The global currency monitors look around and see Lebanon, Palestine, Iraq and Iran. They hear arguments for a Shiite state in eastern Iraq, where most of the oil fields are and they realize that Iran has won the first battle in the war for energy assets in the Iraq region. We predict that many more battles for energy assets in this region may develop soon.

Seeing these developments they say to themselves the following: The U.S. will be spending money to secure this region while maintaining a full plate of domestic spending. They also recall the statement by Milton Friedman who famously said, “Nothing is so permanent as a temporary government program.” We can argue Middle East military spending started as a temporary government program and has grown to a much bigger and more permanent program.

5 YEAR CHART OF THE U.S. DOLLAR

This means more bond sales by the U.S., more interest expense and bigger deficits. It also requires finding someone to buy the bonds.

Many friendly countries have been going through the following process for the last few months, and realizing that a balanced U.S. budget is far in the future.

1. Realizing that President Bush is militarily and economically overextended.
2. Realizing that the U.S. is in a very weak negotiating position, many countries are using the current opportunity to protect their big asset in U.S. dollar debt.

How will the friends of the U.S. do this?

1. By shifting their assets from the U.S. dollar to the Euro or some other currency.
2. By buying more gold to hold as an asset in their treasury instead of IOU’s from a free spending, heavy bond issuing country.
3. By stockpiling more base metals and oil.

They want to diversify out of the dollar, but want to do so without setting off a major rout of the dollar. It is a delicate balance, especially for the friends of the U.S.

The enemies of the U.S. have an even bigger goal. It is to destroy the U.S. as an international power. In this effort, they are being aided unwittingly by those who will spend public funds to a level beyond the means of the U.S. economy to support the expenditures.

This unwise allocation of resources will lead to economic destruction if not identified and corrected.

“The Rise and Fall of the Great Powers” by Paul Kennedy is a book that I have mentioned in these memos several times over the past years. The story it tells is a familiar one to students of economic history.

A major country tries to expand its political clout beyond it borders on an international or global level. In order to do this, it builds a big and expensive military and engages itself as the world’s policeman. Eventually, its military spending outstrips its ability to pay, and it loses its military, economic and political power. Part of this loss of power is the loss of its reputation as an economic power, and as a safe place to invest. Once one’s reputation is lost, one’s currency loses its allure to foreign investors.

The dollar is falling because of the problems outlined in above.

What we see ahead is more of the same. But why?

How can the U.S. quickly correct the problem? I cannot think of a quick fix for this problem. All the solutions, even the most radical, will take at a minimum of several years. Many will take much longer.

A recent study by State Street Research points out that U.S. consumption of goods and services exceeds domestic income by 7 %. In recent years, people have borrowed against their assets to finance this spending. The study shows that asset values (mainly real estate) and household debt would have to rise forever in relation to incomes to keep the current U.S. growth rate trending at the same level.

I would now like to quote John Plender of the Financial Times who said in an article entitled, “The Waning Dollar and the Brave new World” published Dec 4 2006:

“Markets are adjustment mechanisms. When liberalized, as the capital markets have been on a global basis, they tolerate extremes for longer while retaining the potential to revert more brutally to the mean when policy fails to address economic problems.”

Most obviously, U.S. economic policy has failed to address the problem of our triple deficits. In my opinion, a REVERSION TO THE MEAN would send the dollar to much lower levels versus other major currencies. Part of the adjustment process could easily be the U.S. standard of living falling for an extended period of time. Not a pretty picture.

1 YEAR CHART OF THE U.S. DOLLAR

PROTECT YOURSELF

Live within your means, and vote for people who will have the U.S. live within its means. Own foreign currencies, precious metals and foreign stocks, which may hold their value much better than the U.S. dollar over the long run.

These are themes we have supported for a long time. The recent and continuing decline in the U.S. dollar brings them more into focus and should cause more investors to get serious about protecting themselves and beginning to act to solve the problem.