Monday, July 6, 2009

Collapse of the Dollar? I Don't Think So

There's a very good chance that dollar will decline in value relative to many currencies in the next few years. But to call it a collapse is hyperbole. Even if it collapses like the stock market did the previous two years, it would still be less than a 50% correction other than a very short-term steep trough at the zenith. As we pointed out in June, Robert Prechter is the only reputable analyst declaring equity investments dead.

Nevertheless, the hottest topic these days seems to be the collapse of the dollar because of America's horrendous debt load, the Fed's quantitative easing, loss of world reserve status, and who knows what else. We here at SBC would be inclined to bet you could find someone blame the dollar's demise on global warming, even.

Well, lets see if we can compare the British pound history to the same argument about reserve status. In the 18th century, the pound was the most equivalent asset to today's reserve currency, if you leave gold out of the discussion. At that time, it traded in the 20-cent range (relative to the U.S. dollar). The question of value is one of the most clearly subjective questions one can think of. Lucky for us someone has created a web site, Measuring Worth, that tries to provide "price" data for very long periods of time.

We can now compare the old reserve currency to the modern reserve currency and see what one should expect of the dollar exchange rate if in fact someone (like the IMF?) comes up with a replacement currency. We can see the dollar to pound exchange rate for more than 200 years was mostly stable in the low 20s during it's reserve period. Shortly after the first Bretton Woods agreement it started falling, and was again relatively stable for around 17 years (1950 - 1967). From that point on it enjoyed the roller-coaster thrill of the new world order of completely free exchange rates, apparently initiated by what Wikipedia called the "Floating" Bretton Woods. But in spite of that, the 2007 price was hardly different than 1967.

In the end, after 200 years of currency history, the British pound lost it's reserve status and sits about about 1/2 it's value from the reserve days. The only clear currency-based investment choice we can see from the advantage of hindsight from 1949 to the present is converting pounds to gold rather than converting pounds into the new global currency reserve emerging in that day (the dollar). Our friends at Kitco have some nice gold charting tools where one can compare the performance of gold relative to the dollar, and with a little work, convert that price chart to gold in British pounds.

We leave it as an exercise for the reader to analyze the choice between reserve currencies and stocks and bonds. But to argue that losing it's reserve status will ensure the "collapse" of the dollar is an exaggeration in light of reserve currency history. The real movers are more than just reserve status. When the data catches up with us, we'll look at foreign net purchase of U.S. debt in the early summer of 2009 and see how that theory is holding up.


  1. So, what is your opinion what happens to the dollar over the next 5 - 10 years if the debt in our country isn't appeased? The Chinese clearly are trying to make a move at challenging the dollar. You could say the Indians and Russians are as well. I'm not saying the later two are in a position to do anything about it, but one could argue the Chinese are. In the short term the dollar is safe even if it loses some value. But what about long term?

  2. What happens to the dollar depends on what happens with everything else. The value of the dollar (like the value of anything) is relative to the alternatives.

    Even if IMF SDRs become a new reserve currency, the dollar's value relative to those SDRs will determine the value of the dollar relative to other nations' domestic currencies, and the value of all those national currencies will be determined by the same factors as today: political stability, property rights, domestic economic policies, fiscal and monetary policies, etc. The US was supposed to collapse in the '70s and '80s after the collapse of Bretton Woods and the reckless debt explosion of President Reagan. But people figured out how to adapt, businesses adjusted, politics changed. The creative ingenuity of mankind will always trump ideological and economic myopia.

    We at SBC are not experts in geo-politics of all nations, so we can't make informed deductions about the long term price of dollars in Yen, Euros, or whatever, since our scope of geo-politics is limited. We can see clearly, though, quantitative easing is not a US only affair, and debt-to-gdp ratios are not as bad in the U.S. as some other western or emerging nations. What we do know is China will most likely remain under Communist Party control, and they will continue to maintain currency controls as a export/import control mechanism to favor exports.

    China still has tremendous need to build infrastructure for a large part of their country. It will be at least a decade before domestic demand can fuel enough internal consumption to fund all their capital investment, and even then, they don't have enough raw materials in the mainland to be economically self-sufficient through the next decade. They have to sell something to someone to acquire resources for capital expansion. But China is severely limited. PBS did a show circa 2008 stating that if China were to consume as much per capita as Americans, they would need seven earths to meet the natural resource needs! Having the biggest pile of cash doesn't solve that fundamental problem.

    One might tend to think a managed economy like China, with it's currency controls, investment restrictions, censorship, and other command-economy modus operandi can outperform the socialist-capitalist mix in the west. We at SBC don't think so. The U.S. may be fiscally crazy at the moment, but our open society can shift, adapt, and change much faster than a command economy. Instead, we expect both systems to struggle equally for the next five years when taken in whole. The west from it's fiscal, monetary, and tax policies. The BRIC nations from their close-ended command systems, or political dangers from huge gaps between rich and poor, while being dependent on others for their export businesses. Our symbiotic relationships are both good and bad for all parties. We see a weaker dollar in the next 12 to 24 months, but beyond that politics makes the world a much more fuzzy picture other than the price of everything in all currencies will be higher.

    There will be isolated macro-economic metrics that look horrible, but we don't see a new multi-generational era of global poverty or prosperity coming any time soon. The most likely scenario is just another global boom-bust cycle. Maybe stretched out a bit, but boom-bust all the same. With global quantitative easing on all fronts, expect some interesting global inflation as piles of money jerk around asset prices looking for some sense of stability.