Gold, the Dollar, and the Dollar Index
Good article today by Michael S. Rozeff on Lew Rockwell.com:
This article responds to a request to explain the recent strength in the dollar, by which I think was meant the dollar index. The following discussion explains some of the longer term factors that I think are important. This provides perspective on the recent movement. After that, the discussion turns to the question of gold prices.
A long-term view of the dollar index is here. The dollar index is not the dollar against gold. It is the dollar against other major currencies like the Euro, British pound, and yen. The current period of rally in the dollar (index) is from 74.82 to 82.46 today. The index had gone to a new long-term low and stabilized there for 5 months (March-July of 2008) before starting the current rally.
The dollar was strong in the early 1980s, as U.S. growth improved. However, the national debt rose sharply (it doubled) from 1980 to 1985. The 1985 Plaza Accord made matters worse. Despite the debt rise, the U.S. agreed to a weaker dollar. It also agreed to cut its budget deficit, which it didn't. By 1991, the debt had again doubled! The dollar fell sharply, from 164.72 to the 80s area where it stabilized. This was a 50% devaluation in terms of other currencies.
Increased U.S. debt is a factor that undermines the dollar. Better U.S. growth helps the dollar. The reason for this is that the dollar's value depends on its backing on the Federal Reserve's balance sheet. The backing consists of two main items: gold and U.S. Treasury debt securities. The backing of the U.S. bonds is the tax collections of the federal government. As the debt rises, all else equal, the greater debt must be serviced by the same amount of taxes. This reduces the debt's quality. The backing of the dollar worsens and it declines. The Fed could maintain the dollar's value by selling bonds, but it chooses not to do that because that tends to impact the economy negatively. As growth increases, all else equal, the dollar gains strength because the tax revenues improve and the dollar's bond backing improves in quality. The dollar index is also influenced by what the other countries are experiencing for their deficits and growth rates.
The dollar index mounted a strong rally starting in 1995 and through mid-2001. The debt rise in those years was "only" from 5 trillion to 6 trillion, which was at a far lower rate than when it was doubling every 5 years. The U.S. government ran a surplus at times and was able to retire some debt. The dollar's backing thus improved and so did its value. Meanwhile, growth was robust and that helped too.
The recession in 2001-2002 ended this rosy picture. Tax revenues fell as growth fell. Since government spending remained high, more bonds were issued. The growth of government debt accelerated sharply. The Bush administration added to this of its own accord by big rises in deficit spending. The dollar started falling in mid-2001 and really has not had a rally yet that clearly indicates a change in that trend.
The latest little rally is against some other currencies in the index whose economies have taken an even greater turn for the worse (except the strong yen). That is probably why the dollar index has shown some strength. As the U.S. enters another recession, which looks to be deep and prolonged, deficits will mount even more as growth slows. This is bad news for the dollar. The news will be bad for some other countries too that are in the dollar index, and the index need not decline if those other countries face even greater difficulties than the U.S..
The dollar index will strengthen if the next administration raises taxes and holds spending in line, as the Clinton administration did. An end to the Iraq war spending would help the dollar.
The dollar versus gold is another matter. They have to move inversely to one another. The course of gold prices tells that story. Continue reading here...
Get LewRockwell.com in your inbox - lots to learn, lots to consider!
11 October 2008 by Gerald
