The Domino Effect

Back in the 1960s, with the rising costs of the Vietnam War and the NASA exploration program (you might remember the first moon walk), a debt crisis in the U.S. led to the breakup of the Bretton Woods Accord.

Bretton Woods was a fixed currency exchange rate system agreed to by about 50 nations at a historic 1944 meeting in Bretton Woods, New Hampshire.

By the 1970s, not only was the Bretton Woods Accord history, but so was the link between the U.S. dollar and gold. You see, way back when, US$35 was backed by one ounce of gold. So we went from a currency system backed by gold to a currency system of fixed exchange rates to a floating rate system.

Fast forward to 2004, and we have another debt crisis looming. An $80-billion war in Iraq, $5 billion for NASA, tax cuts, a $500-billion deficit shortfall for the Federal Government fiscal year ending September 30, 2004, and another projected $500- billion deficit for our next fiscal year.

We’re having what you may call “money troubles.” If a consumer has financial problems (more money going out than what is coming in), the consumer approaches various financial institutions to cover his or her shortfall until the financial condition of the family improves. But there is one caveat… banks only lend consumers money if they meet certain pre- determined debt and income ratios.

The only time banks lend money to customers in trouble is when the customer owes the bank so much money that the bank itself will be trouble if it doesn’t keep its customer floating. You might have heard of the old adage, “Owe the bank a small amount of money and it’s your problem… Owe the bank a lot of money and it’s the bank’s problem.”

And that, my dear reader, brings me to the issue at hand. Our debt is funded by foreigners who, because of their own motives, have no choice but to buy our debt to support our dollar. Only a short 14 years ago, in 1990, foreign exchange flows into U.S. bonds were near zero. Last year, foreign exchange flows into U.S. bonds were about $500 billion. The foreigners are practically financing our government’s annual deficit. Asian central banks alone accounted for the purchase of 60% of the U.S. bonds bought by foreigners last year.

So who is the U.S. government’s bank? It has two banks: Japan and China. My question is, how long can Japan and China continue buying U.S. bonds that do not provide a return on investment? In fact, as our currency continues to decline in value against other world currencies, Japan and China are actually taking a “hit” on the U.S. bonds they buy.

The end result, in my opinion, will be a deteriorating U.S. dollar that will cause a domino economic effect against world economies. The only alternative is to raise domestic interest rates to support our dollar, which would kill the economy, and the Fed will not let that happen too quickly.

Could this customer be going down with its banks in tow? I think yes.