Friday, May 22, 2009

Putting the "dollar collapse" in perspective

The Drudge Report headline today: "Dollar Plunge; Fear over Debt." Lots of people worry that the possible downgrade of U.K. debt is just a forewarning of what will eventually happen to the U.S. as the Treasury prepares for an avalance of debt sales that could last for years.

Not wanting to join immediately in the hysteria, I offer this chart as a way to begin to put things in perspective. The dollar is indeed weak, and it could get weaker, but in inflation-adjusted terms it's only about 5% below its long-term average.

However, the dollar's true weakness is being masked these days because all major currencies are falling against objective benchmarks, the principal one being gold. All major central banks, with the possible exception of the Bank of Japan, have followed the Fed's lead and are pursuing very accommodative monetary policies in an effort to pull their economies out of the current recession/financial crisis.

So it's not really a "dollar collapse" that is of concern, it's the potential for a revival of inflation around the globe.

To be sure, the U.S. will be selling mountains of Treasury bills and bonds for as far as the eye can see. But that is not the source of inflation. What is potentially inflationary is the Fed's purchase of significant amounts of that debt, otherwise called debt monetization. When the Fed buys Treasury bonds it is equivalent to the Fed printing up some money and handing it to Treasury so that Treasury can pay the government's bills. This is how Argentina operated for many years, and after a long time (decades) it finally led to what might be called hyperinflation. We're a long way from something like that.

When we see gold and other commodity prices rising, it tells us two things: one, global demand is reviving as the worst of the financial panic has passed; and two, everywhere, people and governments (e.g., China) are deciding that they don't need all the money they accumulated during the panic (otherwise referred to as a collapse in money velocity). By trying to unload their unwanted money balances they are pushing up the prices of things (otherwise referred to as rising money velocity). Money was something that people were desperate to acquire and hold onto; now it is becoming a sort of hot potato. It is getting passed around instead of sitting in bank accounts, and that is lifting prices.

I imagine we are only in the early stages of this process. At some point central banks will see this and other signs of recovery and begin to withdraw the money they have injected into the global economy. Whether they do that in a timely fashion should be the real focus of everyone's attention. If they err on the side of caution, as seems likely, we will see inflation rise.

UPDATE: I note this speech from the People's Bank of China regarding a global currency reform proposal. Seems to me that Robert Mundell has been educating these folks. They are now pushing for a monetary system that would be at least partially anchored by some objective standards. Some good news amidst the gloom.


me said...
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Unknown said...

Scott, I know you use the price of gold as a good gauge as to the value of the dollar. The question I have is if this link is as strong and as clear as it appears to be (or as the late Jude Wanniski believed it to be) then why not just manage the money supply using a gold price rule? Is it purely political or is there a good reason not to believe in a gold price rule/target modeled in the fashion that Wanniski and others have called for?

Scott Grannis said...

I think there are several obstacles to going on a gold standard (of which there are a few varieties). For one, there aren't any recent examples of anyone who has done it, and thus no way to "prove" that it would work as gold fans argue it would. Of course we have lots of history during which inflation was nil during periods when countries were on gold standards, but critics can come up with lots of objections to block it and at least cast significant doubt. The world is so much bigger, the supply of gold might be finite/might not grow at the same rate as the world economy, etc.

Two, there is the political obstacle, which is formidable. Politicians would abdicate their supposed ability to fine tune the economy. The central bank would become a mere tool, with no discretionary power. Greenspan himself has said this would be a problem: central banks are supposed to have discretion, otherwise what might happen in some unforseen situation?

Three, going on a gold standard might be a fantastic thing, but it's always possible to go off it in the blink of an eye if some powerful politician grabs control of the right levers. Argentina went off its dollar convertibility program overnight and ruined people.

I think Milton Friedman was right about things like this: a gold standard would be so great that it is obviously the best choice, but the political realities and the vested interests make it almost impossible.

I knew Jude very well for many years, and I know how much he fought for a gold standard, but I think he would agree that it is pie in the sky for the moment.

It's not impossible, though. Maybe some eminent Nobel prize-winning economist will start pushing the idea. Robert Mundell (also a long-time and close friend of Jude's) got the Europeans to adopt a single currency, and he's working with the Chinese on currency ideas. Maybe he could get the world to agree to a gold standard. But even then it would take many many years.

BlackSheep said...

Scott I'm glad to see this post from you. It seems like many people in finance are mixing their politics with their analysis. Rather than taking a balanced view of the deflationary forces and impending inflation. I hope you don't join the ideologues who fail to see the extraordinary times, and the alternative to not taking some of these unpleasant measures.

The administration will do the right thing next year on the spending issues, i.e. reverse positions on spending, just like they did for the Guantanamo. pictures and prosecution of CIA.

It takes a conservative to reach out to communists (nixon). And liberal to cut spending/welfare and balance budgets (Clinton). someone from the south to pass the civil rights (Johnsom). In the same thread once we are through the crisis you'll see that Obama will also do the fiscally responsible thing. I cannot believe a pragmatic person whose inner circle of people is almost entirely composed of private equity/ investment banking/ and entrepreneurial people, won't cut spending starting next year.

Scott Grannis said...

BlackSheep: I really, really hope you are right about Obama reversing himself on the spending next year. But if he is so well-advised, why in the world did he allow Pelosi and Reid to spend $800 billion on a hodge-podge of wasteful programs that couldn't possibly do anything to jump-start the economy when it most needed the help?

dave said...

We are not on a Gold standard because it is politically inconvenient.

How big of an ego do you think the "world's central banker" ie Ben Bernanke has? Jude once asked Greenspan about going back to a gold standard and his reply indicated that if we went back to a gold standard where the value of the dollar was pegged to the price of a certain quantity of gold he would be reduced to nothing more than a clerk.

There are any number of countries that run loosely pegged or even a fixed pegs to the dollar, in other words they adjust the quantity of their currency based upon a relationship to the dollar. Substitute gold instead of the dollars and you have a gold standard.

Jude said many times that if you run a gold standard properly you need not have any gold at all. The only time you need gold is to redeem dollars because people have lost confidence in it's value, which by definition can't happen on a "gold standard".

The problems that people speak of in connection with the gold standard are usually problems associated with re establishing the standard once you have left it or going off the standard to begin with.

It is an oxymornic statement to say that the floating dollar is a monetary policy because in fact it is a non a policy

Spiral said...

I think it would be far better to simply make the supply of dollars (fiat currency) predictable and transparent. Such is not the case now and people who hold cash can be blindsided by a massive increase in the money supply. At least create a situation where the money supply can not increase drastically without warning. Then people could make decisions as to how much cash they should hold based on what the federal reserve is doing. Allowing the Fed to manipulate the money supply in near secrecy is what is really dangerous and damaging to the economy.

Scott Grannis said...

Spiral: a commodity or gold standard would address your concerns, which are certainly valid.