The Dollar and the Damage Done

♠ Posted by Emmanuel in at 6/04/2007 11:53:00 PM
Here is Bill Fleckenstein's take on how excess dollar liquidity spawned by the easy money conditions post-2001 US recession eventually fueled markets worldwide. Although I have slight quibbles with his description of events, Fleckenstein does provide a reasonable picture of how we got where we are--and of where we are going. Needless to say, it's not a very attractive picture:

We're in the midst of a leveraged-buyout mania and a worldwide stock frenzy, running the gamut from just plain wild to completely out of control.

From time to time I find myself wondering: How did we get here? So today, I'm sharing my thoughts on that subject because if you don't know how you got to where you are, it's hard to be prepared for what may happen next.

To make a long story short: The process was started by money printing in America to bail out the last bubble.

That induced money printing in much of the world because so many countries had linked their currencies to the dollar. More importantly, the very regions that were primed to grow -- think Asia, India and the Middle East -- exploded, in no small part, thanks to money printing. Thus, America's housing boom kept our economy growing. Growth in the other parts of the world I just mentioned, together with the attendant commodities boom, conspired to create the worldwide growth (and inflation) that we have experienced.

A lot of what's transpired has been a function of absurdly low interest rates, given the level of inflation around the world, and the collapse in risk premiums, aided by ratings-agency alchemy, which has allowed debt -- from moderately risky to total garbage -- to be spun into high-quality credit structures. In other words, the debt markets have acted as unindicted co-conspirators in the frenzy.

A major reason why our Treasurys market has traded as well as it has stems from the accumulation of dollars by the aforementioned regions and their desire to keep their currencies weak against the dollar. (China, Japan, South Korea, Taiwan and India have accumulated more than $2.5 trillion in less than 10 years, according to the May 23 Financial Times.)

The trillions of dollars printed "forced" those countries to print trillions of dollars' worth of their own currencies to keep them from appreciating too quickly. After they printed their currencies to buy ours, they wound up buying mostly Treasurys with those electronic greenbacks (that is, until recently).

Thus, currency-suppression techniques and blind reliance on formulas on the part of ratings agencies, combined with organic growth, plus the madness of the crowds, have brought us to where we are. But important changes are under way that at some point will derail the process I've just described.

First of all, Kuwait's dollar de-linking and China's sliding of the band (to pick the two most recent examples) will, at the margin, require less dollar buying and ultimately less Treasurys buying. Additionally, it appeared the Chinese were already spending fewer of their dollars on Treasurys and more on commodities, even before they took a flier on the Blackstone purchase. This is a roundabout way of saying that the world's bond markets might finally experience rising rates as the ranks of buyers thin out.