Gold shines as dollar's days as lynchpin currency wane
July 28, 2009
By Sandy McGregor
Doubts have emerged as to whether the US is a financial safe haven and whether the dollar will maintain the most important attribute of a reserve currency - that it be a stable store of value. The recent strength of the gold price suggests we may be witnessing the early stages of a flight from the dollar.
We have commented previously that gold has the characteristics of both a commodity and a currency. Since the sub-prime mortgage crisis broke in July 2007, the role of gold as a store of value has become increasingly prominent, with its price rising to $980 (R7 650) an ounce from $660 at a time when almost all other commodity prices have declined significantly.
This is not simply a matter of a weak dollar. Gold's value is up 42 percent in euros and 17 percent in yen. If gold is regarded as a currency, it has been the best performer of its class since the start of the financial crisis.
What is driving people to invest in a financial instrument that economist John Maynard Keynes famously described as a barbarous relic?
Underlying the shift of sentiment towards gold is concern about governments generally abandoning fiscal and monetary discipline in an attempt to stabilise global economic conditions, and worries about the dollar as the world's reserve currency.
In modern times there have been two reserve currencies. The pound sterling played a central role in global finance over the century between the end of the Napoleonic wars and the outbreak of the First World War in 1914. Two world wars destroyed Britain's financial hegemony.
In 1945 the dollar emerged as the lynchpin of the global financial system.
While prior to 1914 Britain did not abuse its privileged position at the centre of the world's financial system, generally running balanced budgets and current account surpluses, the same cannot be said of the US. Since 1981 the US has run huge current account deficits. Initially, this did not matter because it had substantial foreign assets to offset foreign obligations.
However, over time the US has become the largest net debtor. The dollar's special role has allowed Americans to live beyond their means for almost three decades. The rest of the world has been willing to finance this spendthrift behaviour because it has prized, perhaps irrationally, US assets above all others. In addition, many countries have supported the dollar in order to grow their own economies.
Japan, the Asian Tigers and China have all used export-led growth to create their present prosperity. They boosted exports by maintaining artificially competitive exchange rates, generating large current account surpluses and accumulating substantial dollar foreign exchange reserves.
Confidence in the dollar is eroding among foreign central banks, which continue to prop up the dollar because they have no alternative.
In contrast, private investors have the freedom to act and are doing so. The market as a whole has become increasingly neurotic about US government finances. Doubts are emerging as to whether the US is in fact a financial safe haven and whether the dollar is a stable store of value.
At the heart of the problem is the US fiscal deficit, which will be between $1.5 trillion and $2 trillion this year. The Federal Reserve is planning to fund a substantial part of the deficit by printing money. The Federal Budget Office projects that federal debt will increase from 41 percent of gross domestic product (GDP) at the end of last year to 82 percent in 10 years' time - provided certain policy changes are made. Without these changes the debt will exceed 100 percent of GDP.
Can the spiralling US deficit be brought under control?
Economic history is replete with examples of countries that have managed to bring seemingly intractable budget deficits under control. However, it is very difficult to see how the US is going to extricate itself from this fiscal morass when we consider the traditional ways this has been achieved.
Strong economic growth. This is unlikely at this stage. Strong US growth would boost fiscal revenues and reduce the level of debt relative to GDP. However, the huge debt burden is likely to limit growth for many years to come.
Increase tax collections. This is difficult to achieve, because the US tax base has been severely eroded by declining profits and dividends, low interest rates, capital losses, unemployment and a contraction in remuneration packages.
Reduce spending. This is equally unlikely. It is always the last resort politically and can be achieved only when the electorate supports such harsh remedies, as for instance in the political revolutions at the end of the 1970s when Ronald Reagan and Margaret Thatcher came to power.
Given that the deficit is unlikely to be brought under control by growth, tax increases or by reduced expenditure, one way out may be inflation.
Inflation is a stealth tax. Generally, people do not realise that it is a regressive levy on their earnings. It erodes the value of liabilities such as the national debt, while boosting asset prices.
US monetary policy now clearly has an inflationary bias with the Fed printing money to buy government bonds.
Given the large surplus of capacity and high levels of unemployment, inflation seems improbable in the near term, but once world economic growth resumes, it could return with a vengeance.
Many investors are choosing gold for fear that the prices of goods and services will spiral upwards. As yet there is little evidence of this happening, but the concerns are there. Hence the rise in the gold price.
Sandy McGregor is a portfolio manager at Allan Gray.
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