Saturday, July 31, 2010

Looking at the dollar in the old-fashion way

Below you will find my critique, highlighted in bold font, of a recent article which appeared in the periodical, The Economist.


WHEN the Bretton Woods system was cracking in the early 1970s the price of a troy ounce of gold, in dollar terms, was raised in two steps from $35 to $42.22. This was, in effect, a devaluation of the dollar.

[My Comments: the phrase, “was cracking,” without any context presumes the system itself was unsustainable and therefore was collapsing. On the contrary, the Bretton Woods system “was cracking” because, politicians being as they are, refused to play by the rules; namely, don’t print more money without sufficient gold holdings.]

The authorities then still thought it worth expressing the shift in terms of bullion, rather than against another currency like the Japanese yen or French franc. In the 1930s Franklin Roosevelt had a specific policy of devaluing the dollar against gold, pushing the price from $20.67 to $35 in the belief this would push commodity prices (and thus farm incomes) higher and reduce the burden of debt service.

[My Comment: This is classic half-truth statement. Indeed, “Franklin Roosevelt had a specific policy of devaluing the dollar against gold.” He did this, however, by declaring the use of gold as currency to be a criminal activity; the people were required to sell to the federal government all their gold holdings at $20.67 per ounce. After doing this, FDR sold the gold holdings they legally confiscated to the Federal Reserve at $35 dollars. And they return the extra $15 per ouce to the people, right? Don’t be silly, of course not. They pocketed the difference. Read about it here.]

Nowadays the price of gold is set by the market rather than by official diktat. When explaining shifts in the bullion market people tend to think in terms of supply and demand. Perhaps, however, they should view gold-price movements in terms of investors’ confidence in the dollar, and in paper money in general.

[My comment: agree]

After gold was set loose in 1973 its price rose at a rapid rate for the rest of the decade, peaking at $850 an ounce in 1980. In other words the dollar had lost around 90% of its value since the demise of Bretton Woods. The 1970s was a period when economic policy in the developed world seemed to be in disarray, with inflation and unemployment high, and confidence in central bankers low.

[My comment: The devaluation of the US Dollar happened despite the fact that one of the function of the central bank is to maintain stable prices.]

The appointment of Paul Volcker as chairman of the Federal Reserve in 1979 appeared to be a turning-point. He broke the inflationary spiral in the early 1980s, albeit at the cost of a double-dip recession. From 1982 onwards developed economies seemed to enter the “great moderation”: inflation was low or falling, and recessions were rare and mild. The authorities developed the knack of delivering stability with paper money, thanks to independent central banks committed to a low inflation target. Gold fell from $850 to $253 by 1999. With confidence in economic policy restored, the dollar was revalued by 236% over almost two decades.

[My Comment: This statement is a classic example of “correlation does not imply causation.” The reason for falling price inflation and mild recessions had less to do with monetary policy and more about luck. The 1980s witness the fall of communism and a greater push of market-based economics in China. These two events alone caused in large measure the so called “great moderation.” These events also explain why gold went on a 20 year bear market starting in the early 1980s.]

By the late 1990s, however, belief in the eternal wisdom of central bankers was nearing its peak: “Maestro”, Bob Woodward’s portrait of Alan Greenspan, came out in 2000. The dotcom and housing bubbles led to a reappraisal of Mr Greenspan’s career. Many commentators now feel he paid too little attention to credit growth and asset prices. As Charles Dumas of Lombard Street Research tartly remarks, Mr Greenspan displayed “asymmetric ignorance”. He claimed not to know when asset prices were in a bubble but he did always claim to know when falling asset prices were likely to cause havoc. Investors were given a one-way bet.

[My comment: I cannot agree more with Mr. Dumas’ assertions.]

The credit crunch also laid bare a conflict in central banking that goes back to the days of the gold standard. As well as safeguarding the value of the currency, central banks act as lenders of last resort. When push comes to shove the latter duty seems to outweigh the former, and the bankers turn on the monetary taps. The result has been a loss of confidence in the dollar. Gold’s rise since 1999 in effect means a near-80% devaluation of the dollar over the past decade (see chart).

[My comment: Rule # 1 in life: there is no such thing as a free lunch. Rule # 2: Do not forget Rule # 1. Rule # 3: Don’t listen to anyone who rejects Rule # 1 and Rule # 2.]

What is striking about the history of the past 40 years is that these three swings in the value of the dollar (ranging from a rise of 236% to a fall of 90%) are huge by previous standards. But they have not been noticed because the dollar is now compared with other paper currencies—like the euro and yuan—where shifts have been nothing like as extreme.

[My comment: Ben Bernanke, et. al., do not want you to know this truth. The erosion in the value of the dollar is called by economists as seigniorage; however, in the real world it would be called theft. In addition, when the dollar is compared with other paper currencies we are not measuing value, but prices. All paper currencies have zero (yes, ZERO) value.]

This raises a further puzzle. One reason why countries tried so hard to maintain the gold standard and the Bretton Woods system was to reassure creditors that they would be repaid in sound money. Since 1971 most countries have had the right to repay creditors in money they could print at will. The likes of America and Britain are now perceived as “lucky” because they, unlike Greece, can devalue their currencies and default in real terms.

[My comment: This “puzzle,” at The Economist puts it, is what will bring the collapse of our present monetary system. One truism about life is that if things aught to be a certain way, but aren’t at this moment, at some point in the future it will be. The day of recknoning is fast approaching among us where this “puzzle” will cease to exist.]

That prospect did alarm creditors in the 1980s when the real yields on government debt shot up. But it does not seem to now. America and Britain are paying only 3-3.5% to borrow for ten years. That may be because deflation seems the more immediate threat. It may be because bond markets are now dominated by other central banks, which are more interested in managing exchange rates than in raising returns. But it is not stable to combine low yields, high deficits and governments that are happy to see their currencies depreciate. Something has to give.

[My comments: Indeed, “something has to give.” And it will.]

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