Gold, Inflation, and the Velocity of Money Part 2
The Dollar’s Decline Is Nearing a Tipping Point
Money is at the root of all inflations. Whenever there are no effective brakes on the creation of money, the creation of too much money and credit eventually follows. Government would always like to see interest rates a little lower and the economic environment more supportive in financing its deficits so it can spend more money. Certainly, this is the case with the Obama administration.
Since August 1971, when the U.S. dollar was cut loose from its link to gold, the dollar’s internal purchasing power has declined by 80%. It has declined 97% against gold and 75% against a basket of commodities. Beginning with the raging inflation that culminated in 1979-80, the Federal Reserve began to follow expansionary policies that caused foreign central banks to become concerned with U.S. deficits and loose monetary policies. A series of booms and busts followed, with market crashes occurring along the way: 1987, 1990, 1997-98, 2000-02, and the outright panic of 2008-09. After each bubble burst, the Fed stepped up its expansion of money and credit.
Despite the fact that the Fed grew the money supply rapidly, the Consumer Price Index (CPI) stayed relatively quiet, confounding monetarists who believe there is a tight link between changes in money, the economy, and the CPI. Until 2008, the reason for the lack of increase in the CPI was that confidence in U.S. money had returned and people were prepared to hold more of it. Today we can see that phenomenon in the huge amounts of dollars still held by foreign countries – like China! However, that confidence is rapidly diminishing.
After the panic of 2008-09, the Fed moved once again to reflate the economy. This time, however, its efforts, consisting of fiscal stimulus and numerous bailouts, have dwarfed anything ever seen before in peacetime. Ever since 2008-09, not only the U.S. but central banks and governments the world over have pumped ever-increasing amounts of liquidity into the global economy in an attempt to inject new life after a near-death experience. The panic nearly brought down the global banking system and has created a huge black hole. The effort to reflate, to pump air back into the bubble, has been on a huge scale that has never been seen before.
Switzerland, referred to as a “paragon of safety in finance,” provides an excellent example of the lengths to which central banks are going to devalue their currencies in order to protect their exports, which – in the case of the Swiss – produce more than half of GDP. In order to prevent Swiss francs from climbing against the euro, which would make Swiss exports prohibitively expensive in the Eurozone, which makes up the largest share of its market, the Swiss National Bank is printing as many Swiss francs as it has to. Since 2010, the Swiss central bank has printed francs to buy euros and other currencies at a rate that is four times what it was at the start of 2010.
The world’s giant economies are also continuing to flood the market with liquidity. The U.S. Fed, the European Central Bank (ECB), and the People’s Bank of China (PBOC) are all following similar paths. The Fed began its third round of quantitative easing in September, while the ECB is offering unlimited purchases of bonds of troubled Eurozone countries and the PBOC has cut interest rates repeatedly and trimmed reserve requirements. In addition, the policies of developing countries are very inflationary, with large fiscal deficits and very easy monetary policies.
The reflationary policies of global central banks stem from the financial crisis of 2008-09. To prevent a collapse and then try to nurse ailing economies back to health, the world’s largest central banks first pushed short-term interest rates to historic lows. Weak recoveries have since led those central banks to more aggressive moves, but all these strategies have the common objective of injecting more and more liquidity into global markets. Are they sowing seeds of future inflation? It doesn’t seem so today, with much of the world experiencing stagnant wages and prices. It will, however, in the very near future, as more and more of this liquidity is injected into the global economies by the banks and other financial institutions that have been the medium of transmission of that liquidity.
Massive money printing by the Fed has increased the U.S. monetary base from $800 billion in early 2009 to more than $3 trillion as of December 2012. You can’t increase the monetary base by more than 300% and not eventually create large-scale inflation.
Will the Dollar Continue as the World’s Reserve Currency?
For more than 50 years, U.S. Treasury bills and bonds, because of their unique combination of safety and liquidity, have been the dominant vehicle for bank funding on a global basis. The vast majority of foreign exchange reserves are held in dollar form, and the role of dollar credit in financing international trade far exceeds the U.S. share of international merchandise transactions.
However, the dollar no longer offers the safety that investors have come to expect, and soon will not be seen as an appropriate vehicle for international merchandise transactions or as an attractive form in which to hold international reserves. As emerging markets continue to rise, the U.S. will account for a declining percentage of global GDP, limiting its ability to supply safe and liquid assets to an ever-growing global economy. With the developing countries’ markets growing at a far faster rate than that of the U.S., the ability of the U.S. Treasury and the Fed to supply safe and liquid assets will inevitably lag behind the increase in global transactions.
Already, the world’s appetite for dollar-denominated assets is declining rapidly and the Fed is becoming the buyer of last resort of Treasury issues.
“The Fed buys, believe it or not, 80% of everything that Treasury issues right now. They’re buying $1 trillion worth of bonds and mortgages a year.”
PIMCO executive Bill Gross on CNBC, January 2013
“The Fed is buying $85 billion of bonds a month, or $1.02 trillion at an annual rate, which represents more than 100% of the OMB-projected fiscal 2013 budget deficit.”
Grant’s Interest Rate Observer, Jan. 11, 2013
For decades, the majority of global trade has been in done in U.S. dollars. That is still the case today. However, international alliances are being forged that are based on moving away from the U.S. dollar and on using other currencies in global trade. China, the second-largest economy in the world, has been particularly aggressive in forging agreements with other nations to conduct trade in currencies other than the dollar. Chinese leaders have been very candid about discussing their view that the world should not continue to conduct the vast majority of all global trade in U.S. dollars. Their complaints are particularly focused on the Fed’s seemingly endless rounds of dollar reflation.
Beijing says replacing the dollar with its own currency, the yuan (also known as the renminbi), can reduce volatility in oil and commodity prices and eventually eliminate the “exorbitant privilege” the United States enjoys as the issuer of the reserve currency. In fact, much of the world is moving away from the trap in which it feels it has been caught. The Japanese government recently announced that Japan and China will promote direct trading with the yen and the yuan without using dollars. China is Japan’s biggest trading partner and, because China is the world’s second-largest economy and Japan is the third, their decision to bypass the dollar and engage in direct currency trade is a real blow to the hegemony of the dollar.
China and Russia have dropped the dollar in bilateral trade, while China and Iran plan to bypass the dollar and to arrive at an oil barter system. Japan, China, Russia, India, and Iran all have bilateral arrangements to bypass the dollar. That’s just the beginning. The list of countries dumping the dollar in bilateral trade also includes Brazil, Argentina, Indonesia, India, Iran, the United Arab Emirates, Belarus, South Korea, Malaysia, Venezuela, Syria, Cuba, Turkey, and Dubai.
What would be the consequences if the rest of the world started to reject the U.S. dollar as the global reserve currency and started moving to other currencies such as the Chinese yuan? Until today, there has been a constantly growing demand for more dollars to buy oil and traded goods, which has served to prop up the dollar’s value despite remarkably loose monetary policies. If the rest of the globe started rejecting the dollar, it would drop like a rock. As a result, imports would become more expensive, the price of gold would soar, and the cost of just about everything made outside the country would go higher.
The Impact of Inflation and Dollar Devaluation on Gold
The only way we could avoid future inflation at this point would be to stop all additional money printing and begin to take some of that newly printed money away, in a process called reverse quantitative easing. However, the Fed not only isn’t implementing such a strategy, but it also continues to print even more dollars at the rate of more than $40 billion per month (along with buying $40 billion worth of mortgage-backed securities a month). There is no exit strategy.
The Fed is creating money out of thin air and pumping it into the financial system. The first ones to get their hands on this new money are Wall Street banks and major financial institutions, on the theory that eventually all this new money will “trickle down” and help average Americans. Although that hasn’t happened yet, it will. And with the injection of all this new liquidity into the system will come inflation and much higher gold prices. What to look for? If, by the end of this year, you are paying $3 for a loaf of bread, more than $4 for a gallon of milk, and $5 for a gallon of gasoline, you’ll know that our inflation nightmare is upon us. The purchasing power of all the dollars that we have accumulated is going down. What are investors to do? Capital will be eroded by that evil pair: taxes and inflation. Buy gold, and profit from the disaster!