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Guest Post: Why the U.S. Dollar Is Not Going to Zero Anytime Soon
Submitted by Charles Hugh Smith from Of Two Minds
Why the U.S. Dollar Is Not Going to Zero Anytime Soon
The market considers a variety of inputs in pricing the value of a floating currency. The dollar has more going for it than is generally understood.
The conventional view looks at the domestic credit bubble, the trillions in derivatives and the phantom assets propping the whole mess up and concludes that the only way out is to print the U.S. dollar into oblivion, i.e. create enough dollars that the debts can be paid but in doing so, depreciate the dollar's purchasing power to near-zero.
This process of extravagant creation of paper money is also called hyper-inflation.
While it is compelling to see hyper-inflation as the only way out in terms of the domestic credit/leverage bubble, the dollar has an entirely different dynamic if we look at foreign exchange (FX) and foreign trade.
Many analysts fixate on monetary policy as if it and the relationship of gold to the dollar are the foundation of our problems. These analysts often pinpoint the 1971 decision by President Nixon to abandon the gold standard as the start of our troubles. That decision certainly had a number of consequences, but 80% the dollar's loss of purchasing power occurred before the abandonment of dollar convertibility to gold.
The depreciation from 1971 on looks rather modest on this chart. Clearly, dropping the convertibility of the dollar to gold did not change the overall depreciation dynamic much; the dollar had been losing purchasing power since the turn of the century.
Here is the dollar's purchasing power plotted by another source. Note how the purchasing power fluctuated significantly in the 19th century. The emergence of the (privately owned) Federal Reserve as the issuer of the dollar accelerated the dollar's depreciation--a decline interrupted only by the deflationary Great Depression.
To understand the dollar's primary role as a means of exchange for trade, let's start with the relative size of the foreign exchange market. The FX markets trade some $2 trillion a day, far larger than either the credit or stock markets.
Fiat currency is the ultimate phantom asset. It is quite miraculous when you think about it. We print some symbols and images on a piece of paper, and we can exchange that intrinsically worthless paper for real goods and materials: oil, electronics, vehicles, and so on. That magic privilege is certainly worth maintaining.
So why would anyone trade real tangible wealth (say, oil) for specially printed paper? There are basically three reasons:
1. They can use the paper to buy goods and services from other nations.
2. They can buy bonds with the paper money that will draw interest and be paid as promised.
3. When the money is withdrawn to exchange for goods and services, it has retained the vast majority of the purchasing power it held when deposited.
If we look at the charts above, we might wonder why anyone would accept U.S. dollars (USD) as payment for real goods when it so steadily loses purchasing power. The answer can be found by re-reading the three conditions above: if the USD draw interest, and that income is larger than the loss of purchasing power, then the money will still retain its purchasing power when withdrawn.
For instance, if the USD deposits draw 5% annual interest and the USD loses 3% of purchasing power every year, the owner of the dollar still earned a 2% positive return.
There is another interesting feature of interest-bearing bonds: as interest rates decline, the bond rises in value. This sets up the delicious irony of the Chinese whining about their $1 trillion in U.S. Treasury bonds earning such low yields, while in fact their holdings have greatly increased in value as interest rates have declined.
But what underpins a fiat currency's purchasing power? Ultimately, the value of any paper (free-floating) currency is based on the issuer's ability to enforce claims on reliably stable income streams and assets.
Any nation that promises to pay interest on bonds denominated in its currency must be able to enforce its claim on the national income via taxation. If the national income is too unreliable or unstable to support the claim, the international community loses faith in the currency and it depreciates to zero even if the currency isn't printed with abandon.
In other words, the value of the currency as an international means of exchange is not just a function of monetary policy or money supply; the market "prices" a free-floating currency on a number of factors, all related to the three above points.
We all understand gold is an asset. The key to understanding Nixon's decision to break the international convertibility of the dollar to gold was the transition of the U.S. from a net exporter to a net importer.
In the 1960s, France famously demanded that the trade imbalance between the U.S. and France be settled in gold: when the U.S. ran a trade deficit with France, the "amount due" France had to be paid in gold.
Once U.S. domestic oil production peaked and it became necessary to import oil, the U.S. became a net importer in a deeply structural sense. With the dollar convertible to gold, eventually the exporting nations would have ended up with all the U.S.'s gold, and that was not going to happen.
The solution was to float the dollar and trade paper money for the oil.
(There is another fundamental reason why the U.S. became a net importer not just of oil but of finished goods and raw materials, and we'll look at that later.)
But the magic of trading paper for oil could only be maintained if the paper retained the vast majority of its purchasing power over typical investment timeframes.
In this, the U.S. held the immense advantage of issuing the reserve currency, i.e. paper money accepted globally for payment of debts. But this privilege was not magic; the currency still had to reliably draw interest and retain its purchasing power.
Ultimately, the USD retains its value based on the U.S. government's claim to the nation's immense income stream, its assets and its ability to attract international capital.
We can understand the market's "pricing" of these variables by asking: if we had to hold a currency for trading purposes, i.e. to settle debts resulting from global trade, and we needed to hold some of that currency for five years, which currency would be most likely to retain its purchasing power, based on the income stream, assets and capital flows of the issuing nation?
This question illuminates the varied nature of assets. Yes, gold and oil are assets; but so is enabling the free flow of international trade, for example. We can ask the question somewhat differently: is it within the power of the currency's issuer to mandate its purchasing power five years hence? How much of the market's "pricing" is outside the control of the issuer?
Take the euro as an example. Does anyone seriously believe the European Central Bank (ECB) retains sufficient global control over the euro's valuation to mandate its value five years hence? The currency's viability is in question even now, never mind in five years.
Clearly, much of the market's pricing of the euro's value is outside the control of the euro's issuers; whether they admit it or not is irrelevant.
In a similar fashion, China dares not let the renminbi float lest the market "price in" the instabilities implicit in China's economy and trade. If we were able to tote up true capital flows out of China, it is entirely possible that capital flows have reversed, and more capital is flowing out of China into the U.S. than is flowing from the U.S. to China.
If we don't understand capital flows are assets, then we understand neither capital flows nor what constitutes an asset.
How about Japan? The yen is currently viewed as a "safe haven" due to the great stability and wealth of Japan. But two decades of massive deficit spending and debt accumulation are finally putting pressure on Japan, Inc., and those willing to bet the yen will retain its current purchasing power for five more years are taking on an extraordinary amount of risk that has yet to be priced into the yen.
Once again, the question boils down to how much of the yen's purchasing power is in the hands of its issuers. For 20 years, Japan's domestic purchases of its own debt kept the global market at bay. As domestic savings rates dry up and the ageing Baby Boomers start cashing in their bonds and drawing pensions, the system may finally be exposed to global market "pricing" of risk. That exposure could destabilize the yen's position as "safe haven."
Whatever your calculus, it is self-evident that of all the issuers of major currencies, the U.S. retains the most control over the elements the market uses to "price" the risk that the dollar's value as a means of exchange and store of value is unsettled.
There is yet another way to understand the market's valuation of the dollar, and any other floating currency. If you are holding a large amount of a nation's currency, the ultimate value of that currency can be discovered by what you can buy in the issuer's nation with its paper money. If restrictions on foreign ownership crimp what you can buy, the currency's value reflects that. If there is relatively little of value to buy, or the risks of ownership are high, then once again the market will mark down the "price" of that currency.
Despite its myriad problems and challenges, the U.S. allows a fairly broad range of foreign ownership of land, corporations, etc. If you have surplus dollars, you can buy property or an oil well in the U.S. It may not produce much oil, but the output can be sold domestically and its value is relatively easy to calculate. The U.S. economy is vast and there's a wide variety of things and assets to buy with your dollars. In other words, there is a vast market that will accept your dollars in exchange for tangible goods and assets.
I have made the case technically for over a year that the U.S. dollar has reversed its long downtrend and is now in a structural advance. If we examine the multiple dynamics of FX, foreign trade and the market's pricing of currencies, we can discern a strong fundamental case for this advance as well. There is no magic in free-floating currencies, there is only the market discovering the price of numerous inputs, only some of which are easily quantifiable.
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If the Euro collapses, (a distinct possibility) and the individual states worst affected e.g PIIGS revert to their own national currency the values would gyrate wildly. If, say Italy, found itself unable to survive economically in this environment it may be forced to take the drastic action of reverting to its own.......gold standard. In a weak global economic environment that would strengthen its currency and it could import again. Seeing this the other PIIGS would start doing the same? Eventually would this not expose the weakness of other fiat currencies, even the US $, perhaps forcing it to have to re-consider the gold standard?
If the Euro collapses then the dollar will be toast as it keys priamrily off of the Franc and Deutschmark components of the Euro and these will rebound strongly after they drop the PIIGS.
Pls do these charts as semi-Log or log. That will give a more clear understanding of these relative price changes such as YOY changes, etc. Tx
"In other words, there is a vast market that will accept your dollars in exchange for tangible goods and assets."
Right, unless you are Chinese and want to buy one of the "US strategic assets" with your excess USD's...
"the U.S. Dollar Is Not Going to Zero Anytime Soon"
All depends on what you mean "anytime soon"? Tommorrow, Next Month or even Next year I would agree. However it looks like the Euro just might go to zero in the next year or two depending on what Northern EU members choose to do. It is clear all of the southern EU members are insolvent, and its just a matter of time before they are forced to declare bankruptcy. After the EU Collapse, Japan looks like its ready for a collapse. The aftermath of the march 2011 is quickly taking its toll on the Japanese economy and with the EU and the US importing less Japanese goods it seems unlikely that Japan will be able to ride out the storm.
Then the crisis will come home to the US. The US simply can't pay its debts and must borrow (print) over $1 Trillion USD ever year to keep its doors open. Its difficult to believe that the rest of the world will be interested in exchanging dollars when the they see the US national debt exceed $21 Trillion (three times Real GDP of $7 Trillion if gov't spending is excluded) and their are wide spread munibond debts as well as private sector defaults and other large defaults such as Student loans. At some point the US will reach a tipping point, just like Greece, and now Italy and Spain have. Until the Tipping point is reached the Dollar will continue to retain is value. However after the tipping point the dollars valve will likely collapse in a very short period. We saw this happen durring the fall of the Soviet Union. The ruble held its value until it reached its tipping point and completely collapsed in a matter of weeks.
The Fast Track to High\hyperinflation is likely food inflation. When Food shortages occure because of Drought, or Crop failures, it can trigger food inflation. Since Food is such an important commodity, it can result in systemic high inflation. I would recommend keeping an eye on this years drought to see if its bad enough to trigger inflation. Once Inflation kicks off, the Fed has no power to stop it. If they where to raise interest rates it would almost certainly force the US gov't into default. Most of the recent run up in new Debt has been financed with short term debt. A return of normalized interest rates would prevent the US gov't from borrowing the $1 Trillion it needs and the send interest payments soaring. The Fed will have no choice be to keep interest rates below inflation. To put it simply, the US Gov't is on a one way ticket to collapse.
From the article, talking about the purchasing power of the US dollar,
"The depreciation from 1971 on looks rather modest on this chart."
That's because the Y axis of the plot is not on a logarithmic scale. Do that so that the same % drop in the dollar is the same vertical distance no matter what the value, and the plot will look a lot different. CHS is in over his head talking about econ and finance.
Interesting. A "Tyler" who understands some things. Who let that one in here?
I found the article very helpful in elevating my general sense of the gestalt of what I see happening to my honored homeland,the USA. I also found many of the responses clearly presented, acknowledgably aware and also helpful to me. I am, however, still waiting patiently for the comments section to elevate itself to the majority being of constructive suggestions as to assisting us in finding, recognizing and evaluating more effective long and short positions for our emotions, money and belief systems. The later that I see as the foundation of our individual reality, which we all are in hope of being as positive as is possible for our planet and all it's life systems.
There are enough of you still hanging in and expressing yourselves positively to keep me hooked over these past years. It took about 2.5 years before I even registered and I am always glad that I found this blog.....Thank you.
Grin
If you are at 0 you can't go to 0.
"See this graph? The dollar lost 80% of its power while still on the gold standard"...what bubble-blowing blonde wrote this ... those three sharp devaluations represent the War of 1812, the Civil War, WWI, Great Depression, and post-Roosevelt gold confiscation roughly, and I say roughly because at the 10-year increment of the rather childish graph (from "wikipedia"?) the devaluations look natural/gradual rather than completely driven by monetary policy, which is precisely how they were driven.
Thank you. Well said.
58% of the US Dollar Index is the Euro. When the Euro falls, the US Dollar rises.
Elliott wave count on the US Dollar is bullish. The Euro? Bearish.
http://bullandbearmash.com/index/usd/daily/
Would a person knowingly join a crooked card game? Sure, if it's the only game in town and you think you are smarter than the crooks.
Are there disadvantages of running a crooked card game? Yes, you run out of suckers and you attract people who are smarter and more devious than you.
Where we disagree, Charles, is on cause and effect. Is there is an underlying reality which will assert itself? Do crooks run out of room to maneuver when times become desperate? Aren't desperate times a reflection of a marketplace adjusting to a crooked game? The system collapses because people take evasive action. Are enough people doing that yet?
We cannot know the future, but we can see the trends. We are in the endgame of the Gold Exchange Standard and its subsequent fiat dollar standard. The only thing propping up the dollar is confidence.
Many people, including its victims, have reasons not to rock the boat. But the boat is almost swamped. How much more water (debt) can it take on? Black Swans are circling. Who knows when one will land and destabilize the world. Are you betting that one won't land?
What the shit is going on here? I typed in ZeroHedge.com not HuffingtonPost.com
I think Stephanie Pomboy's scenario is more likely.
http://online.barrons.com/article/SB50001424053111904346504577531052271788084.html#articleTabs_article%3D0
"God. That bastard, he doesn't exist." -Samuel Beckett
I would say, "The U.S. Government. Those bastards, it no longer exists."
I'm as much of a gold bug as anybody here, and agree with the ocmments about log scales v nominal. But Charles makes one very good point that none of us has countered, much less denied: interest payments correct for much, if not all, of the dollar's so-called "loss of value".
If somebody has a log chart of the past century's dollar value WITH INTEREST payments, I'd love to see it.
Now, I will admit that I am no Nobel prize winning economist - but doesn't ZIRP imply that interest rates on dollars are going to be fairly lowish for a while? Doesn't running huge deficits paid for by monetization also imply some inflation risk? Doesn't staggering levels of private and govt debt imply slow growth, and limited investment opportunities? Don't low interest rates push up the valuations on all other income producing assets, diluting their returns?
Dunno - but if people are going to be paying for the privilege of owning treasuries, that can no longer go up in value (because we are zirp'd - and they have a nominal face value) and are making negative real returns - wouldn't they be better off owning something that has no upper limit on appreciation (either nominal or real), no counter party risk, and is shiny?
I buy gold and silver because its shiny - nuff said.
While it may be true that there must be contraction and deleveraging, and this is deflationary - there seems to be very few ways I can interpret a deflationary contraction due to defaults on US denominated paper to be bullish for the dollar. It is in fact the risk of defaults, along with low returns that might encourage some (not quite totally braindead) investors to perhaps sell some US denominated paper and get rid of the cash by purchasing tangible assets. Converting $US into tangible assests seems unlikely to send the dollar to the moon.
One US citizen seeing the light... US citizens have been running an extortion of the weak, farming of the poor.
Running of weak and poor would be very dangerous to US world order.
Hedge accordingly.
Zoom zoom zoom!
Zoom zoom zoom zoom.
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Keep that citizenism pedal firmly pressed all the way to the floorboard, though, AnAnonymous! I simply can't wait to see the inevitable roadside wreck --- it should be epic. At least you will have all those mountains of imported trash and Chinese citizenism citizen turds to cushion the impact.
akak said:
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Chinese citizenism pedal being pressed firmly the dangdang.
Roadside turd impact absorber being clever the inventingness Peoples Liberation Transportation Safety Ministry of glorious endeavor.
Now beholding crafty the Chinese citizenism consistency. Pre-impact and post-impact the both, status remains unchanged: Chinese citizenism crap spreader. Illustrious makings of Chinese citizenism leaves US of A inventation behind on the dustiness.
The older empires faded because a new rival arose. Who is the new rival now? China? Not anytime soon.
Ok, I get it.
He's basically saying the US is the best looking horse in the glue factory.
For now.
Disappointed not to read any discussion of the Shanghai Co-Operation Organisation and its Interbank Association, which is essentially voting with its feet and setting up for its member countries a trade settlement system which does not involve the USD, and the effect this might have on the future role and value of the USD.
dollar bullls, blatent journalistic lying and racists. what a night. ive had a great evening. This wasnt it.