Doubts are starting to emerge as to whether the United States is a financial safe-haven and whether the dollar will continue to have the most important attribute of a reserve currency — that it be a stable store of value. The recent strength of the gold price suggests we may be witnessing the early stages of a flight from the dollar. Sandy McGregor explains…

We have commented previously that gold has the characteristics of both a commodity and a currency. Since the sub-prime crisis broke in July 2007, the role of gold as a store of value has become increasingly prominent, with its dollar price rising from US$660 to US$980 at a time when almost all other commodity prices have declined significantly. This is not simply a matter of a weak dollar. In euros, gold is up 42 percent and in yen, 17 percent. If gold is regarded as a currency, it has been the best performer of its class since the start of the financial crisis.

What is driving people to invest in a financial instrument that economist John Maynard Keynes famously described as a barbarous relic? Underlying the shift of investor sentiment towards gold is concern about governments generally abandoning fiscal and monetary discipline in an attempt to stabilise global economic conditions, and, in particular, worries about the dollar as the world’s reserve currency.

The rise and fall of reserve currencies

In modern times there have been two reserve currencies. The first was the pound sterling, which played the central role in global finance over the century between the end of the Napoleonic wars and the outbreak of the First World War in 1914. Two world wars destroyed Britain’s financial hegemony and, after a period of considerable confusion, in 1945 the dollar emerged as the lynchpin of the world’s financial system, a position it has held ever since.

While prior to 1914 Britain did not abuse its privileged position at the centre of the world’s financial system, generally running balanced budgets and current account surpluses, the same cannot be said of the United States. Since 1981 the US has run huge current account deficits. Initially, this did not matter because it had substantial foreign assets to offset foreign obligations. However, over time the US has become the world’s largest net debtor. The dollar’s special role has allowed Americans to live beyond their means for almost three decades. The rest of the world has been willing to finance this spendthrift behaviour because it has prized, perhaps irrationally, US assets above all others. In addition, many countries have supported the dollar in order to grow their own economies.

Japan, the Asian Tigers (Indonesia, South Korea, Malaysia, Thailand and the Philippines) and, more recently, China have all used export-led growth to create their present prosperity. They have boosted exports by maintaining artificially competitive exchange rates, generating large current account surpluses and, as a consequence, have accumulated substantial dollar foreign exchange reserves. The great boom in emerging markets over the past decade has been based on this simple formula of undervalued currencies. As is the nature of such things, matters got out of control and went to excess, the most dramatic manifestation of which has been China’s accumulation of foreign reserves valued at US$2-trillion.

Confidence in the dollar is eroding

Foreign central banks continue to prop up the dollar because they have no alternative. They would like to diversify their reserves into other currencies but cannot do so without causing a major realignment in exchange rates, with unfavourable consequences for world trade. In contrast, private investors have the freedom to act and are doing so. The market as a whole has become increasingly neurotic about US government finances. Doubts are starting to emerge as to whether the US is in fact a financial safe-haven, and whether the dollar will continue to have the most important attribute of a reserve currency — that it be a stable store of value.

At the heart of the problem is the US fiscal deficit, which will be between US$1.5-trillion and US$2-trillion this year. The Federal Reserve is planning to fund a substantial part of the deficit by printing money. The Federal Budget Office projects that federal debt will increase from 41 percent of GDP at the end of 2008 to 82 percent in 10 years' time — provided certain policy changes are made. Without these changes the debt will exceed 100 percent of GDP. Such projections are at the best of times very unreliable, but clearly the US faces a severe fiscal crisis.

Continued on page two: Why is the Fed is printing money and can the spiralling US deficit be brought under control? Is inflation, and a weakening dollar, the only way out?

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