[OPE-L] Signals of the end of the dollar standard

From: glevy@PRATT.EDU
Date: Fri Oct 07 2005 - 11:09:29 EDT

An interesting  guest commentary from <http://www.prudentbear.com>
by Rob Lee
Signals of the End of the Dollar Standard
October 5, 2005

Rob Lee is an economist who has been involved in
investment markets for 30 years, the last few in
nominal retirement.

I am an economist who worked for 25 years in large
investment companies in South Africa. I "retired" to
the UK a few years ago. For most of my career I
lobbied for policies such as money supply targets and
later inflation targets that were (implicitly)
intended to substitute the role of gold as an
independent anchor for the monetary system. I was
never an advocate of any form of gold standard, unlike
the current Fed Chairman, now ironically testing the
fiat money system to destruction.

However, in recent years the scales have fallen from
my eyes. As Voltaire said in 1729 "paper money
eventually goes down to its intrinsic value  zero."
Every fiat paper currency before or since has
confirmed to this predictio

n. A fiat paper currency that is also the global
reserve currency becomes this problem writ large. A US
Treasury official of old - Sam Cross - put it this
way: "if you postulate a system that depends on one
country always following the right policies, you will
find that sooner or later no such country exists. The
system is eventually going to break down". In my view
the Dollar Standard system is irretrievably breaking
down, as signaled by four recent developments
described below:

1. China has ended its currency peg to the dollar. The
new exchange rate system for the Yuan is admittedly
not yet a dramatic break from the dollar fixed peg .
That is not the Chinese way. It is nevertheless hugely
symbolic. It serves notice that China will be
increasingly reluctant to accumulate dollars they know
will depreciate in value over time. Chinese economic
spokesmen have made no secret in public of their alarm
at US profligacy - what is said behind closed doors?

China is clearly intent on exchanging its paper assets
(predominantly dollars) for real assets, notably
commodities in general and energy products in
particular. On gold the strategy focuses on
encouraging private citizens to own gold- deregulation
of the gold market has been rapid by Chinese
standards. [Ironically it may now be easier for
citizens of China to invest directly in gold than it
is in many western democracies].

China is likely to prefer to remove dollar support
only gradually. Bear in mind though that most of the
smaller economies in Asia tend to follow China -
Malaysia announced a similar change to its exchange
rate system very soon after the Chinese. Other
countries from outside the region - notably Russia and
Saudi Arabia - have indicated an intention to
downgrade the dollar in their currency arrangements.
Iran is attempting to create an oil trading exchange
that does not transact in dollars. These are ominous
straws in the wind for a currency so dependent on
foreign capital.

2. Deflation in Japan is coming to an end. Japan is
the biggest foreign holder of US dollars. For example,
Japan held $680bn in US Treasury Securities at the end
of June - nearly 34% of total foreign holdings. This
compares with $291bn held by China (including Hong
Kong). Japan will therefore play a critical part in
any changes to the world's currency system.

US-Japan relations are far closer than those between
the US and China. Japan also has literally more to
lose from the demise of the dollar than China.
Nevertheless the same logic that impels China's move
away from US paper applies to Japan. As long as
deflation remained the key economic concern in Japan
supporting the dollar was the paramount objective of
its exchange rate policy. However, there are clear
signs of a self-sustaining recovery of domestic
employment, investment, and consumption in Japan. The
recent election victory of PM Koizumi should reinforce
reform and recovery. These forces are simultaneously
bringing an end to both the deflationary process and
to dependence on exports for growth. The imperative to
support the dollar will erode and interest rates in
Japan will begin to normalize. Another straw in the
wind - Japan did not increase its holdings of US
Treasuries in the first half of 2005.

3. The US in effect now has to borrow abroad in order
to service all its foreign debt. The remarkable down
spiral in the US foreign financial position took
another crucial but little noticed twist recently. In
the second quarter of 2005 the US paid out more in
income to foreigners on their US assets than it
received in income on its foreign assets. Technically
net foreign investment income went negative. No
comfort should be taken from the fact the second
quarter investment income deficit was a mere $0.5bn.
The income deficit will deteriorate rapidly in coming
years. The US has net foreign debt (foreign
liabilities minus foreign assets) of more than $ 2.5
trillion, and this debt will grow rapidly as the US
continues to rack up huge current account deficits
(now roughly $800bn annually). The income deficit on
this debt has only just gone negative because the US
receives a rate of return on its foreign assets
roughly double that of overseas investors in the US -
about 7% versus 3.4% between 2002 and 2004.

This differential return reflects the fact that
Americans have invested largely in riskier assets
abroad while foreigners have opted more for Treasury
securities. A world economic downturn (likely in my
view) would reduce returns on US overseas assets,
while rising US interest rates will raise the return
to foreigners. The longer term dynamics of this
process are alarming. Within a short period of years
the US will be borrowing hundreds of billions merely
to service existing debt. Economists call this the
"debt trap" - and the US economy is heading inexorably
into it Can the US dollar sustain its position as the
world reserve currency in the face of these
fundamentals? As the saying goes, you only have to ask
the question to know the answer.

4. The gold price is breaking out in all key
currencies. Not all the world's investors (or central
bankers!) are blind to the scary developments sketched
above. Gold in dollars has definitively been in a bull
market for some time, but in recent weeks gold has
decisively broken out all key currencies including the
Euro, Yen, Swiss Franc and Sterling. Markets are
recognizing that the failure of the Dollar Standard is
one not only of US economic management but one
inherent in the fiat money system itself. In the long
term they may demand gold's return as an anchor to the
global monetary system.

The flight from paper assets (and especially dollars)
towards hard assets is now underway in earnest. There
is still time - this is a multi-year trend - for
investors to switch from devaluing dollars to rising
gold. Those ahead of the herd are moving but the herd
itself is yet to stir.

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