The Floating Dollar in an Unstable World
As is well-known now, the dollar hit all-time lows in the late ‘70s and early ‘80s, with gold reaching an historical high at the time of $850/ounce in February of 1980. From then on the dollar reversed course such that gold began a long, twenty-year slide.
Many tie the dollar’s rise to more aggressive Federal Reserve policy, but it should be said that rate hikes began three years earlier, and occurred alongside a collapsing unit of account. More realistically, it's important to remember that the demand for money shifts all the time, and a combination of domestic and world events in 1980 was the catalyst for a rising greenback.
First off, it became apparent amidst the GOP primaries in 1980 that the Republicans would nominate a tax-cutting deregulator who was very public with his belief that no great nation long lacked a currency defined in gold. Ronald Reagan’s looming election arguably did much of Paul Volcker’s work for him.
Secondly, Europe was rapidly destabilizing. The Soviet Union had already invaded Afghanistan, and there existed the threat of it invading Poland. Worse for Europe, the French had recently elected a socialist who was known to be hostile to wealth. Reagan’s election joined with European turmoil, and the dollar was twice blessed as it were. The great ‘70s inflation effectively ended thanks to U.S. elections that occurred in concert with European uncertainty that made their currencies less attractive relative to the dollar.
Fast forward twenty years and uncertainty reigned once again. Though it’s fashionable now to date dollar weakness to last September when the Fed began reducing its rate target, true dollar weakness that revealed itself through rising gold and oil prices began in 2001. The tragedy that was 9/11 joined with rising protectionism, regulation and a war on terror to make undefined paper currencies less attractive relative to tangible items in an uncertain world.
All of this takes on even greater importance in light of the events which transpired on Friday. It is said by some that a surprisingly weak employment report told the story of the dollar’s fall, but with the influx of seasonal workers into the marketplace, it’s likely that at least part of Friday’s unemployment jump was already priced in. It also could be said that the report made further rate cuts likely, thus aiding the dollar’s fall, but with dollar weakness seven years old, and having occurred amidst rate cuts and rate hikes, it seems the direction of the Fed’s rate target is overrated as the cause.
Arguably the major reason for Friday’s commodity spike/dollar fall occurred far from the United States. Without getting into the good or bad of U.S. foreign policy, it’s fair to say that what happens in the Middle East strongly impacts the U.S. market/dollar outlook. At the very least it should be said that whatever our policies we’re a terrorist target, and when the Middle East flares up, the uncertainty greatly impacts our domestic outlook.
Along those lines, Pakistani officials on Friday announced that they had foiled a major terror plot that included bomb-laden vehicles and a number of potential suicide attackers. While the foiled plot would in theory be a dollar positive, the news perhaps reminded investors how dangerous the Middle East still is; the danger magnified in U.S. markets given our reliance on Pakistan to keep terror plots at bay.
In addition, Israeli Transport Minister Shaul Mofaz told a prominent Israeli paper that an attack was “unavoidable” if Iran continued to push forward its nuclear program. Due to the U.S.’s tight foreign-policy link with Israel, an attack by our ally on one of our enemies would in many ways be seen as an invasion countenanced by U.S. defense officials, and one that would eventually draw in U.S. troops. As an Agence France Press (AFP) story noted, Mofaz said such an operation could only be done with U.S. support.
To show the impactful nature of Mofaz’s comments on the dollar, we need only look at the price of gold in response to AFP’s release of the story at 3:36 am eastern standard time. As Bretton Woods Research chief economist Paul Hoffmeister wrote in a client piece, gold and oil markets began “to move slightly upward within 2 hours before 3:36 am, and then significantly higher after the AFP news report, sparking the dramatic upward trends throughout the day.” In short, the world became a much scarier place on Friday, and markets quickly adjusted the dollar to this uncertainty.
The dollar’s Friday collapse revealed yet again how unsuited our monetary policy is to a frequently unstable world. While the direction of the Fed funds rate has sparked much debate among those eager to see a stronger dollar, it should be said that these discussions are very much a non sequitur considering world events.
Even if rates are the valve through which the Fed injects dollar liquidity (many, including this writer, say that’s not the case), Friday’s events show how worthless the rate mechanism is in a world where currency demand shifts day to day, hour to hour, and minute to minute. Given the infrequency of FOMC meetings, any rate it sets can in no way synthesize the ever changing supply/demand of and for the dollar in such a way that the latter will achieve any semblance of stability.
That the rate mechanism is charitably feckless in an unstable world speaks to the importance of the Treasury and Fed adopting a price rule. Doing so would be a huge boost to the markets in that it would reveal to investors that the dollar’s value won’t be held hostage by events thousands of miles away.
Notably, Treasury Secretary Paulson did not rule out dollar intervention in a CNBC interview yesterday, and gold fell slightly. Rather than lightly hinting at a dollar fix, Paulson should recognize that the dollar is utterly insignificant except as a measuring stick that facilitates the wealth-enhancing exchange of goods.
Put simply, when the dollar is unstable so is the trade that is the basis of economic activity. So instead of waiting, Friday’s dollar activity should encourage Paulson to quickly announce a dollar/gold relationship that would insure currency stability while offering true “stimulus” to the economy. Indeed, in an uncertain and warring world, it’s essential that our economy be firing on all cylinders, free of inflation. Right now, that’s not the case.