Wednesday, October 7, 2009

Revisiting Triffin's Dilemma, and gold as an escape hatch

This will probably be my last post on gold for awhile. I want to move back into energy issues over the next few weeks, but I felt there were a few more things that I wanted to say about gold. I will return to the paper I wrote in March on the dollar and comment on what appears to be a growing reality - that gold's use as a monetary asset is waxing.

The paper I wrote in March commented on the special dynamics that apply to the US dollar, that prevent the adjustments one would expect from a country with a large and persistent trade deficit. While there seems to have been a marginal resumption of the bearish dollar trend, anecdotal evidence appears to support the idea that foreign asset preferences remain favorable to the dollar (the past 5 months of TIC reports are one piece of anecdotal evidence that this is the case.) Furthermore, although foreign creditors such as China have been vocal in their opposition to large US deficits, their actions do not match their words. Trade deficits and budget deficits have a strong correlation The Chinese might want the US to have more fiscal responsibility. However, the continued pegging of the Yuan (and pegging of other trade partners) to the dollar means that either the US government or the US citizenry must be in deficit. It has been widely observed that the US consumer is "tapped out" and is not going into more debt. So long as the Chinese, Saudis, etc, keep their exchange rates pegged at stimulative levels, either the US consumer or the US government will have to be in deficit. Actions speak louder than words, and the continued currency peg means that the Chinese prefer a US deficit (either public or private) to a fairly valued currency.
As much as the Chinese want a pegged currency for economic reasons however, they are now realizing that at some point their store of dollars will not be worth much in real terms. The possibility of replacing the dollar as the reserve currency is immaterial to this fact. Regardless of whether the US dollar is replaced as the reserve currency, its value will decline so long as economic activity is healthy. The fact that gold remains as a monetary asset that cannot be devalued is a fact that I think is slowly dawning on the large dollar holders of the world. It is for this reason, more than any other, that the continued increase in gold price is assured. Gold will be the safety valve, the escape hatch, and the attempted route out of the dollar holder dilemma.

I like to theorize about various options the Chinese face in dealing with their large dollar foreign exchange holdings. Assuming that they will at some point realize their dilemma of dollar exposure, how might they go about a change? If you feel I have missed any possibilities, please feel free to comment below.

Option 1: Increase the value of the Yuan
Costs: 1) decrease in exports, employment, and GDP
2) a decrease in the value of the dollar relative to the Yuan decreases the nominal Yuan value of foreign exchange holdings.

Benefits: 1) Increased purchasing power of the Yuan.
2) Long-term financial and economic health of the US is increased. Since the majority of foreign exchange is held in US dollars, this means the long term real value of these holdings might be stabilized.

Option 2: Continue the pegging of the Yuan.

This is the inverse of option 1
Costs: 1) Supporting a dynamic that results in continued budget deficits or private deficits (S-I<0) in the United States. Since the majority of foreign exchange is held in dollars, this destabilizes the long term real value of the large Chinese foreign exchange. This is a cost that may well be discontinuous, meaning that it will seem to be a small cost, and then dramatically shift to being a huge or total loss. Amazingly, this cost seems not to have dawned on the Chinese monetary authorities until after the 2008 financial crisis.
2) Decreased purchasing power of the Yuan; so long as economic activity is robust, this increases the price of real goods (particularly energy) and would stimulate inflation in China, (in spite of sterilization by the CB.)

Benefits: 1) Continued strength in exports support short-term employment and GDP goals.
2) Continued pegging allows the nominal value of Chinese foreign exchange to remain high in Yuan terms.

Option 3: Continue pegging but divest foreign exchange into gold and other real assets

Benefits: 1) Allows the continuation of advantageous trade terms. Exports>Imports keeps employment and GDP numbers high.
2) Nominal Yuan value of foreign exchange holdings are maintained.
3) Real value of foreign exchange holdings are maintained due to a diversification into real assets.
4) Dependence on the long-term solvency and productive capacity of the US is decreased.

Costs: 1) Potential for a bubble to form in real assets (particularly real monetary assets such as silver and gold).
2) The real value of foreign exchange will still go down since the possible scale of divestment into real assets is limited compared to the size of forex reserves.

In essence the costs of option 3 are more subtle but still present: either the amount of divestment is not significant, or it will create bubble values in the assets that are chosen for diversification. In spite of these costs, I think that option 3 probably represents the smoothest transition for Chinese and other dollar holders out of their dollar trap dilemma.

For the US the implications of this strategy will be increased financial stability, but an increase in the cost of real goods in the US market. The Federal Reserve will continue to be placed in an untenable position: any attempt to head off inflation will increase the value of the dollar but immediately crash the US economy. This appears to be the holding pattern that we are currently in, but I imagine that we will need to go through at least one more iteration of crashing the economy before the Fed catches on to this dynamic.

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