Bond''s Wallace Street Journal: The bad guys in silver are outnumbered now

Heading for a fall, by fiat

The Economist
February 26, 2004
a href=http://www.economist.com/finance/displayStory.cfm?story_id=2459841http:/...

Is the problem with the dollar only that it is falling?

It has certainly been doing that. This month, it fell
to $1.29 against the euro. This is its lowest-ever
rate against the euro, and represents a decline of
19 percent since the beginning of 2003. In
trade-weighted terms, the dollar has fallen less over
the same period (15 percent), but mainly because
Asian central banks have been intervening heavily
to stem their currencies' rise against it. Of late, it
has been wobbling around unconvincingly: America
needs a weaker dollar to correct its
current-account deficit.

But given the dollar's role as a currency of last
resort, some wonder if its decline heralds not just
an economic adjustment by the United States but
a crisis of sorts in the value of paper money itself.

Money in its present form is a relatively new
invention. For most of human history money meant
either gold or silver, either directly, or indirectly by
means of the quot;gold standardquot; which meant, at least
in theory, that all paper money was backed by gold.

Enthusiasm for the gold standard evaporated in the
1930s, when it made dreadful conditions worse. But
it was adopted in a watered-down version after the
Second World War, when only the dollar was backed
by gold. This arrangement made some sense, since
America held three-quarters of the world's gold stock.

But it came to an end in 1971, when inflationary
pressures in America caused the country's
manufacturers to become uncompetitive and forced
the country off the gold standard. Since then the
world has relied on quot;fiat money,quot; so-called because it
is created by government fiat and is backed only by
the promises of central bankers to protect the value
of their currencies. It is the value of those promises
that some are now questioning.

Certainly, those promises have been worth only
much in recent years. In the early years of fiat
money, inflation took off, especially in America, in
part because of the two oil shocks of the 1970s.
This debased the value of the dollar, and the price
of gold climbed from $35 an ounce to $850.

It was only in 1979, in his famous quot;Saturday night
special,quot; that Paul Volcker, then chairman of the
Federal Reserve, raised interest rates sharply to
clamp down on inflation. The gold price
subsequently fell sharply and in its place came a
bull market in government bonds that has, with a
few sharp interruptions, continued to this day.

Although central banks around the world still hold
about 30,000 tonnes of gold in their reserves,
many have been offloading their stocks over the
years. They can earn only a nugatory rate of
interest on these stocks (by lending them out)
compared with what they can earn on government
bonds. For most people, gold has been relegated
to the status, in the words of Keynes, of a
quot;barbrous relicquot;; its price has risen only feebly
when investors have fretted about inflation.

Those who doubt the continued worth of paper
money as a store of value point to two things.
The first is that the price of gold has been rising
even though official inflation is low. From $253
an ounce in the late 1990s, gold now fetches just
over $400 an ounce, and it rose as high as $430
an ounce this year.

It is not just the price of gold that has been rising:
so, too, have the prices of precious and base
metals. There may, of course, be many other
reasons for these rises. China's rapidly expanding
economy is gobbling up metals and other
commodities for its factories. Moreover, the rise
in the price of commodities also reflects the
weakness in the dollar: these rises look much less
impressive when quoted in euros or yen. But the
rise in the price of gold in particular has raised
questions.

The biggest of these -- and the second main
reason for concern -- is the amount of debt that
rich-country governments have been running up.
America's official budget deficit has surged in the
three years since George Bush became president,
to around $520 billion and climbing.

But this is just the shortfall this year. The
government's total future liabilities are much larger.
In fact, according to a forthcoming book by
Laurence Kotlikoff, an economist, the present value
of the American government's future obligations,
taking into account promised pensions and
health-care benefits, is a staggering $45 trillion.
European governments are only slightly better at
managing their budgets -- witness the breaching
of the single currency's growth and stability pact.
Japan's attempts to coax its economy back to life
have left it with a gross national debt of some
160 percent of GDP, the highest of any big country.
No country has tried harder to debase its currency.

In theory, such debts would not be tolerated for
long by investors, since the easy way out for central
banks is to quot;monetisequot; them with inflation. Bond
prices would fall (and thus yields rise) as investors
worried that they would be paid back in a debased
currency. But capital markets currently seem
oblivious to spiralling debts. At some 4 percent,
yields on 10-year American Treasury bonds are
close to their lowest in two generations, although
this is partly explained by huge purchases by Asian
central banks. Yields elsewhere are also very low,
nowhere more so than in Japan, where ten-year
government-bond yields are now 1.3 percent.

The problem may be that bond investors, far from
being farsighted, are in fact myopic, and are perhaps
being fooled by the temporary disinflationary effects
of excess capacity and debts built up over the bubble
years in both Japan and America. Perhaps, too,
investors have been lulled into a false sense of
security by the performance of central banks in
recent years, and the independence that has been
granted to many of them by governments.

But this very aura of inviolability may be storing up
problems, since it means that governments can
borrow still more at cheap rates. And if governments
then find themselves crushed by debt, you can rest
assured that this independence will be taken away.
And then, once again, the paper in your pocket will
only be as good as a politician's promise.

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