Dollar Weakness Begets World Inflation
Amidst the dollar’s impressive weakness in recent years there’s been much commentary about the strength of non-dollar currencies relative to the greenback. More specifically, money has been made by currency traders selling dollars for the currencies of countries whose economies are commodity based. But do the currencies of commodity countries actually strengthen when the dollar is weak?
One theoretical argument suggesting they do hinges on the view that economic growth begets currency strength, and when commodities are booming, so do the currencies of countries reliant on a prosperous commodity sector. Measured in dollars at least, commodity-country currencies have certainly done well over the last few years.
Looked at mechanically, some argue that “home bias” explains commodity currency strength. Though commodities are priced in dollars, when the dollar is weak commodity countries take in copious amounts of dollars thanks to rising prices, but then sell those dollars for the home currency. Notably, when North Sea oil discoveries briefly made England a substantial petroleum player in the ‘70s, the late ‘70s spike in the oil price is said to have played into pound strength.
Still, when a currency’s direction is considered, the benchmark is usually the dollar itself. And there lies the misunderstanding. Like all currencies today the dollar is merely a paper concept. As such, currency strength relative to the dollar is very much a fluid idea. If the paper dollar is severely weakening as it has in recent years, strength relative to it could be masking actual weakness in the rising currency. Conversely, dollar strength from 1996 to 2001 made a lot of currencies seem weaker than they actually were.
To best understand the impact of commodity booms on commodity currencies requires measuring their direction against the commodity known to be most stable in real terms: gold. When the price of gold moves, the movement chiefly reflects changes in the value of the currency in which it’s priced. Sure enough, when we factor in the gold price of commodity currencies during times of commodity strength and weakness, a different story emerges.
Soon after President Nixon ended the Bretton Woods system of fixed exchange rates in August of 1971, the dollar’s value plummeted, and commodities, from oil to wheat to soybeans, rallied. Lacking the credibility that the gold link had previously lent it, the dollar predictably fell against all manner of currencies, including three commodity-country currencies: the Australian (AUD) and Canadian (CAD) dollar units, plus the Norwegian Krone (NOK).
From August of 1971 to December of 1974 the Krone and Aussie dollar respectively rose 32 and 17 percent against the dollar, while the Canadian dollar rose a less impressive 2 percent. But when we measure those same currencies against gold, what becomes apparent is that all three lost substantial value. While the dollar/gold price rose 330 percent during the time in question, the gold price in the Norwegian, Australian and Canadian currencies also rose 224, 270 and 320 percent.
In June of 1977, when Carter Treasury Secretary Michael Blumenthal communicated to the markets his displeasure with alleged yen weakness, the dollar went into freefall; thus sparking another boom in commodities. Interestingly, in the timeframe covered here (June ’77 – January ’80), there was no discernible strength among the commodity currencies - even against the dollar.
Measured in dollars, the Krone rose 7 percent versus .2 percent for the Aussie dollar, while the Canadian dollar actually fell 10 percent. In gold terms, while it rose 359 percent in dollars, as one might expect gold also rose 328 percent in Krones, 358 percent in Aussie dollars, and the gold price in “loonies” rose 402 percent.
Fast forward to the new millennium, the tragedy that was 9/11 combined with Sarbanes-Oxley, new tariff barriers against steel, lumber and shrimp, and a Bush Administration that has spoken with a forked tongue when it comes to currency strength, the dollar has entered yet another period of weakness. And as has always happened during bouts of dollar weakness, commodities have boomed.
Since June of 2001 the dollar price of gold has risen over 235 percent to all-time highs, and amidst the once mighty dollar’s fall, much has been made of the strength of other, non-dollar currencies. If we look at the commodity currencies covered in this piece, the Canadian dollar is up 51 percent, the Aussie dollar 73 percent, and the Krone tops them both with a 77 percent jump.
Despite the aforementioned strength relative to the dollar, all three currencies look less impressive once we bring gold into the equation. Indeed, since 2001 gold has appreciated 89 percent in Krone, 94 percent in Aussie dollars, and 122 percent in Canadian dollars. In short, when my Wainwright colleagues David Ranson and Penny Russell wrote in the Wall Street Journal last July that we were experiencing “another classic ‘run’ on paper currencies,” this included the very commodity currencies thought to weather inflationary outbreaks stateside.
The question then becomes one of why dollar inflation tends to be a world event. The answer seems to be a pretty simple one. While it’s true that “money is a veil” such that countries cannot generate more than fleeting trading advantages through devaluation, prices are sticky, and they’re particularly sticky in the United States. When the dollar weakens, monetary authorities around the world seek to maintain some semblance of currency parity so that their exporters are able to readily market their goods here.
Seeking to keep their currencies from rising too much relative to the dollar, monetary authorities sell the home currency for the dollar, and in the process inflate their own currencies; albeit not to the extent that the dollar inflates. This perhaps helps to explain why inflation in Euroland and the U.K. is hardly quiescent, not to mention December consumer price inflation of 3.7 percent in Australia combined with a 17 percent 12-month rise in fuel costs for a country that some dollar-watchers would say has a strong currency. Dollar weakness equates with world currency weakness.
All this raises the question of how dollar strength affects the same commodity currencies covered in periods of dollar weakness. Once again, the real truth is hidden by the tendency of currency-watchers to measure the health of non-dollar currencies against the dollar.
As is well known now, after monetary authorities stateside failed to accommodate the economic growth that resulted from capital gains tax cuts in 1996, the dollar experienced a great deal of strength from 1996 to 2001. Gold in dollars fell 31 percent, while the dollar rose 11 percent against the loonie, 31 percent against the Krone, and 36 percent versus the Aussie dollar. Due to dollar strength at the time, commodities across the board were weak with oil alone hitting a modern low of $10/barrel in 1998.
Conventional wisdom would have said that the aforementioned commodity currencies were weak due to falling commodity prices, but gold once again told a different story. It in fact depreciated 22 percent in the Canadian currency, was flat in Krone, and rose a mere 7 percent in Australian dollars. And just as worldwide monetary authorities inflate to slow the dollar’s fall amidst dollar weakness, they reverse course during periods of dollar strength through purchases of the home currency for dollars. Dollar disinflation is world disinflation, even for currencies whose countries are commodity-based.
If there’s a lesson here it is one telling us to pay little heed to currency commentary engaged in by mainstream media members. Oblivious to the truth that in a world of paper currencies there are no currency benchmarks, the wise men and women who report the news will continue to write about currency strength as though there’s a lot of information revealed in the interplay between two paper concepts. In truth, commodity booms are merely dollar routs, and to the extent that non-dollar currencies (commodity or otherwise) exhibit what many deem strength during the aforementioned booms, their seeming vitality is almost assuredly a money illusion masked by even greater dollar debasement.
Unfortunately, gyrating currency values wreck the crucial debtor/creditor relationship, all the while wreaking havoc on trade agreements whose values need to be hedged and re-hedged thanks to irresponsible management of the currency by central banks; the U.S. Treasury being the main miscreant as it were. So the broader lesson here is the simple truism which says that money itself is utterly insignificant except as a facilitator of the all-important beneficial exchange of goods. With the dollar’s status as reserve currency secure for now, we’ll see more wealth-enhancing trade once U.S. monetary authorities shed their mercantilist ways and get serious about providing the world with a stable unit of account.