Monday, May 5, 2008

Biography of the Dollar

There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. John Maynard Keynes, The Economic Consequences of the Peace.

If you have ever wondered how the dollar came to be where it is today, and what the significance it is on the world stage, the Biography of a Dollar is a good primer understanding the history of the dollar and its current status. John R. Taylor of FX concepts is a major player in the hedge fund industry and foreign exchange trading, an industry that most people do not understand, but it is an industry that plays a major role in determining the value of what the dollar is worth. Taylor bets on currency movements within markets. The value of the currency is measured against the value of other currencies. Currencies are bought and sold within thin trading margins. Foreign exchange trading gave rise to the hedge fund.

Hedge funds are not required to register with the SEC since they are only available to large institutions or wealthy individuals. Hedge Funds gained notoriety largely because of high-profile men like George Soros. Soros gained the reputation for the man who broke, "the bank of England." George Soros sold short more than 10 billion dollars worth of British pounds. Soros bet that the Bank of England would be reluctant to protect its currency by raising interest rates. Raising interest rates would only further aggravate England's recession. Soros figured, and rightly so, that England would be forced to withdraw its pound from the European Exchange Rate Mechanism. Soros bet that England would devalue its currency. England, not able to keep up with Soros, who bet against the pound, was unable to keep the pound at its agreed upon price and therefore capitulated. One man Soros was able to affect the entire economy of England, and it was estimated that Soros pocketed 1 billion dollars. This cost England an estimated 3.4 billion pounds, and is known as Black Wednesday.

What made this new industry possible? In 1944, the United States signed the Bretton Woods Agreement. This pegged the US dollar to gold bullion at 35$ an ounce. This guaranteed that every dollar could be exchanged for gold. The problem was after years of being pegged to the gold, there were more dollars than gold available, so concern mounted that there would be a run on the dollar. In 1971 Nixon took the dollar off the gold standard. This allowed the government to print more dollars and it also allowed for the nascent foreign exchange market to develop.

In 1973, Nixon abandoned the final restrictions of the Bretton Agreement. This allowed the market to determine the price of the dollar, and in a short period the American economy was in terrible shape. The Arab nations cut back oil production, leading to a global energy crisis - Gas lines grew long, patience grew short. The world saw a fourfold rise in the price of crude oil by The Organization of Petroleum Exporting Countries, (OPEC). This made worse an economic crisis that was already bad. The oil producing countries were trying to recoup the losses they perceived they would reap as a result of taking the dollar off the gold standard. The OPEC nations used the excuse that they were ceasing shipments to countries that supported Israel during the Yom Kippur War when in reality the oil embargo was in direct response to U.S. inflation to protect them against future U.S. inflation. Inflation was running at 13%. This also sparked a vicious cycle leading to higher prices on everything from food to clothing affected by higher transportation costs. Rising inflation also caused Nixon to impose his ill-fated policy on wage-price controls. Many thought this was a disaster in the making.

Arthur Burns, the then Federal Reserve Chairman was one of the principal players of negating the Bretton woods Agreement, and he went down in ignominy because of the economic disaster that ensued after taking the dollar off the gold standard. Two other Fed Chairmen followed, William Miller who was considered even more ineffectual than Burns and Paul Volcker who aggressively raised interest rates until inflation was under control. It was Alan Greenspan, however, who garnered most of the credit for the robust economy that occurred after the Nixon administration. When the dollar was taken off of the gold standard, the economy was beset with high inflation and high interest rates, but Greenspan's tenure occurred during the greatest economic boom in US history partly as a result of taking the dollar off of the gold standard. Negating the Bretton agreement set the stage for the dollar to dominate as a universal world-wide currency.

The Biography of the Dollar discusses the problem of counterfeiting. Counterfeiting has always been a problem as long as there has been currency. Not only have individuals tried to counterfeit a country's currency, but countries have tried to cripple a country's economy as a means of economic warfare. NAZI Germany tried to cripple England after the failed blitzkrieg. Washington suspects North Korea of creating what they coin as the "Supernote", a counterfeit US currency that look extremely realistic. Previously, Columbia was the threat in counterfeiting, but now it's North Korea. The Supernotes are so good that they are hard to distinguish from the real thing by the experts. North Korean leader Kim Jong ll uses the same identical paper of three quarters cotton and one quarter linen, and the same intaglio press. New methods, processes watermarks are being devised to foil counterfeiters especially in this age of high technology where counterfeiting is becoming much easier.

The Biography of the Dollar describes how some countries have dropped their currency entirely such as Ecuador. Ecuador stopped printing its Sucre, and began using dollars on a permanent basis. This is called dollarization.. It explores the good and the bad of dollarization. Dollarization is only possible however because of the dominance of the American dollar.

Can the dollar retain its global dominance? With the country's growing current account deficit, other currencies rivaling the dollar such as the Euro have put the US dollar in doubt. The United States is the largest debtor nation. Some foreign bank officials have raised concern that there could someday be a run on the dollar causing a massive devaluation of the dollar. Countries have talked about diversifying their currency reserves which in the vernacular means "dumping dollars in exchange for other currencies." Two thirds of the US government is run by the US taxpayers, the other one third is run by lending money in the form of US treasuries to foreign countries. Worldwide reserves of the dollar have already begun to decline. Russia used to hold 50% of its reserves in US dollars. That number is currently 30%. Oil, commodities, foreign exchange trading are all pegged to the US dollar, but how long can that last? If we lose currency reserve status, it will lead to a series of economic and political crisis.

However, there has to be a viable alternative before the US dollar loses its status as the global currency. The Euro has its own set of problems. There are other currencies that also have other problems, but that does not mean it cannot happen. Famed investor Warren Buffet told his shareholders in 2004 he was stepping up investments abroad over fears of the decline in the dollar. If countries lose confidence in the dollar as a result of growing deficits, the devaluation of the dollar, low interest rates or a whole host of other reasons, may decide to look elsewhere for their currency reserves.

A weak dollar is not good for America.

The Biography of the Dollar gives a good history of the dollar, its current status, and where the dollar might head.

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