The End of the US Dollar?

October 20, 2003

With the introduction of the new peach-toned $20 bills is the US signalling the end of the greenback? Well certainly the greenback, which has been in place for over 100 years, will now have to share some space with money of a different colour but is it really the end of the US dollar as some have intimated?

We doubt it but when the currency has fallen 24% since peaking in July 2001 some will jump on any excuse to say the bottom is falling out. The US Dollar has been the reserve currency of the world since the end of WW2 and the Bretton Woods Agreement (July 1944). Bretton Woods signalled the end of the British Pound as the world's reserve currency. The Pound was the principal currency of the world for over 100 years from 1816 to 1933 and it was backed by gold.

But at the outset of WW1 Britain and other European countries came off the gold standard because of the financial dislocations caused by the war. The US$ still backed by gold slowly began to replace the faltering British Pound but by 1933 the US joined them in coming off the gold standard due to the deteriorating deflationary conditions of the Great Depression. The period was also marked by the collapse in international trade and financial flows prior To WW2.

With Britain and Europe in ruins after WW2 the way was clear for the US, who emerged unscathed by war to assume the role as the world's reserve currency and the king of the international financial markets. And backing the US Dollar was once again convertibility into gold. The Bretton Woods Agreement saw other key features such as fixed but adjustable exchange rates against the US Dollar and the birth of the International Monetary Fund (IMF) and the World Bank.

But by the early 1970's growing structural imbalances amongst the world's leading economies led to increased currency speculation, the floating of the Pound Sterling followed by others, and deteriorating confidence in the US Dollar. The gold standard and Bretton Woods collapsed in 1971 and by 1973 the floating exchange rate system took hold. Since then we have been through a roller coaster ride for the US Dollar and numerous other currencies. The US Dollar after falling precipitously through the 1970's regained strength in the 1980's particularly following the election of the Reagan administration in 1980. That ended in 1985 with the Plaza Accord as the strong US Dollar was causing structural imbalances with the growing US twin deficits of budget and trade (sound familiar). In less then two years the US Dollar lost half its value.

The 1990's was the decade of currency crises. The British Pound (1992), the Mexican Peso (1994), the Asian contagion (1997) followed by Asian Contagion II in 1998 along with the collapse of the Russian Ruble. This led to the collapse of the giant hedge fund Long Term Capital Management (LTCM) that required the Federal Reserve to bail the banks that were threatened with collapse. To a lesser degree we also had the Turkish Lira crisis and numerous currency and financial woes in Latin America especially Argentina. And least we forget, the Canadian Dollar also fell to new multi year lows although it was never described as a crisis in the same breath as any of the above.

But the biggest threat to the world's financial system was the falling US Dollar. The US did return to small trade surpluses in the early 1990's but the weak dollar was causing other problems particularly with the Japanese Yen. In 1994 the world was mired in a global recession with Japan almost in an outright depression. The US bond market collapsed in response to the weak dollar. In order to spur the Japanese and US economies and prevent a potential financial collapse the US and Japan agreed to change places. From 1995-2000 the stated goal of the Clinton Administration was a strong dollar.

During each and every currency crisis the Federal Reserve stepped in and either cut interest rates and/or provided massive doses of liquidity to the banking system in order to stem any crisis. We saw this in 1994 following the Mexican Peso crisis, again in 1997 and especially 1998 after LTCM and the Asian Contagion crisis. Then along came Y2K (1999) and September 11, 2001 and each crisis was met with massive liquidity injections and sometimes rapid interest rate cuts. With money growing at an average of 8-10% throughout the late 1990's faster than the rate of economic growth coupled with a debt boom a great deal of the excess liquidity found its way in the stock market and aided the tech bubble.

The latest round of interest rate cuts and massive liquidity injections came with Gulf War II. With economic growth remaining very anaemic pundits seize on any rise in economic activity to hail the great recovery. But it is false hopes. The US Dollar once strong is now beginning to fall precipitously even though statements emanating from the Bush Administration remain very confusing as Treasury Secretary Snow assails the Chinese in particular and the Japanese in general that their currencies must revalue upwards while the White House says the US Dollar is strong.

The Chinese who have been the beneficiaries of jobs from America are reluctant to spoil a good thing by setting their Renminbi to float. The Japanese desperate to prevent the Yen from rising have been seen actively buying US bonds and Bills to stem the rise. This type of activity is precisely what happened in the 1930's as trade wars and currency devaluations added to the Great Depression.

But the world is noticing the falling Dollar and now the Russians have decided that they will henceforth require payment for exports of oil in Euros rather than US Dollars. Russia is the world's second largest oil exporter and has the world's largest reserves of natural gas. The exports go to Europe so in some respects the move is logical. But this will weaken further the demand for US$ and others such as Indonesia and Malaysia are contemplating similar moves. We recall up until the Russians decided to accept only Euros that before that only Iraq under Saddam required payment for oil in Euros.

The US Dollar is becoming increasingly unstable. Neither the US Stock market nor the US bond market can withstand a sustained decline in the US$. The current complacency in the stock market, aided by the interest rate cuts and massive liquidity injections, is unprecedented in the face of a clear threat to the US markets. The twin deficits of budget and trade are unsustainable no matter what some may say. A rising US$ puts pressure on a host of commodity prices, particularly oil, that are all priced in US$. But a devaluing US dollar cuts both ways as it monetizes the debt for the US while holders of the debt outside of the US are losing twice with a falling bond market and a declining US$. Over 40% of US debt is held outside the US. And of $6.2 trillion external debt, $1.2 trillion comes due in the next few months.

The US Dollar makes up roughly 70% of the world's central bank reserves whereas the Euro only makes up about 13%. Many central bankers are becoming concerned and would like to increase their holdings of other currencies, particularly the Euro and gold. Recently Viktor Khristenko, Russian Vice Premier said that he saw the dollar being increasingly replaced by the Euro as something "unavoidable". Some including perennial Democratic Presidential candidate Lyndon LaRouche have been calling for a new Bretton Woods. He has being getting a receptive audience particularly in Europe.

And of course any new monetary system would be backed by gold returning to the one element that has provided stability for money in the past. The major enemy of a gold standard of course is the central bankers who can not grow money supply at levels that may keep them happy and of course the private banking system that would not be able to expand their loan base the way they have become accustomed to.

But massive unsustainable levels of debt in a society with little or no savings and collapsing currencies is not stability and we will continue to lurch from crisis to crisis until such time as we hit a real panic crisis that can not be controlled. We can as we have in the past throw money at it but while in the short run this stems the crisis it does not resolve it and merely puts off the inevitability of a debt, monetary and currency collapse that we have thus far managed to avoid. When other currencies are falling it is that country's problem but when the world's reserve currency is falling it becomes the world's problem.

Gold, the currency of last resort, as we oft stated in the past is available as bullion from banks and coin dealers in coins and bars. In funds the best vehicles remain Central Fund of Canada (CEF.A-TSX, CEF-AMEX), a closed end fund and the Millennium BullionFund, an open-end mutual fund trust. In stocks we prefer the junior producers and some of our favourites are Eldorado Gold Corp. (ELD-TSX), Bema Gold Corp. (BGO-TSX), Northgate Explorations Ltd. (NGX-TSX), and we might add River Gold Mines Ltd. (RIV-TSX).

So are we entering the period that will signal the end of the US Dollar as the world's reserve currency? We doubt that it will completely but we are entering a period of currency and financial instability that will shake the foundations of the world.

Palladium, platinum and silver are the most common substitutes for gold that closely retain its desired properties.