As our $10 trillion "shadow" banking system unravels, the big question now is: How does one protect "deposits" during such a run on the bank that no one can see?
We all know that home prices, financial stocks with subprime exposure, consumer-based equities, and the U.S. dollar did especially good during the formation of the shadow banking system.
The question now is: "So, what's next?"
The U.S. rescue plan is calling for an increase in the public debt limit, boosting it to $11.3 trillion (that's $38,850 per capita) from $10.6 trillion. The Congressional Budget Office expected to run a federal deficit in 2009 of $438 billion, or 3 percent of gross domestic product.
The $700 b billion mortgage securities rescue fund could be authorized for two years, but even if not all of it is spent in the first year, the federal deficit could easily top $1 trillion in 2009.
Heightened caution for all serious investors will be the key denominator for the foreseeable future. There will be an increased focus on such fundamental factors as the scale of government deficits as well as the economic drag of funding them. In this regard, the United States appears to be very poorly placed.
It is not to be expected that the combination of loose monetary policy and loose fiscal policy in the United States will sit well with foreign investors in U.S. government paper and holders of U.S. dollars in general. In particular, I wonder how reserve managers who accumulated major U.S. dollar holdings between 2002 and this year will view all of this.
With reserve growth likely to slow significantly in the latter part of this year and with the U.S. dollar 10 percent above the lows that it reached in July, I think the bailout will provide an increased impetus to diversify existing U.S. dollar reserves.
Faced with the choice of holding U.S. paper in the face of an enormous expansion of supply, it would be logical that we will see a growing number of international investors who will, instead, turn to assets such as gold as their preferred store of value.
Other commodities like oil may, despite the likelihood of a slowdown in global economic growth, also benefit from such buying.
It is also likely that we will see investors favor currencies where the central banks retain an constant anti-inflationary stance, like the European, Swiss, and Norwegian banks, and where there is a well-developed government bond market where they can leave their capital.
In my opinion, the euro will be the dominant storage place for such investment flows.
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