What happens to gold if the dollar collapses as the U.N. suggests?
Now the U.N. warns of dollar collapse. If it happens how ill it materialise and what would it mean for the price of gold?
Posted: Tuesday , 07 Jun 2011
Last week the U.N. warned of a possible collapse of the US dollar - if its value against other currencies continues to decline. The U.N. mid-year review of the world economy did not get extensive coverage. Their economic division said that a crisis of confidence in the dollar, stemming from the falling value of foreign dollar holdings, would imperil the global financial system. This trend had recently been driven by interest rate differentials between the U.S. and other major economies and growing concern about the sustainability of the U.S. public debt, half of which is held by foreigners including the Chinese government.
There is a real sense of both desperation and denial about the debt crisis and the global nature of the debt crisis. On Friday Moody's threatened the U.S. with a downgrade if the ‘ceiling' is not raised by mid-July. Bad labor figures made QE 3 more of a possibility and we see a continued slowdown in the developed world economies.
The solution of creating more public debt to cure a private debt crisis will be seen as a blunder and will likely lead to greater financial and economic woes. Part of the solution will be to utilize gold in the monetary system in hopes that it will support and shore-up the monetary system. What else is there that is trusted globally?
Is the U.N. economic division incompetent? Are their opinions of little consequence?
The statement they made is huge. A collapse of the US dollar! Maybe the news is too much for the media and the world to cope? Maybe we're in denial. "So far, so good!" said the man who fell off the 50-storey building, as he passed the 12th floor...
Importance of the US Dollar
The US dollar replaced gold as the fulcrum of the global money systems of the world in 1971 at a time when its value was falling alongside the British pound. It was accepted back then because it was tied to the oil price. This made the US dollar indispensable. If you used oil you needed the dollar to pay for it. You had to convert every other currency to get oil. Everyone sold it in the US dollar.
Moreover, the U.S. persuaded Europe (at the time led by President Charles de Gaulle) to stop converting their dollars into gold and accept them as vital currency. The link to oil forced their hand. The dollar had no other virtues at the time, and so that ingredient changed their thinking.
We had thought many times that the oil producers themselves would have broken the link as the dollar's reputation floundered. But they all realized that their country's power was, in a way, permitted by the kind permission of the U.S. -as we saw in Kuwait, then in Iraq and no doubt, by extension in Libya. The U.S. guarantee of security has made them putty in U.S. hands.
Even O.P.E.C. realizes that things are changing and their oil is all they have. Middle Eastern oil producers discussed setting up a Persian Gulf currency the year before last, but nothing has come of it. There will most likely be no Gulf currency unless monetary chaos ensues. If the dollar collapses, their incomes will collapse with it, and in turn their power base. They mostly likely have a plan B. Until then they will keep oil prices in the US dollar and raise them as the dollar falls.
Russia is another kettle of fish. They are not part of O.P.E.C. and will accept the Yuan in payment of their oil as well as the dollar. Iran is fearful, but independent of the U.S. and has discarded all their dollar reserves as well as priced their oil in Euros. But the rest of O.P.E.C. will keep their oil priced in the dollar.
Since the oil price fell back to $35 in the credit crunch, they have demonstrated that they can manage the oil price. For the last year we've seen the price of oil more than compensate for the fall in the US dollar. Right now it is holding the $100 level up from $80 last year, countering the fall in the dollar against hard currencies. As a result the oil price has been steady in the euro.
Now that the U.S. consumer (and the U.S. recovery) is faltering we hear loud calls for increased oil supplies. This would drop the oil price, but be unacceptable to O.P.E.C. The U.S. government will accept higher oil prices because of the importance of the $:oil link.
It looked as though the world was stuck with the US dollar until two new elements emerged to change the picture...
Mismanagement of the US Dollar
Apart from U.S. gold reserves, there are only a small amount of currencies to protect the U.S. if the dollar were to become unacceptable for international payment. U.S. foreign exchange reserves are structured so that the dollar is the only global reserve currency. It's rather like the use of English in the world. Why learn another language when English is the globally-accepted language? To date foreigners have had to accept the dollars because there is no viable alternative. If the States needs more they print more.
Because of its connection with oil, the dollar will be used until other nations can pay oil producers in other currencies, and if that occurs then usage of the dollar will shrink considerably. Furthermore, The U.S. balance of payments developed this perpetual trade deficit, a form of tribute exacted from the rest of the world. Over the last forty to fifty years, this has worked well as developing countries use the dollar to promote growth. It would work even better if the management of the dollar were handled with its global reserve status in mind and not the U.S. economic situation as the priority. Who cares the world boomed over the last half century?
Once dollar issuance increased to fund imports -as well as to counter the credit crunch-global economic interests were subject to the health and integrity of the U.S. economy. From the day the euro was first issued in 1999 until now we have seen a 46% decline in the value of the dollar against the euro alone. The rest of the world cannot afford to allow the U.S. to continue to take advantage of the world. Still worse, the government deficit in the U.S. has ensured that they are getting increasingly reliant on the reinvestment of foreign (mainly Asian and oil-producing nations) surpluses into the U.S. for its solvency.
Now the U.S. is facing a downturn and is heavily extended on the credit front. Nations are closer to making changes to the currency hierarchy in hopes they can overcome a potential dollar collapse. There is a point when actions against the dollar will be precipitous. The poor, Friday labor report has us watching the dollar fall and points to levels beyond €1: $1.50.
Holders of dollars have to act in the interests of retaining the value of their reserves. This can mean supporting the dollar on foreign exchanges or it can mean selling the dollars for assets, resources and other foreign currencies. At some point, it will mean not accepting the dollar in payment of foreign goods. It is only a matter of time for the dollar to be removed from its pole position, where it is already causing so much volatility and damage to profits.
The biggest potential damage that could blindside the dollar is a switch by Asian nations from pricing their products in the U.S. dollar to the Yuan or other currencies. This is so they stop accumulating dollars; however, they still need it for as long as oil is being sold in the dollar.
This position can only be changed if oil producers (other than O.P.E.C.) accept currencies other than the dollar. These changes are needed now, but they will not come until the damage to the dollar's value can be ‘contained' by the surplus holders. China is already using Roubles and the Yuan to pay Russia for oil and the day may not be far off when Europe does the same. If O.P.E.C. felt the pain of a dollar collapse (or even excessive inflation inside the U.S.) it might accept other currencies from buyers (U.S. excluded). O.P.E.C. cannot continue raising the dollar oil price because of the outcry it would cause in the U.S.
THE EMERGENCE OF ASIA
U.S. global wealth and power is on the decline. China is the world's second largest global economy. If the current rate of development is sustained it is only a matter of time before China becomes the world's largest -before the Yuan becomes the world's reserve currency. It is only a matter of time before nations will need Yuan in their reserves to pay for Chinese imports.
Part of the emergence of Asia is the replacement of the dollar in global trade. The only dollars reserved are to pay for U.S. goods and oil. When other currencies are used in place of the dollar, the purchasing power of the US dollar will decline. This is happening fast!
There is nothing to convince us that the will stop declining. From now until then, the gold price will move in the opposite direction.
Julian Phillips is a long time specialist analyst of the gold and silver markets and is the principal contributor to the Gold Forecaster - www.goldforecaster.com - and Silver Forecaster- www.silverforecaster.com - websites and newsletters