The Dollar Hit Parade
The greenback still reigns supreme, holding sway over all other paper currencies – for now. Justice Litle explains how the dollar is still holding on as the world’s reserve currency…
There are only a few ways for the bull market in gold to play out, and supposedly a fixed ending in all cases. The yellow metal’s dollar price will violently launch into orbit at some point, arc into a near vertical crescendo and ultimately burn itself out supernova style. Either that or a long, drawn-out grind – a steady sloshing higher over the course of years, punctuated by occasional hiccups and countertrends to keep us on our toes. Or perhaps a combination of both, in homage to the disco era – a multiyear rise capped off with a blaze of glory.
But no matter how it happens, gold will eventually return to Earth. The fixed ending is a return to normalcy, which in gold’s case equates to dormancy. After all, what goes up must come down. Right? It’s only logical. That is what everyone expects. Yet what if, this time, the future doesn’t look like the past? What if gold were to climb to new highs, breaking the $1,000 an ounce barrier, and never return from whence it came? With apologies to Thomas Wolfe, what if the bankers can’t go home again?
Now that would be something.
It is usually the case that the greater the stake in a specific outcome, the less freedom one has to connect the dots. But the ability to foresee a wide range of possibilities, including the extreme and the unexpected, is a hallmark of the exceptional trader or investor. When asked what traits made him so successful, legendary hedge fund manager Bruce Kovner observed, "I have the ability to imagine configurations of the world different from today, and really believe it can happen." In that spirit, we lay the groundwork for our golden scenario… and one cannot hardly discuss the outlook for gold without first considering the dollar.
In spite of all the pessimism and diversification talk of recent years, IMF figures show that dollars still make up roughly two-thirds of the world’s foreign exchange holdings. Eat your heart out, Charles de Gaulle. It’s good to be king.
So why is the dollar so popular? What gives America free reign to settle debts in its own currency, print more of it at will and impose its fiscal whims on the rest of the world? There are five elements currently supporting the dollar as world reserve currency. We will now discuss each in turn.
The World’s Reserve Currency: Security
The first critical element is security, provided in the form of military and economic dominance. Charles and Louis-Vincent Gave, of research house GaveKal, theorize that the world’s reserve currency is primarily held as a form of insurance in the event of crisis. Based on this theory, GaveKal has come up with four key requirements, as follows:
Attribute #1: "The issuing country must be dominant militarily. And here the logic is simple: One holds a reserve currency for random crisis events. Wars are random crisis events. One wants to ensure that, in case of a war, one is able to buy the best possible weapons… and be sure that the weapons will be delivered."
Attribute #2: "The issuing country must be dominant technologically (see above)."
Attribute #3: "The issuing country must be dominant agriculturally so that in case of a random crisis, reserves can be morphed into food to feed local populations."
Attribute #4: "The issuing country must be mature financially (i.e., have developed financial markets) so that in a random crisis, the afflicted country has the ability to raise money in the financial markets."
By this reckoning, the dollar is more than just a paper liability of the U.S. government; it is backed by the best-in-class physical strength of the U.S. military and the best-in-class financial strength of the U.S. economy. This provides a sense of security to smaller countries facing greater exposure to the dangers of political unrest, military conflict or economic shock. When the local unit of exchange is being buffeted this way and that like a dinghy in a hurricane, it is good to have a stash of dollars on hand.
The security factor also underlines why the euro, the yen and the yuan are all pretenders to the throne. While they have sufficient economic heft, Europe and Japan do not have the ability to project military power of any real significance, let alone the capability to challenge the U.S. militarily. And while China is making headway on the military front, the Middle Kingdom’s financial structure and capital markets have nowhere near the depth, breadth and stability that would be required to support reserve currency status for the yuan.
The World’s Reserve Currency: Universal Acceptance
The second element underpinning the dollar as world’s reserve currency is universal acceptance. One could accurately rehash the old credit card slogan: "Greenbacks – they’re everywhere you want to be." Whether you are a tax accountant in Togo, a spice merchant in the Maldives or a drug runner for the Albanian mafia in Montenegro, you probably accept American money. There is no greater testament to the dollar’s widespread acceptance than the enthusiastic endorsement of organized crime. Got a hundred dollar bill in your wallet? It probably has traces of cocaine on it. The dollar also acts as a go-between for parties who would have trouble conducting transactions otherwise. If I have shekels and you have kopeks, it might be tough to do a deal – I cast a dubious eye on your medium of exchange, and you on mine. If we make the transaction in dollars, however, our problems are solved. The dollar thus acts as a go-between for less liquid currencies, greasing the wheels of world trade.
The World’s Reserve Currency: The Network Effect
The third element supporting the dollar is the network effect, where the value of something increases in proportion to the number of users. The more widely circulated dollars become, the more people are willing to use them, reinforcing their competitive advantage as a medium of exchange. Eventually, the dominance of the marketplace is so strong that it becomes very hard, if not impossible, for competitors to find a real foothold. The phenomenon can be described in slang terms with the expression, "Them that has, gets."
The World’s Reserve Currency: The Spender of Last Resort
Fourth in the dollar hit parade is America’s willingness to act as spender of last resort. You have probably heard pundits refer to the United States as the "engine of growth to the world." Issuing the world’s reserve currency gives America huge privileges, chief among them fiscal autonomy, and with those privileges come responsibilities. In times of gloom, the leader is expected to step up, running deficits if necessary, until global growth gets back on track. Those who see America’s current account deficit as benign argue that this is exactly what the United States has been doing of late: spending more to make up for anemic demand elsewhere. Just being a responsible global citizen, thanks very much. A large chunk of America’s spending power is due to creative financial innovations and deep capital markets; Europeans, on the other hand, are not nearly as adept at turning their homes into spending cash while still living in them. As more exporting countries rely on the prodigious appetite of the United States, more and more dollars find their way into global circulation.
The World’s Reserve Currency: Inertia
Last but not least, a significant element propping up king dollar’s throne is plain old inertia. When things have been done the same way for a very long time, it is hard to introduce change. An example that immediately comes to mind is the popular engineering anecdote entitled "standards last forever," in which specifications for the space shuttle are traced back to the wheel spacing on a Roman war chariot. So many essential goods and services are priced in dollars today, and so many transactions are conducted in dollars by tradition, that it would be nearly impossible to coordinate a mass switchover.
So how might the king be toppled? There is precious little to work with in terms of past example. The Economist observes the last regime change:
"The pound was king during the era of the gold standard. But in the years after 1914, Britain switched from net creditor to net debtor, and by the 1920s, the dollar was the only currency convertible to gold (although the pound returned to gold in 1925). Two costly wars and two episodes of currency devaluation in Britain later, the dollar was unchallenged as the world’s chief reserve currency."
It arguably took two world wars and a global depression to dislodge the pound. That is a fairly tall order; no wonder the consensus belief is that king dollar will maintain his throne. But for all the elements working in its favor, the reign of America’s world-beating currency has a large strike against it: The profligate policies of America itself. While it took a series of extraordinary events over the space of decades to dislodge the pound, Britain never spent others’ money with the wild abandon America has shown.
To put it bluntly, the United States has taken a jackhammer to its financial credibility. The U.S. consumer is happily in hock up to his eyeballs, betting on further housing appreciation to bail him out, while the accelerating pace of U.S. government spending boggles the mind. The current administration appears to have less grasp of financial responsibility than a 16-year-old girl set loose with her father’s credit card.
for The Daily Reckoning
November 03, 2005
Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall).
There are many ways to make money. The trouble is, many of them are demeaning, dull and dreary. Those mommas who guide their babies into the financial business might as well lay a mother’s curse upon them. Yes, you can make money by shuffling cash, but what glory is there in that? You go to the right nursery school, the right private secondary school, the right university, the right business school, and you end up with a job at Morgan Stanley and a house in the Hamptons. There is no creativity in it…no adventure…no serendipity.
Mommas used to encourage their sons and daughters to become doctors, lawyers and such. There was the money, yes, but there was also the satisfaction of performing a heart operation, or suing the bejeesus out of the s.o.b. who performed one badly!
Nor is there any real satisfaction to be had in rising house prices. You can make a fortune; but there is something abnormal and ignoble about it. It is like being mistaken for a movie star. The good fortune comes to you under false pretenses. You can’t really enjoy it. Always, in the back alleys of your own soul, there will be a mugger with a tire iron ready to take it away from you. And when he does, you won’t even report it to the police, for it was never really yours in the first place.
House price inflation is only a real gain to dead people. Only when you shed your mortal coil can you also get rid of the roof over your head. Otherwise, your gain is largely an illusion, and an attractive nuisance. You can’t take advantage of it without sleeping under a bridge. You can only use it to decrease your real net wealth – using the inflated value of your house to borrow money that you will eventually have to pay back.
The Bernanke-Snow team insists that there is no bubble in housing. But then…what’s that hissing noise?
USAToday reports that median house prices fell 5.7% in the month of September…though they were still up 13.4% for the year. We’re not sure which figure is more alarming – that prices are falling sharply, or that they are rising four times as fast as the CPI.
The median house price in San Francisco has reached $726,900. Is this too high? How much should a house in San Francisco sell for? We don’t know. But we know that the typical resident of Northern California cannot afford to buy the typical house. Which makes us wonder who does buy them.
In Tempe, Arizona, six months ago it took about a week to sell a house. Now it takes a month. In Detroit, sellers find they have to reduce their prices two, three, and even four times before getting a sale. And even in Las Vegas’s Mondo Condo madness, the market seems to be "softening," say the experts.
Real estate prices seem to be "leveling off," says one source. The market is "returning to normal," says another. No one seems very worried about it. But why should they be? What is wrong with "normal"?
Meanwhile, a study by PMI concluded that houses in L.A. are 33.7% too expensive. In central New Jersey, they are 25.6% overpriced. They are about the same in Las Vegas. And in Washington, DC, houses are nearly 20% higher than they should be.
There is nothing wrong with returning to "normal," except that many people can’t afford it. They’ve gotten used to living on the inflated "equity" in their houses. They’ll be more than disappointed when it disappears.
More news from our cohorts at The Rude Awakening…
Chris Mayer, reporting from Gaithersburg, Maryland:
"The U.S. is not Zimbabwe, of course, and Hathaway in no way meant to imply that it was. But he did mean to imply that the endgame for the U.S. dollar might closely resemble that of its Zimbabwean counterpart."
Bill Bonner, back in Paris with more deliberations…
*** From Addison:
"As you know, Bill has been laboring to establish the parameters of America’s empire of debt for the past several months, including such nuggets as these:
Alan Greenspan took office on Aug. 11, 1987. Since then:
* Consumer Credit Outstanding has grown from $672.2 billion to $2,147.4 billion (a 219% jump)
* Household Credit Market Debt Outstanding has grown $2,711.54 billion to $10,764.54 billion (a 297% jump)
* Domestic Non-financial Business Debt shot from $1,974.1 billion to $5,269.4 billion (a 168% jump)
* The ISDA reports that international interest rate and currency derivatives outstanding shot from $865 billion in 1987 to $201.413 trillion in 2005.
* M3, the broadest measure of money, has soared from $3620.160 billion to $9976.729 billion (a 175% jump)
* The currency portion of the money stock has gone from $190 billion to $715 billion (a 276% jump)
* The trade deficit has gone from -150.7 to -756.8
* The total of foreign-owned U.S. assets has shot from $1.7 trillion to $11.5 trillion.
"We’ve collected all these observations, added a few more, fleshed out a few new ideas and added some nifty charts…pulled the whole mess together in a book we now call The Empire of Debt. The book, a sequel-of-sorts to our previous book Financial Reckoning Day, is in the process of being shipped to bookstores around the country.
"But here’s an idea…tell me what you think…we’re going to ship 567 copies of Empire of Debt to Washington…one earmarked for each and every Congressman, Senator – and a special package for Mr. Bush at 1600 Pennsylvania Avenue. We’ll send another next door to the Federal Reserve for good measure.
"Why? Well, apart from the Honorable Ron Paul, it doesn’t appear there’s a simple soul inside the beltway who’s aware of what’s going on with the nation’s balance sheet. Or if they are aware, they are incapable of doing anything about the increasing levels of spending going on. And as the government goes, so goes consumer behavior. As one real estate agent we know here in Baltimore stated this week, ‘Hey, there’s free money out there, why not grab some and spend it?’
"Anyway, write in to DR@dailyreckoning.com and tell us what you think. Maybe we should send out the copies and arrange a day in the future to have all the readers of The Daily Reckoning call in to their Congressman’s office and say: ‘Hey, we sent you a book today. If nothing else you have to at least read the introduction.’
*** Getting something for nothing is a hard habit to break. It is like a broken slot machine that pays off every time. Even after it has been fixed, people still pull the handle expecting another big win.
So, too, are people reluctant to believe that a housing boom is over. When prices go down, they buy, thinking they have just got a bargain. That is what seems to be holding up the London property market – where prices have been falling since the beginning of the year.
Steve Sjuggerud reports:
"London was a great reminder, just like the Nasdaq bust, that people continue to believe all the way down.
"A bear market ‘sails down a river hope,’ the old saying goes.
"A bull market ‘climbs a wall of worry,’ they say. No worries from my friend, because, even a year into the bust, he still believes – he hopes – that ‘you can’t go wrong in real estate.’
"If my trip to London was any indication, the real estate bubble in the United States will burst oh-so-slowly, just like in England. People will clamor to pick up ‘bargains’ on the way down, only to see that bargain price look expensive a few months down the road.
"It’s what bear markets do; they suck in as many possible participants, thinking they’re getting a great deal.
"Once everyone has finally given up on real estate, and thinks ‘you’ll never make money in real estate,’ it’ll be time to buy with all you’ve got, again. But we’re the polar opposite from that now.
"You’ve got time to sell, but now’s the time. Hey, maybe I’ll pass your card on to a friend in London…he’ll think U.S. prices are a steal."
*** Panic and spend…panic and spend. War…flood…now plague. The latest source of panic in the Bush Administration is an epizootic that doesn’t even exist. Avian flu may kill 1.9 million Americans, says a headline. But bird flu will not pose a threat to humans until it makes a critical mutation, allowing it to pass from one human to another. George W. Bush said he is spending $7.16 billion of the public’s money just in case.
*** The little church at the center of our neighboring village was packed for the All Saints service. After the bells tolled, people filed out and made their way over to the graveyard to pay their respects to the dead. Many of the graves were decorated with pots of flowers. Small groups of people clustered around the monuments. Here and there, children leaped over tombs and ran down the alleys in the city of the dead.
"Here lies Marie-Josephe Aliot," says one marker, "Daughter of Henri and Marie-Francoise Dupont." "Here lies Ferdinand Aliot, husband of Marie-Josephe, father of Jean-Baptiste Aliot," says another. "Here lies Jean Baptiste Aliot…" says a third. After a while, you can trace the entire family to its most recent grave.
"You Americans has such diverse backgrounds," said a French friend we met in the graveyard. "You have ancestors from all over Europe, I guess. But all my family is right here."
Only a small part of our family is in the graveyard – a maiden aunt who moved to France with us and died here. We found her grave in a new section and paid our respects.
"Oh, isn’t it beautiful?" said a lady old enough to want to be on good terms with a cemetery. "You know, at this time of the year, this is the prettiest garden in town."
"I don’t know," said Elizabeth, later. "I don’t think I want to be buried here. I think I’d prefer to be buried back in Maryland. The graveyard is more restful."
"I’d prefer not to be buried at all," Henry replied.
"You mean you want to be cremated?"
"No, I mean I’d prefer not to die."