The 7 stages of a dollar crisis

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Tue, 28 Feb 2006 00:24:53 EST

The 7 stages of a dollar crisis

 

 

 

 

http://moneycentral.msn.com/content/P72747.asp

 

 

The 7 stages of a dollar crisis

 

 

'Experts' simplistically tout a weak dollar as good news. No wonder

many regular folks are unaware that its dramatic decline could spell

real trouble.

 

By Bill Fleckenstein

 

Along the way to a full-blown crisis, the steps leading up to it may

either pass unnoticed or prompt insufficient concern. That is the

story of the dollar. Its decline continues to strike many folks as

good news. It is only a matter of time before that perception changes.

The inevitable crisis will inflict damage, but those who see where we

are headed can protect themselves beforehand. To this end, I'll

explain where I believe we are in that process.

 

G7's 'lingo limbo:' How low can the dollar go?

Recently, the Group of Seven finance ministers met in Boca Raton,

Fla., to hammer out a much-parsed currencies communiqué. Why folks

take this exercise in semantics seriously beats me. The fact is, even

the seven ministers, who are capable of speaking five languages, can't

tell you what the heck they mean. Of course, one reason they can't

tell you is that their differing agendas make it hard to pretend like

they're all on the same page.

 

That said, the foreign ministers probably agree on one point: The

dollar is becoming a problem, which is why the gist of their

communiqué stated that too much volatility (read: dollar weakness) is

not a good thing.

 

 

What we are witnessing is the unfolding of a dollar crisis. Though its

external value seems to be a nebulous concept for many folks, as the

dollar's ongoing decline builds to a crisis, it will have a

significant impact on the workings of financial markets -- and affect

everyone's financial well-being. (For review, please see my past

columns: " The dollar's dramatic decline comes out of your wallet " ;

" The dollar: linchpin to stocks and the economy " ; " Face up to the

falling dollar " ; " Fantasy, the Fed and the falling dollar: Oh my! " ;

and " The dollar is on borrowed time. " )

 

7 small steps to crisis

Here, then, is my outline of a 7-step process of creating a full-blown

crisis.

 

* Step 1.

Nobody notices or pays attention that the dollar is falling.

* Step 2.

Folks wake up, but they either don't care or rationalize dollar

weakness as a good thing.

* Step 3.

The central banks now know they have a problem, but the bankers

think the market will obey them. It will, for a while. (This is the

step we have now reached and what emerged at the G7 meeting.)

* Step 4.

The dollar now tests everyone's resolve by resuming its decline.

The currency markets will not respond to jawboning by finance ministers.

* Step 5.

In this step, the finance ministers are forced to take action.

(Think about it. Even if they'd stated that they wanted the dollar to

go up, nothing either explicit or implied indicates they'll do

anything about what's happening. That will come next.) When they do

take action, the market will do what they want -- but only for a while.

* Step 6.

The ministers take some additional action, but it won't be

enough, and the currency markets won't do what the ministers want.

* Step 7.

Finally, we'll have a full-blown crisis, and that will be the

end game.

 

 

Pssst, Economist: It's Al (Greenspan), not Asia

To buttress my claim that we are segueing from the initial stages

where no one cares to the next and dicier stages, I'd like to share a

few quotes from " Let the dollar drop, " the lead editorial in last

week's issue of The Economist. Though the writer first takes a

why-worry attitude toward the decline, he seems to recognize that all

this central-bank dithering can lead to real trouble. So, confusion of

conclusions notwithstanding, it's worthwhile spending a minute on the

article.

 

Starting with the why-worry theme, the writer argues the nonsensical

case that the dollar has, in fact, been too strong. (If that isn't an

example of drinking 'em pretty, I don't know what is.) A weaker

dollar, he says, " will help to reduce America's vast current-account

deficit. "

 

Well, I've got news for him. The dollar's slide of nearly 30% from the

peak of its valuation two years ago to where it is now hasn't done a

whole heck of a lot to reduce the imbalances. A further slide may help

some, but it's not going to do a lot, either. So much of our

manufacturing has been wiped out as we ship jobs to Asia that we're

exporting less and less of what the world wants. Thus, it's kind of

hard to fix all these problems simply by having the dollar collapse.

 

Continuing on, the writer points out Asia as the problem, while

missing the real issue -- incompetence and recklessness on the part of

the Fed: " In the short term, " he says, " Asia might thus be seen as

America's savior. But in the longer term, Asian governments are

delaying a necessary adjustment by allowing America's deficit to loom

large for longer. This is likely to lead to an even bigger and more

dangerous build-up of American foreign debt. "

 

That's all true, but this is exactly the same problem that has been

precipitated by the Fed, in terms of trying to reflate the prior

bubble -- and the horrendous outcome will be the same when this

attempt at bubble-building in the housing and stock markets again unwinds.

 

Vendor-financing a spending binge

He then explains why Asia has done as it's done, by saying that it's

" buying American Treasury bonds in order to ensure that Americans can

afford to keep spending money on Asian goods. " That is, the Asians are

vendor-financing our spending binge. And he then states the obvious:

" This cannot go on forever, " and " sooner or later, Asia's central

banks will have to face the fact that they are holding far too many

risky, low-yielding dollars. . . . Delaying the natural adjustment in

the dollar and bond yields is likely to mean that when the inevitable

correction comes, it will be much more painful. " (The emphasis is

mine.) Again, this is the same point that I just raised about the

ultimate adjustments we still have not made from our prior stock mania.

 

Next, the writer opines that, when the blame gets levied, Asia will be

faulted for tinkering with its currencies, but further adds: " America

must bear much of the blame for its failure to do anything to curb

household and government borrowing, and so boost saving. Its easy

monetary and fiscal policies are now beginning to look reckless. "

 

Well, all I can say is, now beginning? It's been that way for a very

long time.

 

In 'Dollar Crisis, Act II,' Bofinger follows the 'script'

To return to steps 3 and 4 of the process, I note that Peter Bofinger,

a newly appointed member of the German panel of economic advisers,

last Tuesday told Bloomberg News that what the G7 had done showed

" indecision " about currencies. The ECB should have " acted more boldly "

with respect to the euro. He therefore thinks that the dollar will

continue to fall against the euro. If the dollar fell below .769,

European exporters would experience difficulties. It was at .781 euros

last week, or about $1.28 per euro. The problem would arise if the

euro rose above $1.30.

 

Meanwhile, as you can see, this particular fellow is talking about

that stage of the evolution of the crisis where central bankers must,

in fact, do something. He is criticizing the G7 for not having stated

that they would do something. But, of course, as I just pointed out,

arrogant central bankers first think it will be good enough simply to

tell the market what to do. Only after that doesn't work will they

decide to take some action. The interesting thing will be to see how

long that takes to happen.

 

The moral of the story is this: Ultimately, the adjustment to our

bubbles is going to come. It's going to be very painful. And the

pressure will in all likelihood be precipitated by the foreign

exchange market, though other factors could certainly do it. To repeat

my thoughts from the beginning of this discussion, we're in the middle

stages of the process, and from here, the ride will only get hairier.

Folks who understand the ongoing process of this decline will be in

the best position to protect themselves from the ramifications as they

unfold.

 

Bill Fleckenstein is president of Fleckenstein Capital, which manages

a hedge fund based in Seattle. He also writes a daily Market Rap

column on his Fleckensteincapital.com site. His investment positions

can change at any time. Under no circumstances does the information in

this column represent a recommendation to buy, sell or hold any

security. The views and opinions expressed in Bill Fleckenstein's

columns are his own and not necessarily those of CNBC on MSN Money.