The Falling U.S. Dollar

Until 1963, money consisted of gold and silver coins in the U.S. In 1863 the first U.S. currency was issued in the form of gold and silver certificates. The gold certificate read, “This certifies that there have been deposited in the Treasury of the United States ten dollars in gold payable to the bearer on demand”. Silver certificates were similar.

Fifty years later, The Federal Reserve Act of 1913 established the politically independent Federal Reserve System (the “Fed”). The Fed was established to provide a “superior currency” to replace all the paper money being issued in the form of notes from private banks of varying credit quality. The principal purposes of the Fed were to:

  • Supervise and regulate the banking system
  • Manage the supply of money through the purchase and sale of government securities (called “monetary policy”)
  • Act as a clearinghouse for the transfer of funds throughout the banking system

The Fed then issued “Federal Reserve notes”, redeemable in gold or “lawful money” at any Federal Reserve Bank (a private, national bank). Lawful money consisted of Treasury notes, silver coins and silver certificates.

However the Gold Reserve Act in 1934 removed the word “gold” from Federal Reserve notes. The new redemption clause read, “This note is legal tender for all debts, public and private, and is redeemable in lawful money at the United States Treasury, or at any Federal Reserve Bank”.

The U.S. and the heads of allied countries held a meeting in 1944 called the United Nations Monetary and Financial Conference to discuss the state of the international economy following WW II. Since the meeting was held at Bretton Woods, New Hampshire, the conference and the related agreements became known as “Bretton Woods”. The International Bank for Reconstruction and Development (World Bank) and the International Monetary Fund (IMF) were established as a result of this meeting.

Bretton Woods established the U.S. dollar as the world’s reserve currency. Plans were made to fix the rate of exchange for all foreign currencies in Europe and Asia in relation to the U.S. dollar. And the dollar would be tied to gold to permit international settlement at a fixed price. Therefore, a foreign currency would always be worth a fixed number of dollars which, in turn, would always be exchangeable for gold. The dollar was accepted by the world as the reserve currency because of:

  • America’s superior industrial strength
  • Its status as the world’s leading exporter of manufactured goods and the world's biggest creditor nation
  • The fact that its currency was fully backed by, and redeemable in, a fixed quantity of gold.

None of these attributes exist in the U.S. today. The U.S. is now the world’s biggest debtor nation.

Being the reserve currency meant that the dollar became the currency used by other governments and institutions as part of their foreign exchange reserves. It also meant that gold, oil and many other products which were traded on global markets would be priced in U.S. dollars. Therefore, countries involved in international trade had to accumulate dollars and build reserves.

As a result of the U.S. postwar growth and prosperity and the Bretton Woods agreements, the free world had relative monetary stability from 1945 through the early 1960s. But on November 2, 1963, the redemption clause on our money was completely eliminated, leaving the note to read, “This note is legal tender for all debts, public and private”. Eliminating the ability to exchange our money for something of basic value (gold or silver) meant that the subsequent value of the dollar would depend purely on its purchasing power. The purchasing power would depend on the financial strength of the U.S. economy and how the supply of dollars was regulated.

The Kennedy administration decided that the money supply should be used to stimulate spending when the economy slowed in order to stop contractions and create expansions. Increased federal spending in the 1960s created significant budget deficits which were financed primarily by increasing the money supply. This created high inflation. European and Asian countries had returned to economic growth by this time but were being forced to increase their money supplies along with the U.S. in order to maintain the agreed-upon ratios of their currencies to the dollar. Since this process created inflation overseas, they began to return their excess dollars to the U.S., demanding redemption in gold at the agreed-upon rate of exchange. This caused the U.S. gold supply to fall to dangerously low levels.

President Nixon was forced to cancel our agreement with other nations in 1971 and go off the gold standard (close the “gold window”), meaning that the U.S. would no longer exchange dollars for gold. Since then, our currency exchange rates have been allowed to float, being determined by the supply of and demand for currencies. This decision destroyed the orderly economic policies that had been made possible through Bretton Woods. The concept of currencies being "strong" or "weak" then became very important.

The relationship between exports and imports, a country’s political and economic stability, the rate of return on its' securities, etc. establish the supply and demand relationship between currencies. Weak and strong refer to a currency’s rate of exchange with another currency rather than the currency’s local purchasing power. A strong or weak currency can be good or bad. For example, a strong currency is good for local consumers because it makes imported goods cheaper. But a strong currency is bad for companies that export because it makes their products more expensive to foreign buyers and therefore harder to sell. And the reverse is true for weak currencies.

The Dollar Index (symbol USDX) compares a dollar with a basket of currencies: the Euro, the Yen, the British Pound Sterling, the Canadian Dollar, the Swedish Krona and the Swiss Franc. The dollar Index is currently at about 75 (relative to 100 being even). The 52-week low is $74.78 and the 52-week high is $89.62. Based on the reports I have been reading, the dollar seems to be weak because our economy has serious fundamental problems. Over the years, our economy has shifted from a manufacturing economy to a service economy with fewer goods to export. Yet we continue to spend on imports from countries that save and produce. This process has created massive trade deficits that we finance with money borrowed from our trading partners, especially China. This appears to be money that we cannot repay because of huge budget deficits and national debt.

“There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.” -John Maynard Keynes

The dollar index is down by about 16% since the March low in the U.S. stock market. A change in the value of the dollar of this magnitude during such a short period is considered to be quite significant. During this time there has been an almost exact inverse correlation between the dollar and things priced in dollars. Especially significant to me, as a financial advisor who accepts the fiduciary standard, is that the dollar and the stock markets have had an inverse relationship on a daily basis. I’m sure there have been some daily exceptions but I expect they have been few. Until this trend is broken the formula is: dollar down = stocks up; dollar up = stocks down. But trends like this do not last forever.

I read of a recent public interview with Treasury Secretary Timothy Geithner. When asked about his plan to address the currency crisis Mr. Geithner responded that he doesn’t usually talk about daily activity in the currency markets. He also indicated that “…the U.S. dollar’s strength remains readily apparent”. While in Tokyo, Mr. Giethner stated that, “I believe deeply that it’s very important in the United States, to the economic health of the United States, that we maintain a strong dollar”. I wonder if Japan, China and others see the U.S. as facing a credibility crisis.

Despite its importance as the world’s reserve currency, the G20 leaders refrained from addressing the weakness in the dollar at their recent meeting. Mr. Geithner”s request was for these countries to “take a chance again on the American economy”. With no indication of active support from the world’s leaders, the dollar closed down another 1%. Trading down a full percentage point in a day, for any currency, and especially the world’s reserve currency, is a really bad day. What’s negative for the U.S. economy is negative for the dollar.

Foreign central banks are now shifting their reserves into other currencies. In the second quarter of this year only 37% of incremental foreign currency fund flows were allocated to the dollar with the rest being allocated to the Euro and the Yen. At the end of the second quarter less than 63% of total central bank reserves were held in dollars. That is the lowest level of dollar representation ever. The Treasury International Data shows capital outflows in five of the past six months. If the U.S. is loosing capital, it suggests the dollar will continue to weaken or interest rates will rise significantly, or both. It means that our country might have a hard time getting financing for deficit spending.

The difference between short-term interest rates (2 years) and long-term interest rates (10 years) is called the “yield spread”. The yield spread is currently very near the highest ever. For example, banks are paying very low interest rates on their customer’s life savings but are charging much higher interest on loans to borrowers. So if a bank borrows money from one customer in the form of a CD paying 1% interest and loans it to struggling small business owner at 7%, the bank makes a profit of 6% on the deal. For 2009, Wall Street compensation includes $30 billion in bonuses to the big three bankers—JP Morgan, Morgan Stanley, and Goldman Sachs. These are firms that were recently helped out of their apparent mismanagement with taxpayer money. They are “too big to fail” but obviously not too big to get paid. Bankers, debtors and politicians get paid and the American savers and consumers get the bill. In other words, American savers finance Wall Street’s risk taking and compensation structures.

416 banks are currently on the FDIC’s watch list, meaning they are in poor financial condition and are prospects for being taken over by the FDIC. According to Bloomberg, bank failures to date have cost the FDIC’s fund about $25 billion and are expected to cost another $100 billion through 2013. The FDIC’s fund has been substantially depleted. Could it be that they are postponing bank take-overs because they don’t have funds available to do so?

China is our biggest trading partner. We buy lots of goods from China but they don’t buy much from us. Since we are buying on credit, we owe them lots of money. China’s currency (the Yuan) is tied to the dollar, so they must take measures to make the Yuan’s value change in step with the dollar. China has apparently postponed the reckoning by sending money back to the U.S. by buying Treasury securities. But the interest rate they are being paid is very low. Therefore, their buying is slowing. They are not happy with the fact that our currency is falling. And China wants a new reserve currency.

The dollar’s weakness has been a major concern overseas for quite a while and it now appears that more Americans are beginning to share the concern. A front-page headline in today’s Wall Street Journal reads: “World Tries to Buck Up Dollar. Thailand, Korea, Russia Seen Buying U.S. Currency; Pressure on China to Boost Yuan. The first paragraph says “Governments around the world stepped up efforts to stem the U.S. dollar’s slide, as officials grow increasingly concerned about the impact of the weak greenback on their nascent economic recoveries.” Their efforts involve buying dollars. It goes on to say that Mr. Geithner thinks China should abandon its policy of managing its currency. (If you would like for me to send you a copy of the article, just let me know.)

Our leaders in Washington have some very important and very difficult decisions to make. If other countries stop buying dollars and start sending dollars back home, it appears that hyper-inflation could be the result. If interest rates are increased in order to make it more beneficial for foreigners to hold dollars, it could result in another round of recession. So, it appears to me that we are stuck between high inflation and recession with no easy way out.

I certainly do not have all the answers. Using a single factor such as the dollar’s status to make investment decisions for my clients would be foolish. But, in my opinion, this is a very serious matter for the health of our economy and it is a very important factor in my daily investment and risk-management decisions on behalf of my clients. If you have comments for me on this subject please let me know.

God bless America. Thank you for the opportunity to serve.

Gary Clark
11-12-2009

If My people who are called by My name will humble themselves, and pray and seek My face, and turn from their wicked ways, then I will hear from heaven, and will forgive their sin and heal their land. -2 Chronicles 7:14

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