The Fragility of a Dollar-Based Money System

We got back from South America on Friday…ready for a rest. So, we spent the weekend reading…and occasionally, thinking.

What we’ve been thinking is that the dollar is dead meat in the long run. But in the short run, it might have enough life in it to bite investors on the derriere.

The US stock market rose 73 points on Friday, to bring the Dow just 30 points south of the 10,300 mark. Why is this level important? It’s not really. But it reminds us that this is still just in “bounce range.” Big drops in stock prices are followed by bounces – always. A bounce of 50% of what was lost is not unusual. That’s what happened after the Crash of ’29, for example. So, there’s nothing exceptional about what we’re seeing on Wall Street.

Our comrades over at The 5-Minute Forecast provided this sobering chart in Friday’s issue.

Dow in 1930

But here at The Daily Reckoning we’re not smart enough or fast enough to play the countertrends. We want investment positions that we can ignore for years… We want to be able to go on a long trip…say, down the Inca Road or over the Hindu Kush. And when we come back, we want to find that we have at least as much money as when we left.

If stock market buyers – in the US – have more money a year from now than they have now, we’ll be surprised. The private sector is still more than 2/3rds of the economy. And the private sector has begun de-leveraging. Nothing that has happened in the last 8 months makes us think that that trend is going to reverse any time soon. There are 70 million baby boomers who need money for retirement. They’ve got to save. That means cutting back on spending. And that means less income for business. Are stock prices really going to go up when business income is going down? No.

We leave our “Crash Alert” flag flying, here at the worldwide headquarters. We don’t know when…or IF…stock prices will crash. But the downside risk is not worth the possible upside. Daily Reckoning readers should be out of all US stocks, except those they wouldn’t mind holding through a 50% correction.

The other thing we mistrust – aside from politicians, stock promoters and tap water – is the dollar. But here the story is more complicated. Because the next downswing in stocks could push the dollar up! Everyone is betting against the dollar. And most think it is a one-way gamble. But it’s not like Mr. Market to grant investors a one-way bet. He’s got something up his sleeve.

Last week, The Financial Times reported that a group of IMF economists had made a “Plea to reduce demand for dollar reserves.”

That is another way of saying: find something else to put in your vaults rather than dollars!

Why? Because a world money system that uses dollars as a reserve currency is fragile and vulnerable. It makes the whole world hostage to America’s financial problems.

“The US, at the center of the system, was under pressure to run large current account deficits in order to supply the world with the dollar assets it wants, they said, while there was no effective discipline on either the US or countries such as China that have big external surpluses to adjust their policies.”

This move by IMF economists is only the most recent effort to reduce the world’s reliance on the dollar. Everyone can see the dollar is weak. And everyone with any sense wants to protect himself from it.

On Friday, the price of gold moved up to $1,116. Gold is the obvious choice for those who wish to protect themselves from the dollar. But readers are cautioned: that doesn’t mean the price of gold is going up.

Over the long run, sure. All paper currencies eventually go to their intrinsic value, which is zero. And gold always goes to its traditional value too – at a level where a man can take an ounce of it and get himself a suit of clothes, about 30 bottles of good whisky…one horse…or a trip across the Atlantic in economy class.

But things that ought to happen do not always happen when you think they should. It could take many years – of long, drawn-out recession…a la Japan – before the Bernanke Fed gets its helicopters revved up. In the meantime, all those hot shots who borrowed dollars from the Fed in order to bet against the greenback are going to be in trouble. They’ll have to unwind their carry trade positions at a loss…and pay back more expensive dollars. The process could take years.