Dollar Bubble Dot Com
There are striking similarities between the dotcom bubble and what is fuelling the US economy today — the purchase of US dollars by central banks, especially those of China and Japan. What is still holding up the dollar is the yuan peg and, once it is dismantled, there may be a precipitous drop.
Mainstream financial companies have rarely made timely predictions of the bubbles that have happened around us. Prominent examples would include the Nasdaq bubble and the currently unwinding US housing bubble. Though the former Fed chief, Mr Alan Greenspan, did talk about "Irrational Exuberance" in 1996, by 1998 he was singing paeans about the IT-induced productivity gains and the New Economy.
Regarding the current housing bubble, though the Fed Chairman, Dr Ben Bernanke, did acknowledge extreme pricing, he also suggested that the markets would stabilise soon. This is ignoring the fact that when markets correct after a bubble, they tend to drop anywhere between 50 and 90 per cent. The Nasdaq corrected more than 80 per cent from its peak level and today, five years after the bubble burst, it is still down 50 per cent from its peak, even in nominal terms.
However, the literal mother of both the bubbles mentioned above was "The Dollar Bubble". It was the dollar excesses that manifested themselves in the form of a Nasdaq and a housing bubble. A basic understanding of the nature of currencies is essential to understand why these bubbles form.
Currencies are IOUs issued by the central bank of a country, and are claims on an asset of that country. Hence, when there is too large a set of outstanding IOUs to what can be meaningfully purchased, then a bubble is formed. Some previous currency bubbles include the ones in the Weimar Republic (1920s), the Russian Ruble (late 1990s) and the current Zimbabwe dollar.
The Dollar Bubble
There are remarkable similarities between what happened during the dotcom days in a particular sector and what is happening to the entire US economy today. Before listing the parallels, it is important to understand the common denominator that fuelled the dotcom bubble and what is fuelling the US economy today.
In the former case, it was the purchase of the securities of dotcom companies by investors and, in the latter, it is the purchase of US dollars by the central banks, particularly the Asian central banks (ACB) of China and Japan.
While it might seem a huge leap to compare securities with currencies, the similarities are far greater than the differences in this context. Both are claims on the assets and future earnings. When companies dilute equity or when central banks debase their currencies (by printing money) without a corresponding increase in assets, the claims outstanding on each of these units tend to fall.
The main difference is in the effect of overvaluations. In securities, the value of a security can go to zero. However, in currencies, the absolute value itself does not change; what declines is the purchasing power. The difference is, however, more symbolic than real — that is, priced in terms of a real currency such as gold, the observed decline in values would be very similar for currencies.
So why is the dollar a bubble? It is because of a $1-trillion trade deficit, a $400-billion budget deficit, a negative savings rate, a national debt of $8.5 trillion and unfunded liabilities of $65 trillion.
The only way the US Government can even remotely meet these obligations is by indulging in large-scale inflation that would debase its currency while allowing it to meet the obligations in nominal terms. Besides, the manufacturing infrastructure has been completely wound down and replaced with non-exportable services (such as burger-flippers and wedding planners). So, for the US to become a more equal trading partner on the world stage would require a painful period of savings, under-consumption and rebuilding lost infrastructure.
The Yuan Peg
The decline of the dollar purchasing power, as indicated by the US Dollar Index, started around 2002 and, although it had a brief upswing coinciding with the housing bubble, the long-term trend is set to continue in the years ahead.
Most major currencies — the euro, British pound, Australian dollar and the New Zealand dollar — are quoting at multi-decade highs against the dollar. What is still holding up the dollar is the yuan peg and, once it is dismantled, there may be a precipitous drop. The time-line for such an event may be five years, at best, but it could very well be next year.
A few years from now, when we sit back and look at the events that unfolded, the ACBs would be stunned as to how gullible their behaviour was in holding on to the paper dollars.
As Peter Schiff of Europacific Capital explains: "America is playing the part of one of its icons, the lovable beguiler Tom Sawyer, who is able to convince others to whitewash his fence for him, and even con them into paying for the privilege. By convincing Asians that work is a means in itself, that fulfilment is derived from the toil of the harvest (even as others enjoy its bounty), Americans have managed to outdo old Tom."
