"The Dollar - Is There Gold in its Future?"

Sydney M. Williams

Thought of the Day

“The Dollar – Is There Gold in its Future?”

April 4, 2011

Like a following sea, dollar bears have increased as the Dollar Index has declined. During the past ten years the Index is down 35%; gold is up six fold and inflation has eroded the value of the dollar by 22%. The reserve status of the dollar is being questioned, as is the concept of fiat currencies in general. Monetary conservatives like James Grant, Lewis Lehrman, Ron Paul, Paul Singer, Ben Steil and Manuel Hinds (among others) are raising the possibility that a return to some “modernized” version of the gold standard should be considered.

As we emerge from the “Great Recession” a declining dollar, over the short term, helps our export economy, but it raises the cost of imported goods. The effect is inflationary – an insidious tax which, regressive in nature, hurts the poor far more than the wealthy. The ability to invest excess cash in assets such as equities has historically offset the ravages of inflation over any extended period of time. And, while half of all Americans own stock either directly or indirectly, half do not.

A depreciating dollar presents the buyer of Treasuries a Hobson’s choice – one’s principal may be secure, but the erosion in purchasing power will not likely be offset by interest received. Higher interest rates will result in lower bond prices. This point seems to be missed by most members of Congress who persist in their pursuit of fiscal recklessness. In her recent book, Willful Blindness: Why We Ignore the Obvious at Our Peril, Margaret Hefferman writes of a “selective vision” governed by ideology, fear and the desire to conform that let’s people ignore what later seems obvious. Those in Washington who argue against reforming or rationalizing our entitlement programs as nothing more than cutting off aid to the neediest are practicing political expediency and choosing to be willfully blind to a Tsunami of debt that threatens to drown us.

Whether the correct step is a return to some form of a gold standard is beyond my abilities, but no system appears free of risk. The years between 1879 and 1914 are generally considered the “classical” gold standard period. During those thirty-six years the dollar was essentially flat, declining a modest 2.5%. However, those years were not idyllic, as the American economy experienced six recessions and four panics. Two of the recessions (1882-1885 and 1902-1904) were fairly long lasting and deflationary in nature. The first led to the Free Silver movement – and William Jennings famous “Cross of Gold” speech – pitting creditors (bankers and financiers in the East) against debtors (farmers in the Midwest and South and miners in the West.) The Panic of 1907, initiated by a run on the Knickerbocker Trust, witnessed a severe monetary contraction, which led to the formation of the Federal Reserve in 1913.

(One could substitute today’s Chinese for yesterday’s Eastern states, and profligate Americans for those states in the Midwest, South and West for yesterday’s farmers and miners to help understand the conundrum facing monetary and fiscal authorities today.)

Of course the decision by the Nixon administration in 1972 to totally depart from any ties to gold did not protect the economy from recession – there have been six since 1972 – nor panic, as we learned in 1987, 1997 and 2007-2008. On the other hand, since that moment when Nixon intoned that “we are all Keynesians now” the dollar has lost over 80% of its purchasing power – again hurting the poor far more than the wealthy. (The Dow Jones has risen from 1020.01at the end of 1972 to 11577.51 on December 31, 2010, thereby permitting equity investors to stay securely ahead of inflation.) Ironically, it is the politicians who purport to speak for the poor that have been the strongest advocates of today’s inflationary policies.

Real wages (adjusted for inflation) have stagnated for average workers over the past forty years, while society’s compunction to consume continued unabated, leaving little opportunity for lower income people to save or invest.

Fiscal policy has only hampered monetary policy. Gillian Tett’s lament in the weekend edition of the Financial Times that Americans have not yet learned to share pain is a familiar refrain, but she suggests a different explanation. Economic growth, to Americans, has always appeared eternal. A country “built by pioneers knows no borders,” its future seems limitless. She suggests that the pie may no longer be expanding, or at least at a rate far below historic norms. Ms. Tett compares today’s spiraling debt to the near-default in New York City in 1975. Crisis concentrated American minds at that time, “albeit at the eleventh hour.” She suggests, optimistically, that perhaps that will happen today in the nation’s capital.

Perhaps it will happen; we can all take some small comfort by what is happening in New York and California. But the two parties in Washington are in an angry mood, pitting Tea Party fiscal conservatives against Democratic big spenders. Fiscal irresponsibility on the part of many, including public unions, has turned dreams into nightmares.

Unfortunately, in terms of monetary policy, one size does not fit all times. Expansive policies were necessary in the wake of 9/11, but the Fed kept rates too low for too long, fueling a bubble in home prices. In the aftermath of the credit collapse in 2007-2008 (in part a consequence of the Fed), monetary expansion was again critical. The question is will the Fed wait too long to tighten, or have they already done so?

Will Federal Reserve Chairman Ben Bernanke prove to be our Virgil as we descend into this abyss of debt that, left alone, will assuredly lead to inflation and a depreciating dollar? Interest rate rises, if not initiated by the Fed, will prove inevitable, as our creditors will demand higher returns for the risks they are assuming – a depreciating dollar. A stable currency will be necessary to attract the type of investor our country needs to continue to grow. Will that stabilization involve some form of gold backing? I don’t know, but I wouldn’t bet against it.