JAPAN AND THE CASE FOR A RISING DOLLAR, PART 1
by Michael A. Nystrom
July 11, 2006

Falling Markets

Before I get onto the main topic, let's take a look at today's (July 10) market activity. Yesterday I suggested that commodity prices may have topped, and invited reader's opinions. Today, the prices the commodities whose charts I featured yesterday continued to fall (with the exception of copper): Gold (down 9), crude oil, sugar and the CRB commodity index. Meanwhile, the dollar continued with its fledgling, choppy rally, today with an impressive jump of over half a point. The big news about the Dow was not that it closed up 13 points, but that it was up over 80 points early in the session but could not hold the gains.

The Case for a Rising Dollar

It seems that at present, there is near unanimous opinion that the dollar will continue to fall, and commodities rise in a hyperinflationary blowout. But the last time we had this near unanimous opinion that the dollar would fall was at the end of 2004, when the billionaire buddies Buffet and Gates (among others) both decided to short the dollar. At the time, the whole world just knew the dollar was going to fall. The only problem was that someone forgot to tell the dollar, which instead decided to go on its merry way and rally 15% through most of 2005. But now that the dollar is on the ropes again, investors are piling on again, seemingly unanimous in their conviction that there is but one way for the dollar: Down.



Based on the wisdom of that old adage that you never want to get fooled by the same thing twice, I took it upon myself to try to imagine what could possibly come out of the blue this time to cause the dollar to rally and catch everyone by surprise once again. I didn't have to stretch my imagination too far, for just as I began my musings, I was assaulted by a headline splashed across the front page of the Drudge Report - a headline that chilled my blood:



Japan Considers Pre-Emptive Strike Against North Korea.

The chilling effect came about because something fundamental is changing in the world. Since the end of WWII, Japan has been a pacifist nation, banned by its Constitution from ever making war again. Chapter II, Article 9 of Japan's Constitution (that was written by the Americans following WWII) could not be more clear:

Chapter II
Renunciation of War
Article 9

Aspiring sincerely to an international peace based on justice and order, the Japanese people forever renounce war as a sovereign right of the nation and the threat or use of force as means of settling international disputes. 2) In order to accomplish the aim of the preceding paragraph, land, sea, and air forces, as well as other war potential, will never be maintained. The right of belligerency of the state will not be recognized.

The news article states that Japanese Constitutional scholars are now debating whether or not a first strike against North Korea could be somehow construed as constitutional. Lawyers being lawyers there is little doubt that they'll be able to twist the meaning of words to suit their their convenience. Regardless of the clarity of the words written above, the Bush Doctrine has loudly and forcefully declared that first strikes are within the realm of self-defense of a nation. In the coming days or weeks or months, expect the declaration to come, whether from Japanese scholars or politicians, that yes, a first strike against North Korea is definitely an option. This changes everything.

The balance of power in Asia will shift radically. How would China and Russia react to a military strike against North Korea, considering they are already opposed even to economic sanctions? Not only this, but China - Japan's avowed enemy - will be forced to consider the consequences of a new, more muscular Japan. China will have to consider which of its own actions constitute an act of aggression that might lead to a first strike by Japan in self defense. You can imagine the possibilities for friction in a new Asia in which Japan begins to flex its military might. This is just the first step. Pulitzer Prize winner Michael Goodwin yesterday wrote that WWIII has already started. While this may be a somewhat dramatic claim to make (or not!), temperatures around the globe are heating up, and not just from global warming!

Though Japan is currently limited to its Self Defense Forces, its military spending is still the largest in the region, still ahead of China. And because of Article 9, (and because of its tragic, first hand experience with them) nuclear weapons are outlawed in Japan. But from the belief that a first strike is self defense, it is only a short stretch to the idea that nuclear weapons are a defensive necessity against an enemy which already has them - i.e. either/both North Korea and China. How will Russia, China, and the rest of the world community respond to a Japan that wishes to arm itself with nuclear weapons? (Japan already has nuclear power plants and submarines, and I would not be a bit surprised if they don't already have the Bomb, secretly tucked away for use at a time just like this.)

But getting back to the point - if there is anything that markets hate, it is uncertainty. The scenario outlined above - a newly aggressive Japan in Asia and a growing threat of regional instability - introduces a plethora of uncertainty. One need look back only to last week, when North Korea was testing its new missiles to see how markets will likely react. The North Korean missile tests were both unexpected and scary - scary to the people in Japan and the rest of the people of the free world, and markets reacted accordingly. Stock markets in the US and Japan tanked. Gold fell too, after initially rising. And where did all the money run to? That good old stalwart, the US dollar.



Safe Haven in a Time of Crisis
Let us not forget that the US dollar is still the world's reserve currency, and though it has been much maligned and battered in the last few years, its old luster begins to shine once again in times of crisis. Running to the US dollar in a time of crisis is an old habit, and old habits die hard (though die one day they always do, one way or another).

At the end of the day, from an international perspective, where is there a safer bet? Gold may be a tempting option, but the price of gold is currently being set in the futures market, which is a leveraged market subject to the same mood swings and fear as any other market. Look at how volatile it has been recently - is that a safe haven? Even gold bugs are expecting a substantial correction.

Real, physical gold is of course the safest haven - it is an asset with no corresponding liability -- but it is still clumsy to transport and store. A million bucks in gold would amount to 1600 ounces - 100 pounds at today's prices. It is not that practical, and practical alternatives exist. In spite of the abuse it has taken, Dollars are still accepted easily and readily -- as good as gold -- around the world. Undoubtedly this will not always be the case in the future, but for now it remains fact.

Make no mistake - in the long run, the dollar is toast, and physical gold is going to be the best way to store hard earned savings for posterity. But the dollar may have (at least) one last hurrah left in it. As they say, the market can usually stay irrational longer than you can stay solvent! If that is the case, consider yourself lucky to have this opportunity to start thinking about where you're going to safely store your several (hundred?) pounds of physical gold, because any paper representation of gold (stocks, mutual funds, etc.) simply won't cut it in the future we're heading towards.

The developing situation in Asia is not the only factor that could contribute to a rising dollar, but I've taken enough of your time already. I'll leave you to ponder this until tomorrow, and would appreciate your thoughts and comments on the topic here. Tomorrow I'll lay out a few of my other ideas that could really put some juice into the old buck, at a time when nearly hardly anyone expects it.

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© 2006 Michael A. Nystrom
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Michael A. Nystrom
Cambridge, MA
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