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People often ask us which currency they should hold and whether or not we think the US dollar is about to plummet, so I thought it would be a good topic for a primer. Basically, the value of a currency can be looked at in two ways - relative to other currencies internationally and relative to goods and services domestically. It is the former that people are generally concerned about, but it should be the latter. Deflation is already outpacing the ability of central bankers and governments to 'print money' (monetize debt), and in a deflation, cash is king, relative to goods and services.

This is the intro to today's post over at The Automatic Earth.

You need liquidity, and you need it in a form that will be accepted in your locality, whatever that currency is worth relative to others. As a fully liquid cash equivalent, you could also consider short term bonds (30-90 days) issued by your own government, as long as your government isn't Zimbabwe or anywhere comparable. Our horizons will contract drastically as we move towards a far more local world - a world where trading one currency for another might not be possible at all for most people. For most people, the time to think internationally is over. Credit expansion effectively shrank the world and turned it into a global village, but the world is about to get much larger again.

In the past, most people were born and lived and died all within about a five mile radius, and that is the world we are returning to. What good would a foreign currency be under those circumstances? If you are caught with foreign currency you can't legally trade, you would lose either all or most of its value (depending on the availability of a black market, but that has its own risks). Also, in a world that will be increasingly jingoistic and xenophobic, with the unfolding of an inevitable blame game, holding foreign currency could also be construed as unpatriotic, and that could be dangerous.

If you have liquidity, then you will be able to purchase necessities, and also the hard assets you will eventually need. Deflation will force down the prices of almost everything, hence preserving your purchasing power now will give you options in the future that very few will have. All fiat currencies are eventually inflated away, and in this case that will happen once the credit bubble has finished deflating and the international debt financing model is well and truly broken. I would expect that to be quite some time, as deflation and depression are self-reinforcing, and during that downward spiral it will be impossible to inflate.

During the deflationary phase you will need liquidity, but once it is over you will need to switch to hard assets. I would suggest waiting for very substantial price falls in order to hang on to as much of your wealth as you can, but not to wait for the bottom. The risks of spending a lot of money when no one else has any will grow with time, and you will need time to climb the learning curve associated with any self-sufficiency assets you buy. My guess is that deflation could last for a number of years, and that the best time to shift to hard assets (from a purely financial point of view) should be at least a couple of years away. Others with more resources may make the shift sooner, knowing that they will lose money, but having the luxury of being able to do so in order to buy time to learn new skills.

As for the value of your currency relative to others, that is less important for ordinary people, but may be important for those who are lucky enough to have far more wealth to begin with. Deflation is currently pushing up the value of the US dollar on a flight to safety (temporary pullbacks notwithstanding), and we are on the verge of an unwinding of the yen carry trade, which should also increase the value of the yen substantially. I would expect the euro to fall (temporary rallies notwithstanding) as the internal pressures build in Europe, and currencies that were on the opposite side of the yen carry trade should also fall as the yen rises.

Commodity currencies should do poorly as commodity demand falls and global trade is greatly scaled back, but could recover if we see a supply collapse and commodity prices rise again. This would probably depend on the commodity in question. Beyond a certain point, however, I am expecting currency relationships to become very volatile, if not chaotic. We are likely to see a series of beggar-thy-neighbour competitive devaluations as countries attempt to secure an advantage for themselves, if only temporarily. Where many currencies are falling, relative value depends on which one falls the fastest, or where a perceived safe haven may lie this week. My guess is that we will move into this kind of environment within the next two years, and quite possibly sooner rather than later.

As bets on relative currency values form a large part of the derivatives market (along with interest rate bets), sudden bursts of volatility are likely to generate large losses that could further destabilize an already precarious situation. Betting on specific currency swings under such circumstances would amount to very aggressive gambling and is generally a recipe for losing your shirt. At some point we are likely to see a relatively sudden dislocation in the bond market as we see international borrowing become more difficult, with continuous bailouts making the bond market nervous. Essentially, bailouts will be overtaken by events. That would involve bond prices falling substantially and interest rates soaring - quite possibly into the double digits.

People frequently worry that this will be inflationary, but it would actually precipitate an enormous amount of deflationary credit destruction. Interest rates on all debts would rise with bond rates to crippling levels, leading to a huge wave of defaults. This would amount to hitting the 'emergency stop' button on the economy, and is one reason we point out that holding debt can easily be financially fatal during deflation. In addition to a default tsunami, we would see governments cut back services drastically in order to reduce terribly expensive borrowing. This means being on your own in a pay-as-you-go world, which is why we emphasize the need for you to hold cash in hand. For many people, the only way to achieve no debt and cash in hand is to sell property and rent. For others, pooling resources may achieve the same thing.

Whatever the fate of the dollar relative to other currencies during a bond market crisis, its value relative to available goods and services domestically should still be increasing. Of course some goods may not be available at this point if they are sourced from abroad and trade has collapsed. There may therefore be some goods that would be worth purchasing at today's prices, in order to secure items that could be very useful while all it takes is the internet and a credit card.

When we eventually do see inflation, it will not come from the initial havoc in the bond market, but from the aftermath of its destruction. Once deleveraging is over and countries must function in financial isolation, there will be nothing to prevent them from printing actual cash, as opposed to desperately trying to expand credit in a double-or-nothing gamble as they are currently doing. Down that road lies a currency hyperinflation on a Zimbabwean scale, but we are nowhere near that point now. You must survive deflation in order to have to worry about hyperinflation.

Originally posted to Stoneleigh on Sun Jan 11, 2009 at 10:36 AM PST.

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Comment Preferences

    •  It could turn on a Dime (0+ / 0-)

      I'd say, monitor the yield on the 10-year.

      No one wants to be the first to abandon US Treasuries, especially if you have a sig. amount in your coffers.

      So you adopt a wait-and-see strategy.

      But the moment you see the 10 year yield rise 50 or 60 bps in one day, all bets are off.

      At that point, you realize that, if you don't dump Treasuries, your people (as in Chinese citizens) will ask why you didn't.

      Learn about Centrist Economics, learn about Robert Rubin's Hamilton Project.

      by PatriciaVa on Sun Jan 11, 2009 at 11:12:57 AM PST

      [ Parent ]

  •  Thanks for the Currency Essay You Promised (1+ / 0-)
    Recommended by:
    side pocket

    The logical unfolding of events you describe seems sound to me.

    The thing is, I see it in an entirely different speed. My thinking suggests the totality of what you describe will play out (at least in the United States) within the next 6 months -- and no later than August 2009.

    That puts a different complexion on the strategies of where to hold your wealth to protect yourself. Also two factors in the US are violent wildcards that other nations are not facing, and I believe these must be considered by US citizens (in the sense of locality).

    1. The US default on interest payments on our national debt, which will occur no later than June 2009.
    1. The very real and rapid replacement of the Dollar as the world's reserve currency. Currently, many nations trade in Yuan and Euro. Many oil producers will no longer accept Dollars. The Japanese buy oil with Yen.

    I would say the deflationary situation will last only for a month or two -- until the moment that the US can no longer pay its debt. Then, the US has only two reasonable choices:

    1. To default (which will render the dollar worthless all over the world.)
    1. To issue a new currency (or keep the same currency, but declare that each dollar is worth 25 cents). By doing so, the US can pay all of its obligations effortlessly.

    I have gone to some length to pay off all debt, and I just sold a property that will allow me to do so. But now, as I sit here holding a ton of cash from the sale, all of which is earmarked to get me back to zero -- I'm hesitating.

    If these dollars in my hands are going to be devalued, why not put it in a relatively safe tangible like gold for a few months until the US defaults or devalues -- then cash out and pay off my debt a dime on the dollar, just like out government will do.

    As a currency trader, I've merely followed the folly of nations and invested accordingly. That seems to work very well for me.

    •  Why would the US default on its Debt? (1+ / 0-)
      Recommended by:

      We are not Argentina or Mexico.  We hold the world's reserve currency.

      We can monetize our debt.  Why would we default?

      Learn about Centrist Economics, learn about Robert Rubin's Hamilton Project.

      by PatriciaVa on Sun Jan 11, 2009 at 11:15:38 AM PST

      [ Parent ]

      •  I Don't Think the US Will Take That Path (0+ / 0-)

        Or, are you asking why we would be in the position to default?

        If the latter, that's simple. We don't have any money. Zero. Negative. Nada. We don't hold reserves like other nations.

        We borrow 10 billion dollars from foreign nations each anbd every day just to pay the interest on our debt.

        In a deflationary spiral, our debt looms enormous. There is not enough money being sucked into the Madoff-style/treasury ponzi that we're running to cover the interest.

        If we hyper-inflate, the whole world will know it. Thus, the exchange will go down to 25 cents on the dollar.

        •  Two SubOptimal Options (1+ / 0-)
          Recommended by:

          And I don't think the US will ever default.

          We may have hyperinflation for a few years, with a concomitant currency devaluation, but that would be preferable to a debt default.

          Learn about Centrist Economics, learn about Robert Rubin's Hamilton Project.

          by PatriciaVa on Sun Jan 11, 2009 at 11:24:01 AM PST

          [ Parent ]

        •  Even so... (1+ / 0-)
          Recommended by:

          That kind of fall in the dollar would not compensate for the on-going destruction of credit and so the net result would not be inflation.

          All manner of things will become less affordable, but not as a result of inflation. Deflation can achieve the same thing much more quickly through the collapse of purchasing power due to credit destruction.

    •  Outlook on UK Pound? (0+ / 0-)

      I'd be interested in your outlook on the British pound, however, relative to the US dollar and EURO.

      Learn about Centrist Economics, learn about Robert Rubin's Hamilton Project.

      by PatriciaVa on Sun Jan 11, 2009 at 11:16:46 AM PST

      [ Parent ]

      •  The Sterling will Disappear this Year (2+ / 0-)
        Recommended by:
        petral, krnewman be replaced by the Euro.

      •  Pounds sterling (1+ / 0-)
        Recommended by:

        The pound is harder to predict, although as a quasi-commodity currency it could continue to do poorly as the North Sea oil and gas deposits deplete rapidly.

        I'd be surprised if the UK joined the euro at this point after resisting for so long, especially as the pressures on the euro will become more and more evident. The UK is in the same position as Ireland and Spain, both of whom may have to leave the euro as their property bubbles implode. The housing bubble in the UK (where I come from) is far worse than in the US.

    •  Deflation will last much longer than that (1+ / 0-)
      Recommended by:

      Even when we do reach a dislocation in treasuries, it will be a further deflationary impetus, as it will represent a tremendous collapse of credit.

      Deleveraging will take several years I would guess - a minimum of two at a guess, and likely longer. Until the remain debt is acceptably collateralized to the remaining creditors, deflation will continue.

  •  re the dollar (0+ / 0-)

    do you see the dollar as the reserve currency ending? If so approximate time frame? Do you see foreign countries ending the lending/financing the US in the foreseeable future?

    by Soma on Sun Jan 11, 2009 at 11:26:31 AM PST

    •  Well, You Didn't Ask Me... (2+ / 0-)
      Recommended by:
      Gooserock, side pocket

      ...but I do have a bit of news that might answer your question.

      The Japanese has suggested that they will continue to buy Treasuries, but they demand that when they redeem them, they must be paid back in Yen (at the value at the time the investment was made). Including interest.

      I'd say the handwriting is on the wall.

      •  That Appears to be On a Times Square Lightsign nt (1+ / 0-)
        Recommended by:

        We are called to speak for the weak, for the voiceless, for victims of our nation and for those it calls enemy.... --ML King "Beyond Vietnam"

        by Gooserock on Sun Jan 11, 2009 at 11:38:55 AM PST

        [ Parent ]

      •  Really? (0+ / 0-)

        Do you have a link re this? thanks

        by Soma on Sun Jan 11, 2009 at 11:39:34 AM PST

        [ Parent ]

      •  If not us, who? (2+ / 0-)
        Recommended by:
        mickslam, Pluto

        I have huge reservations about viability of the EURO, given that each state must cede its monetary policy to Brussels.

        Imagine if Germany and France hadn't fallen into a recession, and the Spanish were still contending with a doubledigit unemployment rate, freefalling realEstate prices, AND a high EURO rate, as established by the European Central Bank.

        Pluto, I'd be willing to bet that, had the above scenario unfolded, and Brussels refused to lower the rate (so Spain would benefit), the Spanish govt. would have fallen.

        Of course, we, in the US, have had times when specific states fell into recession, without the FED accommodating them.

        But we are a sovereign nation.  The EURO community is comprised of 15 sov. nations.

        Learn about Centrist Economics, learn about Robert Rubin's Hamilton Project.

        by PatriciaVa on Sun Jan 11, 2009 at 11:41:58 AM PST

        [ Parent ]

      •  AIG might accommodate them (2+ / 0-)
        Recommended by:
        Pluto, Wyote

        I'm fairly certain that the good folks who ran AIG's finance operations in the UK might be able to accommodate the Japanese, at very attractive rates.  And if they couldn't cover their bets, as they couldn't with the Goldman hedges, the US taxpayer picks up the tab.

        Heads, I win, Tails U lose.

        Learn about Centrist Economics, learn about Robert Rubin's Hamilton Project.

        by PatriciaVa on Sun Jan 11, 2009 at 11:44:38 AM PST

        [ Parent ]

    •  The dollar will cease to be the reserve currency (0+ / 0-)

      I don't think it will happen yet though. For now we have a flight to safety that is pushing the dollar up despite awful fundamentals. The market is never rational.

  •  Great Post (0+ / 0-)

    but I have recently run across another way of looking at money that is very persuasive to me.  

    I think money is given value through taxes.  The basic demand for any particular currency comes through the requirement that taxes be paid in that currency.

    also I now think that deficit spending creates money to be available for savings.  Think about a country with no money, then they issue money in exchange for goods or services.  If the country runs a balanced budget by taxing for 100% of spending, there are no net dollars that can be saved.  

    Love this post and have been reading over at your other blog for a while - keep it up...

    I am repeating myself, and thats ok.

    by mickslam on Sun Jan 11, 2009 at 11:29:04 AM PST

  •  One more reason we need a global summit n/t (0+ / 0-)

    GOP = Godless opposition party We Hassle to make America a Vassal (state)

    by Shhs on Sun Jan 11, 2009 at 12:00:15 PM PST

  •  Once the recession is over (0+ / 0-)

    Obama will have to massively reduce the size of government and produce a massive surplus each and every year.  He needs to do this for obvious reasons.  No one want to see hyper inflation and a Federal Bankrupcy as that would ruin our country.

    With that said, he will most likely have to reduce military spending and entitlement spending a great deal.  My gues is cutting both by at least 50% is a good starting point.  He will have to raise taxes on everyone making more then $250k as well.

    Bush started this mess when he failed to reduce the size of government.  Obama is correct with deficit spending today, but I am sure he realizes that he is simply punting the potential problem down the road hoping the pain felt from the massive cuts to entitlement and military spending will be less then the pain from a bigger recession.

    What needs to happen now is for Obama to come out and explain the situation.  It would be bad if we are blindsided with these much needed massive cuts to government spending.

    •  Obama will get the Herbert Hoover treatment (0+ / 0-)

      Just as Hoover had the misfortune to preside over the Great Depression, about which he could do exactly nothing, Obama has chosen to drink from the poisoned chalice this time. Personally I think it's tragic as I like the man.

      •  Isn't Bush the Hoover? (0+ / 0-)

        This decline started in 2007.  

        •  Bush is lucky in comnparison (1+ / 0-)
          Recommended by:

          He's escaped with nothing but a reputation as a bumbling idiot (which seems to be thoroughly merited). Hoover was probably the best qualified president ever, but went down in history as an abject failure. The worst of the depression is ahead of us - the part where Wall Street eats Main Street for breakfast. The man who presides over that had better watch his back.

      •  Why can't Obama do nothing? (0+ / 0-)

        If as you say, we will see a global economic collapse within a few months, why won't the Obama jobs program help to put people to work? Why couldn't Obama setup food areas to help feed the hungry? Obama appears to be smart and very intelligent, and he is already warning us that we all will have to sacrifice. There were so many diverse people who supported Obama during the campaign, why wouldn't the same people not support Obama during the remainder of this Presidency?

        •  Obama won't have the freedom of action (1+ / 0-)
          Recommended by:

          He is indeed a smart man, but he will be heavily constrained by the financial black hole that we stand on the brink of. We will see a depression no matter what he does, and sadly he will take the blame for it.

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