May 20, 2002 – In the last letter I explained in graphic detail my oft-stated premise that a flight from the dollar is beginning. I contend therefore that the monetary disruption we now face is not one of inflation or deflation.
The arguments for inflation or deflation focus only on the supply of money, ignoring the equally important demand component of the equation. The value of money – just like the value of any good or service – is a function of supply AND demand. And it is this demand component that I expect will seal the dollar’s fate as we move forward from here.
It is my view that the demand for dollars will decline. As this demand continues to decline, the flight from the dollar will accelerate, regardless whether or not the Federal Reserve reduces the supply of dollars. Sounds hard to believe?
It may sound hard to believe because my expectation flies in the face of conventional wisdom, which states that the demand for dollars will continue to grow. But there is now some additional evidence to support my expectation that the demand for the dollar is indeed declining, and that a flight from the dollar has already begun. Please look at the accompanying chart.
This chart presents the growth rate of the quantity of dollars. The quantity I have used is M3, which is a very broad definition by the Federal Reserve of the total number of dollars in circulation. There are four distinct eras on the chart, with each corresponding roughly to one of the four decades depicted on the chart.
In the 1970’s, the supply of dollars increased at double-digit rates of growth, producing that decade’s double-digit inflation rate. In the 1980’s and until the early 1990’s, the growth rate declined steadily until it reached negative levels in 1992. There were periods of time in that year when the quantity of M3 actually declined from the previous year’s level.
The net effect of these declining rates of M3 growth in the 1980’s was a declining rate of inflation, or ‘disinflation’ if you will. Inflation had dropped from the double-digit rates of the 1970’s to low single-digit rates by the early 1990’s. Thereafter, the quantity of money started growing again.
I call the 1990’s a period of reflation. The Federal Reserve started pumping up the quantity of dollars, perhaps somewhat shaken by the decline in the quantity of dollars in 1992. Nothing like a little whiff of deflation to stir up the images of the deflation scarred 1930’s. And those images are always enough to scare the Fed into action by resorting to the printing press, and did it ever. Throughout the 1990’s the rate of growth of dollars soared, fueling stock market prices and the high-tech bubble, which brings us to the present. I’ve labeled the 2000’s on the chart with my ‘flight from the dollar’ premise.
Note that in recent months the growth rate in the quantity of dollars has been decelerating rapidly. In fact, it is decelerating at an unprecedented rate. Also note that the uptrend channel in place since the early 1990’s has been clearly broken. A major change has taken place. A new trend is emerging.
Clearly, the growth in the quantity of dollars is slowing. But even with this rapid slowdown, the demand for dollars is slowing even more rapidly. How do we know this to be true?
It’s easy. Just look at the international exchange rate of the dollar during this period that the growth in the quantity of dollars has been slowing. We all know that the dollar recently has been dropping against other major world currencies, and in some cases, it has been dropping very hard.
For example, so far this year the dollar has declined 4.2% against the Euro and 5.9% against the Swiss Franc. Thus, even though the Federal Reserve is reducing the growth in the quantity of dollars, it is not reducing the growth rate fast enough to stop the exchange rate of the dollar from falling against the other major currencies of the world. Therefore, the demand for the dollar perforce is falling.
To be precise on this point, let me restate what is happening here. The quantity of dollars is still growing, but at a rate that is rapidly decelerating. Notwithstanding this deceleration on the supply side of the equation, the dollar’s exchange rate is declining. Therefore, the demand for the dollar (if it is still growing at all) must be growing at a rate of growth less than the rate of growth in the quantity of dollars. This difference between supply and demand growth rates means that the demand for the dollar is declining.
So we have a flight from the dollar beginning. But where is the wealth in this flight from the dollar going?
Well, foreign currencies are one answer, and I note above the decline in the exchange value of the dollar. In the last letter I explained how and why that the Dow Industrials provide another answer – investors would rather hold quality blue-chip non-financial stocks than dollar denominated assets. And of course, dollars are flowing into gold, which has climbed 12.7% against the dollar so far this year.
As I noted in the last letter, “There will always be a flight from the currency into safe havens to escape ‘bad money’.” And clearly, the dollar has become bad money. It is based on nothing but promises, and many of these promises are not worth the paper that they are printed on.
They are the hot-air promises of politicians. They are the now discredited promises of Enron and other deadbeats that will never repay their loans to the banks. And they are even the promises of the banks themselves who would like their depositors to believe that they are managing depositor money prudently and wisely. One only need look at the mountain of derivatives held by the banks to know that their promise is empty too.
For a while now, people have ignored this reality. Money continued to flow into the dollar, with the consequence that the dollar climbed against the Swiss franc and euro. But no more.
The tide has turned, and no jawboning from the Federal Reserve or the US Treasury about their “strong dollar” policy will stop that force. The flight from the dollar is beyond their control, unless…
Does the Fed and the Treasury have an alternative to stop the flight from the dollar? Yes, they do. All they have to do is turn the dollar from ‘bad money’ into ‘good money’, but there is only one way in which they can do that.
The US government must abandon its thirty-one year old experiment in which the dollar has not been defined as a weight of gold. In order words, we need to go back to a gold standard, but the odds of that happening are close to zero. So look for the flight from the dollar to continue.