WHITE ELEPHANT

White Elephants
The Daily Reckoning
London, England
Wednesday, September 29, 2004

The irresistible force of excess spending is about to run smack dab into the immoveable object of massive debt. Yesterday, the two closed in on each other. The price of oil rose over $50 a barrel for the first time ever.

Of course, adjusted for inflation, oil is still cheaper than it was at the time of the last oil crisis, 30 years ago. But since then, a lot has changed. Since 1980, the world has pumped out more oil than it has discovered. Last year alone, a billion more barrels were used up than the year before.

But that's not all. Thirty years ago, Americans were in a better position, as more of their oil came from domestic wells. And they had more money to pay for it. Now, with oil less plentiful and more sought after, we can't help wonder: How will Americans be able to afford it? They must rely on the kindness of strangers…

"The United States - long the main engine of global growth and finance - has squandered its domestic saving and is now drawing freely on the rest of the world's saving pool," explains Roach. "East Asian central banks - especially those in Japan and China - have become America's financiers of last resort. But in doing so, they are subjecting their own economies to mounting strains and increasingly serious risk. Breaking points are always tough to pinpoint with any precision. Most serious students of international finance know that these trends are unsustainable…

"[O]verly extended U.S. consumers have wiped out any vestiges of saving - taking the personal saving rate down to a rock-bottom 0.6% in July 2004. In short, America is no longer using surplus foreign saving to support 'good' growth. Instead, it is currently absorbing about 80% of the world's surplus saving in order to finance open-ended government budget deficits and the excess spending of American consumers.

"It wasn't all that long ago that the United States was the world's largest creditor. In 1980, America's net international investment position - the broadest measure of the accumulated claims that the United States has on the rest of the world less those that the rest of the world has on the United States - stood at a surplus of $360 billion. By the end of 2003, that surplus had morphed into a deficit of negative $2.4 trillion, or 24% of U.S. GDP.

"This transformation from the world's largest creditor to the world's largest debtor is, of course, a direct outgrowth of year after year of ever-widening current account deficits. Moreover, reflecting the particularly sharp widening of America's current account deficit in the past year - an external shortfall of 5.7% at mid-2004 that is already running 1.2 percentage points above the 4.5% gap prevailing at year-end 2003 - America's net international indebtedness could easily hit 28% of GDP by the end of this year…As scaled by exports - a good way to measure the ability of any economy to service its external debt - Roubini and Setser point out that U.S. international indebtedness could be closing in on 300% of exports by the end of 2004. By way of comparison, pre-crisis debt-to-export ratios hit about 400% in Argentina and Brazil. Of course, America is far from a 'banana republic' - or is it?"

Roach points out that countries, like individuals, eventually run out of time, out of money and out of luck. When a banana republic slips up…it may be a terrifying event for those in the country, but for us, it is primarily comic. We laugh at triple-digit inflation rates and wonder how the big banks could have been so stupid as to lend them money in the first place.

But when China and Japan stop enabling America's credit habit, many people will fail to see the humor in it. Asset prices will fall, real rates will rise and all of a sudden, people will be poorer than they thought they were…but, of course, no poorer than they ought to be.

"It is not necessary for the market to decline sharply at this time," writes Arch Crawford, gazing at the stars. "The market will do what it pleases. We feel strongly that it will drop steeply before March 23, 2005."

- Bonds have had quite a run lately. Ten-year yields have moved from 4.9% to 4% in little over four months.

- The move is nothing spectacular. For reference, in summer 2003, yields moved from 3.07% to 4.67% in just six weeks. The real story is long bonds are rallying in the early stages of a Fed rate-hiking campaign. This has never happened before. It may also explain why most of the big players in the bond market got so badly burned by the turnaround.

- Of course, it's never a good idea to cast short positions into a unanimously bearish market, as they did. Markets like this have a tendency to snap back. A sudden new trend emerges and the press jumps all over it. The trend becomes self-reinforcing - as economic news confirms the move - sentiment changes and before you know it, everyone is on the bandwagon…in the opposite direction.

- But not your team at The Daily Reckoning. We despise traveling on the bandwagon. And we'd rather lose money than run with the crowd. But when it comes to bonds these days, it's hard to tell if you're riding the wagon or being dragged behind it by the ankles.

- Whatever the long-term direction of yields, we suspect that sentiment has now turned quite bullish in the bond market.

- Of course, we could back up our opinion with dense research on the commitments of noncommercial bond traders or historical yield spread analysis, as we normally do. But today, we have more powerful evidence: A friend of Alan Abelson says so!

- The pal in question has recently turned bearish and dumped his entire bond position. "Prodding failed to yield any overriding factor that determines his negativism, although he is an ornery contrarian," explains Abelson. "We suspect that he has been at it for so long and done so well that trading bonds has become largely an instinctive exercise."

- "But the point in any case is that he's sometimes early and sometimes a tad late, but very rarely wrong. And as we say, after calling the bottom in bonds almost to a basis point, he has turned unequivocally bearish. Caveat emptor."

- Right on cue, we read this morning that the estimate for second-quarter growth was revised higher - by 0.5% - to 3.3%, and bonds are selling off. The yield on the 10-year note is 6 basis points higher…at 4.07%. Yesterday, yields gained modestly, too, rising 1 basis point.

- But the big story continues to be oil. That's because a good cup of freshly brewed Texas tea cost over $50 a barrel - for the first time ever. Oil first threatened the $50 mark on Aug. 20, unsuccessfully. In the weeks that followed, it backed down below $41. But then came four hurricanes and a rebellion in Nigeria…and suddenly oil is making new records again. In yesterday's trade, crude peaked at $50.47, before settling back down to $49.90. In early Wednesday trading, crude continued to slip, meandering down to $49.68.

- Somehow stocks spurned oil's advances…and rose! The Dow Jones Industrial Average cruised to an 89-point gain, just less than 1%. In early trade on Wednesday, the Dow had given back 14 points and was trading at 10,063. Tech investors were equally oblivious…and pushed the Nasdaq 10 points higher in yesterday's trade. And this morning, the rally continues. The last time we looked, the Nasdaq was trading at 1,886, up another 16 points.

- Of all the reasons put forward by newshounds and economists for the rally in bonds - and there are many - we only find two that make sense…there is more demand for bonds than supply. And secondly, as Alan Abelson put it, markets of all stripes love to indulge in sheer perversity. Market perversion comes as standard, but lending money to the U.S. government at less than 4%?

- That's the real perversion…[Ed. Note: Should the government be faced with a Fannie Mae salvage operation, bonds could tank in the rush for capital. Dan Denning's theory of the great mortgage market collapse is becoming reality. Read what he said…

*** A number of studies have been done on the impact of the stock market on presidential elections. Not surprisingly, they show that when prices are rising on Wall Street, the occupant of the White House is very likely to win another term.

*** House prices have been rising three times faster than incomes over the last four years. They can't do that forever. People have to be able to afford to live in houses. In many areas, the median house is already far too expensive for the median householder. England has seen a similar run-up in house prices - especially around London. A typical one-bedroom apartment near the center of the city, for example, costs about $500,000-$800,000. How many Londoners can afford to buy them, we wondered. But recently, prices have been falling. The papers are full of alarums…one reports that prices have dropped as much as 20% over the summer!

*** "You are getting to be such Euro-snobs," said an American friend over dinner.

Must have been something we said. Or something we drank. Everyone likes to feel superior. The beer drinker imagines that he is more authentic and relaxed than the fops and snobs who drink wine. The champagne drinker fancies himself as smooth as David Niven or Cary Grant. And then, people move up the "snob scale" by trying to outdo each other with their knowledge of wine or fashion or art…or whatever…even language.

"If a man says 'often' and pronounces the 't'," explained our friend, "he is snobbing out the poor oafs who say 'offen' as if they didn't know how it was spelled. But then, people who really know anything about language know that you're not supposed to pronounce the 't'…so they can snob out others by saying 'offen' just like the oafs who don't know any better. But if you really want to snob them all out, you say 'often,' with a 't'…It's a way of declaring that you're not bound by silly old rules laid down by a bunch of language snobs a hundred years ago.

"Besides, the rules are mostly wrong - I mean, from a snob's point of view. English is a Germanic language. But the language snobs were trained in Latin and French…because the Normans beat the English 1,000 years ago…so the Latinized version of the language was always the version used by the upper classes, and when they went to write down rules for the language, they applied the Latin rules, the wrong set of rules. But the real snob knows that the more authentic language is German. So when someone asks him, 'Who's there?' he replies, 'It's me.' I don't know if that's really more German or not…but it does make me feel superior."

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The Daily Reckoning PRESENTS : The story of two white elephants, a bucket of white plaster and a fake currency. Read on…

Poor P.T. Barnum. He had gone through all the trouble and expense of getting a real white elephant to the States, only to be upstaged by a phony competitor.

By 1884, just about every large American circus had at least one elephant. Its novelty had worn off, so promoters such as P.T. Barnum had to find something new with which to entertain their customers.

Barnum found what he was looking for in a rare white Burmese elephant. He purchased one, named Toung Taloung, from King Thibaw. Barnum put it on display in London for about a month before its American debut at Madison Square Garden.

Circus organizers, though, are a crafty lot. One of P.T. Barnum's main rivals those days was Adam Forepaugh, proprietor of the Adam Forepaugh Shows, billed as, "The oldest, largest and best circus and menagerie in America."

Not to be outdone, Forepaugh, hearing about Toung Taloung's successful debut in London and stewing over his rival's popular find, decided to trot out his own white elephant in a Philadelphia show - six days before Toung Taloung arrived in America. Forepaugh's elephant was dubbed "The Light of Asia."

How did Forepaugh do it? Easy. He faked it. His animal trainers and handlers scrubbed an ordinary gray elephant with white plaster and used peach-colored tint around the animal's ears, trunk and feet.

The war of words began, of course, with Barnum angrily protesting Forepaugh's "swindling, cheating, false and fraudulent elephant, which he is now knowingly, willfully and criminally imposing upon the community."

The most galling part of it all was that the public vastly preferred Forepaugh's fake - at least for a time.

Today's American dollar is a lot like Forepaugh's white elephant. It is, quite simply, a fake.

For most of the dollar's history, it was defined in terms that people from all nations and from all places understood. It was defined in terms of how much gold you could turn it in for, like redeeming chips for money at a casino. This amount was fixed. For a time, a dollar was 1/35 of an ounce of gold. If you had $35, you could exchange it for an ounce of gold.

That is what a dollar was, and gold was an essential part of it. You could no more separate dollars and gold than you could separate 12 inches from a foot.

But they were separated. It was a long fight - a long, tortured road through all sorts of political swindling and monetary mix-ups. From the classical gold standard (that survived from the time of Waterloo through the beginning of World War I) to the Bretton Woods Agreement, the trend was always to try to free money from the shackles of gold.

A gold-backed dollar was like a shackle because it helped prevent politicians from printing more dollars than they had gold to back it. That was one of the main virtues of the gold standard (though even during gold's heyday, governments and banks would occasionally slip through its chains).

Politicians, understandably, didn't like this kind of restriction. After all, there were wars to be fought, elections to be won. Isn't that always the way? We always want things that we cannot presently afford. The difference is that we can't just go in our basement and turn on a printing press and spend the money the next day. The government can do that, which is why we have huge fiscal deficits. This is an oversimplification, of course, but no so far off. The government also borrows more than anyone else because its power of taxation gives it a power akin to pledging the assets of its people to back the debt.

Quite often in history, this process gets way out of hand, and then you have hyperinflations - like in Germany during the '20s or in Argentina more recently - in which prices are rising astronomically and no one wants to hold paper money anymore. You have debt crises whereby sovereign states default on their debts, like Russia in 1998. Even America's earlier history is stained with the mark of defaulting on its debts.

Today, we have a dollar that is only worth what people believe it might be worth. It is a system based on faith. If large groups of people decided they didn't want dollars, or as many dollars as they had before, that would be a problem, wouldn't it? Suddenly, the dollar would buy a lot less than it did when everyone was faithfully swapping dollars.

But the strange thing was that people seemed to like the new dollar. Despite all the lessons of history, all the books on John Law (the so-called father of paper money) and his bubble, the reams of economic treatises on the dangers of paper money - even the American founders warned against it - the dollar still became the international currency of choice.

The dollar, for many years, towered over its currency brethren, like a giant oak standing in a grove of saplings. All the world's currencies - pounds, marks, yen, lira, punts, guilders and all the rest - roamed in the shadow of the mighty dollar. Whatever functions these currencies provided, they could be provided as well, if not better, by American dollars.

Gold languished. Gold, which had provided able service as a medium of exchange for mankind over hundreds of years, was dismissed as a "barbarous relic." Poor gold. If it had a voice, it would be writing Op-Eds to The Wall Street Journal bemoaning its fate and calling upon the public, as Barnum did, to stop this fraud.

From a low of about $250 per ounce in the third quarter of 1999, gold has woken from its slumber and has once again become a commodity worth following. It peaked earlier in the year at over $420 and has settled down around the $400 range as I write.

Gold has risen and the dollar has weakened. The dollar today buys considerably less on the world markets than it did even two years ago. Today it costs you about 30% more dollars to buy the same amount of euros, for example.

The euro is a creature that the dollar did not have to contend with before, because the euro was created only in 1999. The euro - the currency of the European Union, itself a large and mature market - has become a viable alternative to the dollar.

Not that the euro is a great currency. It suffers from the same shortfalls as the dollar, namely, that it is an anchorless paper currency held together by faith. Yet in a world of anchorless currencies, it may, at times, appear attractive compared to the dollar.

The dollar's long reign as the world's favorite currency is no longer the cinch it once was. Yet one consequence of its long hold on foreigners is that foreigners have built up large exposures to the U.S. dollar.

Editor's Note: Christopher W. Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Christopher's essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is also the editor of The Fleet Street Letter.

As Mr. Mayer writes above, a dollar crisis is now inevitable. When will it strike…and how will it affect American investors?

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