These are uncertain times for the U.S. dollar as every day seems to bring fresh all-time lows for the buck against other major currencies. And an uncertain present tends to make people pine for a rose-colored past.
The most extreme expression of this longing is the call by some for a return to the gold standard.
The longing for the stable currency values seen under the fixed exchange rate system of earlier years is understandable as people fret over the effects of the greenback's fall: everything from a loss of purchasing power at home to higher prices for goods and services on overseas trips.
The value of the dollar has been declining since 2002. The U.S. dollar index, a futures contract offered by the New York Board of Trade, which reflects the dollar's standing vs. other major currencies, has been hovering at 40-year lows since the subprime-fueled liquidity crisis this past summer. On Nov. 20, the euro climbed to a new all-time record high of $1.4815, partly in response to the Federal Reserve's more dire forecast for U.S. economic growth.
Trade Partners Diversify Currencies
Lately, there have been plenty of headlines about the loss of confidence in the dollar by key U.S. trade partners, which could accelerate the dollar's devaluation if any of them decide it's time for a policy change.
Take some of the leading oil-producing countries in the Middle East. With the price of oil poised to break through the $100-per-barrel threshold, countries such as the United Arab Emirates and Qatar are said to be considering moving away from pricing crude in terms of dollars in favor of a basket of currencies. Kuwait exchanged its strict dollar peg for a currency basket earlier this year and there's concern that if other countries follow suit, it could reduce demand for the buck and spur other central banks to diversify their holdings, The Wall Street Journal reported on Nov. 20.
The buck's weakness makes this a perfect time for a return to the gold standard, according to Nathan Lewis, author of Gold: The Once and Future Money. Lewis is advising the UAE to consider adopting a gold peg instead of a basket of currencies if it moves away from a dollar peg for its oil.
Is Gold the Answer to Stability?
Gold bugs like Lewis argue that the ideal currency is one whose value is stable, and they hold that gold is historically the most stable form of money. They believe an unstable currency such as "fiat money," the value of which is determined by governments, is all too vulnerable to manipulation by corrupt politicians and increases the risk of inflation and deflation.
The gold standard that Lewis is advocating wouldn't be the same as the one whose heyday was between 1870 and 1914, when central banks were required to hold a certain portion of gold in reserves to ensure their currencies' stability. Instead, he's pushing for a mechanism under which the value of the dollar would be fixed to a predetermined quantity of gold rather than a targeted interest rate. He proposes that the Fed be replaced by a currency board with only one responsibility—to adjust the money supply in order to maintain a constant value of the dollar in terms of gold. Under such a system, interest rates would be set by the market and the money supply would be set by gold itself.
"You just simply change your target, from an interest rate targeting policy to more like a currency board policy," Lewis says. "Functionally, the dollar would no longer go up and down."
We've Tried It Before
But that's flat-earth thinking to some. Economic historians such as Barry Eichengreen, author of Golden Fetters: The Gold Standard and the Great Depression, 1919-1939, believe that the commitment to the gold standard was a key factor that prevented governments from taking the necessary actions to fight the Great Depression, such as expanding the money supply to encourage business growth. Fearing a bank run, the U.S. finally abandoned the gold standard in 1933 but returned to a modified version of it in 1945, when the Bretton Woods international monetary system of fixed exchange rates was established.
Critics of the gold standard, including most mainstream economists, argue that countries experiencing downward pressure on the value of their currencies are forced to contract their economies, while no comparable adjustment is required of countries whose currencies are gaining value. In fact, under the gold standard, there's a tendency for countries that run trade surpluses to prevent their money supply from expanding when gold flows in from countries with trade deficits by boosting their sales of government bonds and retiring the money they get for them. This disrupts the natural rebalancing of trade and prolongs the suffering of countries whose currencies are under pressure.
"It's been an extremely long time since we've been on the gold standard and it's hard to remember the problems that were associated with it," says Andrew Bernard, director of the Center for International Business at Dartmouth University's Tuck School of Business.
By the early 1970s, U.S. fiscal policy was in disarray, American goods had lost their competitiveness in international markets and the balance of payments surplus of the late 1960s had reversed to a soaring deficit. Worried that it wouldn't be able to meet increased demand by foreign central banks to convert their growing dollar reserves into gold at $35 per ounce, the Nixon administration ended the Bretton Woods system. In August, 1971, the U.S. closed the gold window that allowed foreign governments to convert their dollar assets into gold. A few months later, the imposition of a temporary 10% surcharge on all imports helped convince U.S. trading partners to let the value of the dollar drop against their currencies. The dollar was devalued by roughly 10.4% on average against the currencies of 14 countries with which the U.S. did about two-thirds of its trading.
Giving up the gold peg makes a country's currency more vulnerable to rising price levels. But the rewards include greater monetary flexibility, which can be used to help fight unemployment or recession, says Richard Barnett, assistant professor of economics at the Villanova School of Business outside Philadelphia.
"It smooths out the business cycle a little," he said.
If the goal of monetary policy is a stable currency, central bankers should be able to achieve that with the appropriate target on the inflation rate, Barnett says. He concedes that's more of a challenge for a large country like the U.S. than for smaller countries, because U.S. monetary policy has much bigger implications worldwide.
Treasury Bill Sell-Off Is Unlikely
The growing crisis of confidence in the dollar has recently generated speculation that China's central bank may be thinking of selling a major portion of the dollar assets it has accumulated over the past decade or more to shift into euro assets.
For the past several years, China and Japan have been buying U.S. Treasury bills and other U.S. assets in an effort to maintain a fixed exchange rate relative to the dollar. But with the euro's value rising against that of the dollar, they may be less and less willing to hold dollar assets to prop up the dollar's value.
When Germany decided in 1971 that it couldn't afford to keep importing inflation, it pared its dollar reserves and freed the Deutsche mark to appreciate against the dollar. Germany's abandonment of the fixed exchange rate was one of the factors that led to the demise of the Bretton Woods system. If China and Japan were to stop holding so many dollar assets, it could signal the end of the fixed exchange policy between their currencies and the dollar, Barnett said.
"The big concern is that they'd sell off all these T-bills and the price of T-bills would fall," Barnett said. "And because of the inverse relationship between T-bills and interest rates, interest rates would rise."
The Fed could respond to that by buying up Treasury bills, causing a surge in the U.S. money supply, which would send inflation soaring, he said.
But considering that the Chinese decided to bulk up on dollar assets in the 1990s in order to instill confidence in the Chinese banking system, that may be a reason for them to want to continue to hold dollars, Barnett added.
Any new currency reserve purchases by the Chinese and others are likely to be in euro assets instead of dollar assets, says Bernard at Dartmouth's Tuck School, But countries that hold large quantities of dollar reserves won't sell them because they don't want the value of their dollar assets to fall, he said.
How Far Will It Fall?
For Lewis, the dollar's current weakness is an unsettling reminder of the last time the dollar came under extreme pressure in the 1970s, "I've seen that once [the pace of depreciation] gets moving, it tends to keep going until someone gets aggressive to do something about it," he said.
Just as former Federal Reserve Chairman Paul Volcker had to pump up interest rates in order to arrest the dollar's declining value—a tactic Alan Greenspan also adopted in the late 1980s—Lewis predicts it's just a matter of time before Ben Bernanke turns to the same instrument to keep the dollar from falling further.
The major difference, however, between then and now is that the U.S. economy is currently fairly strong and inflation is pretty low, says Barnett. That's likely to help the dollar avoid a protracted downtrend, he said.
But as long as the greenback's woes remain front and center, some members of the small but enthusiastic gold crowd will continue to insist that a better path for the U.S. currency lies on the Yellow Brick Road.