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Faces of Death: The US Dollar in CrisisRon Hera [extract] 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. Current economic data suggests a number of diverging and unsustainable trends. 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 apparent relief in sight. Inflation, of course, is simply an increase in the money supply rather than rising prices, which is one of the effects of inflation. Deflation is simply a reduction in the money supply rather than falling prices, which are one of the effects of deflation. Nonetheless, 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 baking 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. An 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. At the same time, 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 Keynesian interventions by the US government (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. It is primarily debt defaults that create deflation via bank losses and failures while the engine of inflation (the issuance of new debt) has been separated from the broad US economy and is now concentrated in the banking system and in US government debt rather than being distributed over consumers and non financial businesses. This fundamental change may signal the end of US economic expansion characterized by debt levels rising faster than economic output. Since consumers and non financial businesses remain unable to take on new debt, deflationary pressures continue to stress US banks. 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. Evidently, fewer bank failures have taken place than would have occurred otherwise had it not been for the massive interventions of the US government and the Federal Reserve.  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 as long as the US economy continues to contract, thus shoring up reserves with zero interest loans from the Federal Reserve is only a short-term fix. In any case, 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 and there is no indication that the rate of decline is slowing. The M3 data reflect 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. At the same time, consumer credit card interest rates have gone up sharply in advance of the US consumer-protection law slated to go into effect in February 2010 despite a prime rate near zero. 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. Unless banks issue new loans, deleveraging is, in effect, a deflationary force in the broad US economy outside of the banking system. 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, by a combination of bailouts (TARP and PPIP) and FDIC insurance, and by radical interventions by the Federal Reserve and the US Department of The Treasury, such as the TALF program and the suspension of the Financial Accounting Standards Board (FASB) mark-to-market rule. Unfortunately, saving US banks has not prevented the decline of the broad US economy.... ...to read the full article, click here pdf Oct 7, 2009 About Hera Research: Hera Research provides deeply researched analysis to help investors profit from changing economic and market conditions. Hera Research focuses on relationships between macroeconomics, government, banking, and financial markets in order to identify and analyze investment opportunities with extraordinary upside potential. 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