Why gold is gaining in a world awash with dollars

THE largest collection of warplanes ever assembled is airborne. Their bomb bays are burgeoning. Each flight is approaching its target for a co-ordinated strike. Their targets are not Baghdad or Basra, but the major metropolitan areas of the United States.

But wait. These are US air force planes. So why are they flying a mission that has US cities and citizens as targets?

Have scientists working for Saddam Hussein developed a drug and rendered America’s air force insane? Or has George Dubya finally flipped and ordered the extermination of all potential Democratic presidential candidates and voters?

Hide Ad
Hide Ad

Inspection of the bomb bays shows they are not filled with conventional weapons or weapons of mass destruction: No, the planes are crammed with bundles of greyish-green paper carrying the portrait of a dead president on one side and the words "In God We Trust" on the obverse. These are dollar bills.

Why, you may well ask, is the US being threatened with a massive bombardment with its own currency? Is it a Marxist plot? Karl Marx said that the way to overthrow capitalism was first to destroy its money.

On the contrary, these planes are in the sky 24/7 on "Deflation Watch" and their purpose is to save American capitalism.

A terrible fear-provoking thought is gaining ground among the guardians of the US economy. It is that the man in the street, who for decades has enabled the economy to remain on a long, upward path by consuming more than he produces, may be reaching the limit of his capacity for excess consumption and its corollary debt.

Now, horror of horrors, the ever-rapacious US consumers may be about to abandon profligacy and restore their balance sheets by consuming less and, perish the thought, saving.

In a pre-emptive campaign to prevent the US consumer from abandoning over-spending and embarking on a path of prudent parsimony, Alan Greenspan has already used up most of his conventional firepower and slashed the Federal Funds rate to 1.25 per cent.

The US consumer, like the proverbial horse, has been brought to water but is reluctant to drink more. There is not yet panic within the hallowed halls of the Fed but the spectre of deflation, last seen in the 1930s, is starting to loom larger and it is recognised that unconventional weapons may be needed to prevent it taking grip.

Dubya has already announced an economic stimulus (anti-deflation) tax-cutting initiative. There is a serious misconception that central banks can increase or decrease the money supply at will. The media make much of central banks resorting to the "printing press" to get economies out of trouble (or to get them into trouble by over-cranking the press and causing inflation).

Hide Ad
Hide Ad

In truth, the monetary system only works when there are willing borrowers and willing lenders.

In an attempt to boost money supply, the Fed may aggressively buy Treasury Bonds from the banks, thus forcing down long-term interest rates and leaving the banks with vast sums of cash to do with what they will.

But, if banks customers do not wish to borrow then this "cranking of the printing presses" by the Fed may have no impact on economic activity. Remember, this is the first time since the 1930s that the US has slumped because the cost of capital during the "bubble" was so low as to trigger excess investment.

Thus, cutting the cost of capital (interest rates) is unlikely to bring about a recovery in investment. Only a sustained resurgence of demand will, and if the consumer has also "over-spent" in the bubble, and now needs to reduce indebtedness, low interest rates will have a minimal impact on demand.

The European Central Bank, obsessed with monetary stability, seems determined to plunge Euroland into depression. Nothing could be more inappropriate than the current proposals to raise taxes and cut public spending in Germany and France to reduce budget deficits and comply with the totally ridiculous fiscal Stability Pact.

The Fed, by contrast, is prepared to think outside the box. Ben Bernanke, a recent arrival at the Fed from the academic groves of Princeton, has declared that the Fed will do all within its not inconsiderable powers to "print" its way out of trouble before deflation becomes entrenched.

We should not underestimate the efforts that will be made to prevent deflation. With the US trade deficit nearing 6 per cent of GDP, the US is already pumping out so many billions of dollars that it needs to attract about 80 per cent of all the world’s savings just to maintain the value of the dollar.

With US interest rates already lower than those in Europe, and US share valuations still close to historic bull market highs, attracting capital flows into the States is becoming mighty onerous, further pump priming will only add to the difficulty.

Hide Ad
Hide Ad

The dollar has been able to remain fundamentally and seriously overvalued for years because the rest of the world was gullible enough to believe that the US economy would always outperform and thus its bonds and shares deserved a premium rating. Some 75 per cent of central bank reserves, plus a great deal of non-US private wealth, is held in US dollar assets.

Now that the Fed has declared it will "print" as many dollars as it takes to combat deflation, holders of US dollar assets would have to be extraordinarily nave not to realise that an unlimited increase in the supply of US dollars means dollars will inevitably be worth less.

Thus, far from attracting the 80 per cent of world savings required to maintain the dollar’s value, fear of the bomb bays being opened and the world being showered in paper dollars is likely to cause liquidation of dollar investments.

In a deflationary world every country thinks its currency overvalued and, although the demise of fixed exchange rates has removed "beggar-thy-neighbour" competitive devaluations, if countries resort to the printing press to try and avert deflation all of their currencies become debased.

There is one standard against which this debasement of currencies can be measured and one asset which investors can own to protect themselves: That standard and that asset is gold.

Ian Lamont is an Edinburgh-based commentator and former stockbroker.

Related topics: