March 10, 2003 – The Dollar Index closed this past Friday at 98.04, a new 3-year low, 19% below its 2001 high. Even more importantly, its downward path is accelerating. In contrast to last summer when this index moved sideways for a few months after a protracted decline, this time it has hardly stopped for a breather.
Because of the importance of the dollar’s outlook, I am again including the accompanying chart. It was last presented in February (Letter No. 319, “The Tipping Point“) just after the break of the long-term trend channel had occurred.
I noted in that letter: “That break from the 10-year uptrend channel is significant” because markets do not reverse course without a good reason. And the precipitous drop since its 2001 high is clearly a reversing of its course. I also suggested that the dollar will eventually be “destroyed” because the growing federal debt and resulting interest expense burden will force the Federal Reserve to pursue an increasingly inflationary monetary policy.
I have some additional perspective that I would like to share with you, which reinforces my conclusion about the dire outlook for the dollar. It is a frightful outlook that is foreshadowed by the accompanying chart.
During the past year, the debt of the US federal government rose from $5,985.2 billion to $6,460.6 billion, an increase of $475.4 billion. That it increased at all is worrying, particularly when hundred billion dollar surpluses had been forecast as recently as a couple of years ago. But as bad as that increase in the debt is, an even more worrying outlook arises from an analysis of how that debt is being ‘financed’. I am using that term loosely because as you will soon see, the debt is not being financed at all – it is being monetized.
To provide some background here, monetization of debt can be a pernicious process. To describe monetization, accounting basics come into play. Here’s what happens.
When the federal government borrows dollars, it does so by committing itself to the obligations of a debt instrument, either a Treasury bill, note or bond. It then offers the debt instrument into the market, and one of two things can happen.
First, someone who already has the dollars buys this debt instrument from the federal government. In this case, the dollars move from the checking account of the buyer to the checking account of the federal government. No new dollars are created. The buyer with the dollars foregoes his use of those dollars in exchange for the interest that he will earn by lending his money to the federal government. There is in this alternative no effect on the money supply, the quantity of dollars in circulation.
The second alternative has a very different result. In this case, the Federal Reserve or a commercial bank buys the debt instrument and simply records on its balance sheet an increase in assets (it now owns federal government debt instrument) and an increase in liabilities (it now owes the dollars added to the federal government’s checking account from the purchase of the debt instrument). In short, the federal government debt instrument has been monetized. It has in effect been turned into dollar currency, and this increase is recorded in the money supply.
Monetization of the debt can have harmful results. If the quantity of dollars is expanded by monetization beyond the demand for dollars, the dollar is debased. It loses purchasing power, which is the conclusion of the above chart. The dollar is being devalued against the world’s other major currencies because federal government debt is being monetized. Too many dollars are being created. Here are the numbers to prove it.
As noted, the federal government’s debt increased $475.4 billion over the past twelve months. Of this amount, the Federal Reserve purchased $68.4 billion of debt instruments, and $218.1 billion was purchased by commercial banks. So together, these financial agents who create dollars monetized $286.5 billion, or 60% of the increase in the federal debt. In other words, 60% of this debt was used to create new dollars ‘out of thin air’.
There was no work undertaken to create these new dollars. They did not arise from one’s labor. There was as a result no new wealth created.
These dollars were not loaned by someone who had saved them. So existing wealth wasn’t being transferred.
These dollars were created ‘out of thin air’, transferred to the federal government, and then spent. In time the economy responds to this flood of new dollars, and prices of goods and services rise as a result because there are more dollars in circulation than there is demand for dollars. The purchasing power of the dollar is inflated away, which again is the message of the accompanying chart. But there is one very important detail that should not be overlooked.
The chart shows that the downward spiral of the dollar is accelerating. I’ve already discussed in these letters that I expect the dollar will collapse and be destroyed in 2004. Last week’s renewed downtrend in the dollar suggests that we are still on target for that fateful event.
The next stop in the Dollar Index is likely to be around 92, or 6.1% below its current level. I expect that the dollar will drop quickly to that area, probably in April.