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Losing the dollar? It's a lock

I’ve been thinking about the fate of the U.S. dollar for a long, long time.

The U.S. dollar is truly an amazing edifice. You might not have spent much time thinking about how unusual it is, but there’s never been a paper currency so widely accepted around the world.

And consider this: Thanks to the U.S. dollar’s status, the U.S. government is the only one in the world that can pay for all of its debts with a paper currency only it is legally allowed to print.

What do you guess the odds are our politicians will so abuse this privilege that they lose it? I think it’s a lock – the best, most certain bet in all of global finance.

Officially, our paper standard began in 1971. It’s approaching four decades of service. In that time, its purchasing power has fallen by close to 90 percent. And yet, amazingly, our creditors continue to accept it – primarily because its exchange value doesn’t normally fall by more than a few percentage points each year. But, it’s getting long in the tooth. And the abuse it has taken lately – $1.75 trillion in “quantitative easing” – can’t inspire our creditors with confidence.

What might knock the dollar off of its perch? Well, my guess is the same kind of things that have ruined every other paper currency in history. The big problem with paper money is bankers and politicians inevitably go too far with it. On a commodity standard, like the gold standard, the bankers and politicians have to use a conservative reserve ratio – like say 20 percent – because creditors expect them to produce bullion on demand. But with paper money, this natural restraint is absent. Without it, government and banks can use whatever amount of leverage they deem prudent.

And they always go too far. Like Fannie Mae, which was leveraged more than 70 to 1. Or Bear Stearns, leveraged 50 to 1. Or the U.S. government itself, which now owes foreign creditors roughly $2 trillion over the next year. It continues to run annual deficits in excess of $1.5 trillion and only has about $500 billion in exchange reserves to cover its funding needs in the event of a credit crisis.

Here’s what I’m thinking. The global banking sector still faces big problems. JPMorgan says more than $40 billion of losses are coming from Eastern Europe. Nobody has figured out who is going to pay the $5 billion the Icelandic banks lost to British and Dutch depositors. Several big European banks haven’t been marking their portfolios to market since 2008. If they did, they’d be insolvent.

Bad commercial real estate loans will probably result in more than 500 bank closures in the U.S. over the next 18 months. That will require an additional $500 billion in FDIC funding. The FHA will need a similar amount to cover the bad mortgages it has underwritten. And a similar amount will be needed to cover Fannie and Freddie’s debts. Meanwhile, the number of foreclosures continues to grow, up another 6 percent last month.

If you combine these pressures on the U.S. dollar with a few good trade disputes, you might see some real fireworks. A trade war between the U.S. and China, for example. The U.S. Senate seems eager to label China a currency “manipulator.” In reply, the Chinese might decide to label us “bankrupt.” Foreigners now own roughly 50 percent of our government’s debts. If they come to doubt the stability of the dollar (and they should) and dump our bonds, you will see the largest economic crisis in history.

Is this a real risk? Well, China continues to sell Treasury bonds, dumping about $5 billion worth last month. Paul Krugman – the left-leaning New York Times columnist and Nobel Prize-winning economist – says you have nothing to fear if China dumps our bonds because the falling value of our currency will make Chinese goods more expensive, providing a lift to U.S. manufacturers.

Krugman is insane. According to the same logic, we should all burn our houses to the ground because that will give homebuilders a lift and solve our unemployment problem. It is truly an irony of humanity that we seem unable to learn and remember even the most obvious and basic truth of economics.