Future value of the Dollar

Hans Senholz - Wed 12 Jan, 2005

...We may not be able to see ahead, but we can always learn from the past about the future value of the Dollar...

If the love of money is the root of all evil, the depreciation of money must be the mainspring of all shams and frauds. It works silently and covertly, impoverishing many...while it enriches a few...and thereby inflicts great harm on social cooperation and international relations.

A few economists are sounding the alarm about the decline of the US dollar. In recent months, the world’s reserve currency fell visibly toward the euro and Japanese yen and is likely to fall even lower. But most Americans refuse to be alarmed, as they are unaware of exchange rates and foreign exchange markets. Why should they be troubled about the financial affairs of money traders and dealers?

Future value of the Dollar: the past

We may not be able to see the future, but we can always learn from the past. Looking at the recent history of the dollar, this economist perceives distinct stages with various characteristics, causes, and consequences. One stage was from the end of World War II to 1971, when the US dollar was tied to a small anchor of gold. President Nixon cut its ties and embarked on a wholly new road of fiat dollar management. Many other countries readily accepted the new system, acclaiming its flexibility and manageability.

At this time, the world is still travelling this road, but several countries are making preparations for leaving it and proceeding toward a multiple standard system. It is not clear whether they will depart in an orderly fashion or in crisis and contention.

Throughout the decades, some economists were always worried about the magnitude of the trade deficits and the vulnerability of the American dollar. But their fears proved to be unfounded because they underestimated the worldwide demand for dollars and the willingness of non-US investors and central bankers to trust and hold US dollars. After all, until recently, the deficits never exceeded three percent of American GDP, and Americans still were net creditors in their foreign accounts. By now, the dollar standard has reached a stage in which not only a few economists, but also some foreign creditors are beginning to question its future. The Federal US government is swimming in an ocean of debt. In its first term, the Bush administration increased the Federal debt by $2.2 trillion. Congress raised the Treasury debt ceiling three times, by $450 billion in 2002, by $984 billion in 2003, and by another $800 billion on November 19, 2004, to $8 trillion 184 billion. The ready willingness of Congress to finance such deficits is a clear indication of the political and ideological mould and make of most members of Congress and the public that elects them.

Future value of the Dollar: foreign observers

Foreign observers are drawing similar conclusions. The Bank of Japan, with more than $800 billion in dollar obligations, already announced its reluctance to increase its holding. China, with dollar reserves exceeding $500 billion, is labouring under “unsustainable US trade deficits.” Asian banks altogether, holding more than $2 trillion in American obligations are suffering hundred billion dollar losses in terms of purchasing power. It is not surprising that the central banks of India and Russia, as well as some Middle East investors, have begun to sell dollar obligations.

According to some estimates, foreign banks and investors are holding some $9 trillion of US paper assets. They own some 43 percent of US Treasuries, 25 percent of American corporate bonds, and 12 percent of US corporate equities. They obviously are suffering losses whenever the dollar falls against their respective currencies; even if they are pegged to the dollar, they are incurring losses against all others that are rising.

The dollar standard surely would enter its final phase of disintegration if its holders would panic and start selling their American paper investments - their US Treasuries, US agencies, and corporate bonds and shares. The crash would be felt around the world and neither foreign sellers, nor American authorities, could be trusted to react rationally in the fear and noise of the crash. The scene could be similar to the political bedlam of the early 1930s.

Future value of the Dollar: primary creditors

There always is the hope that the primary creditors will act in concert and once again bail out the debtor. The European Central Bank, the Bank of Japan, the Bank of China, and the Bank of England may decide to avert the unthinkable and support the dollar by mopping up huge quantities. The mopping would stabilise the situation once again by inflating and depreciating their own currencies; they would pass the depreciation losses on to their own nationals. Optimists in our midst are hoping for this scenario; they are convinced that the Bush administration will, in time, save the situation by balancing its budget and the Federal Reserve will allow interest rates to seek market levels. Such a policy would avert the dollar dilemma, although it would lead to a painful recession, forcing all economic factors to readjust to market conditions.

Pessimists in our midst cast doubt on such a scenario. They point not only to the host of legislators and regulators who cherish their position and power, but also to public opinion and ideology, which call for government favours. They are prepared to proceed on the present road and brace for the morrow. A few cynics even contend that a government facing a financial crisis of such magnitude is prone to divert public attention from its ominous path by embarking upon foreign adventures.

This economist is ever mindful that debts do not fade or pass away. Individuals must face them, deal with them, or renege in bankruptcy. Governments have an additional option: As the issuers of their own currencies, they may inflate and depreciate their debts away. The United States government has done this ever since it cast aside the gold standard and imposed the dollar standard. It undoubtedly will continue to do so as far as the eye can see. It is an iniquitous road, which individuals would soon be barred from travelling, but governments love to take, shedding their debts one percent at a time. It is a road of the dollar standard designed at Bretton Woods, built by the US government, managed by the Federal Reserve System, and financed largely by creditor central banks in Europe and Asia. It is a road on which the fall in dollar value has inflicted losses on all foreign dollar holders, each in proportion to the amount of dollars held. It is the political road of debt default the magnitude of which amounts to trillions of dollars, undoubtedly the largest in the history of international relations. It will be remembered for generations to come.

It is unlikely that the US Federal government and the Federal Reserve will soon mend their ways, but it also is doubtful that foreign creditors will continue their support indefinitely. The US dollar is bound to continue to depreciate and gradually surrender its role as the world’s primary reserve currency to a multiple reserve-currency system resting on the euro, Japanese yen, Chinese renminbi, and the American dollar. The multiple-standard system is likely to perform more efficiently and equitably than the dollar standard. Competition would avoid the abuses and inequities of a monopolistic system. Confining the powers of the Federal Reserve System and constraining the deficit aptitude of the US Treasury, it would ward off any further inundation of the world with US dollars.

Future value of the Dollar: gold standard vs dollar standard

In idle reverie of years long past, this economist is tempted to compare the gold standard with the dollar standard. Throughout the long history of the gold standard, the balance of payments of gold-producing countries was usually “unfavourable.” Since the birth of the dollar standard, the United States has assumed the position of the gold-producing countries; its balance of payments usually is unfavourable. Much capital and labour were spent to find, mine, refine, and market gold; the United States bears minuscule expense in the production of its money. Market forces limited the quantity of gold coming to market; the quantity of dollars depends on the judgment of Federal Reserve governors who are appointed by the President. In times of turmoil and war, the quantity of gold mined does decline; in such times the stock of fiat dollars tends to multiply and its value depreciates quickly.

The quantity of gold is limited by nature and its value is enhanced by many non-monetary uses; fiat and fiduciary moneys have no such uses or limitations. They are the sorry creation of politics.


Regards,

Hans Sennholz
for The Daily Reckoning

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