U.S. Dollar Is The Next Financial Shoe To Drop

There are a lot of headlines lately about the debt issues in the United States (not to mention Europe and Japan). But what does this issue mean for the investor? It appears that the whole system of fiat currencies is being challenged. In other words, the real issue here is how long will the Dollar (and Euro and Yen) remain viable currencies?
A little historical background is useful. By definition, fiat currency only has value because of government regulation or law; it is not convertible into anything, like silver or gold, and is declared as legal tender by the issuing country. When citizens and foreigners lose faith in a fiat currency, the value can turn to the price of confetti. In the case of the United States, the term “not worth a continental dollar” originated during the Revolutionary War when the U.S. Continental (a fiat currency) fell badly in value and, by 1780 was worth 1/40th of face value, and by May 1781 was so worthless it ceased to circulate as money. Their fall was blamed on too many bills being printed and counterfeits circulated by the British waging economic warfare. The founding fathers of the United States were very aware of the problems with fiat currency. To prevent runaway inflation from happening again, they included in Section 10 of the United States Constitution the statement that states could not “emit Bills of Credit” and “make any Thing but gold and silver Coin a Tender in Payment of Debts.” At first they included language allowing the federal government to print money, but this was later stricken from the final version. Yes, the founding fathers did not give the federal government of the United States the explicit constitutional right to print fiat currency. Jumping forward to the modern era, rising deficits during the Johnson and Nixon administrations led to a run on the dollar in the late 1960s when foreign holders sought to convert their paper dollars to gold before the U.S. vaults became empty. Facing complete loss of the nation’s gold, Nixon took the U.S. dollar off the gold standard in 1971, defaulting on the U.S promise for countries to redeem their dollars for gold. This event made the U.S. dollar a fiat currency.
Since then, the U.S. money supply has exploded in size. By 2005, it had expanded 13 fold (for perspective, over the prior 34 year time period from 1937 to 1971 it only doubled). Such a rapid monetary expansion can lead to hyperinflation, but the U.S managed to avoid this problem because the dollar is the world’s reserve currency. This has forced the world to buy and hold dollars. But reserve status is a privilege, not a right, and while substitution would be difficult, there are increasing calls around the world to remove the dollar’s reserve status. Recent commentary by the official Xinhua news agency of China questioned whether the U.S. dollar should continue to be the global reserve currency. “International supervision over the issue of U.S. dollars should be introduced and a new, stable and secured global reserve currency may also be an option to avert a catastrophe caused by any single country,” the commentary said.
Loss of reserve status would be catastrophic for the value of the dollar. Foreigners would rush to get out of dollars, either by outright currency conversion or by bidding up the value of U.S. goods as they rushed to unload their dollar holdings. The exact impact is hard to calculate, but according to Peter Schiff of Euro Pacific Capital, the dollar could devalue by more than 70%. And this devaluation may be anticipated in the financial markets judging by the price action in gold and Swiss Francs.

The United States is in a bad financial situation where spending as a percent of GDP is above 25% and U.S. federal receipts as a percent of GDP is below 15% (Robert V. Green derived these figures from NBER, CBO, and White House data and published them at Briefing.com); never since World War II has the difference between these numbers been so large. The sad reality is the United States, in political gridlock, has lost control of its financial well being and the government’s cash flow now depends largely on the willingness of the Chinese government to buy its new Treasury debt.

The Chinese buy our debt because U.S. Treasuries have a deep liquidity pool unequaled by other places the Chinese can invest there excess cash. When the Chinese buy our debt, they also deflate the value of their currency with the view that a weaker Chinese currency helps their country by reducing the cost of their exported goods. While it is easy to argue that such a policy helps Chinese exports, the policy stunts domestic Chinese consumption by reducing domestic spending power with the overall effect of lowering China’s standard of living. By buying the U.S debt, China is essentially funding the U.S. consumer at the expense of the Chinese consumer. But the Chinese, as they lose confidence in the U.S. dollar, will find other places to invest their money.
In the end, the history of highly indebted nations that rely on overseas creditors is not good. My advice is it is far better to be early getting out of U.S dollars than late.
I am currently long gold (GTU), silver (SLV) and the Swiss Franc (FXF) and would be a buyer on dips.