The Canary Is Dying and So Is Our Future

March 10, 2011 05:20

Because prices are the transmission mechanism for economic allocation and change, shifting value in the purchasing power of the dollar will reflect inter-country changes. In effect, the dollar is their early warning mechanism. It is their canary.

From Monty Pelerin’s World

Wikipedia describes the use of animals as early warning sensors. Canaries were used by miners:

The classic example of animals serving as sentinels is the canary coal mine. Well into the 20th century, coal miners in the United Kingdom and the United States brought canaries into coal mines as an early-warning signal for toxic gases including methane and carbon monoxide. The birds, being more sensitive, would become sick before the miners, who would then have a chance to escape or put on protective respirators.

Early warning signals can be useful in finance and economics, although they are difficult to find.  Established and reliable relationships are key. When an established relationship begins to fail, it could provide the same warning as a dying canary in a coal mine. For miners, a dying canary was a sign to take protective action, including leaving the mine. For investors, failing established relationships could provide the same signal.

More than a few sophisticated investors consider the dollar as the key variable to watch. Because prices are the transmission mechanism for economic allocation and change, shifting value in the purchasing power of the dollar will reflect inter-country changes. In effect, the dollar is their early warning mechanism. It is their canary.

The Dollar Relative to Other Currencies

The dollar and Treasuries are considered safe havens. That mantra is one of Wall Street’s favorites. The belief is grounded in many years of history. Since the end of World War II, the US has been considered economically stronger, politically more stable and fiscally more responsible than other countries. When world risk and uncertainty increase, foreign money tends to move into lower risk areas. Dollar-denominated assets, particularly Treasuries, is a preferred destination.

There is nothing inherent in the US that makes it a safe haven. Nor is there any assurance that it will continue to be regarded as such. Just as this status was earned by relatively prudent fiscal and economic behavior, so it can be lost by profligate behavior. The last decade or two, and especially recent years, has dramatically altered the financial condition of the US. Perception seems slow to change, although astute analysts now consider the US to be no safer than some other areas of the world.

Irresponsible behavior on the part of the US government has jeopardized the country’s financial condition. As a result its fiscal condition no longer differs from many other countries. For those who follow such matters closely, the US appears to be the beneficiary of the gap between its actual financial condition and its perceived condition. Many consider the dollar and Treasuries as “the canary in the coal mine.”

To understand the irresponsibility of the US, the dollar’s performance against a basket of other currencies is all that is required:

Click on chart to enlarge

The weakness of the dollar versus other currencies since 2002 is apparent from this chart. From a high of about 120, the dollar dropped to a low of around 72 by 2008, a loss of almost 48%. This loss is a relative one, not an absolute one. That is, it represents a loss against other fiat currencies not against a fixed standard. Given that most fiat currencies were losing purchasing power during this period, the absolute loss is larger, although difficult to measure. What is reflected in the chart is the dollar losing purchasing power faster than other currencies (which also were losing but not at as fast a rate).

Some interesting observations are available from the above chart. The rebound in the dollar in 2008 reflects the financial crisis. Reflexively, there was a run to dollars as a safe haven. Once it was apparent the world was not ending, the dollar reverted to its pattern of decline. In late 2009, the dollar rallied again. That rally reflected the fear that various countries in Europe were going to default and the fear that the Euro might not survive. Once that crisis stabilized, the dollar returned to its longer-term pattern.

Implications of The Decline in the Dollar

The implications of this loss in value of the dollar are significant. A few comments should suffice to provide an understanding:

  • During this period, foreign investors in the US stock market would have had to earn 48% to break even on their investment. Their funds in the US declined by 48% relative to the currency they were repatriated to.
  • US investors in foreign markets, if they broke even in those stock markets, would have realized a 48% gain when they repatriated the funds.
  • In terms of global purchasing power, Americans lost 48% of their purchasing power. This loss reflects a reduction in the standard of living of each American relative to their international counterparts. Their counterparts gained 48% relative to Americans.

The phenomenon of measuring currencies relative to each other is equivalent to measuring the rise and fall of particles floating in a septic tank. At any particular time, one particle may be rising or falling relative to others. At a different time, it may be doing the opposite. This is relative measurement. It is also an appropriate analogy if you understand what a septic tank contains. There is no better analogy for fiat currencies than particles in a septic tank.

The Dollar Relative to Gold

No absolute measurement of the decline in the dollar is perfect. Comparing the dollar to the price of gold is probably the closest one can come.

Throughout history, gold has represented either actual money or an alternative currency. Gold has unique properties because it has little industrial demand to drive its value and its supply is relatively fixed. Fluctuations in gold’s value represent primarily its demand as an alternative to fiat money.

The price of gold is shown in the following chart:

Click on chart to enlarge

From 2002 until today the price of gold rose from about $300 per ounce to over $1,400. In terms of gold, the dollar lost 79% of its value.


For those who think a price index is a more reasonable method to approximate the decline in the dollar, The practical problems of creating and maintaining a proper index are overwhelming and impossible to circumvent. The Consumer Price Index, a well-known index is replete with flaws. It is also highly politicized and manipulated for political advantage. (See for criticisms of the CPI.)

The US government’s own data shows that the dollar has lost 96% of its purchasing power since 1913, when the Federal Reserve was created. Most of this loss occurred subsequent to 1975.

The Value of the Dollar

Regardless of what method you use, the value of the dollar has dropped precipitously. For the period 2002 to 2008, it dropped 48% versus other currencies. We know this figure understates the absolute drop because the comparison (the basket of currencies) was itself deteriorating. This measure alone is indicative of failed policies and a faltering country relative to other countries.

The Dollar as a Canary

Analysts who believe an economic apocalypse is in our future are hard-pressed to describe when and how that unfolds. Almost all, however, point to the dollar as playing a central role in the drama. If the dollar is the transmission mechanism to the next stage, it would appear to be the economic equivalent of the miner’s canary.

In retrospect, the dollar has been a dying canary for a number of years. It may be one of the longest deaths on record as it has been in critical care from 2002 until today. Interestingly, for most of this period, the economy appeared to thrive. The illusion of  economic health was generated by the world’s largest credit boom.

Credit expansion produced increases in GDP and other macro indicators. It also created distortions at lower levels of statistical aggregation. Macroeconomics looked good; the neglected microeconomics did not. While macro gets the headlines, micro eventually wins the game. Distortions at the micro level eventually break through to create the crisis. That is exactly what happened in 2008.

For the period 2002 until 2008, financial markets reflected the underlying damage the government was inflicting on the economy via their continuing devaluing of the dollar. The astute investor heard this canary chirping and looked behind the dollar decline to understand what was happening. The credit expansion was obvious. Less obvious was the hollowing out of the economy that was occurring as a result of distorted prices and interest rates. Mispriced assets and credit cause faulty economic decisions.

Crossing the Rubicon

Even less obvious to most observers was the government crossing the financial Rubicon. Rather than allowing the economy to adjust and purge itself of its excesses and misallocations, government decided to try and cover these up and restart the boom.

Click to enlarge

Current government policy is geared at suppressing the adjustment in distortions by heaping more credit onto the fire. Thus far, it has managed to increase reported GDP while suppressing the coming correction. By embarking on this course, the government has committed to a continuous policy of increasing credit. Not only must credit continue to be increased, it must be increased by ever greater amounts. This course cannot be stopped or altered without plunging the country into a Depression.

Supplying more credit is akin to providing more drink to an alcoholic. All it does is defer the “drying out” period at the cost of making it that much more painful.

Understanding the fact that  simple trend and recognizing that government committed to a treadmill that it had no ability or intention of getting off, Investing in gold for the past ten years was a dramatic winner without a down year. But that is history. Will it continue? Probably, but no one knows for sure. For those who say that gold is a bubble, there are two rejoinders. First, are you watching Ben Bernanke and what he is doing? Second, bubbles typically end with parabolic type moves. Gold has not shown that kind of movement yet.

The Dollar as Continuing Canary

While government can continue to supply unlimited amounts of credit, it cannot control the value of the dollar. Markets are already in the process of writing off the dollar. At some point massive inflation, possibly hyperinflation, will occur if the current course is not altered. Markets are bigger and stronger than governments. They discipline economies and governments, not the other way around.

Is it possible to utilize the dollar as miners used to utilize a canary? There probably is. Bill Bonner of the Daily Reckoning focuses on a key relationship — the behavior of the dollar vis a vis gold and geopolitical events. Given what is happening around the world, especially the unrest in the Middle East, one would have expected the dollar to have strengthened. Mr. Bonner points out:

This could be important: the dollar has NOT gained from the unrest in the Arab nations. People no longer seem to see the dollar as a haven of safety. Instead, they turn to gold…

According to Mr. Bonner, we may have reached the point where the dollar is being increasingly recognized as just another junk fiat currency, afflicted with all the ills that have always plagued fiat currencies. Instead of running to the dollar as in the past, Mr. Bonner points out:

The smart money is buying gold. But the dumb money – which is most of it – is still against gold. It doesn’t understand that monetary systems are temporary…that they ALL fall apart eventually…and that, when they do, people turn back to real money – gold.

He utilized this chart to show the decisive separation of the dollar and gold which coincided with Bernanke announcing QE2:

One thing we know already is that the dollar and gold parted ways last summer, right about the time Ben Bernanke stood before the Grand Tetons at Jackson Hole and announced his grand design to continue debasing the dollar until something good happened.

This chart is the sign of a canary dying. The US no longer has a currency believed in by the rest of the world. It has destroyed its reputation as a fiscally responsible nation and hollowed out its economy with questionable tax and regulatory policies. It is managed by a corrupt class determined to enrich themselves and maintain their positions no matter what harm they inflict on the country.

Our short-term destiny has been written by the Fed and government. We are headed for a Great Depression that will likely make the 1930s look minor. For the last couple of years, everything has been a charade to make the sheeple believe that matters are getting better. In Mr. Bonner’s words:

The party’s a flop. It’s a fraud. A bunch of stuffed-shirt zombies are standing around with drinks in their hands. Listening to awful music. Talking a line of guff. And no one is listening.

Our standard of living will continue to decrease. That is certain. How much is uncertain and a function of government meddling.

The canary may not be dead yet but it is terminal. Take appropriate action now!

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