Emirs take pity for now but dollar's dominance is ending

By Fabrice Taylor
The Globe & Mail, Toronto
Saturday, March 22, 2008

http://www.theglobeandmail.com/servlet/story/LAC.20080322.RTAKINGSTOCK22...

Hot news for investors: The United Arab Emirates will keep the dirham pegged to the U.S. dollar. If you think you can live without that news flash, there's more: The Emirates' central bank was "conceding to U.S. pressure," Bloomberg says, after U.S. embassy officials paid a visit to the UAE central bank governor to register their concern about reports that he was considering dropping the peg.

U.S. officials clearly still recognize the value of owning the premier monetary brand in the world. What's less clear -- what's doubtful, in fact -- is how long Americans, who borrow US$700 billion every year from foreigners, will enjoy the privilege of owning the world's reserve currency. If history is a guide, according to James Grant, the dollar's days in the sun are limited, and there are repercussions for investors.

Mr. Grant is the editor of Grant's Interest Rate Observer, which has chronicled the excesses of U.S. financial markets for a quarter of a century. Along the way, he's made some bold predictions -- or repeated a handful of bold predictions - which failed to come to pass. He once said wryly that he wasn't wrong, but rather, early. He's on time now, though. Gold is up, inflation threatens, the Fed is discredited, and paper money is suspect.

The headline of the latest issue of Grant's is "Hoover without the Depression," which neatly sums up Mr. Grant's take on the latest crisis to strike the U.S. economy. "'Not since the 1930s' is the new journalistic catch phrase," he said in an interview. Not since then has the Fed lent money to investment dealers. Not since then have homes been in such a bear market. Not since then has government seen fit to intervene aggressively on behalf of borrowers.

The only trouble with these Depression-era throwbacks is that there's no Depression. Unemployment is closer to 5 per cent than 25 per cent. The economy may stop growing or even shrink, but there are no signs of the 46-per-cent peak-to-trough GDP tumble of the thirties. "When you can generate depression-like symptoms in the absence of a depression, something must be wrong with the safety and soundness of the financial system."

What's wrong, in his mind, is that this is no mere credit crunch. It's a debt problem overlaid on a long-simmering monetary problem. And the likely outcome is more inflation and a continuing decline in the value of the greenback.

The cause of this twofer is the Federal Reserve's experiment with money printing, which has gone very bad. The Fed was created precisely in response to a series of embarrassing financial crises around the turn of the last century. Fed founders held dear to an idea that seems almost quaint in today's subprime world: proper collateral.

"The soundness of the currency depended on the soundness of the collateral behind it," Mr. Grant says. That collateral? Gold. Back then central bankers and treasurers could print only as much money as they could back up with gold in the vaults.

Most countries turned their backs on the gold standard decades ago, and Fed governors have long lost any affinity they may have had for the metal. In their minds, there was no problem to an unlimited money printing press and to pushing and pulling on central bank levers to "fix prices" and control the economy.

To a degree, they were right. When you own the world's reserve currency you can finance a lavish lifestyle by printing money. His country's standard of living is raised up, he says, not by hard work but by the willingness of its creditors to keep accepting its paper currency: US$700 billion worth every year, remember, which explains why U.S. debt is at 353 per cent of GDP, the highest since at least 1921.

But can that go on? Think of the poor emirs in the UAE. With their currency pegged to the dollar, its value is falling by the day, losing purchasing power. The upshot? Inflation. The value of the U.S. Treasuries they invest their oil riches in looks dubious too.

The Fed is between a rock and a hard place: Raising rates is not an option to appease the emirs because of the currency crunch and economic weakness the Fed helped create. But low rates -- which Mr. Grant points out are negative in real terms -- don't endear foreign dollar holders to the currency.

"We can't have it both ways," Mr. Grant says. That is, the U.S. can't have a world currency and a domestic interest rate. The upshot? The dollar, like the British pound before it, will gradually lose shelf space in the vaults of the world's savers, replaced by something else.

The euro? "It looks fairly dubious too." Gold? Perhaps, he says, but only with the weariness of someone who's been early enough times with his predictions to avoid making another bold one.

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Fabrice Taylor is a chartered financial analyst.

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