How to Ride the Dollar

It's up for now, but can it last?

In the late summer of 1980, the US dollar began a sustained appreciation on foreign-exchange markets that has lasted for four and one-half years. This unprecedented ascent has profoundly affected the world economy—and you.

The rising dollar has dramatically reduced import prices, cost thousands of jobs in US export industries, provided a business bonanza for our trading partners, and postponed the collapse of Third World debtor nations. It has been a major boon to American consumers by substantially reducing the rate of price inflation.

Whether the strong dollar was the stroke of genius of Federal Reserve Board Chairman Paul Volcker or just the result of a random set of chance events, without it the nation would be teetering between a collapse of the banking system and hyperinflation. And it is certain that the Republicans owe their second term in office to dollar strength, for it completely camouflaged the effects of their stunning failure to keep their primary campaign pledge of the 1980 election—balancing the federal budget.

Besides the effects it has had on the economy, the rising dollar has dramatically affected investment markets. It has pushed commodities prices to depression levels and has left gold and silver in the doldrums. As price inflation has fallen, the public's rush to the high yields of the bond market has trampled the demand for all types of inflation hedges. The strong dollar must be given credit for the endurance of the business recovery that began the summer of 1982, and thus for the strength of the stock market.

There are only two possible explanations for the current strong dollar: either economic fundamentals in the United States have improved so that the strength of the dollar reflects a permanent realignment of currency values; or the strength is merely a distortion caused by temporary conditions, in which case the dollar will fall again. If the latter is the case, the changes in trade and investment markets brought about by the dollar's ascent will reverse themselves.

A look at the fundamentals indicates that the dollar not only is overvalued and due for a fall but may also be the only thing holding back an economic avalanche. When the decline begins (and it appears that it may be starting), the world economy could face the greatest crisis of this century. To understand why, and to defend your assets from the turmoil ahead, you should carefully consider the pressures that have built up within the system.

The source of the world's economic turmoil is the creation of money, and the source of most money creation is government. Unable to tax enough to meet outlays, governments borrow, and their borrowing competes for and absorbs available capital, driving interest rates higher. To prevent the collapse of industry and thence banks due to high interest rates, central banks are empowered to "monetize" government IOUs—that is, they convert the IOUs into money by purchasing them with money they create out of thin air.

An increasing money supply causes the value of money to fall, which is to say it causes prices of goods and services to rise. Price inflation, then, creates an explosion of economic symptoms, most of which are not linked in the public's mind to the money inflation that preceded the price inflation, and almost none of which are linked back to the original culprit, deficit spending.

One symptom of price inflation is an imbalance in international trade, which inevitably leads to changes in the relative values of currencies: If prices rise in nation A, and the exchange rate of nation A's currency with the currency of nation B remains fixed, goods in (inflating) nation A rise in price relative to goods in (noninflating) country B. As citizens of nation A import more of the cheap goods from country B and elsewhere abroad, foreigners become less willing to accept nation A's inflated currency, and its value falls on exchange markets.

Thus there is a bridge between deficits and the dollar's exchange value. But to understand the dollar's present strength in the face of the current deficits, and to realize the severity of the situation now facing us, it's necessary to understand in some detail the chain of events that led us to the present.

US national policy became committed to deficit spending during the Great Depression. After World War II, deficit growth became exponential. Total deficits doubled for each five-year period beginning in 1950, and then in the five years from 1974–1979 they tripled. For the entire 30-year period from 1950 to 1980, the percentage increase in the Consumer Price Index has almost exactly matched the percentage increase in federal debt, according to data from the Federal Reserve.

During the 1950s and '60s, however, currency-exchange rates were fixed by the 1944 Bretton Woods agreement, which pegged all other major currencies to the dollar, and the dollar to gold. Under the terms of Bretton Woods, if the central bank of another country accumulated excess dollars, it could exchange them for US Treasury gold, at $35 per ounce. This golden guarantee ensured a ready market for dollars everywhere in the world.

As US price inflation outpaced inflation in other industrialized nations, goods from these countries became cheaper and cheaper relative to US goods. So when citizens of other countries acquired US dollars, rather than spend these dollars on overpriced US goods they instead exchanged them for other currencies, with the dollars ending up in the hands of their central banks. And these central banks exchanged the dollars for US Treasury gold.

Eventually, the unrelenting increase in the US money supply resulted in a depletion of our gold reserves, and in 1971 President Nixon abrogated the Bretton Woods agreement. Gold no longer backed the dollar, and exchange rates were free to "float," which meant the market would set them. The dollar immediately began to fall relative to currencies with lower inflation rates, such as the German mark, Swiss franc, and Japanese yen. The results: a burst of inflation in the United States, as foreign goods rose to parity with inflated US goods; turmoil in investment markets; and confusion in banking circles.

Meanwhile, federal deficits continued their upward spiral, fueling the fire of inflation. Each time inflation spiked, it caused a business recession, which was met by increased deficit spending and increased money creation by the Federal Reserve. These in turn caused renewed inflation and a repeat of the cycle. The final inflation cycle peaked in 1980, at rates of close to 18 percent. Shortly after the peak, the dollar hit its all-time low.

Since 1980, US deficits have become legendary, reaching $200 billion per year with no end in sight. If the deficit-inflation-dollar link is correct, we would have expected the dollar to fall, not rise, and would have predicted another inflation peak, with rates of 25 to 30 percent this year. Yet inflation has fallen steadily from its 1980 peak, and the dollar has risen just as steadily to all-time highs. For the first time in 30 years, the increase in federal debt has not been matched by an increase in consumer prices. Why the anomaly?

In retrospect, it is obvious to me that a combination of fortuitous events has temporarily postponed the effects of the deficits and has lulled the American public into a misplaced, possibly fatal, sense of well-being.

The chain of events began with the decision by the Federal Reserve in late 1978 to curtail the monetization of Treasury IOUs in order to dampen inflation. For three years, from October 1978 through the summer of 1981, the Fed held back, and then, when the banking system was on the brink of total collapse, it reversed course and bought some of its IOUs (T-bills) with a frenzy. Its tight money policy resulted in the worst recession since the 1930s, but it also caused corporate America to trim out the excess fat and tighten its belt. High unemployment and the threat of bankruptcy broke the backs of labor unions, and productivity per worker soared.

Meanwhile, just as the nation was reeling past the 1980 inflation peak and the dollar was at its low, Ronald Reagan was campaigning on a platform of bringing government under control, balancing the budget, and wringing inflation out of the economy forever. His rhetoric was just what the world wanted to hear. As he was elected, inflation was already falling.

Interest rates were falling, too, but not as fast as inflation, which meant that real interest rates—the differential between nominal rates and inflation—were rising. After the Reagan election, foreign capital began to flee the uncertainty of recession and turmoil abroad and home in on the high real interest rates and high hopes for an American economic renaissance. The influx of capital caused the dollar to strengthen, and it began its historic rise.

The strengthening dollar, of course, meant falling prices for imports. Simultaneously, it meant competition for American businesses that made it more difficult for them to raise prices. Thus, the stronger dollar, which was partially inspired by a falling inflation rate, amplified the drop in inflation and reinforced its own continued rise.

Another significant event was unfolding simultaneously. During the latter half of the 1970s, as US interest rates were rising to new highs, US banks found themselves trapped by legal limits on rates they could charge to domestic borrowers. One answer to this was foreign lending, where rates were not controlled. They flocked to Third World countries, where they found governments eager to pay high rates. With rising oil prices and rising commodity prices, it appeared that these Third World suppliers of raw materials would have no trouble repaying.

This flood of lending created a capital outflow that reached over $100 billion per year by 1981. Unfortunately, by then the loans were no longer made to chase higher rates, but rather to forestall disaster, for by 1981 it was clear the banks had made a terrible mistake. Oil prices were plunging, as were commodity prices, and the Third World borrowers were threatening default.

Breathless from the near disaster, the banks pulled back from foreign lending as rapidly as they could, and the capital outflow screeched to a halt, falling from $110 billion in 1982 to a small fraction of that today. This reduction of US lending abroad had an interesting feedback effect of its own. As funds were redirected from foreign markets to US markets, they had the same effect that foreign dollars entering US markets had—that is, they added impetus to the strengthening dollar. In fact, the drop in foreign investment was so great that by 1984 the dollar was climbing at a greater rate than anytime in the four years of its ascent, even though foreign investment in the US was beginning to decline!

The side effect of this new dollar strength was to benefit the banks themselves, for the strong dollar became an incredible boon to Third World debtors: though commodity prices in terms of dollars fell dramatically from 1980 to 1985, in terms of the currencies of these commodity-exporting countries prices jumped. Their exports soared, and so did their profits, at least in terms of their own depreciating currencies. Thus, the US banks, by redirecting their funds to US markets, actually benefited their weak borrowers. The Third World debt disaster was temporarily postponed by a strong dollar.

In summary, the capital flowing into the US, both from foreign savers seeking high returns and low risk and from domestic lenders who were curtailing foreign lending, strengthened the dollar, reduced US price inflation, and helped finance the exploding federal debt. The process was substantially aided by increased US productivity as a result of the deep recession of 1981–82, the deregulation of many industries (including banking), and a stimulative tax policy.

In analyzing this situation, it's important to recognize three critical truths:

First, the dollar strengthened primarily because of capital flows into the United States. This capital was seeking the high real returns generated by a falling inflation rate. When interest rates and inflation make other markets more attractive, capital will flow out of the United States just as rapidly as it flowed in.

Second, the dollar has become substantially overvalued relative to other major currencies when measured by the relative prices of goods. Today, the dollar buys 30 percent more goods in Japan, 70 percent more in Switzerland, 80 percent more in Britain, and 90 percent more in Germany than it did in late 1980. The deficit in the US trade balance is higher than ever before and will continue to grow as long as this overvaluation exists. For both economic and political reasons, such a trade deficit cannot be sustained indefinitely. Exporters will eventually force the government to impose trade barriers unless the dollar falls. Moreover, this outflow of dollars must drive the value of the dollar down the instant the inflow of capital subsides.

Third, the source of all these problems—the US deficits—are continuing and are bound to get even worse. The government has run $200-billion annual deficits during one of the strongest recoveries on record. When this recovery falters—which recoveries always do—those deficits could easily double from present levels.

There is no such thing as something for nothing. The astronomical stream of worthless IOUs issuing from Washington will never be repaid. In reality, they are nothing more than tax receipts disguised as IOUs. The only politically feasible way to prevent these deficits from collapsing the banking system is for the Fed to monetize them, and that means inflation—the greatest inflation in the history of the country.

The dollar is on the brink of a collapse. Whether that collapse is triggered by a drop in real interest rates (they have already begun their decline), a rising inflation rate (dramatic money growth in the first quarter of 1985 ensures that price increases cannot be far off), a banking crisis (banks and savings-and-loans are failing right now at the highest rate since the depth of the Great Depression), or some unforeseen event, the decline is certain.

Once it begins, it will feed on itself just as the strengthening dollar did. Inflation will rise, capital will flow out, and the dollar will fall more. A falling dollar will cause a dangerous drop in Third World commodity exports and reignite the Third World debt crisis. The Fed will be caught in a box. If it protects the banks, inflation will soar. If it doesn't, they could collapse. Bet on money creation—it's a certainty.

To the individual, the coming collapse of the dollar means both risk and opportunity. Initially, interest rates may fall, as the Fed tries to stave off a banking crisis. The failure of several thrifts in Ohio came close to causing a nationwide bank panic, and note what happened. The Fed has brought interest rates down to ease liquidity and protect weaker banks.

The Ohio crisis also gave a glimmer of the pressure that has built up in currency and investment markets. As the crisis developed, the dollar dropped dramatically, and commodities and precious metals soared. The markets are volatile, waiting for the next shoe to drop.

How can the individual protect himself from the coming turmoil?

First, bet on rising prices for foreign currencies, particularly the German mark and Swiss franc. They are bound to appreciate dramatically.

Second, invest in commodities, particularly those depressed items that are produced in large quantities by Third World nations. They will become sought-after inflation hedges in the months ahead.

Third, accumulate gold and silver. They've been in the doldrums, but a resurgence of inflation will bring them back to popularity.

Fourth, once inflation gets under way in earnest, interest rates will move up with it. When rates bottom and start up, get out of bonds. For speculative profits, consider taking short positions in the interest-rate futures market. As interest rates rise, so will your profits on short positions.

Finally, don't believe those pundits who tell you that deficits don't matter and the future will be rosy. There is no such thing as a free lunch. The end result of the creation of endless billions of irredeemable government IOUs must be inflation. There is no other possibility.

John Pugsley is the author of Common Sense Economics and The Alpha Strategy and is editor and publisher of Common Sense Viewpoint and Metals Investor.