Foreign Policy Blogs

World Markets Dump Greenbacks, Buy Gold

The United States Dollar became the global reserve currency of choice via the Bretton Woods agreement after WWII. However, when Republican President Richard M. Nixon took the United States off the Gold Standard in 1971, the US Dollar – the Greenback – became a ‘fiat’ currency; that it is, it was backed only by the “full faith & credit” of the US Governments implied “promise” to repay.  But the mighty US Dollar doesn’t have much clout these days; and I’ve written as much on many occasions here on the Global Markets blog. The Greenback has lost nearly 15% of its value against foreign currencies since the precipitation of the global financial crisis in 2008, and almost 5% since the end of last year. As a result, in 2010, Central Banks around the World became net buyers of Gold reserves for the first time in two decades, adding 87 metric tons of gold in government purchases by countries such as Saudi Arabia, Brazil, Cuba, South Korea, Bolivia, India, Russia and Nigeria, according to World Gold Council data. Interestingly, OPEC which denominates its oil reserves in US Dollars, has recently floated the notion of ditching the Greenback in favor of either the Euro or Gold as an alternative reserve denomination. Consequently, as the value of the US Dollar continues to slide, the World is bullish on Gold.  China, with more than $3 Trn in foreign currency reserves, plans to set up new sovereign funds to invest in precious metals.  Russia alone bought 8 tons of gold in 1st Q 2011.  As developing countries accelerate purchases, gold may reach $2,000 per ounce this year, compared with a record of $1,569.80 at Friday’s close in New York said Robert McEwen, the CEO of US Gold Corp.  “China is out to have more gold than America, and Russia is aspiring to the same,” McEwen said last week in an interview at a Bloomberg Link conference in New York. “When you have debt, you don’t have a lot of flexibility. China wants to show its currency has more backing than the U.S.”  Likewise, Euro Pacific Capital’s Michael Pento, who correctly predicted gold’s highs for the past two years, forecasts a 2011 high of $1,600 per troy ounce.  Gold prices reached record highs 15 times last month on demand from investors seeking an alternative to the US Dollar  after the currency slumped to its lowest levels since 2009, U.S. debt widened, and the Federal Reserve signaled April 27 that borrowing costs will remain near zero percent for an extended period.  Comparatively, China’s economy, the largest foreign holder of US Treasury notes, grew 9.7% in 1st Q 2011.

Meanwhile, Economists in every quarter are debating the end of the era of the dollar, while news organizations paint the Greenback as a 98-pound weakling – wet! Our so-called ‘fiat’ currency, backed only by the full faith and credit of the government, no longer commands respect, as Republican lawmakers threaten intentional default, and Congress debates whether to raise the national debt limit in order to avoid payment default on our outstanding debt as of July 8, 2011.

Interactive Media:  World Gold Reserves vs US Dollar

There are other consequences, however, that we’re missing in the debate over all this red ink. Our budget deficit, as well as the Federal Reserve’s ballooning lending programs and other financial obligations, will accelerate a process already well underway — a changing role for the U.S. dollar in the global economy. The domino effect is straightforward: Higher deficits spark market concerns over future inflation; concerns of inflation contribute to a weaker dollar; and both come together to undermine the greenback’s role as a reliable store of value around the world.  So if the World boots the US Dollar, how would that affect our average daily lives as Americans..?? How do we hedge against fluctuations in the Greenback..?? Barry Eichengreen of the Washngton Post wrote an interesting analysis on that question. You can read more on that here.

Similarly, the Economist magazine’s latest cover issue is titled, ‘What’s Wrong With America’s Economy?’ and it’s a brilliant synopsis from an outsider’s perspective of what’s wrong, and what needs to be done to fix it. Among several issues raised that I found prescient is the propensity across the nation to incarcerate a large – and a racially disparate – segment of its citizens, which among other things drives the influx of illegal immigration, which has an increasingly burdensome impact on government spending at all levels.  You can read more on that here.

As I’ve been prognosticating for several years now – many of my clients still recall I was touting ‘Buy Gold!’ beginning back in 2001 when I was with Morgan Stanley and gold was selling at $374/oz – the era of the US Dollar as the global reserve currency of choice is over. Like it or not, out of the ashes of this national fiscal debacle, a new, more stable global reserve system is emerging. And for the world as a whole, as well as for the US, this could be a good thing. It would lead to a more stable worldwide financial system and stronger global economic growth. The current system entails developing countries putting aside hundreds of billions of dollars a year in currency reserves (US Treasury notes) that can be better spent on their infrastructure and economic development. But doing so only weakens global demand – often for US products – and contributing to our economic difficulties. And just ethically, there is something a little unseemly about poor and developing countries countries lending us trillions of dollars, that stunts their growth; and now at an rate of return close to zero.

 

Discussions on the design of a new system are already underway. The United Nations’ Commission of Experts on Reforms of the International Monetary and Financial System – a body chaired by my former Columbia professor and Nobel-winning economist Joseph Stiglitz, and which included economists, former and current government officials, financial sector participants, central bankers, and business leaders from Asia, Europe, the US, Africa, and Latin America – has argued that a new global reserve currency system may be the most important reform to ensure the long-term health of the global economy; it also suggested how to design an orderly transition from the dollar-based system.

In its interim report in June, the commission described a number of alternatives. Some involve building on the International Monetary Fund’s “special drawing rights,” or SDRs – a currency whose valuation would be based on a “basket” or index of several World currencies, a kind of “IMF money” – but making the issuance of this global reserve money annual and more predictable. (Currently, issuances of SDRs are small and irregular.) Other proposed reforms are more complex and ambitious, such as using China’s Renmenbi or the Swiss Krona as an alternative to the Greenback.

The US has resisted these changes, but change will come inevitably, and it’s better for us to participate in the construction of a new system than have it happen without us. We have seen many benefits and great advantages with the dollar as the world’s reserve currency of choice, particularly the ability to borrow at low interest rates seemingly without limit. But we haven’t seen the costs & consequences as clearly: inevitable trade deficits, susceptibility to foreign interests (eg, China), the economic instability, monetary policy & currency wars (eg, Quantitative Easing), huge global imbalances (eg, China vs. US economic recovery), etc. The benefits to us as Americans are likely to shrink, and rapidly so, as global central banks shift their reserves away from the Greenback and toward, for now, Gold stockpiles. It is happening already, and the process is likely to accelerate. Chinese authorities, for example, have openly expressed concerns about the value of the country’s vast dollar reserves. Not surprisingly, China, Japan, Australia, Brazil and other nations holding lots of US debt (Treasury notes) are leading the efforts in the appropriate global forums to build a new system.

In my view, we should show leadership in helping to shape this new structure and managing the transition, rather than a reactionary resistance to what is inevitable. We may have preferred to keep the old system, in which the Greenback reigned supreme, but by the greed and irresponsibility of few, we have abdicated the throne. That’s how I see it: what do you think..??

 

Source: Economist, Washington Post, Bloomberg, Fire Dog Lake    Chart: WGC.com

 

Author

Elison Elliott
Elison Elliott

Elison Elliott , a native of Belize, is a professional investment advisor for the Global Wealth and Invesment Management division of a major worldwide financial services firm. His experience in the global financial markets span over 18 years in both the public and private sectors. Elison is a graduate, cum laude, of the City College of New York (CUNY), and completed his Masters-level course requirements in the International Finance & Banking (IFB) program at Columbia University (SIPA). Elison lives in the northern suburbs of New York City. He is an avid student of sovereign risk, global economics and market trends, and enjoys writing, aviation, outdoor adventure, International travel, cultural exploration and world affairs.

Areas of Focus:
Market Trends; International Finance; Global Trade; Economics

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