Suiting Up for a Post-Dollar World

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The global
financial crisis is playing out like a slow-moving, highly predicable
stage play. In the current scene, Western governments are caught
between the demands of entitled welfare beneficiaries and the anxiety
of bondholders who fear they will be stuck with the bill. As the
crisis reaches an apex, prime ministers and presidents are forced
into a Sophie’s choice between social unrest and bankruptcy. But
with the "Club Med" economies set to fall like dominoes,
the US Treasury market is not yet acting the role we would have

Our argument
has always been that the US benefits from its reserve-currency status,
allowing it to accumulate unsustainable debts for an unusually long
period without the immediate repercussions of inflation or higher
borrowing costs. But this false sense of security may be setting
us up for a truly monumental crash.

There is fresh
evidence that time is running out for the dollar-centric global
monetary order. In fact, central banks outside the US are already
making swift and discrete preparation for a post-dollar era.

To begin, the
People’s Bank of China has just this week decided to permit a wider
trading range between the yuan and the dollar. This is the first
step toward ending the infernal yuan-dollar peg. While the impetus
behind this abrupt change remains a mystery, I have a sneaking suspicion
that, as my colleague Neeraj Chaudhary explained in his commentary
last week, the nationwide labor strikes were a prime motivator.

In response
to the 2008 credit crunch, the Fed printed so many dollars that
the People’s Bank of China was forced to drive Chinese inflation
into double digits to maintain the peg. The pain has fallen on China’s
workers, who have seen their wages stagnate while prices for everything
from milk to apartments have skyrocketed. This week’s move indicates
that, regardless of its own policy motives, the Communist Party
can no longer afford to keep pace with the dollar’s devaluation.
The result will be a shift in wealth from America to China, which
may trigger a long-anticipated run on the dollar, while creating
investment opportunities in China

Just days before
China’s announcement, Russian President Dmitry Medvedev rattled
his monetary sabre by telling the press of his intention to lead
the world toward a new monetary order based on a broad basket of
currencies. Giving strength to his claim, the Central Bank of Russia
announced that it would be adding Canadian and Australian dollars
to its reserves for the first time. Analysts suggest that the IMF
may follow suit. While Russia floats in the limbo between hopeless
kleptocracy and emerging economy, it does possess vast natural resources
and a toe-hold in both Europe and Asia. In other words, it will
be a strategically important partner for China as it tries to cast
off dollar hegemony.

Speaking of
Europe, the major powers there are moving toward a post-dollar world
by rejecting President Obama’s calls to jump on America’s debt grenade.
The prescriptions coming from Washington translate loosely to: our
airship is on fire, so why don’t you light a candle under yours
so that we may crash and burn together. Given that dollar strength
is largely seen as a function of euro weakness (as Andrew Schiff
discussed in our most recent newsletter),
debt troubles in the eurozone’s fringe economies have created a
distorted confidence in the greenback. However, as you might imagine,
Europe has higher priorities than being America’s fall guy. Led
by an ever-bolder Germany, the European states are wisely choosing
not to throw themselves on our funeral pyre, but to wisely clean
house in anticipation of China’s rise.

In another
ominous sign for the dollar, the Financial Times reported Wednesday
that after two decades as net sellers of gold, foreign central banks
have now become net buyers. What’s more, more than half of central
bank officials surveyed by UBS didn’t think the dollar would be
the world’s reserve in 2035. Among the predicted replacements were
Asian currencies and the euro, but – by far – the favorite was gold.
This is supported by Monday’s revelation by the Saudi central bank
that it had covertly doubled its gold reserves, just about a year
after China made a similar admission. There is no reason to assume
these are isolated incidents, or that the covert trade of dollars
for gold doesn’t continue. To the contrary, this is compelling evidence
that foreign governments are outwardly supporting the status quo
while quietly preparing for the dollar’s almost-inevitable devaluation.
What people like Paul Krugman believe to be a return to medieval
economics may, in fact, be the wave of the future.

In peacetime,
hardened troops will likely tolerate a blowhard general for an extended
period; but when the artillery opens up with live ordnance, an ineffectual
leader risks rapid demotion. The newspapers are now riddled with
hints that foreign governments have lost faith in Washington and
the dollar reserve system. It seems to me only natural that after
a century of war, inflation, and socialism, the next hundred years
would belong to those people who hold the timeless values of hard
money and fiscal prudence. Unfortunately, our policymakers are not
those people.

26, 2010

Browne is senior market strategist for Euro Pacific Capital.

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