January 08, 2004

The Dollar: Europe's Problem Now, The President's Problem at 1.50 to the euro

Below is a great note from Lord Rees-Mogg regarding a dire CBO report about the budget, taxes, and, implicitly, the upcoming U.S. presidental election. I'll be seeing Lord Rees Mogg next week as part of our debut investor's round table here in London. I'll be sure to let you know how it goes... Strategic Insider – 7 January 2004 - William Rees-Mogg In December the Congressional Budget office gave a warning that “unless taxation reaches levels that are unprecedented in the U.S. current spending policies will probably be financially unsustainable over the next 50 years.” Any warning which covers 50 years is likely to be disregarded. Many of us do not expect still to be paying taxes in 50 years time. Those who will are mostly infants or teenagers. And neither infants nor teenagers are regular readers of warnings from the Congressional Budget office. The warning, however, is no joke. What it is really saying, which will be only too familiar to our readers, is that U.S. current expenditures are unsustainable with present levels of taxation. The current Budget deficit is $500 billion. Expenditure will rise. Over the economic cycle the U.S. faces a growing deficit, though the current boom, based on very cheap money, will produce rising tax revenues for the time being, long enough for the Republicans to win re-election in November. Some day, somebody will have to bring spending back into line with taxation or raise taxes to pay for Federal spending. The Federal Budget is politically on the same trend as that of California; it is a disaster waiting to happen, though, unlike California, it is one which can probably be postponed until after the next election. The slide of the dollar is the one aspect of the problem which may force the President, and the Fed. to act. At $1.26 to the euro, it is still possible to argue that the problem is Europe’s rather than America’s. After all, the overvalued euro is the non-competitive currency. It is Europe’s exports which have become too expensive. At $1.50 to the euro, if the market were to reach that point, the problem would very clearly be Washington’s. U.S. monetary policy is very largely determined by the U.S. political cycle, and particularly by the cycle of Presidential elections. It has always been the policy of the Federal Reserve to avoid major policy shifts in an election year. The usual effect is to help the incumbent party. In most Presidential years, the U.S. economy is expanding and stock markets are rising. That is why the Fed. is viewing the present slide of the dollar with such complacency. No-one in Congress, from either party, wants to raise taxes in an election year. However, we are still a long way away from the actual election date. The dollar has already fallen by 30% against the euro and 20% against the pound. At what point will the American public start to notice? Most market analysts expect the slide to continue. At some point, American voters will take the alarm. The slide will have inflationary effects. Both U.S. and foreign producers will start to raise their prices. It is already having some inflationary impact on China, the world’s most competitive producer among the major economies. The Chinese Renminbi is linked to the dollar; that link may have to be broken. The gold price, now over $420 an ounce, will continue to rise. I have been forecasting the rise in the gold price for many months, and I think it has much further to go. At some point, the Fed. will have to react and do something to defend the dollar. The longer the delay, the harder it will be to stop the momentum and reverse it. Yet higher interest rates are very unpopular in an election year, and particularly unpopular with a President seeking re-election. The December warning from the Congressional Budget office is not a 50 year warning. It is more like an 11 month warning. What it is saying is: “Look out for the impact of the Budget deficit on the dollar. It is the one thing that could prevent the re-election of the President.” Now that is a warning that people will notice. Indeed, the President himself will have to notice it. William Rees-Mogg 7 January 2004


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