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Even a rather wobbly reserve currency is a better asset than gold, whose price again crossed the US$1,000 mark last week. Gold is far less liquid than US Treasury securities, costly to store and insure, and above all far more volatile in price.
Gold’s price volatility since January 2000 (the standard deviation of the daily price divided by the average) is 45%, almost triple that of the US dollar-euro exchange rate. In a functioning world financial system, in which investors trust governments to control extreme instability, even an indifferently managed reserve currency with a broad capital market behind it is better than gold.
US$ price volatility, January 2000 to August 2009
Strictly speaking, gold isn’t an investment but an insurance policy against a breakdown of the functioning of the world financial system. In particular, it represents insurance against the breakdown of the political understandings that make possible a world financial system. That is why gold reached its all-time peak (in inflation-adjusted) terms at the end of 1979, when the Soviet Union invaded Afghanistan.
Divided by the US Consumer Price Index (CPI), the price of gold trades at half its 1979 peak, when the world had cause to believe that America would lose the Cold War. American diplomats still were hostage to the Iranian Revolutionary Guards Corps in Tehran; a rescue operation had failed ignominiously; the overall state of America’s military was weaker than at any time since World War II; and the European consensus held that the North Atlantic Treaty Organization would break up. Russia’s move into Afghanistan seemed like the penultimate blow to American power. If America ceased to be the leader of the free world, the dollar also would cease to be the world’s reserve currency. The cost of options on America’s funeral – for that is what the gold price was – went through the ceiling.
America’s position in the world today is far less subject to challenge than it was in those dark days at the end of the Jimmy Carter administration. The US has stuck its hand into the meatgrinder in every venue it visits, but unlike 1979, no hostile power lurks along the road to exploit American weakness.
On the contrary: most of the world (China and India in particular) would prefer that America enhance rather than diminish its world role. The last thing China wants to do, for example, is to have to suppress Islamist insurgencies inspired by Washington’s newfound interest in engaging the Muslim world. The last thing India wants to do is to sort out a Pakistan dominated by the Taliban, whose prospects for victory have risen with American stumbling in Afghanistan.
Thirty years after the dollar’s nadir, and the near-collapse of America’s strategic position, the world’s largest nations look at America like an obnoxious, arrogant, but useful partner who has taken to drink and needs to be picked up out of the gutter from time to time. As annoying as it was to live with America, it would be difficult in the extreme to live without it.
The scurrilous fringe of financial journalism likes to speculate as to when China will dump the dollar, without asking the obvious question: what would China do in the absence of the dollar? The billion people who inhabit China’s interior are no substitute for the 300 million in the American market. They have a fraction of the purchasing power, they have little access to financial services, they have no credit bureaus to calculate their capacity to carry debt, and they have no means to make liquid their limited assets through mortgage markets. Perhaps over a dozen years of Herculean efforts, the situation might be changed – but that is then, and this is now.
It is commonplace that China would be happy to exchange its $2 trillion of US Treasury securities for the same amount of assets producing food, energy and raw materials. But in a world in which corporate control over raw materials is a highly political matter, it will take many years for China to diversify its portfolio enough to make a difference.
The world not only is stuck with the United States for the time being, but wants to be stuck with the United States. But the Barack Obama administration’s attempt to substitute government spending for collapsing consumer spending makes US assets less attractive, while its attempt to diminish America power on dubious ideological grounds forces other countries to act as rivals, unsuited and unwilling as they might be to do so.
That is why options on the end of the US are trading well in the form of the gold price. Gold will have no official role unless America’s international role really does collapse, and the world is reduced from a system of trust (or imperial dictates, which amounts to the same thing) to a kind of barter at the international level. That would be a situation much to be abhorred, but it is not to be excluded. The world may need an alternative to the dollar if Obama persists in his present course.
The same characteristic, namely volatility, that makes gold undesirable as a central bank reserve asset makes it a very desirable hedge. What investors seek in a hedge is volatility, that is, very large price movements with respect to the assets to be hedged.
Gold, euro and yen priced in US dollars (Jan 2000 = 100%)
The euro has risen about 40% since January 2000, while gold is up three and a half times. There is no reason for this pattern to reverse. Everyone owns too many dollars; by definition, a problem in the reserve currency means that the whole world is long an asset they no longer want.
But the dollar is so large that nothing can substitute for it. When the pound sterling collapsed under the weight of Britain’s debt from two world wars, the huge American economy was there to offer the dollar as a substitute. Professor Robert Mundell, the great economist who won the 1999 Nobel Prize for inventing modern international economics, was the father of the euro. He now is proposing to substitute a basket of currencies for the dollar. But that implies a degree of monetary and political cooperation across countries that post-war Europe was able to achieve but the present world will not. Much as I revere Mundell, I do not think his present plan is practical.
Unfortunately, the world will gyrate between the dollar, the reserve currency everyone has but doesn’t want, and options on the end of the world. It is quite possible that gold will continue to rise, even if the price level in the US falls as measured by the CPI.
We are in the first deflation since the Great Depression, albeit a mild one. In fact, raw materials prices have fallen just as far, but our consumption basket has shifted to items whose prices are slower to deflate.
Note that the great deflation of 1929-1933 was followed by a brief increase in inflation (to a 5% year-on-year CPI gain) before falling back into negative numbers. This was the result of president Franklin D. Roosevelt’s devaluation of the dollar against gold, from $20.67 to $35 an ounce (a level that held until August 1971 when president Richard Nixon again devalued the dollar). That the effects of the dollar devaluation were quite temporary is evident from the chart.
The dollar may fall further against other currencies, but it cannot fall too much further. At one euro buying 1.42 US dollars, or one Australian dollar to 0.85 US cents, or one US dollar to 1.08 Canadian dollars, the weak US currency creates painful strains on other economies. But the price of an option on an eventual replacement for the dollar has no natural ceiling. The gold price can go as high as it wants to without provoking economic disruptions of any kind.
Gold, moreover, can keep rising even while the dollar stabilizes against other currencies, or the price level falls. In a service-based economy, most of the measured price level depends on the price of labor. Americans are likely to work more cheaply than ever before. To begin with, the cost of living has fallen dramatically for American workers because the cost of owning a home has fallen. In many parts of the country, the combination of lower home prices and lower mortgage rates has reduced the single-largest item in the household budget by more than half.
To have actual inflation, someone has to take cash and buy goods rather than (for example) securities. If everyone hypothetically wanted to buy securities rather than goods, prices of goods would crash. China will be exchanging securities for goods to the extent it can, but Americans will eschew goods in favor of securities.
An aging population increases its purchases of securities and decreases its purchases of goods as it saves for retirement. Americans have saved nothing for the past 10 years, and the capital gains that they considered savings-substitutes have vanished. That means that an enormous savings deficit accumulated over more than a decade has been exposed, and that Americans must attempt to correct it quickly and under the worst of circumstances. Americans will work more, spend less, and save more. America may have the worst of both worlds: currency devaluation and price deflation, as in the 1930s.
The rate of return on American assets will continue to grind lower under this scenario. If the deterioration of the dollar’s attractiveness is matched by additional strategic blunders, it is possible to envision a collapse of the dollar’s reserve role within a five- or 10-year horizon. I recommended gold in my “Inner Workings” blog on July 3, and continue to believe that it offers a useful hedge against the worst prospective consequences of the Obama administration’s mistakes.