No Requiem for the Greenback
Why the Dollar Will Live to See Another Day
In recent years, investors have flocked to gold, driving its price to an all-time nominal high last December – up more than 40 percent from the beginning of 2009.
John Paulson, whose bet against US subprime mortgages has been dubbed “the greatest trade ever,” came out as a gold bug. Concerned that inflation could hurt the US dollar, Paulson told New York’s Japan Society: “I looked for another currency in which to denominate my assets. I feel that gold is the best currency.”
By that time, retail investors had already begun marching into gold, temporarily clearing the US Mint of its stock of American Eagle coins in November 2009.
The rush into gold reflects its role as a hedge against inflation. Increasing prices erode the value of currencies that, as pieces of paper, are intrinsically useless, but that, by government diktat or fiat, can be employed as a store of value and means of payment – the two main functions of a currency.
Investors in gold fear that the dollar’s capacity to store value will be undone by a failure to mop up the recent expansion in US liquidity. Recent articles with titles such as “Requiem for the Dollar” contend that the US will become the next great power to debase its currency to make its debt affordable.
The US dollar has been the world’s main reserve currency for national authorities for some 80 years. It accounts for 65 percent of central bank reserves. But each dent in the US dollar’s status as a preeminent store of value also reduces the odds that it will remain the principal currency for international transactions.
Inflation concerns are driven by three major factors.
First, interest rates in advanced economies are at historic lows; central banks have massively expanded their balance sheets; and commercial bank reserves – traditionally, a key determinant of credit creation – expanded fifty-fold during the crisis.
Second, government deficits have ballooned. The IMF projects that advanced country deficits will average nine percent of GDP in 2010, and that government debt will rise to an average of 106 percent of GDP – up from 78 percent in 2007.
Third, governments have taken on trillions of dollars in liabilities through public guarantees to, and investments in, financial institutions.
However, as Nouriel Roubini recently cautioned: “The only scenario where gold should rise in value is one where fiat currencies are rapidly debased via inflation.” He went on to argue that there are “more deflationary than inflationary forces in the global economy.”
So far, sluggish growth, idle manufacturing capacity and still-high unemployment have kept consumer prices low in the US.
Excess liquidity is, instead, fuelling new asset-price bubbles in everything from Chinese real estate to food, commodities and fuels.
The gold bubble is the most fragile. Gold cannot be lived in, eaten or burned, and it does not pay any return. As soon as central banks start raising rates as they withdraw liquidity, the opportunity cost of holding gold will increase.
Consequently, the spike in the price of gold looks less like a bellweather of a looming crash in the US dollar than a sign of a gold bubble about to burst.
Joseph Kennedy claimed that he knew trouble loomed in 1929 when his shoeshine boy began giving him stocktips.
Similarly, The Wall Street Journal’s December 2009 report that neighbourhood gold exchanges are supplanting Tupperware and Mary Kay parties in American homes might be a sign that the gold bubble is about to pop.
But what is bad for gold is not necessarily good for the US dollar. The financial crisis and ageing baby-boomers could push the US budget deficit to record levels. Similarly, the American external deficit could double in size as government spending boosts imports and payments begin falling due on the foreign borrowing. US net foreign debt could come to exceed 140 percent of GDP over the next two decades – more than triple the IMF’s threshold for external sustainability. Capital could begin fleeing the US.
To safeguard the greenback, the US will need to control its external deficit by controlling its domestic deficit.
The US Treasury and Fed will have to keep their short-term policy stance loose enough to encourage lending and growth, while laying the foundations for medium-term debt sustainability – not an easy balance, but one supported by US public opinion.
The old saw about FIAT automobiles was that their name stood for ‘fix it again, Tony’ – reflecting their once-miserable reliability. It is perhaps ironic that FIAT is re-entering the US market just as sustaining the US dollar will be a case of ‘fix it again, Tim (Geithner)’.
Brett House is Senior Macroeconomist at The Earth Institute at Columbia University.