Nowhere to Hide

Nowhere to Hide

February 19, 2008

(this originally appeared in the Daily Reckoning on February 19, 2008)

The other side of the “falling dollar,” for some years now, has been a “rising euro” or a “rising pound” or even a “rising Brazilian real.” The dollar has been falling in value against other paper currencies. This affects all kinds of business arrangements, and thus gets lots of attention. European tourists flood into Manhattan, giving the locals an inferiority complex.

However, we may be nearing an end to this process. Other currencies have risen, against the dollar, to the point where European companies, for example, are feeling unfairly disadvantaged. Where are all the domestic tourists?

This “competitive disadvantage” is unpleasant at any time, but it is particularly unwelcome when there is a slowdown due to other reasons, like the property and financial bust which has become a worldwide phenomenon.
So what do these foreign central banks do? They can kill two birds with one stone. They can handle the uncomfortably high currency, and the domestic softness, with what amounts to an “easy” monetary policy. Thus, we see the Bank of England and Bank of Canada cutting their policy rates recently. The Bank of Japan is still stuck at a puny 0.50%. The European Central Bank has been speechifying about inflation recently, but the pressure is on to do something about today’s problems. Yes, the official CPI might be rising faster than they’d like, but it’s not enough of a problem yet that anyone is willing to suffer higher interest rates or a further rise in the currency to do something about it. Besides, isn’t inflation caused by China?

In this way, we come to the point at which all currencies decline in value together, while their exchange rates remain relatively stable. Sort of like today’s dollar bill, ten-dollar bill, and the quarter. They all decline in value together, and their exchange rates remain stable.

This is what happened in the early 1970s. The world’s currencies were pegged at fixed exchange rates to the dollar in those days, while the dollar was pegged to gold. After the dollar left gold in 1971, and its value declined, other countries’ governments said: “Hey, wait a sec. I’m not sure of what you’re trying to do with this cheap-dollar stuff, but we don’t want any part of it.” Sort of like the Middle Eastern dollar-pegged currencies today, or the Chinese yuan recently.

So, in the spring of 1973, they all depegged from the dollar. See ya later, greenback! That was the beginning of the floating currency system we have today.

Immediately after the depegging and floating, the dollar fell against all major currencies (and the minor ones too). The Fed’s dollar index, which remains popular today, shows this drop. This index, by the way, starts in 1973 because it was not necessary before then.

Then what happened? Governments of the time began to chew over the problems that emerged, and came to the same conclusion as governments today. Damn the inflation, we have to keep these forex rates under control!

The dollar index stopped falling. All in all, it only fell about 20%, as all the governments in the world inflated together. During the great dollar collapse of 1978-1979, foreign exchange rates were nearly unchanged.
The dollar actually fell in value by about 10:1 during that decade. It took only $35 to buy an ounce of gold in 1970. In the 1980s and 1990s, it took more like $350. However, this decline became invisible to a lot of people. The dollar/euro rate affects everybody, but the dollar/gold rate directly affects almost nobody.

It was no longer so obvious that inflation was being caused by a “falling dollar.” When it took more dollars to buy things, most people did not figure out that the dollar — and the deutschemark, franc, pound, and yen — were simply losing value. On November 19, 1973, Newsweek magazine proclaimed on its cover that the world was “Running Out of Everything.”

Either that, or those horrible Arabs! It’s true, there were some oil disruptions during the decade. Many people still blame these for the inflation of the time. None of these people has an explanation of why, years after the crises had passed, oil prices didn’t fall back to their 1960s levels around $2.50 a barrel.

A few people saw the way that currencies were losing value compared to gold, the timeless standard of value, and understood instinctively where the inflation was coming from. The government economists, however, didn’t see it that way. They couldn’t quite figure it out, but they were pretty sure that they didn’t want to add to the growing problems with a restrictive monetary policy. The Fed remained “accommodative,” until finally the crisis reached a point that Paul Volcker gained a political mandate to do something about it.

If there is a difference between those times and today, it must certainly be the amazing deterioration of financial conditions around the world. This is matched by a consensus on what to do about it: central bank policy rates that are low, low, low. The big yield curve inversions of the 1970s aren’t coming back right away. Barring some unexpected twist — the Chinese pegging the yuan to gold for example — it looks likely that currencies will all go down together, as they did in the 1970s.

The only place to hide would be in physical things: cattle, corn, steel, and eventually property.

For the 1980 presidential elections, Ronald Reagan actually recorded a television advertisement that promised a return to the gold standard. The departure from gold in 1971 led to the first major episode of inflation in U.S. history. Wasn’t it obvious? The ad didn’t run. He was talked out of it.

Soon, politicians will have another chance. I think the next gold standard will appear in a place that nobody expects, like Moldova, Morocco or Vietnam. Home mortgages denominated in gold have been available in Vietnam for some time, and apparently some shopkeepers there are already adjusting retail prices according to gold exchange rates. They are, in effect, already on a sort of underground gold standard. Not everybody in this world is quite so benighted as our friends at the Federal Reserve.