April 20, 2006

Save the Dollar or Save Housing - Pick One

This week's performance of the U.S. Dollar against the rest of the world's paper money has not been very impressive. The performance against the world's oldest money has been downright scary. More and more, it is looking like new Fed Chairman Ben Bernanke will have precious little time to settle into the big chair at the head of the table before being faced with some tough decisions.

Despite the noise coming from most of the mainstream financial media and from nearly all of government, heralding the robust economic expansion that has reached far and wide in a land of endless bounty, the reality is far from the non-inflationary growth nirvana that those wearing rose-colored glasses describe.

The reality of rising interest rates amidst a faltering housing market has pitted two opposing forces squarely against each other and will result in some agonizing decisions for the new Fed Chairman, who, eleven weeks into his term must regret having accepted this position by now - either that, or he is hopelessly out of touch.

Force Number One

Opposing force number one is the American consumer and his debt. Dependent upon the easy money provided by liberal extraction of home equity gains over recent years, the terms of said extraction are now working in a manner that few could have imagined when they made their bargain to immediately and dramatically improve their standard of living back when cocktail party chatter was dominated by real estate.

The good times have come to an end thanks to former Fed Chairman Alan "Babysteps" Greenspan, who after checking out in January to begin a lucrative speaking tour and work on his memoirs, leaves behind the biggest bubble of them all after having poked at it with a dull pin for much of the last two years. With rising interest rates that are starting to bite and with flat or falling housing prices over the last nine months that are starting to be noticed, the whole idea of living beyond one's means holds little of the appeal that it did a year or two ago.

With the reality of debt service, high fuel bills, and lackluster wage growth staring them down, the American consumer is now starting to blink. As documented in an ever increasing number of news segments about faltering real estate markets and too much debt to accompany too little savings, American consumers have gotten their post-Greenspan wake-up call and they are grumpily stirring, set to begin a new day.

Rising interest rates are not compatible with life as we now know it in America.

Force Number Two

Opposing force number two is the rest of the world and their perception of the U.S. dollar. For many years now the rest of the world has happily gone along with the idea that the greenback was not backed by anything other than faith in the U.S. government to do the right thing and confidence that the American economy would continue to thrive. This has worked out rather well for all involved parties.

Since the implosion of the Japanese economy and the fall of the Soviet Union, that faith has not been questioned in a big way, but it is being questioned now. Many of our trading partners around the world are beginning to suspect that their worst fears may indeed be true - that the robust American economy and the resilient American consumer, the locomotives for global growth since the stock market crash of five years ago, may not be what they appear to be.

Around the rest of the world, the U.S. dollar is losing its luster. The rate raising cycle that began almost two years ago has had the effect of distracting attention from the intractable problems facing the American economy - the twin deficits, long term commitments the government can't keep, and stagnant wages among others. Rising interest rates in the U.S. have restored respectability to the world's reserve currency after rates were held at historically low levels for what seemed like an interminable period of time, but with the recent chatter about the rate raising cycle coming to an end, everything is about to change.

Rising interest rates have been the only thing keeping the U.S. dollar aloft in recent years.

Ben's Choice

So the choice for Ben Bernanke is quite simple - save the dollar or save housing. Pick one, because you can't do both.

Saving the dollar would require continuing to raise interest rates not just to five percent but to six, seven, or even higher. Real interest rates, based on a more sensible gauge of "inflation", must be returned to historical norms to cool rising prices that show up everywhere except for government statistics. The long deferred pain must be delivered to the American consumer who spends too much, saves too little, and borrows much too much.

Continuing to raise interest rates would allow the U.S. Dollar to maintain its place as the world's reserve currency, proving to our trading partners that the dollars and dollar-denominated debt they are accumulating will maintain a good portion of their value over time.

Continuing to raise interest rates will, unfortunately, also kill housing and the economy.

Saving housing would require ceasing the interest rate hike campaign and likely reversing course. The pain already delivered must be dialed back, and what is waiting in the pipeline must somehow be stopped short of delivery. America's love affair with real estate, exotic loans, and adjustable rate mortgages will be forever shattered if the $1.2 trillion of ARMs are allowed to adjust to their prescribed levels next March. We Americans have become soft in recent years and can't take such a punch to the belly.

Easing off on interest rates would allow the housing market to achieve a soft landing where no one gets hurt. Spending will slow down, construction will slow down, and people will find something else to talk about at cocktail parties.

Easing off on interest rates will save the world - for a while.

Ben's choice is clear - the dollar is going down.