The Dollar Standard

The world's current monetary system was basically developed at the end of the second world war. The relative strength of the US economy at that point stood in sharp contrast to Europe, after the chaos and damage of two world wars. A new system, for worldwide transactions was clearly needed, and adopting the US dollar as the world's reserve currency seemed only natural, and, at least initially, the dollar was itself backed gold.

Once this system, called Bretton Woods, was put in place, however, it provided an astonishing benefit to Americans. The president of France in the 1960's, Charles De Gaulle, was acutely aware of this:

De Gaulle clearly understood that the Dollar Standard brought with it enormous advantages to the US. Indeed he so mistrusted this arrangement that in the early 1970s he asked the US to exchange France's foreign reserves of US dollars for gold. Not surprisingly, the US was unwilling to do this, despite the Bretton Woods agreement, and so France's request started a new phase of the dollar standard. The US simply closed the linked between gold and US dollars. The world's currency system had now become completely unlinked to any tangible asset. It was now based solely on the paper currency created at almost no cost in the US.

This created a remarkable advantage or special status to the US. Almost complete control of the world's currency enables enormous benefits and power solely to the US. Government spending could far exceed that of most other countries, and if the US economy experiences any problems, then new money can be created to stimulate spending to an extent not normally available elsewhere.

To this extent Americans have experienced enormous good fortune, and it has lasted for so long, it is quite natural for most Americans to assume it will last forever. After all it is the only system most people have ever known.

However, ultimately there are limits, and while any privilege has great short term benefits, it can also be prone to long term abuse, and can create many damaging habits. In the end the ability to create credit/print money at will can only go so far. The signs are that the US has now reached the point where the dollar's reserve status is now at risk, and along with this, so much else.

Dollars have begun to fall as a percentage of total foreign exchange reserves and the trade weighted dollar index has recently broken down to new 40 year lows, clearly reflecting a change in international preference for holding dollars.

There should be little surprise why this is happening. The US fiscal position is deteriorating sharply. The US is now in debt to the tune of over $9 Trillion and with baby boomers now retiring, the massive unfunded liabilities in the tens of trillions are now beginning to rapidly add to those debt levels. David Walker, until recently, the official accountant for the US government, has continued to be unable to sign the accounts of the Federal government, and has been touring the country to draw citizens attention to the alarming levels of government debt, as well as growth in that debt.

US Dollars have been over supplied to the rest of the world to the tune of over 6 Trillion. Yet every day an additional 2.5 billion has to be added to foreign dollar holdings just to finance the growing deficits of the US. Is it any surprise that foreigners are growing weary of this paper.

For the time being there is no sign of Washington even beginning to address this situation, so the debt just continues to escalate. Without addressing America's accelerating debt position it seems clear that the supply of dollars also has to accelerate into the indefinite future in line with growing debt creation. This currently appears to be the only way that the US intends to plug its gaps in policy and finance. Politically this is also the simplest solution, otherwise they would be forced to address the debt issue.

The problem is that increasingly, dollars are not held willingly by the private sector but by other governments in the form of reserves. Yet, now, even governments have become concerned about preserving the value of these reserves. They have rapidly been turning these reserves into "Sovereign Wealth Funds", to enable them to diversify away from just US dollar related assets.

The US dollar's standing is therefore deteriorating at an accelerating rate. So far this has not become a crisis. but it has now become highly dangerous to assume that this will never be the case. Even if it never becomes a crisis, it is clear that the US dollar is being constantly undermined, and has become increasingly unreliable as a store of purchasing power.

Fall of Dollar Standard will come as a shock

Americans need to consider carefully the consequences of losing the reserve currency status of the dollar. Should this occur, foreign investors would not need to own so many dollars, and interest rates would have to rise to much higher levels to compensate foreign investors for the risks of a deteriorating financial position.

The dollar is increasingly in a position of oversupply as it has now seemingly become the main solution to any economic problem. Excessive money supply is, of course, another word for inflation, so the dollar will continue to lose purchasing power at an accelerating rate.

As this situation becomes increasingly obvious and unacceptable to investors, the current financial system becomes harder to maintain. Ultimately, it becomes very difficult to generate the excessive money supply that is needed to generate the financial support that Americans have come to expect.

Unfortunately this could all happen at a time when so many have assumed record levels of debt. Under the dollar standard credit seemed widely available for what appeared to be an indefinite period of time. However, once the dollar loses its status as reserve currency, Americans would have to adapt to a new set of financial circumstances.

Investors need, therefore to consider the following issues:

1. Holding dollars and dollar related assets, such as bonds, have often been regarded as very safe and low risk. In the current environment this may no longer be the case, as the purchasing power of dollars is deteriorating at a rapid rate. So investors may need to reconsider their asset allocation in a new light given current circumstances.

2. Investors need to own a far greater proportion of real and foreign assets than has been the case before to protect their purchasing power.

3. Americans may need to shift to a much stronger balance sheet and get used to generating savings rather than rising debts. As we have discussed in previous notes, the balance sheets of the average American is simply dreadful, and the national savings rate has recently been in negative territory.

Summary

Certainly, David Walker has found it enormously difficult to get people to focus on this issue, even speaking as the accountant of the US Federal Government, and committing significant resources to his efforts. Whether this is because it does not fit with any experience Americans have had, or whether they don't really understand the mechanics of the monetary system, or more simply because they do not want to hear it, it is hard to say for sure.

Of course, there is no shortage of advocates for the current status quo, but discriminating investors should take note of the caliber and standpoint of a growing list of investors, who are now warning of the accelerating long term risks to the dollar. Warren Buffett, George Soros, and Jim Rogers are perhaps three of the most successful investors over the last 40 years, and they, among many others, are also stating clear concerns about the long term outlook for the dollar.

The probability that the US dollar standard is now coming to an end is too high, and the consequences too far reaching for this issue to be ignored any more.

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