To beat drooping dollar, reduce debt, be flexible

Q: It seems the dollar may have a long drop ahead, as our government continues to ignore the burgeoning federal and trade deficits.

With war costs mounting and the Chinese and Japanese moving away from the dollar, I am wondering how to hedge against a fall. Could you suggest a good investment against a falling dollar?

A: Many readers have sent in variations on this question, including one who sent copies of colorful and pretty — but worthless — currencies. Most people don't want to think about runaway inflation. So let's consider the problem in three stages, recognizing that we may never go beyond stage one:

Stage one: A decline in the dollar that stays in a range that requires material adjustment but not radical change. It entails the kind of inflation pressures we experienced in the late '70s.

Stage two: We lose our position as consumer of last resort. The dollar would be deposed as the world's reserve currency. A significant reduction in our standard of living would follow.

Stage three: There is wholesale weaseling from the government on promised benefits such as Social Security and Medicare. This would create institutional chaos and circumstances worse than the Great Depression. Without major changes, this could easily happen to our children.

We're in the first stage today. This requires that we practice real asset diversification.

That means favoring Treasury inflation-protected notes over conventional coupon securities.

It means owning shares in an unhedged international bond fund or certificates of deposit in other currencies, as well as domestic fixed-income funds. It means investing in energy companies, particularly those with domestic reserves.

It also means having real international equity diversification, probably through the ownership of small international companies and basic industry shares in developing countries.

If you are young and securely employed (almost mutually exclusive today), this is also a good time to maximize your home mortgage, but not maximize the size and cost of your home. You can repay the debt in dollars that are worth less than the dollars you borrow.

Otherwise, this is a good time to eliminate short-term debt, regardless of your age. All these steps will spread your risk and reduce your vulnerability to our currency. They will not make you rich.

The second stage will begin when, and if, the dollar loses its position as the global reserve currency. When that happens, we'll be forced to eliminate our trade deficit and increase our savings rate. Foreigners won't be saving for us. This will bring high interest rates, high inflation and a significant reduction in our standard of living.

The best protection is having needed work skills, little or no debt, flexibility and a willingness to buy fewer services. Note that none of this involves investing.

We could be in this stage before the next presidential election. In stages one and two, gold will be a good "investment" because it will gain relative value.

The third stage will begin when our government is down to two ugly choices, printing money or defaulting on promised benefits, particularly the massive promises of Medicare. This is the runaway inflation that concerns some readers.

Impossible, you say?

We've already done it. It could happen again. When our first currency, the continental, became worthless after the Revolutionary War, it led to the only armed insurrection against government in our history, Shea's Rebellion in Massachusetts. Many gold enthusiasts expect such runaway inflation.

Questions about personal finance and investments may be sent to Scott Burns at The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; by fax at 214-977-8776; or by e-mail at scott@scottburns.com. Questions of general interest will be answered in future columns.