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The Mother of All Currency Crises

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This is it, Fools!

For everyone who has wondered when the consequences of uncontrolled deficit spending and monetary interventions approaching $14 trillion would finally catch up to the U.S. dollar ... that time is now.

The world has seen enough.

On top of an $11 trillion national debt -- actually, it's above $56 trillion including entitlements like Medicare and Social Security -- the specter of $1 trillion deficits for years to come leaves little luster in the wilting greenback. Although the world gazed with detached fascination at Zimbabwe's plight, the role of the U.S. dollar as the planet's primary reserve currency makes this the mother of all currency crises.

History will reveal to our indebted descendants that the Federal Reserve's foray into quantitative easing with a $300 billion purchase of Treasury bonds -- essentially funding debt with more debt -- provided the final straw.

I have harbored concerns for some time that China and Russia would stop playing along with our fiscal madness and begin diversifying away from dollar holdings. In the run-up to a key summit of the G20 leaders in London next week, both nations have become vocal dissenters regarding the dollar-dominated currency regime.

The BRIC builds a wall of opposition
China and Russia are promoting a "super-reserve currency" using a modified instrument of the International Monetary Fund (IMF) called Special Drawing Rights (SDRs). The SDR is a basket of four currencies (the dollar, pound, euro, and yen), but China proposes including a broader set of currencies and using the SDR for international trade and to price commodities. Russia has indicated that the remaining BRIC countries -- Brazil and India -- also support this approach, and together these nations will comprise a formidable force at the upcoming G20 summit.

The United States also wants to deploy SDRs, but for precisely the opposite purpose. Incredibly, senior Treasury officials have called for the IMF to issue huge quantities of SDRs as a kind of global stimulus package. By suggesting that the IMF member nations engage in globalized quantitative easing, the administration provides further evidence of its unfettered resolve to stay the course with this dubious strategy of spending our way out of the crisis.

A former chief economist from the IMF, Simon Johnson, offered this eerie characterization of the proposal: "The principle behind it is that everyone would get bonus dollars and instead of the Federal Reserve having to print them, everyone gets them." Wow, did I miss something? Did he just reveal the existence of a magic money tree? Of course not, but to understand why that is, we have to know about more about SDRs.

Anatomy and history of the SDR
Back in 1969, when dollars remained convertible to gold, the SDR was created to permit the expansion of world trade beyond the confines of available reserves. For a few brief years, SDRs performed the function of a reserve currency. In 1973, when the world abandoned Bretton Woods for a floating fiat model, SDRs became little more than a means of capitalizing the IMF.

According to the IMF: "The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members." Therefore, a global market for SDRs is only achievable through securities (i.e., OTC derivatives). Yes, the very instrument which China and Russia are advocating as the next reserve currency of the world would require the creation of unfathomable values in those same derivatives which Warren Buffett called "financial weapons of mass destruction." Derivatives, dear Fools, are the missing link between Mr. Johnson's above explanation of Treasury's SDR plan and any semblance of actual logic.

The anti-dollar trade is on
Regardless of how the growing global aversion to the U.S. dollar plays out, the critical takeaway for investors is that the dollar is headed into weaker territory as ramped-up spending runs smack into a world with no appetite for the growing risk. Quantitative easing is a very slippery slope, and I am willing to bet that we have not seen the last of the Fed's purchases of Treasury bonds ... not by a long shot.

With that in mind, some of the very same investment opportunities that fell apart last year will come back into vogue. Commodity-related equities within BRIC countries look attractive to me, including Petrobras (NYSE: PBR  ) and Vale (NYSE: RIO  ) in Brazil, or CNOOC (NYSE: CEO  ) and Aluminum Corporation of China (NYSE: ACH  ) in China. Gold and silver remain time-tested hedges against dollar weakness, with Agnico-Eagle Mines (NYSE: AEM  ) , Yamana Gold (NYSE: AUY  ) , and Silver Wheaton (NYSE: SLW  ) topping this Fool's list.

In every respect, we are witnessing the mother of all currency crises. While these events present an unavoidable sense of uncertainty, there is no need to fear as long as you prepare.

Further Foolishness:

One advantage of our modern financial system is that investors can look to defend themselves against dollar weakness by looking abroad. The Motley Fool Global Gains newsletter team is constantly scouring the globe to identify investment opportunities for Fools who wish to diversify out of the domestic markets, and they're ready to share their findings with you.

CNOOC is a Motley Fool Global Gains selection. Petroleo Brasileiro is a Motley Fool Income Investor pick. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Christopher Barker thinks derivatives are a dirty word. He can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He owns shares of Agnico-Eagle Mines, Aluminum Corporation of China, CNOOC, Silver Wheaton, Vale, and Yamana Gold. The Motley Fool's disclosure policy has zero exposure to derivatives.

Read/Post Comments (11) | Recommend This Article (78)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 27, 2009, at 4:23 PM, dudemonkey wrote:

    It's like you've been following my CAPS picks. Well, the good ones anyway!

  • Report this Comment On March 27, 2009, at 6:33 PM, jbromet wrote:

    Isn't the government promoting a ponzie scheme of its own? If Madoff is being prosecuted for his ponzie scheme, why is it legal for the government to do so? Oh, maybe because there's no way to prosecute the "representatives" of the US government for their participation! For the same reason that a turnstyle jumper goes to jail, but a Congressmen who helps bankrupt the country gets a lobbying job in Washington, or worse in the Middle East.

  • Report this Comment On March 27, 2009, at 9:28 PM, byzantic wrote:

    A reserve currency may be a good thing for the US too if it prevents vainglorious politicians from pursuing expensive and counterproductive military chimeras abroad leading to undesirable balance of payments deficits and deaths, and instead focuses their attention on internal economic development in productive and useful sectors.

  • Report this Comment On March 27, 2009, at 10:11 PM, xetn wrote:

    In the not too distant future, Ron Paul's and the Austrian School of Economics' predictions of a crashing dollar become worthless. Your observations are very good. You can not bring an economy out of massive debt with more debt. It is pure insanity. The only way out of this mess is for the government to do absolutely nothing. Let the broke companies fail through bankruptcy and stop inflating the dollar, cut government spending to the bone and cut taxes. These measures will return the economy back quickly and the economy will be much stronger.

  • Report this Comment On March 28, 2009, at 1:33 AM, trenton1ryan wrote:

    Probably the most intelligent and straightforward MF article I've read in a very long time.

    Inflation is the river Styx that we MUST cross to get back some semblance of sanity.

  • Report this Comment On March 28, 2009, at 8:15 AM, SintUniversal wrote:

    As foreigners, we are amazed when visiting USA because everything we buy are made overseas and imported. Top Americans work in financial, engineering, universities and politics (top or bottom category?), others work in restaurants, casinos, movies, sports etc. Almost all Americans work in service industry. You produce nothing except aircrafts, heavy equipment (like Caterpillar), pharmaceuticals, cars and a few others. Any country who import more than export and have huge trade deficit will have problems in the long run, let alone internal National Budget deficit and cities/municipalities overspending. It is a wonder how could USA last until now since Nixon abandoned the gold/dollar standard. The IT breakthrough back in 1970s perhaps prolonged this unavoidable catastrophe. But we really think you now have a great President. So please be patient and patriotic to cooperate with him to bring your nation to glory again. CHANGE your bad habits and remember how your nation founding fathers built this great country on hard work, frugality and morality.

  • Report this Comment On March 28, 2009, at 9:46 AM, XMFSinchiruna wrote:


    Your observations are most astute. The latter challenges you mention are enormous, and will span more than one administration in their realization, but I certainly hold out some measure of hope that we will return to our roots as a nation and honor the legacy of our founding fathers (and mothers). :)

    Thank you very much for your comments and your readership!

  • Report this Comment On March 28, 2009, at 9:57 AM, menefer wrote:

    Our "consumer economy" based on borrowing and bubbles has been leading to a weaker dollar for years. It was a question of "if" not "when". However we are here and what do we do about it? The notion that we do nothing is wrong. We do not "spend" but we "invest" our way to a solid economy. We must create jobs, get the runaway cost of healthcare under control, increase the number of American's with a usable education and get the runaway compensation of the top few back under control. Reading today's headline " Wyeth CEO to get $53 million" illustrates why healthcare costs are too high. I think the Obama administration is moving in the right direction and given our support will turn this economy around. But it will take an investment using borrowed money. We'd better do it now while we can still borrow.

  • Report this Comment On March 28, 2009, at 11:54 AM, none0such wrote:

    Very nice article - a bit different perspective from the Economist's recent take on the issue.

  • Report this Comment On March 28, 2009, at 5:27 PM, XMFSinchiruna wrote:

    Thanks to everyone for your feedback! There is more discussion of this article ongoing at my CAPS Blog:

    Fool on!

  • Report this Comment On March 28, 2009, at 5:28 PM, farmnut1985 wrote:

    Governments #1 philosophy: "If something is wrong, well just throw more money at it and that will fix it." Like said above, minimize spending and let failing companies fail.

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