The market has been reacting to the renewed growth in the U.S. economy and the strong rise in corporate profits. In the third quarter 2003, the U.S. economy grew at around 9% annualized, an unexpected rate of growth for a mature economy. In the same quarter, corporate profits rose by 30% and broke through the $1 trillion barrier for the first time.

I find in the last few weeks that I have regularly been referring to "trillions." When I entered journalism, we counted in "millions"; the inflation of the 1970s taught us to think in "billions"; the 21st century is teaching us to think in "trillions." I wonder who the first "trillionaire" will be. So far as I know, no individual has yet reached the $100 billion mark, though Bill Gates may have done so at the top of the Internet boom.

I did not expect so strong a performance from the U.S. economy, and I am still uncertain about the underlying causes. We do, however, know that it was led by U.S. consumption. It was not savings or exports that did it, nor was it a higher inflow of foreign funds. Foreigners have become nervous of the dollar. I am nervous of this boom in consumption, since it has been financed by a boom in debt, based on the huge borrowings from Japan and China. The prosperity of the United States in 2003 has not been the product of U.S. earnings but of borrowing the earnings of Asian countries.

The world trade and currency relationships reflect this tension, and have been following exactly the forecasts we have been making. On this, your editors and I have the same analysis. It is not an analysis of any single currency, of the dollar, the euro, the yen, the pound, or the renminbi, but of the unsustainable relationships between them. We also treat gold as another currency and use movements of the gold price as a very significant indicator of the underlying balance of the market. Gold has broken through $400 per ounce and seems set to go much higher. Analysts regard $500 as only the next step.

In the last month, our current forecasts have all been on track. The dollar has continued to fall against all the other currencies except the Chinese renminbi, which is tied to it. This has largely corrected the overvaluation of the dollar, but has not corrected the trade deficit of the United States, which currently runs at $500 billion, or half a trillion dollars. It has also produced an acute undervaluation of the renminbi, which is reinforced by China's extremely low labor costs.

The yen has risen closer to the 100 yen-to-the-dollar relationship. In order to maintain export competitiveness, the Japanese have continued to buy dollars on a massive scale. The U.S. trade deficit with Japan is therefore recirculated and used to finance the U.S. deficit.

Britain and Europe are on the receiving end of this movement of the dollar. The euro has risen to its highest level ever. The pound, which has a different trading pattern to the euro, has fallen against the euro but risen by more than 20% against the dollar. The result is that European exports, which already had high costs, have ceased to be competitive, particularly with the exports of Asia.

Germany is sometimes referred to as "the engine of Europe," but the German economy is sick and has fallen back to zero growth. Germany is a manufacturing and exporting country, and German manufacturers are not competitive in world markets. In the whole Eurozone, youth unemployment is one- sixth, a social disaster.

Even China is not free from problems. An undervalued currency is obviously helpful as a way of undercutting one's neighbors and promoting exports. China has tens of millions of workers to introduce into its expanding modern economy. But an undervalued currency introduces inflationary pressures, and China is beginning to suffer from them.

At some point, the renminbi will have to be revalued against the dollar, or floated. Floating would be much the better solution. The present situation, in which the dollar and the renminbi are tied together, but all the other major currencies are floating, is illogical and damaging for all of them. President Abraham Lincoln said that one cannot have "two nations - one slave and one free." It would be equally true to say that the world cannot have two sets of currencies, one floating and one fixed. That is particularly true when the fixed currency is the most competitive on Earth.

The dollar will not be able to settle down to a more stable rate so long as it is fixed to the renminbi. Nor will the euro return to a more competitive level. At present the United States and China are like two fugitives from a chain gang, tied together at the ankle. It may, however, be difficult to cut off their fetters until the U.S. presidential election is out of the way.

William Rees-Mogg
for The Daily Reckoning

Editor's note: Leading political editor William Rees-Mogg is the former Editor-in-Chief for The Times of London and a member of the House of Lords. A version of this essay originally appeared in the January edition of Strategic Investment, to which Lord Rees-Mogg is a frequent contributor.

13 January 2004

The Daily Reckoning ( www.dailyreckoning.com )