DECLINING US DOLLAR vs. GOLD
Can you remember where you were on 15 August 1971? I can, vividly. I was on vacation with my family driving through Lancashire in England when the news that America was cancelling the right of foreign central banks to convert US dollars into gold came over the car radio.
I was shocked by the news. What it meant was that the world was embarking on an era of freely floating exchange rates and that the world was effectively going to be on a US Dollar Standard for the foreseeable future. It was to be a gigantic experiment of trying to operate world finances using only paper money.
It reminded me of the first experiment with pure paper currency that was engineered by John Law in France in 1715 and which ended in disaster. By 1720 the shrewder financiers around started to convert Law’s paper back into gold and found that there was plenty of paper but very little gold. So it has been with every paper (fiat) currency ever since. I felt that the experiment with the US Dollar Standard would also end in tears.
To be fair, it has been more successful than I had ever expected, but that does not alter the inevitability that it will succumb to the same fate as every other fiat currency system. The reason is two-fold. Firstly, politicians cannot resist excessive creation of money and, secondly, the scheme is flawed.
Let me explain. Under the US Dollar Standard every country that runs a trade account deficit must attract a capital account surplus to offset the trade deficit. It does this by raising interest rates, suffering a decline in its currency against the US Dollar and/or possibly resorting to foreign borrowings. The only country to which this does not apply is the USA.
The USA is able to run a large trade deficit because foreigners are prepared to “hold” US Dollars because it is the Standard. Countries with trade surpluses accumulate US Dollars but they do not “hold” them, they immediately invest them in some form of USA investment. In other words, the dollars return to the USA. This situation will continue for as long as foreigners have confidence in the US Dollar.
The absurdity of this arrangement can be illustrated by an analogy. It is akin to going down to the local Mercedes Benz dealer, buying their latest model, paying for it and then borrowing the full price back from the dealer. So you now have a new Mercedes for no cash outlay. Next month you go back and buy yet another vehicle in the same way, and again the month after that ad infinitum.
Eventually, even if your name is Bill Gates, the Mercedes dealer will refuse to supply any more vehicles unless paid in cash, real money. This is exactly how the US Dollar Standard operates. It can continue until the foreign creditors, the equivalent of the Mercedes dealer, say “No More!”
Why do I raise this now? All over the world currencies are popping upwards and giving technical “buy” signals against the US Dollar. The following chart of the Euro illustrates the trend. Once the Euro clears 96 cents the new trend will be undeniable.
Similarly, the US Dollar index has a recent low of 111.0. A violation of this level to the downside will cause technical analysts to get very bearish on the US Dollar.
This has implications for the US Dollar Standard. If the US Dollar goes into serious decline, it will be the first indication that foreigners are losing confidence in the system that has lasted for 31 years. It will be the equivalent of the Mercedes dealer saying “No More!”
Investors worldwide will be faced with the problem of what to do with capital received from the sale of US Dollars assets. Other currencies will initially be beneficiaries, but a small, but increasing, proportion will be channelled into the ultimate money, the final store of value, gold bullion. It will be similar to the dramatic finale of John Law’s experiment in France in 1720.
I have no doubt that the demise of the US Dollar, which seems to be inevitable, will unleash a bull market in gold bullion that even the most avid gold bull cannot now imagine. This is not something that we can contemplate with any degree of comfort because the world that we now know will have changed beyond recognition.
Alf Field |
