debt to improve cash flow (to the new owners, the government). They may decree that businesses cannot lay off employees without government approval.
These are steps that have been taken in other countries. Whatever steps the U.S. government takes as D-Day (Debt-Day) approaches, it’s clear that the decisions will affect currencies and investors everywhere. The likely hardest hit in the U.S. will be upper-middle income and wealthy private U.S. citizens. Why? Because there is no one else with any money that the government can touch. The government will find it hard to reduce entitlements (social security, welfare, etc.) until it absolutely has to because to do so will cost votes.
Ultimately, the buck stops with the people who have the bucks-wealthy individuals, white collar workers, professionals and successful businesses. This is where taxes could be raised and raised again. This is where property (stocks, bonds, corporate real estate, corporate pension funds, etc.) will be confiscated. And this is the group that could be forced to draw assets back from overseas and offshore trusts and investments.
In future chapters, we will look at defenses to use in the event that such action takes place in one’s own country. But first, let’s look at a more positive picture and why stagflation might not take place.
The fact that we live in a global economy is why currency disaster affects all countries. If the U.S. is no longer a global consumer, all economies will be affected. The greater emergence of the global economy is also why stagflation may be avoided.
There is a theory that we must now include the production of emerging countries into labor forces of industrialized economies. Imagine what this means to a high labor cost country (like the U.S.). If the U.S. has low unemployment, rather than having to raise labor costs (inflationary), it can import products from low labor countries, such as Mexico, China, etc. This is a deflationary trend. Suddenly the economy of Mexico or China becomes available, which includes their capital markets and their entire infrastructure.
This factor adds a new dimension to the way we value currencies. There is every chance that no one will understand the final result of this economic unification until events unfold, but what can be sure of is that we cannot just blindly count on inflation or stagflation at this time.
If the theory is correct that the low labor countries will create a deflationary effect in industrialized countries, then there will be another problem, which is a greater polarization of wealth in industrialized countries. The rich will get richer, and the poor poorer. The reason is that those who have wealth, education and access to technology will be more able to use the benefits of other low labor countries. But the poor will be replaced by the low labor countries.
As this course is edited, there are many indicators that this scenario is likely. The Mexican collapse and the way it pulled down the U.S. dollar indicates that capital markets are now more closely connected. The way that low labor and prices in Mexico allowed Mexican tomato producers to ruin Florida tomato farmers shows how the rich benefit (they get tomatoes at lower prices), but the poor suffer. There has been an estimate that 40,000 low wage workers in the U.S. tomato industry will be put out of work.
In the long run, this change is for the best. However, this is little comfort for the tomato workers who lose their jobs if they have no skills, training or education to find other work. These unemployed will have to be fed. Those who become demoralized and ill will have to be kept. Those, who in frustration, turn to crime will have to be jailed. In the end, everyone everywhere will pay these costs. As we have learned in this lesson, no economy is now totally independent. This world is one economy and we are in this world together!
So whether we have stagflation, inflation, deflation or a steady growth, what we can know for sure is that events will not turn out quite like they ever have before. What we can know though is that (as has always been the case) those who are well educated will be ready for whatever scenario unfolds. In the upcoming lessons, we will concentrate on how you can prepare for currency changes whatever they are!