Every week we may hear and read about new corporate mergers and acquisitions. Flush with cash, private equity firms are ever ready for more deal making, bidding for and acquiring another company. The merger and acquisition boom is buoying stock prices across the board, which is benefiting most investors. Moreover, as some corporations are being taken private and others are engaged in stock buybacks, thereby reducing the overall supply of corporate shares, the stock market is enjoying an extraordinary boom, which many investors hope will never end.

Some economists are scoffing at such optimism; they like to point at the bursting of the bubble in 1929, which led to the Great Depression of the 1930s. They also remember the bursting of the Japanese bubble in the early 1990s, which kept the Japanese economy depressed for nearly a decade. And they cannot forget War II and postwar monetary policies which, by the beginning of the 1970s, had flooded the world with U.S. dollars. Some countries finally removed their currency ties to the dollar, and the oil-exporting countries cut their supplies of oil, which caused raw-material prices to soar. In the early 1980s, it took major Federal Reserve restraint to restore some measure of stability and several years for business to repair some damage and allow the American economy to expand again.

At the present, government planners and central bankers are making the same mistakes all over again. They all seem to like low interest rates, thereby rendering capital less expensive. When real interest rates are depressed, as has been the case all over Europe and in the United States early in the present decade, the economy loses a sense of direction, which may allow even unproductive producers to remain in business. In the long run, without the guidance of true market rates of interest, economies lose efficiency and productivity.

In a free economy, interest rates play a role similar to those played by prices and wages. They all spring from the people’s choices and value judgments, giving rise to “demand and supply” and guiding producers in their decisions. The market rate of interest is a gross rate usually consisting of three distinctive components: the pure rate, the depreciation rate, and the debtor’s risk premium. The pure rate is the very core stemming from man’s very nature which forces him to view economic phenomena in the passage of time. He ascribes a lower value to future goods and conditions than to present provisions; the difference is the pure rate. The depreciation component appears whenever government or its central bank inflates, thereby depreciating the currency; the rate of currency depreciation determines the size of the component. The debtor’s risk premium, finally, reflects the reliability and trustworthiness of the debtor.

Central bankers rarely pay attention to the market rate. Their policies are guided by popular doctrines calling for stimulation of national employment and income. They seem to be unaware that all rates other than market rates give false signals to producers and consumers alike; they cause maladjustments. Interest rates that are lower than market rates promptly increase the demand for credit. With all recent rates below the market rate it cannot be surprising that total American debt has surged by several trillion dollars. Last year, household debt alone rose by more than one trillion dollars. The federal government itself has been adding more than two billion every day. The Federal Reserve System, together with some 7,900 commercial banks, provided the funds; and foreign central banks and commercial banks invested their dollar earnings in nearly one-half of the federal government’s debt.

Such credit expansion, unsupported by genuine savings and capital formation, generates illusionary gains making people believe that they are more prosperous than they actually are. Stock and real estate prices soar, tempting people to spend their gains, improve their homes and build mansions. Actually, they all - businessmen and stockbrokers, executives and workers - may consume their material substance. But no matter how low the Federal Reserve may set its rate, the boom is bound to come to an end as soon as the maladjustments inflict losses on business. As more and more businesses face difficulties or even fail, the readjustment begins, forcing them to respond to the actual conditions of the market.

Today, the Federal Reserve is doggedly ignoring the market rate of interest. It continues to direct the credit expansion, which not only has turned housing into a large bubble and rekindled the stock market but also has given rise to a voluminous foreign trade imbalance. Both domestic and foreign maladjustments are inflicting growing pains on commerce and industry.

Some economists are convinced that central banks may have a ready escape from the dilemma: they may gradually return to higher rates of inflation which forces all fixed-income receivers and bond holders to bear the most losses. Optimists even like to point to the impact of globalization, which seems to limit the inflationary effects to real estate and the booming mergers-and-acquisitions market. But most economists are fearful of a recession which is a normal part of a business cycle. Fear may take hold of the minds of businessmen, production may be curtailed, and unemployment may rise. Government is bound to embark upon employment programs and assume increased public welfare responsibilities. It may even reduce some taxes, increase its budget, and force its central bank to lower interest rates another notch. The rate of inflation is bound to soar.

A few pessimistic economists are convinced that a devastating economic cataclysm lies ahead. They usually point to three threats that may have a serious impact on the American economy. There is the burgeoning tower of public and private debt resting on a foundation of greed and overindulgence. There are a multimillion dollar list of promises to a retirement system and a vast building of government guarantees and promises that are bound to be unkept. There even is a world of complex derivatives, the value of which depends on something else, such as stocks, bonds, futures, options, loans, and even promises. They all, according to these economists, will be the victims of the coming cataclysm.

This economist, who has observed central bank policies since the 1950s, is in basic accord and feels sympathy for these pessimists. They seem to have a clear view of the principles of money markets and the policies conducted by governments ever since they discarded the natural money order, that is, the gold and silver standards. But these pessimists tend to ignore the countless ruses, devices, and strategems used by government officials and central bankers to hide the consequences of their policies. Long before there will be a financial Armageddon, there will be a myriad of government regulations, controls, edicts, and rulings that hide the consequences of monetary policies. Policies will be readjusted frequently to cover the actual effects. Given the public confusion and unfamiliarity with monetary policies and their consequences, a large majority of the public is likely to accept official explanations and welcome the regulators and controllers.

After a short period of price and wage controls, the voices of reason, which at the present are barely audible, may be heard again. They may even be allowed to get the American economy moving again, by abolishing the myriad of price and wage controls and allowing wages and prices to readjust to market forces. They may even have to conduct a currency reform, that is, issue new money at various ratios to the old. Most countries all over the globe have suffered currency reforms in recent decades; it would be a new experience for Americans.

This trend of policy and its harmful effects is contravened by the worldwide movement toward globalisation. As trade doors open all over the globe and business capital is free to move to friendly countries enjoying rapidly rising levels of productivity and living, it will be difficult for American political controllers and regulators to hold on to their powers and move toward a command system. They cannot douse the light of economic freedom shining in so many places.

Regards,

Dr. Hans Sennholz
for The Daily Reckoning Australia

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But no matter how bright the economic outlook may be, the international prosperity is exposed to a looming risk, which has even grown in recent months. The war in Iraq and the skirmishes in Afghanistan are an ever-present danger that may destabilize the Middle East and spread the conflict to more countries. The Islamic republic of Iran, which does not hesitate to confront American interests and concerns, may upend the peace at any time. But the greatest concern of many economists is the global economic imbalance, which is clearly visible in the huge balance-of-payments deficits of the United States and in the corresponding surpluses of the creditor countries. Americans are said to consume some 70 percent of the world's savings, while Japan, China, and other developing countries are financing the deficits and accumulating American IOUs. Many economists are convinced that such disproportions and imbalances are unsustainable in the long run.

Surely, American foreign debt has increased significantly, but so has individual income and wealth. Total domestic debt has risen visibly over the last decade, but so have productivity and income. This economic harmony nevertheless is burdened by considerable risk of global imbalances that may cause disruption and upheaval in the future. The debt-and-credit differences of the large national economies continue to grow, the balance-of-payment deficits of the United States surpass all national surpluses. In 2005 the deficits amounted to some $790 billion, which, in relation to gross national product, exceeded six percent. So far this year, it may exceed $800 billion, or 6.5 percent of GDP. Moreover, the federal government continues to suffer huge budget deficits which enlarge the national debt and add weight to the international concern.

The mountain of American debt is matched by large balance-of-payment surpluses in developing Asian countries, as well as by most oil-exporting countries. Many creditors welcome the surpluses. They keep the exchange rates of their currency low, which, in turn, boosts their exports and gives employment to millions of workers who, with American assistance and technology, are learning to produce for the world market. Chinese banks now hold nearly $1 trillion, which is the highest reserve position in the world, having passed Japan this year with some $865 billion. Without such dollar purchases, their currencies would rise immediately, which would boost all export prices, curb exports, and depress economic production and employment.

A few critics believe that the U.S. trade deficits may be the greatest threat to the economic order. Yet the deficits have neither impaired the U.S. dollar nor undermined the position of the United States as the primary economic engine and power. Many observers, therefore, question and disclaim the dangers of American balance-of-payments deficits. They not only cast doubt on official statistics that may exaggerate the case, but also point to the stable rates of exchange in which all participants maintain voluntarily. Stability, after all, benefits everyone.

This economist, nevertheless, is convinced that a correction is unavoidable. All markets function to adjust and readjust any maladjustment. They are burdened and strained by the growing mountain of American debt, raising the question of Americas ability to meet its obligations. If there ever should be any doubt about the stability of the American economy, the worldwide demand for U.S. dollars would decline, causing the dollar exchange rate to plummet. American imports would decline, dampening the surge of consumption and slowing the very growth engines of export countries such as Japan, China, and many others. The whole world would feel the American instability. A weaker dollar and rising import prices also would accelerate the inflation rate which would pressure the Federal Reserve to raise interest rates. Higher rates would slow the American economy and boost the rate of unemployment.

Despite such international imbalances, the U.S. dollar has not weakened significantly in recent months, and the world economy has not fallen into a global recession. At first, Asian central banks, and then also the oil-exporting countries, financed the huge deficits. It is in the economic interest of the Asian developing countries to keep their exchange rates low in order to keep export prices low and thus keep the export motor running. Massive purchases of federal obligations support the exchange rate of the dollar and increase Asian currency reserves.

It is in the interest of the United States, as well as the Asian countries, that the U.S. dollar maintain its high exchange value. Some American economists like to speak of a "Bretton Woods II" arrangement, which would resemble the international system in effect between the Second World War and 1973. Participating countries supported each other's currencies and thus sustained stable exchange rates.

In Bretton Woods I, the member countries supported each other's currencies - in Bretton Woods II, they eagerly support the dollar. The European Central Bank, which actively pursues employment policies, manages to avoid the influx of U.S. dollars by keeping interest rates very low and liquidity plentiful. According to some estimates, the quantity of money in euro countries, since 2000, has increased some 25 percent faster than the gross product. In the United States, it has grown some 10 percent, and in Japan by 15 percent. The European Central Bank even surpassed the Bank of Japan, which is inflating its currency in order to counter powerful deflationary forces. In short, euro liquidity is plentiful and interest rates, seen historically, are exceptionally low.

As the U.S.-Asian imbalances continue to mount, the forces of readjustment are gaining strength. There are indications that the imbalances are correcting slowly and in an orderly fashion. Most governments agree that greater flexibility of the exchange rates, especially of the Asian currencies, is an orderly step toward the correction of the global imbalances. But most governments cling to their old policies. The interest rate differences are closing slowly, which causes more and more investors to shun the dollar risk. Moreover, the American real estate market has cooled off significantly without dramatic crashes. The boom, according to Fed Chairman Ben Bernanke, has given way in an orderly and moderate fashion. But there cannot be any doubt that the decline in the housing market will be felt throughout the economy in months to come.

Some Americans will have to curtail their spending which is bound to slow down the economy. Will it drag the world economy with it? The rate of expansion in many Asian countries undoubtedly will decline, but by less than pessimists predict. Most economic expansion in China, India, and other developing countries in recent years has been driven by domestic demand and supply. Yet we must not underestimate the weighty and consequential role played by the United States in world financial markets. A huge debt casts a shadow on any market; the rapidly growing international debt of the United States is clouding the world economy. It cannot grow perpetually; it will be settled sooner or later either in an orderly and upright fashion or in financial crisis and economic recession.

The finale of the scenario may be played by the Federal Reserve System. It may seek to reassure and pacify numerous Asian creditors by maintaining high market rates of interest or at least approximate them, or cater to the notions and wishes of most legislators and their constituents who usually favor monetary stimulation. Sooner or later Federal Reserve governors will have to choose between economic consideration or political preference. Their choice will determine the future of the U.S. dollar.

Regards,

Dr. Hans Sennholz
for The Daily Reckoning

Editor's Note: Dr. Hans Sennholz is president emeritus of The Foundation for Economic Education (FEE) in Irvington, NY. His essays and articles have appeared in over thirty- six major German journals and newspapers, and 500 more that reach American audiences. Dr. Sennholz is also the author of 17 books covering the Great Depression, Gold, Central Banking and Monetary Policy.

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