DEMISE OF THE DOLLAR

In a country like America, where all sorts of consumer goods are imported, the standard of living depends to a considerable extent on the relative value of the dollar. If that value were to fall, then even in the midst of a recession with high unemployment, inflation would quickly break out, causing a decline in the standard of living.

This is exactly what is going to happen. (It is also why economists who fear deflation get it wrong.)

In general, the value of a currency is governed by the law of supply and demand. Given a fixed supply, increased demand means increased value (and vice versa). In the days before global capital markets, demand for a currency was determined by the flow of international trade.

Countries and their citizens are required to buy foreign exchange in order to pay for things they purchase abroad, so the level of imports from one country to another, relative to the level of its exports, tends to determine the relative value of the two currencies. In this system, any temporary imbalance tends to be self-correcting. As the value of one currency goes up relative to another, it becomes cheaper to buy abroad with the appreciated currency. This increases the level of imports which, over time, causes the value of the importing nation’s currency to decline relative to the exporting nation’s, so that balance is restored.

So why hasn’t that happened in the case of America?

With the advent of global capital markets, a new wrinkle was added. Currency began to be purchased not only for use in trade, but also for use in investment. When this occurred, the relative attractiveness of investment opportunities, as well as the relative attractiveness of goods, became a factor in determining currency values. This meant that a whole range of new factors – interest rates, wage rates, governmental regulations, political stability, rates of growth in the economy – became relevant to currency values.

Still, in theory, relative currency values in a global capital market environment should remain self-correcting because, as capital flows into a nation in search of investment opportunities, interest rates in that nation will tend to come down and, over time, the best investment opportunities will be gone, leaving opportunities that are less attractive. When that happens, capital should move elsewhere, causing the relative value of the currency to decline.

To some degree this has occurred but not nearly to the degree that might be expected. So again, why don’t the laws of supply and demand seem to work in the case of the American currency?

The first reason is that since the second World War, the dollar has been the functioning international reserve currency, and this has increased the demand for dollars.

In the era of fiat currencies, world monetary reserves are held not primarily in precious metals, but in the obligations of foreign governments. (If anything, this trend accelerated after 1999, when the world’s central banks began selling gold to try to earn a return on their foreign exchange assets.) As mentioned, since World War II, the primary reserve currency has been the U.S. dollar, so the net effect of the fiat currency regime has been to add a major new component to the demand for dollars. In essence, the switch from gold to dollars has meant that as the global economy has expanded, the demand for dollars has expanded along with it – quite independently of any demand for U.S. goods or U.S. investment opportunities.

For decades, the reserve currency mechanism has had the effect of increasing the value of the dollar in a way that was not self-correcting. In other words, as the value of the dollar rose, it did not matter that U.S. investments were becoming less attractive or that U.S. goods were becoming prohibitively expensive. U.S. dollars weren’t being purchased for purposes of trade or investment. They were being purchased as a store of value, and as the value of the dollar increased, dollars actually appeared more attractive as a store of value, rather than less so.

The second reason the dollar remains over-valued in terms of its purchasing power is that it is in the interest of some of America’s major trading partners that it remain that way. A number of counties – most notably China, but also to some extent, Japan, Korea, and others – actively intervene in the markets to keep their currencies at a fixed level or range or value relative to the dollar. As a rule, this means that they sell their own currencies and buy dollars in order to prevent their own currencies from rising. The purpose, of course, it to keep the dollar price of their exports attractive.

Like the support provided to the dollar by its role as an international reserve currency, the support provided by foreign government intervention is not in any way self-correcting (though one has to assume there is some limit to how many dollars the Chinese are really willing to own). Since the mechanisms are not self-correcting, they can go on, and have gone on, for substantial periods of time. This has resulted in some other imbalances that have had – and will have – very serious consequences in the future. One in particular is the production (and price) of raw materials.

Regardless of where they are produced and the currency in which the costs of production are paid, most raw materials and energy products are priced in dollars. As the dollar is, and for decades has been, overpriced in terms of most other currencies, the value received by raw materials and energy producers measured in terms of their domestic currencies, is, and for decades has been, artificially low. This has created a natural reticence to invest in productive infrastructure, with the result that this infrastructure is now getting old. Expenditure for exploration and development of new resources has also been held back, resulting in flat to declining productive capacity.

Before the crash of 2008, demand from China, India and other fast-growing economies for raw materials and energy put tremendous upward pressure on prices. The crash of 2008 resulted in a precipitous decline in prices, but these have since rebounded, and as the global economy recovers, upward pressure is sure to return, because only an increase in prices will bring about the increased supply demanded in the market.

So, let’s recap. On the demand side, we know that American exports cannot compete in global markets with the dollar at current levels. We know that real U.S. interest rates are now negative; and we know that returns on corporate stocks were essentially zero in the decade that has just ended. While the dollar still functions as the world’s reserve currency, we know that the aggregate global economy is scarcely growing; and we know that the nations with growing economies that are all talking about diversifying their reserve assets away from the dollar. We know that China is hoarding domestically produced gold rather than selling it; we know that India is buying gold from the IMF; and we know that the European Central banks have slowed their gold sales almost to zero.

None of these factors is positive for dollar demand.

As far as supply is concerned, we know that given a fixed demand for a currency, increased supply means decreased value. So, what about supply? Since August 2008, the monetary base in the United States has more than doubled, to just over $2 trillion. While the Fed has attempted to “sanitize” this money by paying interest on excess bank reserves, the money has not been removed from the system, nor can it be removed without damaging of the banking system liquidity.

Putting all this together, it looks like a recipe for a declining dollar and a serious bout of inflation.