The Economy Guy

Issue: 9/20/07 Thursday

By Global Economy Guru, Tom Harvey…

Is the United States a Banana Republic? – does banana republic deserve to be capitalized for the USA? I sure hope that got your attention because today that elephant in the room that no one is talking about just stood on someone’s toes. Here is the first hint:

The Canadian Dollar is equal to one US Dollar TODAY. I find that shocking news personally. When I was a small child, I can remember the Canadian Dollar being worth more than the US Dollar (in fact I remember it being worth $1.10), and then it gradually and persistently declined year after year, decade after decade. The Canadian dollar was worth about $0.63 5 years ago. How in the world could that socialistic nation to the north start strengthening its currency? Well, it didn’t. The US Dollar just fell and fell and fell.

Since there is no value (meaning no gold backing) for any paper money in the world today, the relative value of one currency against another currency is really determined by the relative rate of inflation between those two currencies. Market oriented dealers will say that an exchange rate is determined by the market, that is by people buying and selling currencies. That’s true, but in the long run, inflation drives the value that people expect when they purchase a currency. Since the US Dollar has been falling against the major currencies of the world, QED the US currency has been inflated more than those major currencies.

The Euro drove through that magic $1.40 level and closed at $1.4065 TODAY.

Here is an obscure news article that came out today that has very big meaning to every US Citizen whether they understand it or not.

Saudi Arabia has refused to cut interest rates in lockstep with the US Federal Reserve for the first time, signaling that the oil-rich Gulf kingdom is preparing to break the dollar currency peg in a move that risks setting off a stampede out of the dollar across the Middle East. “This is a very dangerous situation for the dollar,” said Hans Redeker, currency chief at BNP Paribas. “Saudi Arabia has $800bn in their future generation fund, and the entire region has $3,500bn under management. They face an inflationary threat and do not want to import an interest rate policy set for the recessionary conditions in the United States,” he said. The Saudi central bank said today that it would take “appropriate measures” to halt huge capital inflows into the country, but analysts say this policy is unsustainable and will inevitably lead to the collapse of the dollar peg. As a close ally of the US, Riyadh has so far tried to stick to the peg, but the link is now destabilizing its own economy. The Fed’s dramatic half point cut to 4.75pc yesterday has already caused a plunge in the world dollar index to a fifteen year low. There is now a growing danger that global investors will start to shun the US bond markets. The latest US government data on foreign holdings released this week show a collapse in purchases of US bonds from $97bn to just $19bn in July, with outright net sales of US Treasuries. The danger is that this could now accelerate as the yield gap between the United States and the rest of the world narrows rapidly, leaving America starved of foreign capital flows needed to cover its current account deficit - expected to reach $850bn this year, or 6.5pc of GDP.

The biggest danger for the dollar is that falling US rates will at some point trigger a reversal yen “carry trade”, causing massive flows from the US back to Japan. (Do you remember my discussion of the “carry trade” and its risks last month???)

For Saudi Arabia, the dollar peg has clearly become a liability. Inflation has risen to 4pc and the M3 broad money supply is surging at 22pc. The pressures are even worse in other parts of the Gulf. The United Arab Emirates now faces inflation of 9.3pc, a 20-year high. In Qatar it has reached 13pc. Kuwait became the first of the oil sheikhdoms to break its dollar peg in May, a move that has begun to rein in rampant money supply growth. (Do you think the other Gulf States notice what’s happening in Kuwait, and how easy it was to solve its inflation problem????)

This is really bad news. The US Dollar is being inflated to such an extent that countries around the globe are stating the truth; that it is not worth holding those US Bonds and keeping the US Currency as the world’s Reserve Currency any longer. What’s the logical alternative? Euros!!! The Gulf states hold $3.5 Trillion in US Bonds. If they sold even 10% of those bonds and purchased Euro bonds, then $350B in bonds would be sold (depressing bond prices, and raising bond interest rates) and then sell $350B in Dollars for Euros. That would further depress the US Dollar against the Euro. And that’s only the Gulf states. Even if the Gulf States don’t sell their US Bonds, they probably won’t purchase as many in the future. That has the same affect. And did you see that other obscure data point – July sale of US bonds to foreign nations dropped from $96B to $19B. The handwriting could be on the wall right now for the US Dollar. Stay tuned for updates on this highly volatile situation.

Here are Today’s closing details:

DJ30 – 13,767 (Down 0.35%) Kind of a ho-hum day in the stock market.10 year US Treasury Bond – 4.67% (Up .15%) This is an enormous jump in bond rates, and a foreshadowing of what is reported above. Imagine the impact of increased interest rates across the US spectrum of interest rates.US Dollar - $1.4065/Euro. A new high.

Gold closed at $740 per ounce. (Up $10) That’s about $100 in a month.

Oil Closed at $83.32 (Up 1.39) Another new high today.

Gasoline is $2.14 Gasoline is following oil up.