How the Federal Reserve could destroy the dollar

Last year, I devoted several issues of my Strategic Investment service to the web of structured finance. I think it paid off.

Since then, banks and brokerage stocks were punished. Energy and material stocks have soared-thanks to the Fed's inflation campaign. Fed officials have taken their ability to devalue the U.S. dollar to new heights. What collateral backs today's dollar? Mostly mortgage securities that nobody wants as if Treasury bond collateral weren't bad enough.

Despite the latest "reports," current trends still have room to run. Just consider Fannie Mae and Freddie Mac. Those shareholders could be effectively wiped out by endless equity offerings as early as next year. The mountain of debt holders and bond insurance policyholders comes first.

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Now, it's possible that the federal government could issue hundreds of billions in new Treasuries to officially guarantee Fannie's and Freddie's liabilities. If no one lines up to buy these bonds, the Fed could monetize them. Such a scenario could herald a return to double-digit long-term interest rates and a collapse in confidence in paper money - demanding a new monetary system. We live in interesting times. Billionaire currency speculator George Soros thinks we've just entered the ugly side of a "super bubble."

I wrote about George Soros' investing framework in the August 2007 Strategic Investment. Here's the excerpt on Soros:

The growth of securitization has truly altered the global economy

One negative consequence is that financial markets are starting to shape the destiny of the real economy, not the other way around. Storied currency speculator George Soros was one of the first to speak publicly about the phenomenon of markets shaping economies. He calls it the theory of "reflexivity" and described it when testifying in front of Congress in 1994:

"The generally accepted theory is that financial markets tend toward equilibrium and, on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly, because they do not merely discount the future; they help to shape it."

Here's reflexivity at work: As a company's stock grows more coveted by wild-eyed speculators, its cost of capital gets lower and lower as its stock skyrockets; the higher its stock price, the more capital a company can raise in a secondary stock offering by issuing a set amount of shares. So its ability to reinvest capital and grow its future is shaped by the whims of speculators.

A second consequence of the securitization revolution: The further a lender is separated from a borrower, the more potential there is for fraud on the part of the borrower and underestimation of risk on the part of the lender.

Now, before you dismiss Soros as a Big Government "world improver," keep in mind that he took the right side of every major financial crisis since World War II. The man clearly understands how markets can boom and bust, especially when greed and fear overwhelm rationality.

To see how Soros views the current crisis, I picked up his latest book,

The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means

. In the first half, Soros laments that reflexivity is not taken seriously in university economics departments. In the second half, he argues that the current crisis marks the end of a decades-long expansion of U.S. dollar-based credit. Soros dubs the period from the early 1980s-2007 a "super bubble." He makes a convincing case:

Credit conditions have been relaxed to such an extent that I wonder how they could be relaxed any further. This is certainly true as far as the U.S. consumer is concerned. Credit terms for mortgages, auto loans, and credit cards have reached their maximum extension It may also be true for commercial credit, particularly for leveraged buyouts and commercial real estate.

Only one thing is off the mark: Soros' prescription for more government regulation.

Nowhere in his book will you find an explanation of how the global paper money system practically guaranteed the formation of his "super bubble." This super bubble would not have been possible under an international gold standard. The international gold standard of the late 1800s fostered a time of incredible growth and wealth creation in a stable price environment. It wasn't perfect.

It had periodic depressions. But it was far better than what we're looking at: Government's inflationary policy responses to problems created by its policy of perpetual bailouts.

Don't forget that every paper currency in history eventually fell to its intrinsic value: zero. The dollar is no different, although it has taken longer than most others. For decades, foreign governments have aggressively bought dollars, propping up their value, hoping, thus, to insure long-term economic stability. Instead, this action is heavily responsible for the runaway inflation we're seeing all over the world.

Soros seems to believe that the real economy cannot grow unless credit is growing. This ignores the fact that credit growth does not create economic growth. It merely assists growth. Over the long term, the economy grows as the capacity to produce goods and services grows. No credit necessary.

But we must invest in the environment we face, not the one that we wish were in place. The government response to the ugly side of Soros' reflexivity will seriously impair confidence in paper money.

Look for gold, energy, and other natural resources to keep performing. Avoid financials, real estate, and consumer discretionary stocks.

By Dan Amoss for Whiskey and Gunpowder