The Moribund Dollar's Blowback in Middle-East Economies

The Middle East's oil exporters need to end their peg to the dollar. Virtually all the oil-rich states peg their currencies to the greenback; the combination of skyrocketing oil prices and a dollar that is devaluing by the minute is distorting their economies and fueling inflation. This week's Economist says:

The argument for linking to the greenback was to provide an anchor for the region's economies, many of which are small, open and financially immature. In effect, the Gulf states import America's monetary policy. The trouble is that a fixed currency makes it hard for oil exporters to adjust to swings in the price of oil. And monetary policy in the world's largest oil-importer is not always right for those who sell the stuff...Some smaller Gulf economies now have inflation rates of around 10%.

What should be done about this problem? Switching the peg to a basket of currencies that included both the euro and yen would give the Gulf States more protection against oil-price fluctuations, but this is hardly a panacea for the region's monetary problems. This would still force the Gulf States to link their currencies to monetary conditions that might not suit them, as most big currencies belong to oil importers.

The best idea is probably to abandon currency pegs altogether and adopt the system that developed economies have in place: floating currencies. But instead of aiming for an exchange-rate peg, the States should have an inflation target.

One interesting idea involves including the oil price as part of an amalgam that includes the leading currencies. This would allow their currencies to absorb some of the impact of fluctuations in the price of oil. The worry is that the end of the Gulf States' dollar peg would cause a panic among investors, a real and palpable risk. But with oil prices rising and the dollar continuing to tank, inaction poses a greater threat.

A Small Step Forward or a Pacifier for Clear-Headed Americans?

Ben Bernanke announced recently that the Fed would attempt to be more transparent about their clandestine workings of their monetary policy. Will this stop him and his colleagues from blatantly inflating the value of the dollar and contributing to the decline in imports? Decide for yourself.

Krugman Actually Agrees With Me on the Housing Crisis (read: Switch to Gold Standard and Stop the Fed from Devaluing the Dollar)

Paul Krugman's Op-Ed article today supports what I have been saying about the problems of the dollar and the paradigm of housing:

Most of the bad investments now shaking the financial world seem to have been made in the final frenzy of the housing bubble, or even after the bubble began to deflate.

In fact, according to Fortune, Merrill Lynch made its biggest purchases of bad debt in the first half of this year — after the subprime crisis had already become public knowledge.

Now the bill is coming due, and almost everyone — that is, almost everyone except the people responsible — is having to pay.

The losses suffered by shareholders in Merrill, Citigroup, Bear Stearns and so on are the least of it. Far more important in human terms are the hundreds of thousands if not millions of American families lured into mortgage deals they didn’t understand, who now face sharp increases in their payments — and, in many cases, the loss of their houses — as their interest rates reset.

And then there’s the collateral damage to the economy.

You still hear occasional claims that the subprime fiasco is no big deal. Even though the numbers keep getting bigger — some observers are now talking about $400 billion in losses — these losses are small compared with the total value of financial assets.

Click here for the rest of Krugman's surprisingly correct article.

The Fallacy of the Federal Reserve and the Need to Implement the Gold Standard

As with all matters of investment, everything is clear in hindsight. It's too bad I didn't invest in gold earlier this year, seeing as how it is nearing $750/ounce.

Why wasn't it obvious? The Fed has been inflating the dollar as never before, driving interest rates down to absurdly low levels, even as the federal government has been pushing a mercantile trade policy, and New York City, the hub of the world economy, continues to be threatened by terrorism. The government is failing to prevent more successful attacks by not backing down from foreign policy disasters and by not allowing planes to arm themselves. These are all conditions that make gold particularly attractive.

Or perhaps it is not so obvious why this is true. It's been three decades since the dollar's tie to gold was completely severed, to the hosannas of mainstream economists. There is no stash of gold held by the Fed or the Treasury that backs our currency system. The government owns gold but not as a monetary asset. It owns it the same way it owns national parks and fighter planes. It's just another asset the government keeps to itself.

The dollar, and all our money, is nothing more and nothing less than what it looks like: a cut piece of linen paper with fancy printing on it. You can exchange it for other currency at a fixed rate and for any good or service at a flexible rate. But there is no established exchange rate between the dollar and gold, either at home or internationally.

The supply of money is not limited by the amount of gold. Gold is just another good for which the dollar can be exchanged, and in that sense is legally no different from a gallon of milk, a tank of gas, or an hour of babysitting services.

Why, then, do people turn to gold in times like these? What is gold used for? Yes, there are industrial uses and there are consumer uses in jewelry and the like. But recessions and inflations don't cause people to want to wear more jewelry or stock up on industrial metal. The investor demand ultimately reflects consumer demand for gold. But that still leaves us with the question of why the consumer demand exists in the first place. Why gold and not sugar or wheat or something else?

There is no getting away from it: investor markets have memories of the days when gold was money. In fact, in the whole history of civilization, gold has served as the basic money of all people wherever it's been available. Other precious metals have been valued and coined, but gold always emerged on top in the great competition for what constitutes the most valuable commodity of all.

There is nothing intrinsic about gold that makes it money. It has certain properties that lend itself to monetary use, like portability, divisibility, scarcity, durability, and uniformity. But these are just descriptors of certain qualities of the metal, not explanations as to why it became money. Gold became money for only one reason: because that's what the markets chose.

Why isn't gold money now? Because governments destroyed the gold standard. Why? Because they regarded it as too inflexible. Or maybe because it held them accountable; if people lose faith in the currency, they could exchange it directly for gold. To be sure, monetary inflexibility is the friend of free markets. Without the ability to create money out of nothing, governments tend to run tight financial ships. Banks are more careful about the lending when they can't rely on a lender of last resort with access to a money-creation machine like the Fed.

A fixed money stock means that overall prices are generally more stable. The problems of inflation and business cycles disappear entirely. Under the gold standard, in fact, increased market productivity causes prices to generally decline over time as the purchasing power of money increases.

In 1967, Alan Greenspan once wrote an article called Gold and Economic Freedom. He wrote that:
"An almost hysterical antagonism toward the gold standard is one issue which unites statists of all persuasions. They seem to sense--perhaps more clearly and subtly than many consistent defenders of laissez-faire--that gold and economic freedom are inseparable, that the gold standard is an instrument of laissez-faire and that each implies and requires the other. . . . This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights."

He was right. Gold and freedom go together. Gold money is both the result of freedom and its leading protector. When money is as good as gold, the government cannot manipulate the supply for its own purposes. Just as the rule of law puts limits on the despotic use of police power, a gold standard puts extreme limits on the government's ability to spend, borrow, and otherwise create crazily unworkable programs. It is forced to raise its revenue through taxation, not inflation, and generally keep its house in order.

Without the gold standard, government is free to work with the Fed to inflate the currency without limit. Even in our own times, we've seen governments do that and thereby spread mass misery.

Now, our government is stupid but not so stupid as to pull stunts like this. Most of the time, our government is pleased to inflate the currency so long as they don't have to pay the price in the form of mass bankruptcies, falling exchange rates, and inflation.

In the real world, of course, there is a lag time between cause and effect. The Fed has been inflating the currency at very high levels for longer than a year. The consequences of this disastrous policy are showing up only recently in the form of a falling dollar and higher gold prices. And so what does the Fed do? It is pulling back now. Some measures of money (M2 and MZM) are showing a falling money stock, a rarity in recent decades, which is likely to prompt a recession.

Chairman Bernanke now finds himself on the horns of a very serious dilemma. If he continues to pull back on money, the economy could dip into a serious recession. This is especially a danger given rising protectionism, which mirrors the events of the early 1930s. On the other hand, a continuation of the loose policy we have been pursuing recently endangers the value of the dollar overseas.

How much easier matters were when we didn't have to rely on the wisdom of exalted monetary central planners like Bernanke and, before him, Greenspan. Under the gold standard, the supply of money regulated itself. The government kept within limits. Banks were more cautious. Savings were high because credit was tight and saving was rewarded. This approach to economics is the foundation of a sustainable prosperity.

Is a gold standard feasible again? Of course. The dollar could be redefined in terms of gold. Interest rates would reflect the real supply and demand for credit. We could shut down the Fed and we would never need to worry again what the chairman of the Fed wanted.

What keeps the gold standard from becoming a reality again is the love of big government and war. If we ever fall in love with freedom again, the gold standard will once more become a hot issue in public debate.

Disagreeing with Paul Krugman

Krugman recently asserted that there was no conceivable way that a lower government deficit could lead to a stronger dollar and a lower trade deficit without causing a recession. But there is a fairly straightforward way this could happen...

China is basically using our Treasury notes as a bank for future consumption, and, like all banks, it could fail by a series of poor business decisions. Under the Bush administration, the "bank" has been making such decisions, and China has, therefore, recently entertained ideas of diversifying. This contributes to widespread consternation (among other countries) and confidence in the "bank" declines.

We can solve this problem, therefore, by making better business decisions. One way to do so is to address budget deficits, real and imagined (the imagined are various entitlement shortfalls), so other countries will regain confidence in the bank.

While this does not solve the problem directly, it gives America time to get some fundamentals in place- namely, handling the savings rate. The rate plunged for two reasons: first, the Fed flooded the country with money, which made housing artificially cheap and led to a speculative bubble. This made people feel rich and they increased their consumption accordingly. This is why our economy is still growing at a decent rate even though real income is down. Second, income amongst nearly all Americans has declined due to the tax and regulatory policies of the Bush administration, so maxing out on home loans was necessary to maintain the standard of living. A change in tax policies, which would provide money to middle class Americans, combined with the current readjustment in the true cost of money, should allow for an eventual increase in the value of the dollar while simultaneously avoiding a recession.

Bernanke Gives a Grim Prediction

Federal Reserve Chairman Ben Bernanke said today that the economy will most likely slow in the months ahead, but he gave no indication that the Fed would cut interest rates. Bernanke cited the meltdown in housing, which has yet to bottom out, as well as tighter credit conditions and a surge in oil prices as the foremost factors behind the projected economic downturn. Bernanke, however, did not predict any kind of recession, saying the Fed's previous interest rate cut would prevent this.

Importantly, Bernanke reminded the Joint Economic Comittee that inflation was the pervasive element governing all the Fed's actions. He was clear to refer first to the Fed's attention to price stability and second to its interest in sustainable growth.

The bottom line is that the projected growth of this year's economy, 4%, is no longer a reality and that the more likely figure at the end of the quarter will be closer to 1%.

GM Posts Big Losses

General Motors recorded its largest quarterly losses to date- $39 billion and nearly $69 a share- ending their 3-quarter profitable streak. This time last year, GM had reported losing 26 cents a share. Their shares fell more than 4%, dropping to $34.66 on the morning NYSE. These monumental losses come on the heels of a recent Detroit gloom; many analysts expect total auto sales to fall even further in 2008. Ford is expected to report a loss of $1 billion tomorrow while Chrysler is expected to cut 11,000 jobs. So these problems are not specific to GM.

Further, GM said that they would undertake the responsibility of removing net deferred tax assets from its books. These could have been used to offset taxes on future profits, with their termination suggesting that GM does not expect to earn significant profits in the near future. This does not augur well for the future of automobiles, but it suggests that Americans are deciding to restrict spending on cars as the crude oil price nears $100 a barrel.

Shift in Foreign Policy is Needed

It struck me today that perhaps Ron Paul is right about rethinking foreign policy in the Middle East. Sure the 9/11 attacks were unprecedented and directly unprovoked, but shouldn't we have prepared for something like that? We've been meddling in Middle Eastern affairs for decades, and it has never turned out well for us or our supposed beneficiaries. From deposing the Shah to funding Afghanistan's struggle against the Soviet Union to our unquestioned support of Israel to our sanctions against Iraq (and Iran), can we honestly say that we, as a nation, did nothing to stir up sentiment against us in that area of the world? Can we with perfect sincerity say that America was blameless on that terrible September morning six years ago?

The time has come for a change in foreign policy. We need to heed the advice of Washington and avoid entangling alliances. We need to pursue a much more isolationist foreign policy. Why do we have combat troops in countries all around the world? Isn't it time to forget saving face and do what is in the best interests of the country and its people?

A salient point presented in the Economist:

Should America focus on the tiny number of angry Muslims with guns, or the millions who have voted for Islamic parties in Egypt, Pakistan, Turkey, Algeria, and Palestine? If most religious fanatics were bent on conquest and terror rather than democracy, their causes would be easier to discredit. And if religion were the sole cause of the conflicts, it would be easier to work out 'why they hate us.'

The Mother of All Tax Reforms?

Charlie Rangel, one of the Democrats' top taxwriters, has unveiled his plans for restructuring America's tax code. Dubbed "The mother of all tax reforms" by the Congressman from New York, Rangel's proposal effectively raises taxes in some areas while reducing them in others. Contrary to what Rangel's shameless self-promotion might suggest, this new proposal only slightly tweaks the convoluted tax code.

From this week's Economist:

If Mr. Rangel's vision shapes the tax agenda after 2008...it will represent a missed opportunity. That is because America's next president and Congress will have the best chance for reform since Ronald Reagan to an axe to the tax code in 1986.

This is a keen appraisal of the approaching situation America will find itself in. With the expiration of the Bush tax cuts (due to occur in 2010) and the rise of the Alternative Minimum Tax (which ensures that wealthy Americans cannot avoid taxation by escaping behind the code's myriad deductions), change will inevitably occur in tax policy and the common perception of it. So what plan are Rangel and the Democrats proposing? This particularly insightful Economist article continues:

Mr. Rangel...wants to eliminate the AMT [Alternative Minimum Tax], at a cost of some $800 billion over the next decade, and pay for this by levying a surcharge on rich Americans, particularly those earning over $500,000 a year. Getting rid of the AMT will indeed make the tax code simpler. But raising the top marginal rate will blunt incentives. If the Bush tax cuts are allowed to expire, America's top rate of income tax could rise to almost 45%, up from 35% today, with state taxes on top of that.

So why should we undertake such a risk? Rangel recites the rote party line that raising taxes on the wealthiest Americans while cutting taxes on the poorer classes will shrink the margin between the rich and the poor. But is this worth inflicting damage to incentives at the top?

Rangel could have proposed progressive reforms that simultaneously simplify the code. Deductions, worth several hundred billion dollars per year, ultimately narrow the tax base, with benefits flowing disproportionately to the richest taxpayers. Perhaps Rangel could have addressed this issue to subsidize his AMT repeal.

Rangel's plan does have a positive aspect, namely that he plans to cut America's rate of corporate income tax from 35% to 30%. This revenue would allow for the abolishment of several deductions, such as a tax credit for American manufacturers. In this regard, Rangel's plan is a step in the right direction, an attempt to do something that Democrats have long refused to do. But, as the Economist says, "Too bad he couldn't muster the courage to do the same in the rest of the bill."

Sexist Democrats?

As proud as Hillary Clinton is of her accomplishment as Senator and her husband as President, she is shameless enough to play the "sex card," even when her opponents in the poker game are all Democrats. From the NYT:

Some of Mrs. Clinton’s supporters are accusing rival candidates and the questioners of “piling on,” to use the words of the Clinton campaign, at the [last week's] debate, which rattled the Clinton camp. They noted that John Edwards had been especially critical of Mrs. Clinton.

“John Edwards, specifically, as well as the press, would never attack Barack Obama for two hours they way they attacked her,” said Geraldine Ferraro, the 1984 vice presidential candidate who supports Mrs. Clinton. “It’s O.K. in this country to be sexist,” Ms. Ferraro said.

“It’s certainly not O.K. to be racist. I think if Barack Obama had been attacked for two hours — well, I don’t think Barack Obama would have been attacked for two hours.”

Such a grilling could not have been aimed at her because she is the frontrunner, could it?

I suppose it was only a matter of time before Hillary capitulated to an archaic view of her gender: that she is not intellectually equipped to answer important questions. From her own mouth and from the pie-holes of her supporters, the view is constantly espoused that because Hillary has ovaries, different political rules apply.

My own take on why Clinton and her supporters feel the need to constantly establish the fact that she is, in fact, a woman is simple. Clinton felt the need to compensate for a poor debate; her supporters want the other contenders to treat her more gingerly in the upcoming debates so as not to tarnish her spotless pontificating. She is, after all, a member of the physically weaker sex so it follows naturally that her ideological scrutiny be less intense than that of her testosterone-filled competition.

The real question is whether or not Ferraro is living vicariously through Hillary's success. Does she believe that an affront to Mrs. Clinton's views and proposals is a challenge to the legitimacy of her own pathetic campaign 20 years ago? As a fellow woman, it should not surprise us that Ferraro supports Clinton, for, as she said herself, "We can’t let them [?] do this in a presidential race. They say we’re playing the gender card. We are not. We are not. We have got to stand up." Female solidarity is, after all, vastly more important than the issues to which "the first black President's" wife failed to provide strong answers. According to Ferraro, if Barack Obama was the frontrunner, his race would have prevented him from being asked important questions (of course, it's racist to ask questions of someone of a different color!). It's not like he (or Hillary Clinton, for that matter) is aspiring to become the most powerful man (or *woman*) in the world...

Inauspicious News In the World of Banking

A recent New York Times article shed light on the recent problems at Citigroup, a multi-faceted brokerage firm, commercial bank, and investment bank. Subprime mortgages have forced the firm to take an $11 billion write down, following the already dismal October cut of nearly $6 billion. Robert Rubin is now fulfilling the duties of chairman, after the recent resignation of Charles O. Prince III, the company's (now former) chief executive and chairman. This comes on the heels of similar news from Merill Lynch. E. Stanley O'Neal was forced to retire last week, making for two disgraced banking foremen in as many weeks.

It will be interesting to see what ramifications this will have on other big commercial and investment firms. For the whole story, click here.