Therefore, it is, if you like, a "Heads Up" SitRep, from which to better understand the imminent fiscal disaster which potentially faces the global financial system and particularly, workers, pensioners and savers in the USA. - MCF)

As I have suggested in these columns before, the mighty Greenback is now struggling.

However, what does this mean to the average person in the USA? Anything? Nothing; or cause for concern?

Well, let's examine the root causes and the potential outcomes.

What is actually happening in the global Forex (Foreign Exchange) markets, is that central Banks (the nation states' equivalent of the Fed) are dumping US dollars and investing in Euros as their bastion of hedging.

Now, what does this mean, exactly and why is suddenly the Euro, flavour of the month?

For many years, banks used gold as the guarantee of integrity of their notes. Simply, banknotes were a new phenomenon. Trusted banks issued what were effective IOUs, or if you like, Promises to Pay. In theory, any holder of a banknote could shassy up to a bank's counter and demand gold, bullion or coinage, in exchange for their notes.

As might be imagined, banks issuing notes ensured that for the total value of notes issued, there was the direct value equivalent of gold in their vaults, if the owners wished their banking house to enjoy credibility and stability.

As is common with human nature, gunslinger banks, issued far more notes in value terms than they had bullion and coinage in their vaults! This enabled them to rapidly expand their lending and their apparent capital base.

As would be soon expected, this lead to a rash of bank closures and bankruptcies.

Accordingly in 1694, the British Parliament passed the Bank Act and created the Bank of England, probably, the World's first central Bank.

In 1844, the Bank Charter Act made the Bank of England notes, fully backed by gold, the legal standard of convertible tender. In other words, only Bank of England issued notes were convertible into gold and silver.

By a prototypical quirk of British law, Scotland were also allowed to issue notes, backed by the Bank of Scotland.

Thereafter, banknotes were "backed" by bullion in the vaults.

This is referred to as "being on the Gold Standard". In other words, the total value of a currency, was completely backed by gold bullion.

Various nation states drifted onto and out of the Gold Standard and some, including the USA were at times, partially on the gold standard and the UK, in the late 1920s. It is beyond the scope of this article to delve deeper into this subject, other than to pose the question, "What value backs a currency and in this case particularly, the US dollar?"

Just before the end of WW II, John Maynard Keynes, the British economist, was fundamental in drawing the allied nations together and creating the International Monetary Fund (IMF) at the Bretton Woods Conference New Hampshire, 1944.

Keynes correctly predicted that post-war reconstruction would create significant financial and fiscal instability: worse, it would create an ideal climate for arbitragers to speculate wildly, against currencies in the Forex markets, when what was needed above all else, was stability.

At this time, Great Britain was effectively bankrupt: all its bullion reserves had been shipped to the USA to pay for lease Lend and ongoing materials for the war effort.

Keynes proposed that the US dollar ought to be the focus currency and post-Bretton Woods, all other significant currencies were "pegged" against the dollar, for exchange purposes, with a small margin of float. The dollar itself, would be partially "pegged" to gold.

A major value system for currency levels was the price of gold bullion, which itself would be "fixed" at an agreed value. This system was called Managed Flexibility.

As with all things, the world moved on.

One of the key factors which destroyed Managed Flexibility was the singular reality that gold was increasingly valued above the fixed market official rate, which encouraged smuggling, particularly to countries which used gold for such items as dowries.

Originally, of course, all currencies were fixed to bullion: since Central Banks were expected to be able to back-up their notes with gold. This was thus a true value relationship, since notes issued and therefore money supply (the total value of all currency in circulation, on deposit, etc) could be fairly denominated in gold bullion.

Another nail in the coffin of Managed Flexibility was the supra-rapid expansion of global trade, through the 60s and 70s, which even Keynes could not have envisaged.

One further reality - and perhaps the most telling, was that as global trade grew, exponentially, there was not sufficient gold bullion in the world to create enough currency to finance it!

Federal Reserve abandons its own gold fix

In 1971, the Federal Reserve abandoned its own gold fix, as bullion reserves in Fort Knox were insufficient to back or partially back the increasing money supply.

In 1975 the US dollar "Floated" and many other major currencies followed suit, the pound sterling floating in 1972 with what was termed "Managed Floating. Now managed floating is where the currency's Central Bank intervenes to either buy or sell their currency to either drive it up or drive it down, normally with the assistance of other Central Banks acting in concert and the IMF.

What has actually happened is that the US dollar has become what is known as a Fiat Standard: i.e. it has NO intrinsic value other than trust.

Trust in what? To place this in clear focus if all the currency issued by the Fed was backed on the Gold Standard in 1993 - in terms of the total bullion held by the Fed - it is estimated that this gold would have to enjoy a value of $25,000 per ounce! The general selling price of gold in 1993, was obviously nowhere near that level, being at roughly $ 361/oz. And between 1995 and 2004 money supply has effectively doubled! (Source M3: Federal Reserve).

Well, in global financial dynamics, currencies are "trusted" on the overall realities and strengths of the underlying economy.

Since WW II, the US dollar has been the major global currency: most commodities are denominated in dollars. The most obvious is or perhaps more accurately, has been crude oil.

From the 1970s onwards, the World's economic system has expanded: in lock-step, the global financial and banking systems have expanded, simultaneously.

One seminal cause of dollar denomination, was George Marshall's. post World War Two aid scheme, aimed at re-establishing, industry and above all else, social and political stability.

Marshall Aid created huge external (to the USA) dollar balances, glugging around the global financial system. It has to be remembered, that at the end of this war, the USA was the strongest industrial and manufacturing economy in the World. The US industrial base had enjoyed no homeland conflict and a rapid expansion of manufacturing and technology as a direct result of the war. Further, the USA had circa $40 billion in gold reserves.

As Germany and Japan emerged from the devastation, they both grew a massive export-led industrial base. Worse, when OPEC savagely increased crude oil costs, in the early 70s a new phenomenon emerged: the so-called Petro-Dollar. Middle East states suddenly accumulated vast dollar balances - which they mainly deposited back in the USA!

Well, this was fine - temporarily - since the increased cost of crude imports, was offset by US dollars flowing back as investments, plus emerging desires for both US military technology, training and infrastructure, created huge opportunities for American corporations, such as Bechtel Inc, to export, construction, consulting, design and management services to the very states which were, fiscally, holding the USA to ransom! Massive exports of US armaments and military support, to such as Iran and Saudi Arabia and then Iraq assisted in re-dressing the balance, whilst increasing US influence and presence in the Middle East.

This scenario changed, considerably through the mid 80s to nineties, when OPEC states' spending increased dramatically, much of their imports coming from the USA. However, since 1998, US exports to OPEC states has reduced 20% - and rising! Much of their spending and investments are now in the Euro Zone. Yet US oil imports have continued to grow as consumption rises, thereby exacerbating the imbalance.

Meanwhile, Japan, particularly, were also investing heavily in US securities: indeed, at one time, through the late 70s and early 80s, Japan's Central Bank was aggressively bidding and buying circa 30% of all Federal Reserve "revolving" paper, at the monthly auction.

Simply, trust.

As the US Current Account (external obligation) has grown out of control caused by printing too much money, manufacturing and exporting too little and above all else, importing far too much, particularly consumer goods from Asia, global investors have become increasingly uneasy in the validity, future value and sanctity of the dollar.

The growth, success and stability of the Euro has also compounded this reality.

Professor Kenneth Rogoff of Princeton believes that the European decision to print 500 euro notes is an explicit effort to compete for the business of the underground economy, for example! Suddenly, the Euro has become the currency of choice for drug dealers and those wishing to avoid taxes. Russian "Mafia" criminals are now dumping cash dollars and using Euros!

Yet another problem is of course China. As their trade and industrial base has rocketed, exports to the USA have created a huge trade imbalance. China devoutly refuses to revalue the Yuan and is amassing dollar balances, to rival and soon exceed Japan. By keeping the Yuan falsely depressed (on the basis of their whole economy and fiscal indicators), China can export capital and consumer goods at stunningly low prices. It is worth noting here, that despite internal fiscal and monetary problems, Japan is still creating massive export surpluses - which until now, have been invested into US dollars.

However, the old realities are changing. There is increasing concern over the true value of the US dollar.

Since it is "fiat" currency, people holding dollars have to look with jaundiced eye at America's long term ability to meet its currency and fiscal obligations. Most analysts agree that the Budget deficit will grow alarmingly, from hereon forward. Factor in the problems with Social Security, social healthcare costs, increasing longevity of pensioners and there is an inescapable and rapidly growing problem. Add the costs of the Iraq adventure and Afghanistan and the budget deficit becomes alarming!

Most analysts now believe that the US dollar could lose up to 40% of its present low value on the international markets. However, it doesn't matter whether it is 40%, 30% or even 20%. Such a drop would have an instant and devastating effect, in various ways.

For many years, as the US dollar became the major "Reserve" currency, (the currency of choice stored by Central Banks with their bullion as rainy day money): this has meant that up until recently, probably 30% of US external debt has been financed free of any interest costs. This is called, technically, "seignorage".

If the US dollar experiences a massive drop, however, it would understandably be dumped in favour of Euros. Now as with any commodity market and that's what this is, if lots of major institutions start dumping hundreds of millions of US dollars into the global currency market is will create a glut and the price will fall, yet further. So in trying to safeguard their positions, Central Banks will be skewing the markets against their own interest. But, these markets operate mainly on confidence: panic selling sets in and devil take the hindmost. Despite support from the Fed and the IMF, it would be a stampede that no one could control, since the holistic system relies on the very G8 states to support the currency under attack that they themselves are attacking!

Eventually, it would mean that the Federal Reserve would have to pay interest charges on probably 25% of its deficit financing, as the cosy support of seignorage would have vanished!

Worse, the cost of importing oil and all other commodities would suffer a rapid upwards hike, putting instant pressure on prices and thus creating what could be an inflationary spiral leading to hyper-inflation! Which would exacerbate the position, since the US dollar would be worth less and less. A self-fuelling, self-destructive circular loop.

One of the core problems with the present system of Floating Exchange Rates, is that coordinated by the IMF, a concord exists where all the major Central Banks cooperate to support another state's currency when it is under attack. Obviously, it is in everyone's interest, since it stabilises Forex markets. Support simply means that if one currency is being widely sold, thus depressing its price, then the Central Banks buy it, therefore "flooding" the market with their own and other currencies in exchange, thereby reducing the sheer volume of the attacked currency and trying to make it rise.

However, as was shown by Great Britain's foolish Chancellor Lamont, when the pound was attacked just prior to its exit from the Exchange Rate Mechanism (ERM), you can spend nearly all your currency and bullion reserves (he did!) vainly trying to support your currency, you can hike interest rates (at one point they exceeded 15%!), thus in theory making your currency a better investment, but if the attack is major and sustained, it is impossible to defend.

If global distrust in the future integrity of the US dollar continues to increase, can we really expect major Central banks to compromise their own future integrity and stability, by short-selling their own currencies and buying dollars? Of course not!

One of the greatest current problems is the essential system-hystereisis, of the European Central Bank (ECB). Many major manufacturers and exporters in Europe, are agitating for lower core Euro interest rates, since the high Euro is crippling their exports and thereby threatening profits and jobs. There is, frankly, a case to depress Euro interest rates, despite the various underlying economic and fiscal realities. However, in order to achieve this, the ECB has to gain agreement from all the participating states' own Central Banks and Governments - no easy task. Thus, inertia creeps into the system. Simply, it is going to take too long, in all probability.

So, what does all this mean for you, the average working man and woman and perhaps equally as important, what does it mean for all of us, in Western society?

Fairly obviously, if the US dollar loses a significant portion of its value, then all imported goods and commodities would cost considerably more in real terms, particularly crude oil and therefore oil product. Sell that Hummer now! In turn, this would raise the most people's cost of living.

Manufacture, Distribution, Banking

Classic economics textbook theory dictates that a low currency is good, at times, since it rapidly increases the cost of imports thereby reducing them and makes the cost of home manufactured and exported goods cheaper and therefore more competitive. Nice theory. The problem is, that when a nation reaches the condition of the UK and the USA, what do we actually manufacture that can be exported in rapidly increasing volumes? Not a lot! China, at present, is reaping the reward of term investment in an industrial base. These things do not happen overnight, however.

To ramp-up exports, of any object, excepting raw commodities, takes significant investment in Research and Design, manufacturing, marketing, distribution and so on. Above all else it takes time. The holistic process starts with school and then college. When Financial Services attracts the best graduates and promises them fame and fortune, it is hard to expect young people to study engineering, for example.

Far too often, Financial Services is about churning, and buying and selling what already exists. It doesn't create new capital, new jobs and new fresh, real wealth. In fact, it has a contrary affect. Mergers and acquisitions invariably lose jobs, as a new mega-corp is "Rationalized".

However, worse problems could lie in store. Consider a major bank. Let's suppose that its value is say, 100 million dollars. Well, at a stroke, it could find its value has been reduced by anywhere from 20-40%!

How about pensions? If the dollar lost a significant portion of its value, then a number of events would happen, in train. Pensions would be worth less in terms of real worth, as cost-bases rise and inflation starts to bite. Along with this, Social Security and public health, which are already forecast to become an increasing problem over the next fifteen years would be increasingly inundated with demand, as previously secure pensioners found their income failing to match their necessary expenditure.

Interest rates would rise, to combat inflation and try and attract international investors back into dollars. The Fed cannot have two or three significantly different rates. To do so would be to encourage arbitrage, which would simply make matters worse. This reality is one of the huge paradoxes of the present globalised banking and foreign exchange markets. Pragmatically, a country needs one level of interest for holders of its currency if it wishes to keep the exchange price high: and possibly a lower level of interest if it wishes to boost internal trade, manufacturing and thus exports. Unfortunately, interest rates used as a moderator of any state's economy become a two-way street. Raise them to defend the currency and simultaneously, this puts pressure on business and consumer credit.

The most insidious problem, however, lies in the vary nature of international banking, as it has developed. In earlier articles, I have illustrated how banks are each beholden to other banks for what is effectively unsecured lending and borrowing, through the massively dynamic global money markets.

No problems with term loans at fixed interest. It does become a huge problem, where short-term deals are concerned, such as overnight, two day, one week etc. And this is much of the global capital market.

If the dollar drops, rapidly, then many foreign banks will be calling in their loans when they are due. The result would be a large and threatening liquidity crisis. Now, normally, the Federal reserve smoothes out such problems by providing liquidity to the market, since in banking and fiscal parlance, the Federal Reserve is what is known as "The Lender of Last Resort". However, since more and more investors may well switch to the Euro, in the cause of greater safety and stability, the Fed will have its own problems in finding funds to replace investors in Federal paper, for example! Print more money? Nice idea, but this will simply, again, exacerbate the problem, since it will further depreciate the currency and encourage a shift into higher-geared inflation.

For over twenty years, economists and bankers have feared the ultimate "Domino Effect"; this is where a series of obligation defaults from one bank to another create an energy of their own volition. Bank A is owed funds from Bank B, but also owes Bank C. Bank C calls its funds and Bank A calls it funds from Bank B and so on. If all US banks are in a similar position, they each knock the other over!

Worse, a sudden plunge of US dollar values could cause various derivative products to unwind: and no one knows the true downside in this case.

When Continental Illinois suffered a similar plight, in 1984, Paul Volcker as Chairman of the Fed and his opposite number at the NDIC stepped in to sort out the mess. At the time, Volcker stated that if the Fed had have let Continental Illinois go, then this could have tripped the feared Domino Effect.

Presently, there is a growing energy amongst Islamic states, to switch to some form of gold backed currency, simply, because the US dollar, is rapidly becoming un-trusted.

The problem and downside for any investor, is that if a currency suddenly loses say 30% of its exchange value, then the investor has just lost 30% of their capital! This is called, traditionally, the "exchange risk exposure".

As more and more major investors switch into Euros as against dollars, the situation will rapidly worsen: at present Russia is riding the fence. President Putin, however, is in a commanding position in the global oil and gas market and may well soon jump. This would create a mass exodus from the US dollar into Euros, as other nation states follow, who are at present carefully watching the temperature of the water. Investors are like lemmings: a dash can rapidly become an uncontrollable stampede.

Dominos anyone?

� Copyright 2004 by AxisofLogic.com