Cool Video: Weaponization of the Dollar and the Search for an Alternative

I talked to Rick Santelli on CNBC earlier today about the dollar.  A link to the video clip can be found here.  Our brief discussion had two components.  In the first, talked about the seemingly never-ending quest for an alternative to the dollar.  I have argued that the biggest threat to the greenback's role in economics and finance does not arise from a challenger.  There is no compelling alternative. 

A far bigger threat arises from the US removing what was an international public good, a utility, if you will, namely the dollar and access to the dollar funding market and re-nationalizing it.  The US now increasingly uses it as a weapon to punish those that it regards as bad actors.  Treasury Secretary Mnuchin denies this, but that is not the way it is being experienced by others. 

In purely quantitative terms, it is difficult to refute.  SWIFT, the international messaging network used by financial institutions, is based in Belgium, for example. Still, in order to remain free to do business in the US, it had to cut Iranian banks off when America pulled out of the agreement with Iran, even though Europe remained committed.  The point here, too, is that it is not just US rivals, like Russia, Iran, and China that look for an alternative, but so do many of its allies.  

Rick noted that several central banks have been buyers of gold this year.  Some apparently think that a new financial architecture would be based on gold.  This view is also shared by some private investors as well.  It strikes me as fanciful and so 19th century.  The capital markets are so much larger than the market for goods and services.  Consider that average daily foreign exchange turnover is around $6.6 trillion a day, according to the Bank for International Settlement.  

Throughout human history, there have been around 190,000 tonnes of gold mined.  At current market prices, a tonne of gold is worth about $48 mln, making all the gold in the world (not just monetary gold) worth about $9.1 trillion.  The GDP of the world's five largest economies is about $45 trillion.  To back M2 in the five largest economies, the price of gold would need to increase at least five-fold, and more if deflationary forces are not to be unleashed.  Only about 2000-3000 tonnes of gold are mined a year, and that would limit economic expansion, 

As of a couple of years ago, the US gold holdings of about 8100 tonnes were not only the most in the world, but they were more than the holdings of the next three combined.  However, its dollar value is less than $400 mln.  The US net international investment position (what the US owns of the world's financial and real assets minus what the world own of US financial assets and real assets) is about $10 trillion in deficit.  If a new financial architecture required this deficit to be reduced by half, one would need a more than 10-fold increase in the price of gold.  

When everything is said and done, more has been said than done.  The Dollar Index is up 1% since the end of last year.  More important, from a policy point of view, the Fed's real broad trade-index was lower marginally on the year as of the end of November.  So far here in December, the dollar is lower against nearly all the world currencies in nominal terms.  

While I have been a dollar bull since before my first book, Making Sense of the Dollar (Bloomberg) was published in 2009, I have become decidedly less so over the past couple of quarters.  The policy mix has shifted toward a less dollar-supportive combination. Short-term interest rate differentials have been trending against the US since late last year, which I find often signals the latter stages of a dollar rally. The dollar is overvalued against most of the major currencies.  The elastic that connects the price of OECD currencies to value (PPP) is about 25%, and at today's prices, the euro is about 22.5% undervalued.  Hence, I think the end of the third dollar rally since the end of Bretton Woods is over or nearly so.  Yet, until there is better news from Europe and Japan, it may be a slog.   

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