Issue: March, 2006

Can the Present Dollar System Survive?
by: John R. Hummel

Americans take many things for granted. High on that long list would be the stability and universal acceptance of their currency, the dollar. To most, its continued existence is on par with the arrival of daylight each morning—it always has been and always will be. Few appreciate what an anachronism the concept of a continuing, stable and universally acceptable currency is in the history of the world. Few also appreciate the special role that the dollar plays as the world’s reserve asset in financial markets around the world. In a sense the U.S. operates under a special set of conventions unavailable to other countries and their currencies. There are growing reasons to question the continuation of the dollar’s special role in world monetary transactions. A change in this role could have profound consequences for investors.

Natural Optimists?
Richard Fortey, the senior paleontologist at the Natural History Museum in London, writing about natural disasters in a December 26, 2005 article in The New York Times said: “Human beings are never prepared for natural disasters. There is a kind of optimism built into our species that seems to prefer to live in the comfortable present rather than confront the possibility of destruction. It may happen, we seem to believe, but not now, and not to us. There is nothing new in this attitude.”

For the past 34 years, since August 1971, the world economy has operated on what is known as the “dollar exchange standard.” Under this system most of the world’s trade has been settled in dollar terms. Furthermore, countries with positive trade balances have historically accepted dollars as the primary means of holding their exchange reserves. Since 1971 the dollar standard has been a totally fiat money system. In other words, the dollar is not convertible into anything. It is simply backed by the expectation that the United States will maintain the dollar’s integrity.

A Little History From mid-1944, following the Bretton Woods Conference, through August 1971, the world functioned on a gold exchange standard in which foreign governments (but not private citizens) could convert the dollar into 1/35th of an ounce of gold. During that 27-year period other nations maintained fixed exchange rates to the dollar, periodically adjusting these exchange rates when misalignments occurred. In August 1971 President Nixon ended the gold convertibility clause due to an unsustainable pressure by foreign governments (led by France) to convert excess dollars into gold. After the gold convertibility clause ended, most nations allowed their currencies to float in value against the dollar. In addition, the price of gold was now set by free market transactions, and in December 1974 U.S. citizens were once again allowed to own gold. At the time of the Bretton Woods conference, an allied victory in WW II was considered only a matter of time. Therefore, economic planners sought to establish a monetary system that would allow for a transition to a growing peacetime world economy. The United States was the dominant economic and financial power in the world, and also one of the few countries unscathed from the destruction of war. The U.S. owned approximately 75 percent of the world’s official gold holdings, had a positive balance of trade and a positive net investment balance with the rest of the world. In summary, it dominated the world economy and its currency was nearly “as good as gold.” The conference outcome was to build a monetary system with the dollar at its center. In the 61 years since Bretton Woods, the world has changed dramatically. Most significantly, the U.S. has gone from being the world’s largest net creditor to the world’s largest net debtor. All of the core reasons for originally building a world monetary structure around the dollar are nonexistent today. If the equivalent of another Bretton Woods were called today, the outcome would most likely not be the current dollar standard. Because a monetary structure built from scratch today would most likely not result in the present dollar system, the question arises, can the present system survive? If it cannot survive long term, how soon might it fail, what form will failure take, and what are the consequences of an international monetary breakdown?

Co-Dependency
There is a scene from Woody Allen’s movie Annie Hall in which Allen tells his psychiatrist that his brother thinks he is a chicken. The psychiatrist asks if the family has gotten help for his brother. Allen replies that they haven’t because the family needs the eggs. In a certain sense this describes the current international monetary system. The United States is living beyond its means and the rest of the world keeps financing its profligacy because they want the export business.

The present currency system consists of certain currencies that float freely against the dollar (e.g. euro), others that have a dirty float due to frequent government intervention (e.g. yen) and other currencies that have fixed or close to fixed exchange rates to the dollar (e.g. Chinese yuan). By fixing the currency rate against the dollar the Chinese have maintained their currency at an undervalued level, which allows them to export more successfully to the U.S.

Under this system the U.S. has been running progressively larger current account deficits, now running in excess of six percent of GDP. Concurrently the rest of the world has been running progressively larger current account surpluses. In the process they continue to build up larger holdings of dollar-denominated investments, primarily U.S. government debt securities but also private sector debt and equity investments. So long as investors and foreign central banks perceive that the dollar will maintain a reasonable semblance of worth, most world constituencies enjoy the arrangement. Foreign exporters appreciate the growing sales, foreign workers experience improved economic conditions, and foreign governments accommodate the process as they build larger foreign exchange reserves. Likewise, within the U.S., consumers benefit from the lower prices of imported goods, and investors and borrowers benefit from the lower interest rates that result from foreign investment. In summary, there are multiple constituencies both within the U.S. and in foreign countries who benefit from the current system. Given the broad nature of the constituencies who benefit, there is a tendency to downplay the risks or to hope for benign outcomes for any future “adjustments.”

Weak Links
There are, however, factors that may work towards a system breakdown. For one, as with any borrower and lender arrangement, there is probably a limit beyond which the U.S. will find it difficult to borrow internationally. That limit will depend both on the perceived ability of the U.S. to repay its borrowings, and on the availability and competition for world savings. In addition, portions of the U.S. workforce bear the brunt of this state of affairs. Jobs in higher-paying manufacturing industries are rapidly disappearing. Displaced workers are often only able to find work in the service sector at reduced pay, often averaging only two-thirds of their former income. This is becoming a more significant political factor in areas such as the Southeast (textiles) and in the industrial Midwest; therefore, the potential for increasing protectionist pressures is building.

Easy Borrowing
Because the dollar standard has allowed the U.S. unlimited borrowing privileges, it has enabled the U.S. to pursue worldwide military activities that would otherwise not be available. If the U.S. was forced to borrow in other currencies to engage in foreign military activities, it is unlikely that we would have the current level of military presence. Because certain countries are not totally enamored with U.S. military strength, they may make decisions that will weaken the dollar in the future. France clearly played this card in the late 1960s and eventually forced the U.S. to close the gold window in 1971.

Another factor, which may work to the dollar’s detriment, is the developing shortage of key raw materials as the world’s economy grows. The current economic environment is one in which raw materials prices are rising faster than finished goods prices. This trend is likely to continue and potentially become more serious. If it does, other countries may find it in their best interests to allow their currencies to appreciate against the dollar. While an appreciating currency will cause a country’s finished goods export prices to rise, it will also lower their respective import bills of raw materials. Countries heavily dependent on raw material imports may find that the trade off of lower import costs will more than offset the negative effects of having to raise their export prices. A prior example of this is Japan in the 1970s. The yen appreciated significantly against the dollar during the 1970s but Japan maintained its export edge largely because of the benefits of lower relative import costs for its raw materials. China, Japan and the other Asian export countries may find a similar advantage from currency strength as oil and other raw materials prices continue to rise. This single factor may be the key catalyst for dethroning the dollar exchange standard.

Were it not for heavy central bank buying of dollars in the past several years to encourage their respective country’s exports, the dollar would be substantially lower relative to other currencies. The private sector throughout the world is not clamoring for dollar ownership. In fact the reverse is true because they sell dollars received for exports, leaving their respective central banks holding the dollar balances.

The Bottom Line
The world currently operates on a monetary system that uses the world’s largest debtor nation’s currency as its medium of exchange. The U.S. continues to generate additional foreign-owned debt to support its consumption habits. In turn the rest of the world’s central banks readily purchase this debt to support the U.S.’s consumption habits in order to sell more of their countries’ exports. Figure 1 graphically illustrates the accelerating nature of this trend. The cumulative current account balance as a percent of GDP (see Figure 2) is now approximately 40 percent and rising each year.


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There is no hard and fast number beyond which U.S. borrowings can go. The limiting factor, to a large extent, is a confidence issue. But most experts agree that there is some finite limit and that an “adjustment” is necessary at some point. There are, however, certain optimists, such as incoming Federal Reserve Chairman Bernanke, who describe the problem as one of a “glut” of world savings simply seeking a good return in U.S. assets. The former Fed Chairman Alan Greenspan has stated several times that the current account deficit must eventually stop growing because the debt servicing would become untenable. However he has also stated that he did not believe that it would have to be economically painful or disorderly. More recently he has put a more positive spin on the problem, relegating it to a one time shift due to greater globalization and a decline in what economists call “home bias,” the tendency of investors to hold funds in their home country.

Due for an Adjustment?
Regardless of whether the world has a savings glut and whether there is a movement away from “home bias,” there is a point at which the increasing obligations of the U.S. will be perceived as larger than it is capable of repaying. Where that point is anyone’s guess and largely a confidence issue on the part of those holding the obligations. Several years ago the Fed prepared a research paper on currency crises. Their conclusion was that once a country’s current account deficit reached five percent of GDP it typically led to an “adjustment” or crisis. The U.S. annual deficit is now in excess of six percent and rising. It is primarily because the U.S. dollar is the world’s reserve currency that we have been able to reach this point without a crisis developing. However, one has to conclude that the U.S. is on the equivalent of monetary thin ice at this point.

Remember the Levees?
In a monetary sense the U.S. is in a similar position to New Orleans before Katrina. New Orleans had levees capable of withstanding a level three hurricane. Experts knew that a level four or greater hurricane would be devastating. Human nature being what it is, individuals continued to live and work in that environment assuming the big disaster would never happen because it hadn’t happened to that point. From an investment standpoint it is difficult to make decisions on the probability of a non-linear event occurring. It is particularly difficult for companies or professional investment firms operating in a competitive environment. Holding back reserves for dealing with an uncertain event will hurt overall returns so long as normalcy prevails. Therefore, there is a strong tendency on the part of businesses and investors to make decisions in a way that ignores the possibility of non-linear events such as a potential currency crisis.

Ignoring the potential of a major monetary “adjustment” at this point appears increasingly foolish. One could argue that the adjustment process began at the end of 2001 (see Figure 3) and that 2005 was just a short-term interruption to a long-term dollar collapse. To date the dollar decline has been orderly. However, if the dollar decline resumes and goes to new all-time lows, what has been an orderly decline could turn into a crisis.


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It All Depends On…
The wild card in this equation is likely to be oil prices and to a lesser degree other raw material price trends. If the world is truly moving towards an environment of peak oil in which absolute supply constraints rather than just high prices are on the horizon, then a dollar collapse is quite possible. Imagine if you will an environment in which sufficient oil supplies are not available for ordinary economic growth. In this environment prices could reach the unimaginable and countries would be jockeying for adequate supplies. In this environment countries could enter a period of competitive currency revaluations in which they attempt to boost the value of their currency in order to drive down the cost of oil in local currency terms. In this environment there would be no natural buyers of dollars other than the Federal Reserve. No one knows if such a scenario will ever occur, but it is not out of the realm of possibilities. The odds are high that further dollar weakness will occur over the next several years. It is more a question of whether the decline is orderly or chaotic.

What Does It Mean For Mom and Pop?
If the dollar declines, what are the implications for investors? First, one would expect a significant rise in long-term bond rates. The Federal Reserve can control short-term rates, but long-term rates are set by the market. In an environment of declining dollar confidence, long-term bond holders would be major losers. The Federal Reserve could attempt to buy long-term bonds, but it would be viewed as a stop gap measure and highly inflationary. An attempt by the Federal Reserve to buy long-term bonds at levels above free market prices would entice more selling by foreigners, which in turn would cause further weakness for the dollar. Likewise an attempt by the Federal Reserve to support the dollar would create excess money growth domestically, which would be highly inflationary. Historically, long-term bondholders in countries experiencing severe currency weakness are major losers.

Reviewing events in other countries that have experienced a currency collapse, their stock markets have often experienced major declines (e.g. 50 to 70 percent) before recovering. Recoveries usually begin once stocks become viewed as investment plays on their underlying assets as an inflationary psychology takes hold. Commodities and gold would likely be major beneficiaries of a dollar crisis. Because commodities are traded in dollar terms, they can be expected to rise by at least the inverse amount that the dollar declines. Given that we already appear to be in an environment of rising relative commodity prices, dollar weakness would be one more factor encouraging commodity inventory hoarding.

The Yellow Metal
Gold is likely to be a major beneficiary of a dollar collapse. Gold is an investment asset that attracts highly emotional rhetoric at both ends of the spectrum. There are those who insist that gold must be returned to its 19th century role as the only legitimate money. At the other end of the spectrum are those who argue it is a barbaric metal no longer needed in this age of enlightened economic knowledge. Most Americans, in their present state of economic complacency, primarily think of it as a component of expensive jewelry. However, in many other societies that have histories of government and currency instability, gold is still viewed as a legitimate store of value and a vehicle for potential capital gain.

Gold’s historical role as money and its perception as a store of value emanates from its relative scarcity and its durability. Almost all of the gold ever mined is still in existence (approximately 153,000 tonnes) and about a third of it is still held by central banks, with the U.S. being the largest net holder. Gold is difficult to mine and newly mined supplies are only increasing the total supply by 1.5 to 2.5 percent per year. This relatively low growth in new supplies contrasts with the growth in various monetary aggregates of six to ten percent per year (see Figure 4). Although gold pays no interest and has a storage cost attached to it, with monetary aggregates growing significantly faster than new gold supplies, simple mathematics suggests that gold’s price should rise over time. Its rising price has never been a straight line, as with most investments. However, historically it has risen fastest during periods of inflation or monetary upheaval.


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If we are entering a period of decreasing confidence in the U.S. dollar as the world’s primary reserve asset, gold may turn out to be a major price beneficiary of declining fiat currency confidence. In 1980 when monetary turmoil prevailed, gold reached $850 an ounce, a level that would have allowed the U.S. Treasury to redeem all foreign held dollars in exchange for its gold. Today a comparable level would probably require a price of $4,000 to $6,000 an ounce. No one knows what lies ahead for the U.S. dollar but the risk/reward trade-off for owning gold still appears attractive to this investor.

Earlier Richard Fortey was quoted regarding the human response to the potential for natural disasters. While he was speaking about natural disasters, the same can be said about the human emotional response to pending economic risks. The new Federal Reserve Board Chairman, Ben Bernanke, is a student of the 1930s deflationary depression. He is convinced that a central bank should not intervene when financial bubbles occur. Furthermore, he believes that it is the bank’s responsibility to overwhelm any bursting speculative bubbles when they occur with sufficient monetary ease to maintain economic growth. However, it is questionable whether the modern American monetary experience includes a sufficient understanding of, or a political will for, what is required to maintain continued currency integrity.

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