I never understood the arguments of those who said the dollar was going to "collapse." Collapse against what? The euro? The yen? The pound? The yuan?
As the world's reserve currency, the dollar acts as an anchor to which all other fiat currencies are attached. The euro replace the dollar? Please. We already see the structural deficiencies of the euro, but Europe grows slower than America and is generally more politically hostile towards capital. The yen? Japan still has enormous structural problems and will have serious demographic issues in the future. The pound? Sterling is merely the dollar on steroids. The yuan? Can you freely convert your Chinese currency into dollars yet? I thought not. Plus, there's this wee issue of the massive housing bubble in China.
No, if the dollar were to collapse, it would take all other fiat currencies with it, the euro included.
It should be painfully obvious why the euro isn't about to replace the dollar anytime soon. A currency union can only work if the union has a valve that releases economic pressure for weak regions. If one region is economically stronger than another within the currency union, then there must be some mechanism which alleviates the economic pain in the weak region at the expense of the strong region.
There are two ways of doing this - free movement of labour and/or direct monetary transfers from the strong region to the weak region.
In America, there has been a migration away from the Rust Belt to the South. The former manufacturing powerhouse of America, which encircled the Great Lakes from Wisconsin to New England, was gutted in the 1970s and 1980s as manufacturers re-located to the cheaper South. As plants shut down in the Northeast and Midwest, labour migrated out of the Rust Belt and into the South. Also, because of social programs, money paid by taxpayers in the economically strong states flowed to the weaker states. The pressure valves in the dollar currency union were the free movement of labor from the Rust Belt to the South, and the wealth transfers of social program payments via the government.
Canada offers an even more stark example of how a monetary should work. The richest provinces in Canada have generally been Ontario, Alberta, BC and sometimes Saskatchewan. The poorest provinces have generally been Quebec, Manitoba, sometimes Saskatchewan and the Maritime provinces. The flow of labour has been from east to west, as lack of employment opportunities in the Maritimes has prompted many Maritimers to move to Ontario and the West, alleviating excess labor capacity in Eastern Canada. Canada also has a mechanism of direct wealth transference from the rich provinces to the poor provinces known as Equalization. Based on a formula, every year wealthy provinces directly transfer funds to the poorer provinces, much of which is used for social programs and job creation in the poorer provinces.
In theory, the Eurozone has both wealth transfers and free movement of labor. In the EU, poorer countries are subsidized by richer countries, and any EU citizen can freely work in any EU member country. In practice, the subsidies are not great enough and there are barriers to the movement of labour. Theoretically, a large number Greeks could migrate to Germany or Sweden. However, it is difficult for Greeks to easily assimilate in those countries, and the subsidies from the rest of the EU are not large enough to release the pressure from an over-valued currency in Greece. Greek labour was over-priced relative to German labour, so the Greek government borrowed to maintain the country's standard of living given that Greece could not devalue its currency relative to Germany. But this is untenable over the long-run and thus we have a currency crisis in Europe.
The actions of the EU are unequivocally bearish for the euro. German and French banks are large owners of Greek bonds. Debt - Greek debt - is being transferred from German and French banks to the German and French states as well as to the European Central Bank. This is what happened in the US and the UK. American and British bank liabilities were transferred directly from the banks to the state after the housing collapse. When the state takes on a greater amount of liabilities relative to GDP, it weakens the currency. The core nations of the EU are now devaluing the euro by hoisting more liabilities onto the currency by absorbing the debt of Greece via French and German banks.
Devaluation of fiat currencies is ultimately bullish for real assets. It is good for stocks, commodities, real estate, art, wine, stamps, you name it. And it is best for real assets in structural bull markets, such as gold.
It is difficult for a value investor such as myself to invest in assets hitting all-time highs, but I do not see how the policy responses by governments are anything but bullish for gold over the intermediate-term. Countries have assumed massive liabilities, and the coming demographic problems regarding state-funded pensions and medical systems will only make the situations worse. I do not know how gold is going to do anything but rise over the next several years.
During the past few months, gold has decoupled from its inverse relationship with the dollar. This is the ultimate end game. Because the dollar is the anchor for all fiat currencies, a falling dollar eventually leads to all fiat currencies falling against real assets. This is now happening.
How will the gold bull market end? I see three ways.
One way is through increased supply. Gold output rose last year but has been falling for the past decade.
Another way is through significant monetary tightening. And I mean "significant," where the real rate of interest is substantially positive. The Fed funds rate was 6.25% in 2007 and the price of gold was double what it was five years earlier. Given all the problems in the world today, it is hard to see central banks jacking up interest rates significantly for some time.
Finally, the price of gold will get so stupid that it eventually falls under it's own weight. But we aren't there yet.
Ultimately, I think it will be some combination of the three that kills the gold market, with the price ultimately getting really stupid being the biggest reason.
I am long gold. I own calls on the GLD, to which I added my position today. I am expecting a pullback in the price of gold followed by a successful re-test of the highs, leading to new highs in the future. But the price action today was fantastic, and new highs may come sooner than I am expecting.
T.
First, thanks for this new post. Second, gold is in a secular bull and secular bulls move up; every timing error going long will eventually be corrected by the secular bull.
Now, regarding currencies, yes, bailing out and buying bonds and dropping money from helicopters or whatever stupid theories on printing towards prosperity will end badly for that country. A simple yet efficient way to look at credit conditions for a country is:
1) saving rates of the population; if they are negative (like is for UK or US) that is not good at all.
2) deficits; countries borrowing abroad to build bridges because it will bring prosperity in 30 years is non-sense; if there is a way to make money out of building bridges, entrepreneurs will build those bridges I assume. If they see no interest building bridges, it probably means there is none. I know that is debatable and entrepreneurs are not right all the time (like any human actually); but to believe that spending as the bureaucrats know what projects we need is amazing! I say this because I read hear and there to do more of those.
I mention this to make a link with the value of currencies; I highly respect your arguments and I read every post of yours carefully and enjoy it; I'm not literate in finance and economics hence I don't want to give any lessons here; but as you know better than me currencies trade in pairs, your statement that a falling dollar will drag the other currencies with it is wrong imo. It won't; what will happen to the dollar in this cycle (coming decade) will be unprecedented; actually, I think it will put an end to the fractional reserve system.
Easy-Al managed for the first time in history to drag the dollar index to 80; his fellow colleague and disciple, Heli-Ben, managed to push it below 80 for the first time in history; those thinking this fool will stop here are naive imo. And while the dollar will go to hell, other currencies won't go with it (the kiwi, Canadian dollar, Norvegian crown, gold, etc.). And the big devaluation of the dollar will come because of Chine I think; everyone expect the yuan to go up; China has a massive problem today and I bet they will actually devaluate it! The US will have to follow and devalue the dollar because of that; it can go very ugly for the dollar.
It is my idea, I might be dead wrong of course.
Posted by: dacian | May 12, 2010 at 04:52 AM