The Downward Spiral

The Downward Spiral

The Daily Reckoning

Paris, France

Wednesday, 12 March 2003

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*** Real reason for the war against Iraq...
A public-sector export industry!

*** $3 trillion in deficits...who will pay?

*** 5.2 dollars per euro? Nikkei at 23-year low...Fed to
cut rates...but gold...and more!

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War...oil...bad weather...

Many are the reasons given for the sluggish performance of
the U.S. economy and its stock market. The upcoming war
against Iraq is usually at the front of the list.

Who wants to make a major investment now? Who wants to put
his money on the line...or make a major business
commitment? "I think I'll wait until after the war is
over..." is the standard postponement.

We have never understood the desire for war. Not that we
don't like war; au contraire, we like war as much as
anyone. What is more gratifying than to see your enemies
get blown up?

That was just the problem; we never understood how Iraq
became the enemy du jour. We thought Osama bin Laden was
public enemy #1...

But, little by little, the fog has lifted, and we're
beginning to see the lay of the land more clearly. Frankly,
we were startled and alarmed when we got our first peek at
it, but after a day or two of reflection, we've become to
appreciate it. If nothing else, the next few years ought to
be very entertaining...

You see, dear reader, an article in Esquire magazine
finally clarified the administration's war aims for us. As
we suspected, Iraq has not been targeted because Saddam is
a monster or because it supports terrorism. And what nation
doesn't have 'weapons of mass destruction'?

"The real reason I support a war like this," explains
Thomas P.M. Barnett of the Naval War College, "is that the
resulting long-term military commitment will finally force
America to deal with the entire Gap [the part of the world
which is not notably pro-Western] as a strategic threat
environment."

There, now you know. And now we turn to economist Stephen
Roach to show why we bring this up:

"Despite the desire to bring American troops home quickly
after a likely victory in Iraq, the risk of a prolonged
presence in the defeated nation seems quite likely. Lasting
American military presence in the Middle East could well be
a lightening rod for further backlash and terrorist
activity - hardly the stuff of resolution either.

"Without a decisive postwar resolution, recovery dynamics
in the global economy are likely to be impaired. The
downside to oil prices could be limited. The uncertainty
factor could persist - leaving businesses reluctant to hire
and consumers unwilling to spend. While the case for war is
being framed publicly on grounds of national security, I
have little doubt that these economic concerns also creep
into political discussions in Washington.

"Yes, there are also logistical considerations," Roach
continues, "Middle East weather and troop morale [for
example] that appear to be affecting the rush to battle.
But there are also more mundane economic considerations:
the longer the delay, the greater the chance of recession -
and an economy that backfires for yet another Bush
Administration."

Roach is wrong...and right. He is wrong about the desire to
bring U.S. troops back from Baghdad. Once in place, they
are expected to remain there - a more or less permanent
outpost of the new American empire. Whether this will be
good or bad, we cannot say. But it will not give Americans
the swift, happy resolution they are looking for. Plus, it
will be expensive. Who will pay for it?

Meanwhile, what else is happening in the markets? Addison?

-------------

Addison Wiggin, covering the financial news as Eric makes
his way to a Supper Club meeting in the Bahamas...

- The "race to the bottom" regained our attention this
morning. We're talking about the Dow and the Nikkei, of
course. The Dow dropped 44 points to end the session at
7,524...but like the tortoise of La Fontaine's famous kid's
tale, the Nikkei has been putting on an impressive 'slow
but steady' show as of late: yesterday, the Japanese index
shed another 179 to close out the day at 7,862 - a new 23-
year low!

- Still, don't count the Dow out entirely. As we keep
saying, you would think that with a sharply falling dollar,
an 85% reduction of foreign direct investment over the past
2 years and repeated threats that the U.S. could 'go it
alone' in Iraq, something's gotta give...a brief shot of
panic could give the Dow the hare-like speed it needs to
end this tale in legendary fashion.

- Alas, we've noticed that the Dow displays remarkable
tortelesque qualities of its own. The race to the bottom
between these two mammoth world market indices may just
turn out to be one long, boring, over-bloated decline...in
which, by the year 2013, we see the Dow slowly settling in
at around 2365 - its own 23-year low. Yawnnn, stretch.

- Indeed, if the U.S. markets and economy do continue to
wend their way into the meandering, soft, slow deflationary
path cut by the Japanese over the past 13 years, we're not
only likely to see a lower stock market, but we'll probably
get another taste of recession in the near future.
Economists have been begrudgingly reducing their growth
forecasts...but maybe not enough: "The odds of a
recessionary relapse are high and rising," writes Stephen
Roach. The Richmond Fed reports that manufacturing activity
is easing off.

- "I can't help but think," Roach continues, "that the
President's economic plan is in serious trouble. If
national unemployment now starts to rise as the economy
falters, the idea of offering tax relief to wealthier
Americans (i.e., cutting dividend taxes) simply won't fly
in the Congress. It will then be back to the drawing boards
on fiscal policy - a bitter pill for the White House to
swallow."

- Bloomberg estimates that state and local tax increases
will come close to $80 to $100 billion - thus neutralizing
Bush's tax cut.

- And don't be surprised if the Fed cuts rates again. The
policies in place still reflect those of their Japanese
role model - reducing interest rates in order to try to
revive the economy. The U.S. is getting lower de facto
rates as well as de jure ones. Long T-bonds just hit a new
high, putting yields at a 45-year low.

- But that seems to be what happens après-bubble in the
modern age. Unlike the days of yore, when speculative
bubbles - like the one Mississippi's John Law had his hand
in - raised people's spirits and bank accounts, then dashed
them again within a matter of months, today's mass-markets
appear to prolong the period of economic expansion...and
likewise, the tortuous, drawn-out decline.

- The S&P 500 shed 6 to 800 yesterday...the Nasdaq dropped
7 to 1,271...spot gold dropped, too - $4.30. Ho hum...

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Still in Paris...

*** Paul Krugman notes, in the New York Times, that
projections by the Congressional Budget Office have swung
by $7.4 trillion over the last two years. Twenty-four
months ago, the CBO estimated that the federal government
would run a $5.6 trillion surplus in the next 10 years.
Now, it says the figure will be $1.8 trillion in the
opposite direction. Krugman says this $1.8 trillion figure
is far too optimistic. Most likely, the deficit will be at
least $3 trillion, he says, and much is the result of
trying to maintain a 'security' force in miserable hell-
holes like Baghdad.

*** Rushing to a conclusion, we guess that the U.S.
government will go broke. It will have obligations that it
will not be able to pay. Foreigners, upon whom it relies
for credit, will cross the street rather than have to meet
Uncle Sam on the sidewalk. Unable to borrow enough cash,
the U.S. government will resort to the Bernanke solution:
it will create money 'out of thin air.'

The trouble is, investors will not appreciate this new
money as much as they did they old. The dollar will crash
(more from 'investment biker' Jimmy Rogers below...). Long
T-bonds - now at record highs - will get dropped. U.S.
stocks will sink - eventually reaching levels similar to
those in Japan after its 13-year bear market.

What a strange and remarkable thing! The U.S. government
graciously and unselfishly attempts to police the whole
world - and the ungrateful foreigners refuse to pay for it.
Thomas Barnett and other macro-geopolitical hallucinators
will find it unfair, and perhaps intolerable. In their
minds, the U.S. is providing a necessary and valuable
service - security.

"It is the right thing to do," says Barnett of the
anticipated war, "and now is the right time to do it, and
we are the only country that can. Freedom cannot blossom in
the Middle East without security, and security is this
country's most influential public-sector export."

The trouble is the one we identified earlier. The Bush
administration may export security - whether the world
wants it or not. But how will it get paid? Perhaps it
thinks foreigners will continue to take U.S. dollars and
dollar-assets no matter how many of them are put into
circulation. But foreigner investors are not permanently
stupid, just episodically so, like U.S. investors.

A modest final prediction, based purely on a hunch:
exporting 'security' to people who don't want it, at a
loss, when you are already hugely in debt to the rest of
the world, will prove neither rewarding nor stabilizing.
Buy gold.

But who knows what will happen in the short run. Maybe the
war will go better than anyone expects (even though
expectations are already very high). And maybe the price of
gold will drop while stocks rise. If so...buy more gold.

*** "It is fascinating to watch the deconstruction of the
dollar," a friend, Mimi, told her husband in her sleep. In
her dream, the dollar fell to $5.2 to the euro. When the
dreams of opera singers are troubled by the currency
markets, it is time to take cover. (For a few suggestions
on how you can "take cover", see this special report
prepared by our friends at Everbank World Currency markets:

2003: Decline Of The Dollar
[www.agora-inc.com])

*** Here's something interesting: a list of all the places
the U.S. has bombed since WWII:

China 1945-46
Korea 1950-53
China 1950-53
Guatemala 1954
Indonesia 1958
Cuba 1959-60
Guatemala 1960
Congo 1964
Peru 1965
Laos 1964-73
Vietnam 1961-73
Cambodia 1969-70
Guatemala 1967-69
Grenada 1983
Libya 1986
El Salvador 1980s
Nicaragua 1980s
Panama 1989
Iraq 1991-99
Sudan 1998
Afghanistan 1998
Yugoslavia 1999

Well, all these episodes turned out well...didn't they?

The Daily Reckoning PRESENTS: Investment Biker Jim Rogers
comments on the challenge faced by nouveau Treasury man
John Snow...and what investors might expect from an
administration no-longer so committed to a "strong dollar".


THE DOWNWARD SPIRAL
by Jim Rogers

In late January, the Senate confirmed John Snow as our new
U.S. Treasury Secretary, the 73rd in the government
agency's two-hundred-plus-year history. Snow, like Paul
O'Neill and Robert Rubin before him, promised to follow a
strong-dollar policy and take steps to help spur on a U.S.
economic recovery and long-term growth.

Well, I know you've just started your new job, Mr. Snow,
but I've got some sobering news for you. You and your pals
can keep talking about this alleged "strong-dollar policy"
until you're blue in the face, but it's not going to make a
lick of difference if you don't start managing our currency
more responsibly. The dollar is not just in decline; it's a
mess. If something isn't done soon, I believe the dollar
could lose its status as the world's reserve currency and
medium of exchange - which would lead to a huge decline in
the standard of living for U.S. citizens like nothing we've
seen in nearly a century.

"Oh, Jim," the disbelievers crow. "You're just being
extreme. That would never happen. After all, the dollar has
reigned supreme for several decades."

True, but it seems to me that people forget that that
supremacy isn't a gimme. A sound currency, after all,
reflects solid economic fundamentals: little to no debt, a
trade surplus, a stable balance of payments - the
difference between a nation's receipts of foreign currency
and its expenditures of foreign currency - and growing
international reserves.

That's not exactly the picture you get when you look at the
U.S. balance sheet. Our national debt to foreigners is now
around $6.4 trillion, with interest payments alone last
year totaling $333 billion. We're importing far more goods
than we are exporting. International reserves remain around
$60 billion, but we're attracting far less direct foreign
investment every year. Our current account deficit runs at
roughly $500 billion a year, or five percent of our gross
domestic product. Think of it this way: it costs us about
$1.3 billion a day in the foreign markets just to keep the
dollar afloat. Our $60 billion of reserves against our
obligations would last 3 minutes if creditors begin cashing
in. We're like the untrustworthy brother-in-law who keeps
borrowing money, promising to pay it back, but can never
seem to get out of debt. Eventually, people cut that guy
off.

As a result, the U.S. dollar continues to fall against its
foreign counterparts, down 18 percent against the euro in
2002 and 10 percent against the yen. That's not the worst
it has been in history, but it's certainly a substantial
slide. With a war, a slow economic recovery and future
threats of terrorism looming on the horizon, there's little
reason to believe things are going to improve.

What's worse, little is being done by Washington's economic
gurus to pull us out of our economic quagmire. Faithful
readers know I believe Alan Greenspan is the grand maestro
of this economic debacle. Our esteemed Federal Reserve
chairman is the first to "buy any assets" or lower interest
rates to pump money into the economy and give investors the
illusion that things aren't as bad as they really are.
Greenspan is ringing the bell signaling to sell dollars.
Sometimes I wonder if our central bank is just going to
print money until we run out of trees. People say that
inflation is a dead issue, but you wouldn't guess that
shopping where most of us buy things or checking reality
over on the commodity pages.

History teaches us that such imprudent monetary and fiscal
behavior has always led to economic disaster. During the
early 1920s, rampant inflation destroyed the value of the
German currency. German workers had to be paid twice a day
just to survive; it took a wheelbarrow full of bills just
to buy a loaf of bread. In England during the 1970s, the
government continued to boost its money supply, injecting
its economy with liquidity, until debt levels spun out of
control. Suddenly, no other countries would buy their
sovereign bonds. Finally, the International Monetary Fund
had to step in and bail the Brits out. Quite a shift for a
country that only 50 years earlier was the single richest
nation in the world. But during that time, they their
Empire and endured currency controls for 40 years.

Want a more current example? Just look south, to Argentina,
where the Argentine currency recently lost so much value
that the government prohibited its citizens from making
withdrawals at the bank. You could also look to several
Asian "tigers" whose currencies collapsed in the 1990s...or
to Malaysia, where in 1997, the government blamed
everything on "evil foreigners" and blocked bank accounts.

So why doesn't our government do something about our
flagging currency? At least, over the short term, the
declining value of the dollar does have its perks. A
declining dollar is certainly good for domestic
manufacturers who must compete with foreign companies. As
the dollar drops, their manufacturing costs decline, and
it's much easier for these companies to compete. The global
economy is already sluggish, and the falling dollar makes
U.S. exporters far more competitive. Again, it's the
illusion that things are better when they really are not.

Remember also: Our manufacturers may be better off, but
foreigners then suffer, so the world as a whole shows no
improvement. That is why similar practices in the 1930s
were known as "beggar thy neighbor".

While this helps U.S. manufacturers, it's not necessarily
good news for consumers. The cost of imports, like foreign
cars and foreign liquor, will rise. Since foreign goods
will become more expensive, U.S. companies may respond by
raising their prices, even slightly, because they can. In
the end, the dollar loses value, but we're still paying the
same real amount for many goods.

The bigger problem for the American economy is that foreign
investors and foreign governments may soon lose their
appetite for the declining U.S. dollar. Interest rates,
which are now absurdly low, will need to rise to give
foreign investors an incentive to invest and hold on to our
currency. If not, these foreign governments and investors
may look for somewhere else to hold their money.
Historically, when investors recognize that a currency is
being debased or devalued, they tend to look for sanctuary
in currencies that remain stable at the insistence of the
population. For years, the Swiss franc was synonymous with
monetary stability.

While currencies like the Swiss franc or the Japanese yen
or the Danish krone - all of which I own - are in better
shape than the U.S. dollar, I don't have a whole lot of
confidence in them either. All of these countries'
governments have adopted the U.S.'s dangerous habit of
manipulating their own currencies to compete in the world
market. It's a double-bind of sorts: Singapore's government
wants to keep its currency strong and sound, but if every
other country's currency is declining against the Singapore
dollar, their exports become prohibitively expensive and it
becomes impossible for them to compete. They are forced to
play monetary monopoly, shuffling the money supply,
adjusting interest rates, just to make their products
competitive.

And what about the euro? It's certainly stronger than the
U.S. dollar, which is down 18 percent against the euro for
2002. I believe the success or failure of the euro is one
of the most important questions of the twenty-first
century, one with profound implications on the global
economy. The world needs the euro, because it needs an
alternative to the dollar. There really are only two
currencies with enough liquidity to be the world's currency
- the U.S. dollar and the Japanese yen. (The Swiss may have
a sound currency, but there just aren't enough francs out
there.) The European Union has everything going for it - an
enormous population base, a balance of trade surplus. Most
of its nations are creditors, not debtors. If the euro
succeeds, people may actually stop using the dollar as a
medium of exchange and as a reserve currency.

That said, I believe that the euro is a flawed currency.
Many of the European Union's 12 member nations just don't
run a tight ship. Germany, which became the poster boy of
fiscal responsibility in the mid-twentieth century, has
again started running up huge debts. (Have they forgotten
about the wheelbarrows?) The Portuguese are running an
enormous deficit. The French recently said they are going
to ignore the treaty establishing the euro. What's going to
happen when these countries can't balance their books? Is
Brussels going to send tanks into Lisbon? I doubt it. It
may take years, even decades to root out all the problems
in the EU's inherently flawed system. Remember: Hundreds of
billions of dollars (yes, dollars, for the moment) have
been invested in this new currency. Banking systems have
changed. Accounting systems have changed. Even parking
meters have changed. If it fails or even struggles, there
may be huge economic losses.

So by default, the issue of the euro is one of the world's
most important issues: [1] If it works, the replacement of
the U.S. dollar as the world's currency will surely impact
us all. [2] If it fails, hundreds of billions will be lost.

In the meantime, I actually own some euros, because the
currency is less flawed than the U.S. dollar.

How long does the dollar have? A year? A decade? I'm not so
sure. As long as there's no other currency stepping up to
the plate, and the EU continues to struggle with the euro,
the U.S. government will likely be able to continue to
jiggle the books, essentially floating our enormous tab on
the backs of the rest of the world. No country in history
which has gotten itself into such a situation has escaped
without at least a semi-crisis eventually.

But remember: whenever there has been an economic crisis
like this, a new player has always emerged on the economic
landscape. A century ago, few people would have believed
that the dollar was going to emerge out of the 19th century
as the dominant world currency. There's always a phoenix
that rises from the ashes. Who will it be for the 21st
century? My guess is the Chinese yuan may eventually have
its day in the sun - certainly if the euro fails. The
nation has a recipe for a sound currency - a huge
population, an enormous balance of payments surplus, and a
sizeable GDP to match. China is now the world's largest
importer and the world's second-largest creditor (Japan is
first). For the moment, its currency is not convertible,
which must change now that it has been admitted to the
World Trade Organization. There are still a lot of cultural
barriers to get over - rampant xenophobia and fear of
capitalist interests - but nothing assuages fears like
steady flows of money into your coffers.

Gresham's law says that bad money tends to drive out good
money. Well, whether we like it or not, whether we want to
believe it or not, the U.S. dollar has become bad money.
Despite proclamations from Washington about a strong dollar
policy, I see no reason to believe that the dollar won't
continue to decline, that we won't continue to borrow like
beggars and put Band-Aids on gaping wounds in our fiscal,
monetary and tax policies. That is, until the day when our
creditors say enough is enough. And that day may not be far
off.


Regards,


Jim Rogers,
for The Daily Reckoning


Editor's note: Erstwhile money-manager for George Soros,
Jim Rogers is perhaps best known for his fantastic
motorcycle journey around the globe and subsequent best-
seller: "Investment Biker". Following his journey by bike,
Jim and partner Paige Parker have retraced the original
route in search of real investment opportunities world-
wide, this time in a swanky yellow Mercedes and mobile
satellite hook-up.