Where it Stops, Nobody Knows

News websites could just permanently affix a headline to their pages with the words "Dollar drops to new low against the Euro." This could be the headline everyday. It isn't likely to stop anytime soon. The Federal Reserve has made it clear: rates are heading lower. The European Central Bank has also made themselves clear: rates aren't heading anywhere. Inflation (like misery) loves company. But the dollar isn't getting any love these days.

And this is where the dirty little secret about oil prices begins to expose itself. This week we have heard President Bush calling for OPEC to boost oil production because prices are putting a squeeze on Americans and "causing" inflation. As if we needed any further proof that President Bush doesn't have an understanding of economics, he keeps bringing it our way.

First, we might need to play Myth Busters: The Economy Edition. There is a pervasive notion that a rise in energy prices causes inflation. Even the President of the United States seems to believe this. This concept, known as "cost plus" inflation, posits that whenever the price of an essential input into a good goes up, then it drives up the cost of the good and if it is something like oil, which is an input into almost everything, then it drives up the cost of everything else. This is pure fantasy. In an economic setting where there is no monetary inflation--that is, there is a perfectly stable money supply, prices do not rise, but rather demand for certain things fall, some goods are no longer profitable produce and their production ceases, and everything goes back into equilibrium. We do not live in that world, however, because we do have monetary inflation. And it is monetary inflation that is the cause of price inflation, not oil.

To illustrate this point, I found three important historical charts that I am reprinting below for your convenience. The first chart is a five year historical chart of the US Dollar's exchange rate with the Euro. For those of you who might not be familiar with the way exchange rates are quoted, the graph you are seeing immediately below shows the value of the Dollar relative to the value of the Euro. You will notice that the Dollar has more or less steadily fallen against the Euro since January 2004, with the total depreciation reaching 28%.

Similarly, we find that Oil prices have risen, meaning that the dollar has lost value relative to oil, over the same period. The graph below illustrates this, showing the price of oil in Dollars from 1999 to present:

Notice especially that the price of oil in 2004 was approximately $30 per barrel. Today it is $105 per barrel. If we invert the comparison, and price the dollar in terms of barrels of oil, what we find is that in 2004, 300/1,000 of a barrel of oil would get you $1. Today, it only takes 9/1,000 of a barrel of oil to get a dollar. That is a 97% decline in the value of the dollar in terms of oil.

Finally, we must look at Gold, the hard currency that everybody reverts to when inflation seems to be on the rise:

As you can see, in January 2004, the price of Gold was hovering just above $400 an ounce. Today, however, at the moment I am writing this blog, Gold is trading at $976 an ounce in the spot market. To make the comparisons equal, let's look at gold in terms of the dollar. In 2004 an you could get a dollar for 0.0025 ounces of gold. Today it only takes 0.001 ounces of gold to get the same dollar. That's a 60% decline in the value of the dollar in terms of gold.

Before we get to the analysis of all of this, let's summarize what we see in these graphs one more time...

Since 2004, the value of the dollar has declined 28% against the Euro, 97% against oil, and 60% against gold.

The twin culprits for this massive atrocity are U.S. Fiscal Policy (Thank you Congress & President Bush) and U.S. Monetary Policy (Thank you Alan Greenspan and Ben Bernanke). Let's start by looking at why Fiscal Policy is responsible for the situation.

Fiscal policy refers to taxing and spending, the powers of which are delegated to Congress by Article I of the US Constitution. Due to the ascension of the Imperial Presidency since The New Deal, the President now plays a pivotal role in fiscal policy, certainly not one envisioned by the framers of the Constitution, who saw the president as purely a referee, stopping bad fiscal legislation, rather than being responsible for proposing the government's budget each year. But these days, Congress serves more of a consultative role in the budget process. Nevertheless, Congress has as much blood on their hands as the President has on his, since budgets can't gain adoption without Congress's approval.

And Congress and the President have been on a spending orgy for the last 8 years. Balanced budgets and fiscal discipline are nothing more than the rally cry of the opposition--whoever it is. It reminds me of what G.K. Chesterton once wrote "When a politician is in opposition he is an expert on the means to some end; and when he is in office he is an expert on the obstacles to it." Nowhere has this been more true than on the subject of balanced budgets.

The only two times since the Eisenhower Administration that the U.S. has run a balanced budget have been under the two most scandal-ridden Presidents (Nixon and Clinton) when Congress was controlled by the opposite party of the President. Should it really require complete gridlock to achieve responsible spending policies?

Our other culprit is of course the much venerated Federal Reserve. If consumerism were a religion, the Fed Chairman would be its Pope. Everybody waits to hear the edict from on high that "everything will be ok. God is taking care of it." In this case, The Fed thinks itself both Pope and God. And just like the Old Testament manna from heaven, the Fed has promised more liquidity than we could ever ask for. The only problem is that unlike manna, Greenbacks aren't edible. Especially electronic ones.

Everybody is looking to Ben Bernanke to save the economy. Congress brings him in to testify and assure them that the economy will get better so that they can keep doing nothing and still keep their jobs. Yet Mr. Bernanke could not offer them much hope. In his recent testimony before the House committee charged with overseeing the Fed, he offered up what the Fed is doing at present to help remedy the situation:

The Federal Reserve continues to work with financial institutions, public officials, and community groups around the country to help homeowners avoid foreclosures. We have called on mortgage lenders and servicers to pursue prudent loan workouts and have supported the development of streamlined, systematic approaches to expedite the loan modification process. We also have been providing community groups, counseling agencies, regulators, and others with detailed analyses to help identify neighborhoods at high risk from foreclosures so that local outreach efforts to help troubled borrowers can be as focused and effective as possible. We are actively pursuing other ways to leverage the Federal Reserve's analytical resources, regional presence, and community connections to address this critical issue.

For an institution who has been given god-like respect, the Fed doesn't seem to have all the answers--and certainly not all the power. If I had been an ancient Israelite after the Exodus, complaining to Moses that we were fat and happy in Egypt and now we are starving, I don't know that I would have been satisfied if he had said "The Lord your God continues to work with Aaron and I to support the development of streamlined, systematic approaches to expedite the food provision process. He has also been providing us with detailed analyses about how hungry you are and how you might hunt, if there were actually any animals around, or to farm if it happened that you were to occasion upon fertile soil."

Like the spoofed George W. Bush from Saturday Night Live's 2000 Election Debate special, we hear Mr. Bernanke and the Federal Reserve giving us a blank stare and shouting "PASS." But they can't pass. When it comes to monetary policy, the buck stops with the Fed. Or does it?

The Federal Reserve Act was passed on December 23, 1913, in a late-night session that threatened to prevent members from being home to their families on Christmas. As an attempt to prevent future bank runs and shore up the stability and credibility of the American currency, the Federal Reserve was created to oversee America's money. Its legacy is not so grand. Within the first two decades of the Fed's existence, America endured its most memorable and lasting depression, the legacy of which remains with us today in the form of crippling entitlement programs and worse, an entitlement culture that threatens the solvency of the Republic.

Congress created the Federal Reserve, and Congress can constrain it, criticize it, and even eliminate it. The Constitution envisioned Congress with the authority to control the monetary policy of the country--which was surely less complicated in 1787 than it is today. I certainly would shudder at the thought of Congress manipulating the money supply in the way the Federal Reserve does, but if we lived in a fantasy world where members of Congress were responsible, then one could theorize that we could have a stable monetary policy based on a hard-money standard with strong anti-inflationary components. This is unlikely to happen.

Mayer Amschel Rothschild said "Give me control of a nation's money and I care not who makes her laws." And so the mega-banks and Academic Economists have wrested control of our nation's money from our nation's lawmakers. As I previously intimated, this is a double edged sword. Given the incompetence of Congress, we might rejoice that anybody other than they are in control. Yet the mega banks and their wealthy mega bankers certainly benefit the most from the Federal Reserve system. After all, nobody rushes to the aid of the small business in middle America when it is about to go belly up. But you can rest assured that CitiGroup will never seriously have to worry about bankruptcy. They will always have the golden, or at least green, ripcord of the Fed to parachute them safely to the ground.

It is a parachute we all pay for, though. We pay for it with $100+ oil and $3.25 at the pump. We pay for it with $5 gallons of milk and $1,000 gold. The piper always gets paid--the question is just about who does the paying. In America, it's the average guy on the street, not the politicians who gave us a faulty system and not the mega bankers who abused that system for fraudulent profits.

There is a silver lining. But only a lining. Unlike most people throughout history, America's people are not powerless against such forces. The Constitution of the United States gives us a mechanism for changing and fixing broken policies. It doesn't happen on its own, though, and we have to do our part. We can start by rejecting more bad policy. That means saying "We can't afford..." to all of the proposed entitlement programs that we will be promised in 2008. That means saying "we know we have to have a recession. Bring it on."

It is a true saying that "all is not gold that glitters," and even the glitter is starting to wear off of the fool's gold these days. That's why the price of real gold keeps going up, up, up. And where it stops--nobody knows. Especially not the Fed.