TECHNICAL SCOOP Charts and commentary
by David Chapman February 24, 2011
Charts and commentary by David Chapman
February 24, 2011
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The End of the US Dollar?
The turmoil across North Africa and the Middle East is threatening not only to overthrow aging dictatorships, autocracies and monarchies, but also to upset the geopolitical balance between the countries of that region and the Western powers that has existed since at least the 1950s. For the West, the issue has always been the security of oil. For the US there is a second issue, and that is the security of Israel. Now both are under threat.
Some 56 per cent of the world’s oil reserves are in the Middle East, with another nine per cent in Africa. Therefore, unrest in the region could be the catalyst that sets off a global monetary-oil shock. The unrest in Libya has sparked a sharp rise in oil price. Libya holds the world’s ninth-largest reserves and is the twelfth-largest exporter, providing about two per cent of the world’s daily oil supply. Not large and it is possible that Saudi Arabia could pick up the slack but it sends out a wave of uncertainty and it is unknown where the next outburst might occur.
Saudi Arabia is the world’s second largest producer, behind Russia. Saudi Arabia exports roughly 75 per cent of its production. If the unrest spreads to Saudi Arabia then all bets might be off the table as to how high oil prices can go.
Saudi Arabia is governed by an absolute monarchy which rules by decree. While its people are generally well-off, it has a minority Shia Muslim population (about 20 per cent), largely employed in the oil-producing regions, who are at the margins of the society. Saudi Arabia has a poor human rights record and its Wabbabi brand of Sunni Muslim religion has often been noted to be behind alleged terrorist organizations. Unemployment is high at just under 11 per cent, although that is better than most Arab countries.
The US is the world’s largest consumer of oil, at roughly 19 million barrels per day. It imports almost 10 million barrels per day. China is now the second-largest consumer. Among the top 15 consumers we also find Japan, Germany, France, Canada, Italy and the UK. Yet outside of Canada and China (which, like the US, produces roughly half of its daily consumption and is also the world’s third-largest producer), none of the others are in the top 15 for production. And amongst the Western economies, only Norway and Canada are listed in the world’s top 15 exporters.
It has often been said the US dollar is a petrodollar. That is to say, it is earned through the sale of oil. Oil-producing countries such as Saudi Arabia and Venezuela, which peg their currencies (within a band) to the US dollar, are as result quite dependent on the value of the US dollar. These countries and many others earn large amounts of US dollars because of their oil production.
The US dollar is also the world’s reserve currency. All commodities are priced in dollars – not just oil. It is the most marketed currency in the world and it is owned more widely than any other currency. One would therefore believe that a strong dollar is not only in the interest of the United States, but everyone else as well.
But the US dollar is also a fiat currency. A fiat currency has value only because the government says so. The Latin word fiat translates as “let it be done”. Thus, the value of money is dictated by government decree.
Today, all national currencies are fiat currencies. The trend began in August 1971 when President Richard Nixon took the US dollar off the gold standard thus also taking the world off of the gold standard. Increasingly from then on, money was whatever a government said it was. As such it has no real value except being declared legal tender.
Fiat currencies have a long history, mostly of failure .The Romans didn’t have paper money but they developed an early form of fiat by constantly decreasing the amount of silver used in the denarius, their main medium of exchange. They continued this debasement until the coinage became intrinsically almost worthless.
The Chinese were the first to issue paper currency in around the tenth century but eventually they printed so much that hyperinflation occurred and their currency became worthless, even though its usage lasted close to 400 years.
History is respite with the failure of fiat currencies. The most recent example was collapse of the Zimbabwean dollar, and a famous example was the Weimar Republic of Germany in the 1920s.
Fiat currencies have a history of ending in hyperinflation – if a country starts printing money excessively, it is often on the road to ruin and hyperinflation. And this is the United States today. The US has unparalleled deficits and debt; it has increasing expansion of its money supply, using a fiat currency; and it is being misleading about its true economic situation through its published economic statistics.
But it also has the world’s reserve currency, and international trade is carried out in US dollars. Any country buying oil, for example, must first convert its currency into dollars to pay for it. The selling country receives those dollars, which are often recycled right back into purchasing US debt, so that the selling country does not adversely impact its own currency.
But the US dollar is a declining currency. In the last 100 years it has lost over 96 per cent of its purchasing power (this process accelerated after 1971). The chart below shows the long decline. The second chart shows how public debt and money supply exploded after cutting the link with gold, and how a fiat currency can be expanded at will, with nothing to prevent it from being issued.
The third chart shows the decline of the purchasing power of the US dollar when using inflation numbers based on the way inflation was calculated up until the early 1990s. At that time the US began to change the way of calculating inflation, the net effect being to lower the reported rate of inflation.
Many items, including Social Security payments, are tied to the reported rate of inflation. With a much higher rate of inflation, many items would have increased in price faster and the US Treasury would have had to pay out far higher entitlements.
The recalculation of the inflation numbers were provided by www.shadowstats.com. That chart suggests that the US dollar has lost over 98 per cent of its purchasing power over the past 100 years.
Many would say that it doesn’t matter, that society today is far better off than it was 100 years ago. And it is, and more appear to be joining the middle class. But technological advances have changed society in a dramatic way from 100 years ago. That and lots of money provided by a rapidly expanding money supply and debt all courtesy of a fiat currency. With nothing tangible to back money, money intrinsically has no value – except what the government says it is.
But with the explosion in debt and money and the decline in the purchasing power of the US dollar, society has become more divided. Income and wealth is increasingly concentrated in fewer and fewer hands. During the financial crisis of 2008 the bailouts went to the financial institutions (and corporations) that were either indirectly involved or directly involved as the cause of the crisis. The taxpayer (public) footed the bill.
Meanwhile the housing market collapsed with tens of thousands (millions?) losing their homes to foreclosure and tens of thousands lost their jobs. General wages have been stagnant for at least the past two decades and those living on fixed incomes (pensions) have seen a constant decline in their living standards. Meanwhile, those involved in the creation of money particularly at the banks and investment management companies have seen an explosion in their wealth and pay packages.
The unemployment rate soared and while the headline unemployment rate (U3) in the US is at 9 per cent, the Bureau of Labour Statistics U6 number is closer to 17 per cent and www.shadowstats.com have calculated that based on calculating unemployment as it was it was done in 1990 the actual rate may be closer to 22 per cent. The current U3 number leaves out longer term unemployed, part time workers looking for full time work and very long term unemployed. If your unemployment insurance runs out the person falls out of the U3 number to the U6 number.
Today, with the future liabilities of Social Security, Medicare and Medicaid estimated (conservatively) to be about US$50 trillion or (more liberally) at upwards of $200 trillion, the US, with a debt at over $14 trillion and rising, has little chance of ever recovering or ever being able to pay it back. It has been said that the US could tax 100 per cent of income and still not be able to cover its commitments.
Further, the world is rife with imbalances. The US is the largest consumer in the world and imports heavily, creating huge trade deficits. It also runs huge budget deficits to finance entitlements and the Pentagon that finances the war machine. The US dollars circulating throughout the world, either because of general imports or because of oil, are recycled back into the US to purchase their debt. All of this appears to have worked reasonably well over the years but now the model is coming under severe stress. These global imbalances are not only causing problems for the US they are causing problems for other countries as well.
If the US were any normal country, its currency would now be in complete collapse and it would be arranging for IMF bailouts such as Greece and Ireland saw recently. But because it is the world’s reserve currency, the US has one big advantage: it can just print more dollars.
This strategy has unnerved the holders of US debt, led by China, which is estimated to hold almost $900 billion as of December 2010. Japan also holds almost as much. The UK has over $500 billion. Almost 60 per cent of the US debt held by foreigners is in the hands of just those three plus the oil producing nations led by Saudi Arabia. Of the total US debt of over $14 trillion, over $9 trillion is held by the public and roughly half of that is held by foreigners.
No wonder there are calls for an end to US dollar hegemony and a new Bretton Woods agreement to determine a new world reserve currency, and possibly even bring back a gold standard. The calls have ranged from the IMF, the World Bank, and many countries including France and Germany and of course China, the country that has the most to lose, given its large holdings of US dollars. Even Saudi Arabia has joined a group of countries seeking an alternative for the pricing of oil solely in US dollars. China and Russia are now conducting trade between themselves in Yuan and Roubles.
US debt is vulnerable to a downgrade as well. The IMF and the rating agencies have issued numerous warnings about the US debt situation. The effect of the US losing its AAA rating could be a financial earthquake. The US is also approaching its legal debt limit and, with the rift in Congress, the Republicans have threatened not to grant a new, higher debt limit. This could in the worst case result in the shutdown of government and a US debt default. This is not to predict that any of this will happen, but only to point out that it could.
Some are also saying that the so-called quantitative easing, or QE, could spiral the US into hyperinflation. While there are currently few signs of it, an event such as an oil shock in the Mid-East could trigger severe inflation which in turn could trigger further QE and start an acceleration in monetary inflation. Sharply rising oil prices have a history of causing recessions so it could stop the current feeble recovery in its tracks. An economy reeling from higher oil prices plus rapid monetary inflation could soon spiral out of control.
In the midst of all of this it is no surprise that gold has soared over 450 per cent in the past decade. Although relatively flat thus far in 2011, gold is up almost 28 per cent since the end of 2009. It is becoming an alternative currency. The world’s central banks still hold some 30,000 metric tonnes of gold, and investment demand for it has brought investment holdings in line with what is in the world’s central banks. In many countries, particularly in Asia, gold is seen as a savings vehicle rather than the speculation it seems to be viewed as in North America.
It is not so much that gold prices are rising but that fiat currencies led by the US dollar are declining. The chart of gold shows the stair step action that has taken place since the double bottom lows of 1999 and 2001. The action since that time has seen a series of triangular patterns form that continually break to the upside. And gold is rising not only in dollars but in all currencies, as the series of charts below attest.
Finally not only is the US Dollar Index declining the trade weighted Dollar Index is also falling. The trade weighted Dollar Index called the Broad Index is a weighted average of the foreign exchange values of the U.S. dollar against the currencies of a large group of major U.S. trading partners. The index weights, which change over time, are derived from U.S. export shares and from U.S. and foreign import shares. In some respects this more fairly reflects the value of the US dollar then does the more broadly watched US Dollar Index. The US Dollar Index is a weighted valuation against a basket of 6 major free trading currencies. Notably the US Dollar Index excludes the Chinese Yuan.
Chart created using Omega TradeStation 2000i. Chart data supplied by Dial Data.
Gold in Euro
Gold in British Pounds
Gold in Cdn$
Gold in Yen
Gold in Chinese Renminbi
US Trade Weighted Dollar
Since the founding of the US Republic over 200 years ago there have been numerous periods of gold standards. The current period of fiat currencies is not the first. But every time the world has moved to fiat currencies, it has eventually come back to a gold standard. The periods are summarized below.
1785-1861: gold standard. The founding fathers of the US were concerned about unrestrained money supply.
1862-79: fiat currency (known as Greenbacks). The shift to fiat was to accommodate the huge costs of the civil war (1860-64). A severe depression in the 1870s brought back a gold standard.
1880-1914: gold standard. A long period of monetary stability.
1915-25: floating fiat currency. A lack of gold with which to back paper currencies (brought on by the printing of money to finance WW1) brought another period of fiat currency.
1926-31: gold standard. The world pegged its currencies to the US dollar and British pound, both of which were convertible into gold.
1931-45: floating fiat currency. The global imbalances brought on by the Great Depression and WW2 took the world back to another period of fiat currencies.
1945-71: gold standard. As fixed by the Bretton Woods agreement, the world pegged itself to the US dollar which was convertible into gold at $35/ounce. In 1965 the US and Canada stopped issuing coins in silver. In 1968 the US$ was no longer convertible into silver.
15 August 1971: President Nixon took the world off the gold standard. No currency was now backed by gold.
1971-73: fixed dollar standard. The Smithsonian agreement pegged world currencies to the US dollar rather than gold, for the first time.
1973-today: floating fiat currency. The Basel Accord established the current system of floating currency rates with the US dollar as the world’s reserve currency.
As the above summary shows, there is no law saying that the US dollar cannot cease to be the world’s reserve currency. Nor is there any law that says the world could not go back to a gold standard. It emphasizes the importance of hedging oneself with gold.
This brings us full circle, back to the potential oil crisis brought on by the unrest in the Mid-East and North Africa. An oil shock could bring on a monetary crisis. Sharply rising oil prices would set back the current feeble recovery in the western economies. Worse, if supply were curtailed because of the outbreak of war or civil war in the region, then shortages would loom along with sharply rising oil prices.
The US is the world’s most indebted nation and is trying to bail itself out by printing money, thus monetizing the debt. The world knows it and many are concerned because of their large holdings of US securities. The printing of money would force up interest rates (long bond rates are already rising), thus putting more strain on the US and global economies. A debt downgrade of US debt could follow, and the looming debt battle in Congress could see a US debt default in the worst case. Any or all of these events could lead to chaotic conditions in the US and a break down in the social, political and economic order.
Oddly, nobody has stated it more succinctly than Fed Chairman Ben Bernanke, who noted that “Meeting these challenges will require policy makers and the public to make some very difficult decisions and to accept some sacrifice”. Even he seems to recognize that this cannot go on forever. All of this leads to the conclusion that the US despite the consequences will probably continue on a path towards hyperinflation despite Mr. Bernanke’s musings. But it is a lose-lose game as history has shown us, and could lead to the end of US dollar hegemony and a breakdown in society.
David Chapman is a director of Bullion Management Group Inc. the
Manager of the BMG BullionFund and the BMG Gold BullionFund www.bmgbullion.com
2011 All Rights Reserved David Chapman
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