The Economic World War

With the growing din of rumors of many countries planning to end the use of the dollar as the world's trade currency, what are the implications?

If this were to happen, expect trillions of dollars to return to America. While U.S. exporters will benefit from the weakened dollar, inflation will increase by a huge amount.

But the curious aspect in this is China's involvement. According to the US-China Business Council, China exported $252 billion in goods to the U.S. in 2008. Overall, China exported $1.4 trillion to all countries. By letting the U.S. dollar fail, China would be risking up to 18% of it's export economy. While it would be unrealistic to expect U.S. imports from China to drop to zero, it would undoubtedly cause a drop in China's export business here.

Here is where it gets interesting. If China maintains their currency peg to the dollar, they could make their goods even cheaper on the world market, and still maintain their export trade with the U.S. But then China would be in the driver's seat economically, allowing them to de-peg their currency from the dollar slowly, allowing them to grow their economy away from a reliance on the U.S. export business. Chinese goods will grow in cost at a rate close to our own inflation rate.

In case you have not already guessed it, the U.S. economy will be a huge mess. While our export businesses will thrive, import businesses will dry up. The price of gas will shoot up, hurting our economy in multiple ways, with the most obvious being the increased cost of goods and services.

Let us not forget, the Federal Reserve will have it's hands tied by our heavy government debt burden. If they increase rates, they will also increase the government's cost of financing our debt, thereby digging our debt hole deeper. If they don't increase rates, inflation will soar.

Technically speaking, the U.S. will be in the middle of a perfect economic storm: heavy government debt with reduced tax revenue, soaring inflation, and weakened domestic businesses leaving unemployment high (and possibly growing). If the Democrats manage to pass universal health care, they will be forced into heavy rationing of it long before they had hoped. With Social Security and Medicare debts coming due as more Baby Boomers retire (or are forced into retirement by unemployment), our government debt burden will increase even more.

In summary, we are screwed if the dollar is removed as the world's trade currency.

Economic Forecast

The following predictions are based on a lack of significant world events, such as a major terrorist bombing in the U.S. or an Iranian war. Any events like those immediately changes the scenario to significantly worse than what I am predicting.

The stock market will continue rising through at least October. After that, it will run into a brick wall, as high unemployment will keep demand for consumer goods down, thereby keeping a lid on earnings. Large businesses can only add in so much efficiency before they need sales to improve. Without increasing sales, they will be faced with flat earnings, and the markets will begin to flounder.

In addition, real estate prices will either stay the same or begin to drop this Fall, as the main real estate season has ended. This will add more pressure to the equities markets. Next year will see another round of home foreclosures/defaults, as many adjustable mortgages come up for re-pricing. If the Federal Reserve raises rates at the beginning of 2010, this could impact the mortgage rates, increasing foreclosures and defaults significantly.

Speaking of the Federal Reserve, they are the wild card in the economic deck. If they decide to keep rates too low for all or most of 2010, we could see a short economic recovery accompanied by a huge burst of inflation, which in turn would push us back into recession. On the other hand, if they raise rates too far too fast, it could kill the housing market. This is just speculation on my part, but I would expect the Fed to dip their toe in the pool with a small rate increase in January, just to see what happens. They will follow this with low to medium-size rate increases through June. Then we will see the economic havoc commence.

Specifically, we will see the rise of stagflation. As commodities begin to react to the excessive money supply, their prices will rise significantly. This in turn will bring economic growth to a screeching halt. The Federal Reserve will predictably reduce their rates once more, which will only exacerbate the problem with commodity prices, which in turn will keep the economy in a slump. Ironically, if the Fed would take the opposite approach, they would probably succeed in righting the economic ship eventually, although somewhat painfully at first.

Another aspect which will be ignored will be the tight credit conditions in the banking industry. Mind you, I consider this a good thing. However, when the government increased bank reserve requirements, they created the tight credit we have. Even a light loosening of the credit would allow for some economic growth, however artificial it might be. Without it, expect any economic growth to be small, if there is any at all.

Because of this, the stock market will drop, possibly even crash, in 2010.

Politically, I expect Obama's health care plans to continue to meet stiff opposition in Congress (especially the Senate), as "blue dog" Democrats are confronted with angry constituents who oppose the public option which more liberal Democrats insist upon. However, their opposition won't save them as the economy comes crashing down. The good news is the Democrats will lose control of the House in 2010. The bad news is the Republicans have no better ideas, but at least will stymie Obama's grandiosely stupid plans. On the bright side, with deadlocked and ineffective government, the economy MIGHT be able to gain some traction by 2012, although I doubt it only because the Federal Reserve will continue to feed the stagflation. Expect Obama to be a one-term president, with a massive sweep out of incumbant politicians in 2012.

For the next 4 years, and possibly longer, your best investment bets will be commodities, such as oil and precious metals, and foreign stocks, ETF's, and mutual funds. I personally recommend China, as they seem to be preparing best for what is about to happen, by purchasing precious metals to shore up their currency, as well as turning the direction of their commerce inwards to their domestic economy.

The Obama Disconnect

According to CNN:

"...at the end of his first quarterly meeting with the Economic Recovery Advisory Board, which was created in February to provide the administration with independent, nonpartisan advice on how to promote economic growth and stability.

...Obama told the board members he's seen "some return to normalcy" in parts of the financial markets."

I would love to hear which part of the financial markets is being referred to by our Dear Leader. According to the Federal Reserve (in a different article from CNN):

"The Federal Reserve's latest forecasts for the U.S. economy are gloomier than the ones released three months earlier, with an expectation for higher unemployment and a steeper drop in economic activity.

The Fed's forecasts, released as part of the minutes from its April meeting, show that its staff now expects the unemployment rate to rise to between 9.2% and 9.6% this year. The central bank had forecast in January that the jobless rate would be in a range of 8.5% to 8.8%, but the unemployment rate topped that in April, hitting 8.9%.

The Fed also now expects the gross domestic product, the broadest measure of the nation's economic activity, to post a drop of between 1.3% and 2% this year. It had previously expected only a 0.5% to 1.3% decline."

Or how about this report (also from CNN):

"Welcome to the summer of the furlough. Manufacturing workers have long suffered from these "temporary layoffs," but the white-collar world is feeling them now, too: During this recession, everyone from universities to technology companies are using furloughs as a way to cut payroll without further trimming their staffs.

And while furloughs are already underway around the nation, human resources specialists say that required unpaid days off are only going to heat up as we head into the summer months, when employees are more amenable to time off -- albeit unpaid.

"Companies have done the huge surgery in terms of offering reductions in forced and involuntary ways," says Fred Crandall with consulting firm Watson Wyatt."

Of course, if Bush had said something as incredibly moronic as what Obama said, the Media would have lambasted Bush. But since it comes from the Obamessiah, not a peep is heard.

For all the protectionists out there...

...here are some must-read links.

We will start with a link to a Center for Trade Policy Studies article by Daniel Griswold, titled ""Bad News" on the Trade Deficit Often Means Good News on the Economy". This article shows:

"...by all three measures of economic performance–GDP, manufacturing output, and the unemployment rate–the U.S. economy performs better in years when the current account deficit [the trade deficit] is rising as a share of GDP than in years when it is shrinking. And it performs especially well in years when the current account deficit is rising most rapidly."

(For a view of this information, see John Stossel's editorial "Losing Sleep Over the Trade Deficit?")

Want more? Here is economist Walter Williams, from his editorial "Trade Deficits: Good or Bad?":

"Professor Don Boudreaux, chairman of George Mason University's Economics Department, wrote "If Trade Surpluses Are So Great, the 1930s Should Have Been a Booming Decade" (www.cafehayek.com). According to data he found at the National Bureau of Economic Research's "Macrohistory Database", it turns out that the U.S. ran a trade surplus in nine of the 10 years of the Great Depression, with 1936 being the lone exception.

During those 10 years, we had a significant trade surplus, with exports totaling $26.05 billion and imports totaling only $21.13 billion. So what do trade surpluses during a depression and trade deficits during an economic boom prove, considering we've had trade deficits for most of our history? Professor Boudreaux says they prove absolutely nothing. Economies are far too complex to draw simplistic causal connections between trade deficits and surpluses and economic welfare and growth."

Still think we need to shrink our trade deficit?

In a survey by Robert Whaples of members of the American Economic Association, 87.5% of the PhD respondents agreed "The U.S. should eliminate remaining tariffs and other barriers to trade."

Still need more?

Ok, here are some classic editorials by Walter Williams, titled "Foreign Trade Angst", and "Our Trade Deficit".

Finally, a perspective on the trade deficit from David Gardner, co-founder of "The Motley Fool" investment website. In "Our Friend, the Trade Deficit", Gardner gives "three basic truths" you need to know before having an opinion on the trade deficit. They are:

1. International trade balance accounting does not count services rendered...

2. In international trade accounting, foreign investment in a country is counted as a "debt."...

3. Finally, trade deficits generally demonstrate a healthy openness to, and appreciation of, the culture and assets of other nations... and demonstrate as well as a trade policy that favors the consumer.

Read the whole article.

Still not convinced? Then keep running around screaming "The sky is falling!", because I won't help you.