December 22, 2003 – It is easy for economists – like generals – to fall into the trap of fighting the last war. The big monetary upheavals of the last century were caused by deflation and inflation. So it is really not surprising that most economists today focus their debates on these two monetary afflictions.
Unfortunately, by looking back instead of forward, these economists are missing the real threat to the dollar. It’s not the supply of dollars that will matter most this time around, but rather, the demand for dollars.
There are two easy ways to explain this point. First, every good has its own supply and demand. That reality is a basic principle of economics. Less well understood, however, is that money also has its own supply and demand factors.
We know about the supply of money, which is the various M’s reported by the Federal Reserve, namely, M1, M2 and M3. But economists do not have the means to accurately measure the demand for money.
Rather than throw away their various mathematical models which require dependable statistical input, they largely ignore the demand for money by assuming that it grows around 2% per annum. And most of the time that assumption is good enough for most economists. But “most of the time” is not all of the time, as we are now finding out, which brings me to the second point.
Even though we cannot measure demand, we can deduce changes in it. For example, look at the accompanying chart, which plots at each month-end since 1975 the year-on-year growth in M3.
Throughout the 1990’s, M3 growth accelerated, ever increasing the supply of money. By the approach of Y2K, that growth climbed into the double-digits, to levels last seen in the 1970s and early 1980’s. But in contrast to the result back then, this double-digit monetary growth in the 1990’s did not produce double-digit inflation, unless of course one measures the price increases of financial assets like the stock market.
In other words, the interminable and excessive 1990’s reflation created the stock market bubble. But this bubble popped as M3 growth rates also began to fall in this current decade. More recently, these growth rates have fallen precipitously, and here is the point I would like to make about demand.
M3 growth is not falling fast enough. We know this to be true because the dollar’s rate of exchange to the world’s other major currencies is falling. This observation means that the demand for dollars is growing less rapidly (if it is growing at all; it may in fact actually be declining because it cannot be measured) than the supply of dollars. Or to state this point another way, the growth in the supply of dollars is not shrinking fast enough for the dollar to maintain its purchasing power against the world’s other major currencies. Consequently, we are seeing what I have been calling for a few years now since first identifying this problem, a ‘flight from the dollar’. The demand for the dollar is waning.
Given this reality, the Federal Reserve has a couple of policy alternatives to keep the dollar from collapsing, which is an aim that it obviously seeks to do. Broadly speaking, these two alternatives are domestic and international actions.
The domestic alternative is to reduce the growth rate in the supply of dollars more rapidly, and/or increase the demand for dollars. This latter objective is usually achieved by raising interest rates.
However, because of its aim to make sure the economic recovery stays on track – no matter how wobbly those tracks may be – the Fed’s hands are tied. It has to keep pumping dollars into the system, so it can’t cut down too tightly on the supply of money. What’s more, it can’t raise interest rates. Not only would higher interest rates pop the housing bubble, it would further hobble the federal government’s already precarious financial position, and each of these outcomes would damage the economic recovery. Consequently, the Fed must seek an international solution, but here too it is a question of supply and demand.
The international demand for the dollar – like its domestic counterpart – relies largely on the dollar’s interest rates, which I noted can’t be raised. So the only alternative left to the Fed is supply, but here I am not referring to dollar supply. I am instead referring to the supply of euros, Swiss francs, Japanese yen, etc., which are the currencies against which the dollar is competing for holders.
Prevailing economic theory has it that if the supply of these currencies can be increased, then the dollar will stop declining against them. In other words, debase the euro, Swiss and yen by creating too many of them, and the dollar will strengthen against these currencies, or so the theory goes. And we will soon find out if this theory is right.
The supply of euros, Swiss francs and yen are being rapidly pumped up by the central banks responsible for those currencies. The supply of Swiss francs for example is growing by nearly double-digit rates of increase. Will this debasement of the Swiss franc and the other currencies be sufficient to cause the demand for dollars to rise, so that the dollar stops declining on the foreign exchange markets? We don’t know the answer to that question yet, but the accompanying chart of the Swiss franc sheds some interesting perspective on this matter.
In Letter No. 286 back on June 25, 2001, I presented this chart and wrote: “That the dollar could not make a new high on its last surge is an indication that its trend is reversing. Therefore, expect the dollar to reverse course at anytime within the next several weeks, with the franc rallying as a result. The target for the franc is the right shoulder that I have placed on the chart, which is the SFr 1.30-1.20 area.“
Well, here we are. The Swiss franc closed last week at Sfr 1.2596 after approaching Sfr 1.24. The objectives on this chart have been filled, so is the Swiss franc about to reverse course? Is the US dollar ready to rally?
We’ll see in due course, but here is my expectation. If the dollar rallies against the Swiss, it will be as a result of capital controls, which is a point of view I expressed back on June 16th in Letter No. 326. And if the Swiss continue to debase their currency (and if the euro and yen and the other currencies with rapid money growth also continue to be debased), the result will not be an increase in the demand for the dollar, but an increase in the demand for gold. In fact, that is what the chart of gold in terms of Swiss francs is indicating (this chart is presented in the December 20th alert at GoldMoney.com).
By expanding the supply of euros, Swiss francs and yen, central bankers are trying a new gambit to save the dollar, but they are just putting lipstick on a pig. All national currencies are fiat currency, and therefore subject to abuse by politicians. But we know how to respond, which is to continue holding goldgrams as our principle form of money.