Tuesday, March 2, 2010

The Dollar Is Vulnerable To Self-Destruction

Ever since the US severed the dollar's link to gold in 1971, the dollar has become vulnerable of self-destruction. As the government continues to print endless amounts of money to fund increased spending, the dollar is becoming more susceptible for a Roman-style currency collapse and a massive exodus of people trading US paper for gold. See the following post from Expected Returns.

What you will see in the years ahead is the spectacular conclusion of one of the most remarkable bull markets of all time. Based on where I see gold prices going, I would be remiss if I didn't bang my fist on the table about the coming explosion in gold prices.

To fully appreciate gold, you must understand history. Without the proper historical backdrop, it's difficult to convey what is going to materialize in the gold market.

Gold has functioned as a medium of exchange for most of recorded human history. Most people don't understand gold's historic role as money, which leads to serious skepticism over the possibilities of $2,000 dollar gold. However, gold has historically been recognized as money due to its unique characteristics, such as fungibility, malleability, and relative scarcity. Look up any great civilization from biblical times, and you'll see that gold played a major role.

Bretton Woods 1944

Following WWII, leaders throughout the world convened in Bretton Woods, New Hampshire to create a new international monetary system. International currencies carried fixed exchange rates relative to the dollar, while the dollar was linked to gold at $35 dollars per ounce. The dollar effectively became the world's reserve currency with the implicit right to print as many "good as gold" dollars as they desired. I don't understand how supposedly intelligent people could have possibly believed you could fix the value of gold in dollars while printing endless amounts of dollars. Regardless, that's the Bretton Woods system in brief.

What people must understand is that the dollar became the world's reserve currency not because of its intrinsic merits, but because America owned 76% of the world's gold. He who owns the gold truly does make the rules.

The flawed Bretton Woods system came to a halt in 1971 when the United States refused to convert dollars into gold. This, of course, led to the monstrous rally in gold prices in the 1970's from $35 dollars an ounce to $850 dollars an ounce since the value of gold was now determined by the free markets. This is why no amount of jawboning by central banks today can stop gold from going much higher.

The Anatomy of Debasement

Currencies tend to self-destruct dynamically, meaning that there is an initial debasement period that is difficult to perceive until much later, when the currency devalues sharply. The Roman Empire provides perhaps the best example of this sudden and sharp devaluation in a currency after centuries of relative stability.

Ever since we severed the link to gold in 1971, the dollar has been on a steady decline that has been imperceptible to most. The coming sharp devaluation in the dollar will be perceptible to all.

Worldwide Devaluation

And it's not just the dollar. There is simply no precedent in world history of countries around the world simultaneously printing endless amounts of money. This is not a sustainable trend in a floating exchange rate system where currencies don't have any backing. Only students of history know how incredibly insane it is to leave a currency devoid of backing by something of real intrinsic value. What you are effectively doing is giving politicians free reign to "print" as much money as they perceive necessary. Times change, but human nature never does. Politicians have always "printed" money to plug budget gaps that require a certain measure of austerity to solve. Instead of cutting spending, governments tend to "print" money. What makes you believe currencies will retain their value when you dramatically increase the supply?

Dollar Safe Haven?

There is a persistent and terribly misguided view that somehow the dollar will rise in the face of global economic instability. This is utter nonsense.

U.S. Treasuries and the U.S. dollar are "safe havens" only in the absolute short-term. When people start exiting the Treasury market, it will take on the form of a stampede, which is why buying U.S. debt is a huge gamble.

In times of crisis, capital flows desperately in search of safety. During the Great Depression and subsequent world war, gold flowed to the United States. Why? Back then, the United States was a major creditor nation while Europe was mired in a debt crisis. As a major exporter, the United States had the privilege of exchanging their vast currency reserves into gold, draining the gold reserves of European nations in the process. Now, the United States is the greatest debtor nation in the history of the world. So what you are witnessing now is the reverse- foreign nations are taking their huge reserves of U.S. dollars and exchanging them for gold.

Paradigm Shifts

We are going to see a wave of sovereign debt defaults in the years ahead. As a result, capital will flow out of bonds and into gold. What you will see is incredible volatility in currencies as capital seeks out a true safe haven.

For gold to reach new heights, the public will have to participate. To get mass participation in gold, you need to see a paradigm shift. The paradigm shift will take on a life of its own as people really start to distrust our government, which logically includes our currency. People really have to let it sink in their heads that states are bankrupt. The Federal government is bankrupt. This is not a joke. In order to keep up the illusion that it will pay off its debt, the U.S. has to devalue the dollar. This means printing massive dollars and "sticking it" to foreigners. Foreigners will respond and "stick it" to the United States by buying gold. What will follow is an incredible rise in the price of gold that seems unfathomable to most today.

This post has been republished from Moses Kim's blog, Expected Returns.

No comments: