As a young man, I lived in Iceland from 1976 to 1978. It was my first time abroad and my first prolonged exposure to a foreign culture. I learned a lot about environment, society, economics, language and faith.

This week the government of Iceland collapsed. That means the governing coalition agreed upon by the political parties fell apart and the prime minister and several cabinet members resigned. There will be new elections and a new political structure. The catalyst for this political catastrophe was the bankruptcy of the country’s economy and the failure of its banking system in 2008.

With the current worldwide economic turmoil, this situation has prompted me to wonder if other nations–including the U.S.–are in jeopardy. If the U.S. banking system were to fail, is our government and our Constitution at risk?

After considerable pondering, I believe the answer to each of the preceding concerns is yes. While such a drastic scenario still seems unlikely at this point, the possibility exists.

It really boils down to a simple question: Will people continue to get paid? If the money keeps flowing, people are willing to live with inflation, corruption, shortages, deception, and a host of other bad circumstances. Once the money is cut off, the government almost instantly loses power and control over the populace.

From 1989 until 1995 my work focused on Russia and Eastern Europe. I witnessed firsthand the collapse of communism and the break up of the Soviet Union. The change from communism to democracy did not occur because the people wanted freedom from political oppression. It occurred because the economies of communist nations ceased to function.

As the communist governments ran into economic troubles, they stopped paying workers. Using military and police force, they could make people report to their jobs at the mines, banks, schools, hospitals and factories, but they could not make them do the work. Before long, nothing was being produced and shelves everywhere were empty. In spite of its scarcity, money became almost worthless, because there was nothing to buy. When the police and military stopped getting paid, they refused to work as well. In a relatively short time, the old Soviet system came to a complete standstill.

The Icelandic government went bankrupt trying to bail out its banking system. With nationalized health care, education, banking, and government subsidies to hosts of other industries, there was no way a bankrupt government could pay all its obligations. Instead of getting paid, workers started getting government IOUs. Soon there were riots in the streets and now the country will have to start over.

The economic collapse of communism was mitigated somewhat because of the economic strength of other countries–primarily the U.S. I experienced times when it was difficult to obtain Russian rubles from Russian banks. At the same time, those banks had stacks of U.S. dollars, British pounds, and Swiss francs. I personally negotiated contracts with Russian government entities that required payment in U.S. dollars. The strength of other currencies served as a crutch to give Russia time to resolve the problems with its own currency.

In recent months the U.S. dollar has risen in value when compared to most other currencies. The dollar is winning by default–not because of its strength, but because it is the least objectionable choice. 

The chart below shows how the U.S. dollar (black line) has fared against some other countries and currencies. These include: China (maroon line), Brazil (blue line), and Europe (gold line). The bottom portion of the chart is a relative strength index (RSI) for the dollar. An investment that can maintain an RSI above 50 shows good strength. Since the middle of summer 2008, global investors are choosing the dollar over virtually any other currency.

In some ways, one could consider this akin to a wager on the United States. Investors are essentially betting that there is a greater chance that the U.S. will be able to solve its economic problems than other countries will be able to resolve theirs. Or perhaps they just understand that the U.S. economy is the lynchpin to the entire global financial system. 

The world can survive bankruptcies and government collapses in places like Iceland– or even large countries like the former Soviet Union–as long as the rest of the world remains stable. 

Right now the United States is seeing a changing of the guard with a new Presidential administration and significant changes in both parties of Congress. Some people are euphoric and believe that the economic situation will rapidly improve. Of course there are also those who believe exactly the opposite. 

The financial sector rose strongly this week on news that the House had passed President Obama’s economic stimulus bill. Today the equity markets are down sharply over renewed concerns about rising unemployment and falling home values. Obviously the situation remains volatile and the direction of the financial markets over the next few weeks remains uncertain. Under those conditions, it is prudent for investors to remain on the sidelines.

In six months the situation could be much improved, significantly worse, or about the same. Fortunately we believe that our tools and methodology will help us properly allocate assets regardless of what transpires.
F.S.