The businessman handed over the keys of a Rolls-Royce parked on the street in front of the bank. Everything checked out and the bank agreed to accept the car as collateral for the loan.

An employee drove the Rolls into the bank's underground garage and parked it there. Two weeks later, the businessman returned, repaid the $5,000 and the interest, which came to $15.41.

The loan officer said, "We are very happy to have had your business, and this transaction has worked out very nicely, but we are a little puzzled. While you were away, we checked you out and found that you are a multimillionaire. What puzzles us is, why a person of your standing would bother to borrow a petty amount like $5,000?"

The businessman smiled. "Where else in New York can I park my car for two weeks for 15 bucks?"

Borrowing is not bad if it is done for some productive purpose. Businessmen have borrowed and prospered throughout the history. A typical Fortune 500 company has billions in borrowings. In fact the more aggressively growing a company, the more it is likely to be fuelling its growth with borrowing, thus proving the veracity of Aristotle Onassis' words: "Behind every millionaire hides a frenzied borrower."

But the same phenomenon of borrowing becomes a noose around your neck if you use the borrowed funds for giving yourself a treat, without really deserving it. And this is what is happening in the US right now.

The US consumption binge, from stocks, bonds and real estate to the money the Americans spend in ritzy shopping malls, is being financed by foreign capital. People are loaded up to the gills in debt and yet they continue their flashy lifestyle. Managing their finances through a heap of credit cards, they go on buying imported plasma tvs, perfumes, watches, luxury condos, expensive wines, golf-associated villas, and SUVs, without bothering about how they will repay the debt.

They are suitably assisted by a government which is running the printing press non-stop. T bonds are being printed at the speed of light and being offered to the foreign trading partners. Remove the umbilicus of the foreign capital and you basically switch off the life support of a terminally ill US economy.

It is this sustained purchases of US debt by foreigners, as well as continuing foreign investment in the US stock market, that has arrested the decline of the dollar against foreign currencies, and given the impression to Wall Street aficionados that all is well under the sun.

This is where I suspect the things will go wrong. A weakening dollar can't go on attracting foreign investment forever. It is unlikely that this amount of foreign investment in the United States will continue for an extended period of time. And when foreign investment begins to decline, the US dollar will come under pressure, and the temporary strength in the dollar will disappear.

In fact, under normal circumstances, the trade deficit of this magnitude would have caused any currency to devalue, already by now. This in turn would have caused foreign goods to increase in price. More expensive foreign goods would have reduced the imports and the cheaper currency would have paved the way for increased exports. Thus the decline in the currency gradually would cause the trade balance to swing from a deficit to a surplus. A trade surplus would have caused the erstwhile weak currency to start increasing against other currencies.

However none of this has not happened in case of the US dollar, simply because of the dominant role of the USA in the world affairs. The robust power of the US diplomacy and its position in the uni-polar world has temporarily led to an aberration in the US economy in particular.

However this aberration, where in spite of an increasing trade deficit the dollar is staying stronger due to foreign investment, is not a manna from heavens but a curse of witches. The history provides enough examples of mighty kings who came crashing down solely due to their vices, even though they wielded enormous power. American diplomatic muscle power can't go on shielding the greenback forever. The exacerbating trade deficit needs to be corrected, and corrected sooner than later, because the more the delay, the stronger the correction.

How stronger? Well...just four major Asian central banks - Japan, China, Korea, and Taiwan - presently hold over one and a quarter trillion dollars worth of bills and treasury paper. Bank of Japan has so many that it is lovingly referred as "Federal Reserve of the East." No doubt some of these countries are holding these papers in order to keep the value of the dollar inflated and thus maintain the level of their exports to the US, yet it is obvious that they are holding more US dollars than they need.

What will happen to the dollar if these countries tomorrow, for some unforeseen reason, decide to sell their dollars? Nick Barisheff, President, Bullion Management Services Inc., has the answer: "If foreign investors get nervous and start selling some of their 10 trillion dollars' worth of US dollar holdings, it may create a descending spiral of further dollar declines coupled with financial asset declines."

Besides, if due to some political reason - and there are many: the Gaza Strip, the invasion of Iraq, excessive US control of Kuwait and Saudi Arabia, bungling up of Osama bin Laden affair, or continuous threats to Iran over nuclear program - the Arab nations stop investing in the US paper, there would be an economic turmoil last seen during the 1970s. "In some ways this is more worrisome than the T-Bond holdings of Asian banks." Says David C. Sacco. "Asian central banking interests are at least concerned enough about their countries' own financial health to avoid intentionally throwing the world into a recession."

Of course, even if the Japanese, Chinese, Korean, Taiwanese and Arabs continue to hold the US treasury paper, ultimately the dollar will have to come under the guillotine of devaluation - forced by the increasing budget and trade deficits. No currency can remain undisturbed when mired in such high level of deficits. Last two decades have shown us enough examples of it; be it Mexican peso, Argentinian peso, Brazilian rael, or Indonesian rupiah.

And once the US dollar begins to decline on foreign exchange markets, the foreign investors will start losing money on their US investments, even if their US investments are not losing money in US dollar terms. Simultaneously the countries which are holding the US dollars with their teeth, in the hope of maintaining the purchasing power of dollar and thus the level of their exports, will suddenly turn around and dump them as if they were tar babies.

At the same time the falling rate of return will compel the foreign investors to unload their investments in the US, even at throwaway prices, and hold clear of US dollars. As Doug Casey says "US dollars are only "legal tender" within the US, whether foreigners continue holding them depends on whether they have confidence in the dollar; confidence can vanish like a house of cards hit by a sirocco."

Of course the sirocco may well come from some other side. The rate increase, which is so lovingly being pursued by the Fed right now, itself may drive the nails in the coffin. "The US is now paying over $300 billion in interest to holders of federal debt." Says Nick Barisheff. "If this rate of increase continues, eventually annual tax revenues will not be enough to even service interest costs."

Suffused with words like "may" and "will", all this may seem a bit far fetched, a mere wishful thinking of perma-bears, but the fact is all this has happened in one country or another during last two decades. Funnily, when other countries were going through such problems, they were given lectures in fiscal responsibility, cutback in expenditure, and austerity measures by the very same people who are responsible for the malaise of the US economy.

And in case we think that all these processes take lots of time and come attached with enough warning signals, we might be slightly far from the facts. Once these processes begin, the changes are dramatic and the speed lightning. Let us remember India, which was having a smooth sailing in 1990 when suddenly it fell into a payment crisis. Just one bank, Citibank, by its non-cooperation, brought a whole country to the knee. India was left with forex reserves sufficient for only a month's imports. Panicked, the country's polity suddenly had to ferry its gold all the way to Britain to secure new foreign exchange loans.

The same was the case with Mexico. The North American country, which had comfortable level of foreign exchange, saw its forex reserves depleting at a rate of 300 million dollars a day. Within three months it was knocking at the doors of IMF for another bailout.

And in case we think that those running the Fed and the government are in control, we may be in for a shock. The critical indices are getting worse. America's debt to GDP ratio has ballooned to over 350% when compared to an already shocking 120% in the 1970's. Over the past 5 years only US$ 1.6 trillion was added to the economy while credit market debt rose sharply by US$ 7.6 trillion. To quote Barishaff again: "Today, the annual increases in the US federal budget deficit are greater than the total federal government debt was in 1971."

Worse the people are completely oblivious to the rot. Way back in the 1970s, when the US had a current account deficit, the people were aghast. It was the first budget deficit in about 100 years and the amount was two billion dollars - for the whole year. Today it is about $2 billion a day; and yet people take it in their stride.

And in case we think that the US is too big to fail; remember the fate of the dinosaurs.

©2006 Shailendra Kakani. All rights reserved.

Shailendra Kakani is the Research Head of Commodity Research Group, Bombay, India, and the Managing Editor of www.commodityresearch.in. He can be reached at editor@commodityresearch.in. or at

+91 98678 33034

-- Posted Wednesday, 24 May 2006 | Digg This Article