The Boat is Sinking! Throw the Dollar Overboard?

(June 7, 2011 - By Mike Getlin  IBTimes.com)

There are several lessons to be taken from the fiscal crisis of 2008 and the ensuing recession. Not least among them is the simple fact that the US government is willing to do nearly whatever it takes to stave off recession, even if it means systematically destroying the dollar. As the crisis unwound, the government created money to prop up Fannie and Freddy. They created money to bailout AIG and a handful of banks. They created money for the “stimulus” package. Then they created money through “quantitative easing” not once, but twice. The pattern is clear: the only real tool at the government’s disposal is the creation of money, and they are not afraid to use it.

Thus it’s no surprise that the abysmal economic data released in the last two weeks has analysts squawking about yet another round of quantitative easing. “QE3” as they would call it, would be just the latest in the long string of money creation and liquidity projects, most of which have yet to patch up the ailing economy. They have however had an extremely positive effect on one thing: you guessed it, the price of gold.

The US Dollar fell broadly today, continuing the downward trend it has followed for over a month. Weaker jobs and manufacturing data, and a slew of other negative numbers have raised question as to whether or not we are headed into a double dip recession. With nothing on the horizon to change that trend, it will likely be up to Uncle Sam to again execute a round of quantitative easing to try and stop the economy from sliding off the cliff. If and when this happens, gold owners will be there to pick up the pieces.

The reality of dollar depreciation is not quite as simple as some might think. We all know that the likelihood is high that the loaf of bread and gallon of milk we buy at the store will go up significantly in price over the next ten years as a result of the Fed’s money creation. What that means is the government is taking action which leads to citizens being able to purchase less with the fruits of their labors. To me, that sounds like taxes. Of course if your Congressman votes to raise taxes he could well see his career grind to a halt. Lucky for him, quantitative easing is a tax imposed by the Fed. Unfortunately you and I don’t get to vote on whether or not Ben Bernanke keeps his job.

The Chinese however, they do have some say. As the single largest holder of US Dollars abroad, when China speaks on the greenback, the world listens. That’s exactly what happened this morning when a high ranking Chinese foreign exchange official made comments that he expected the dollar to continue its slide, and warned of the massive risks in holding “excessive” amounts of US assets. The markets shuddered on the news, but this is not the first time strong words have come from China regarding the US currency. The truth is that China also has a vested interest in keeping the dollar strong, both to help support their exports, but also to maintain the value of their largest currency investment.

So what’s the real danger of a sinking dollar? This is a point that is being endlessly argued around the globe. We know it will result in much higher gold prices, but is that the only real life effect of all this money creation? Not so fast.

Don’t forget that the vast majority of the world’s oil is traded in dollars. Here’s one scenario that scares me. When you look around the western world, you see a massive difference in the cost of gas at the pump. Many European countries pay well over $10 per gallon. In a survey conducted in 2008, the US had the 45^th cheapest gas of the 155 countries surveyed by the research firm AIRINC. Most of the nations below us on the list were heavily subsidized oil producing countries.

So why do the Brits pay twice as much for fuel as we do? Taxes certainly don’t help, but the main reason is that oil is priced in dollars. That means that when they want to go buy oil on the open market, they must convert their currency to dollars first. Thus, the exchange rate to the dollar is crucial in determining how much oil they can buy for the same amount of currency. In the US, we don’t have to worry about the effect of the exchange rate as the oil is priced and sold in our own currency.

Imagine for a moment that OPEC decides to discontinue selling oil in dollars out of fear that the dollar collapse will hurt profits. All of the sudden, dollars would have to be converted to another currency before it could be bought, and the exchange rate would matter. It’s a bit similar to owning a home with an adjustable rate mortgage. When that low payment teaser rate ends, life changes very quickly for the home owner.

What would happen in an America with $8 per gallon gasoline? No one really knows. Suffice to say however, there is little doubt that our quality of life would plummet very quickly. The scary thing is that this is just one potential threat that comes as a result of throwing the dollar overboard. Since there seems to be little hope of ousting the policy makers that are pushing this destruction, the only option left to individuals is self-preservation. As such, it’s no wonder gold just continues to shine.