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Some argue the US Dollar is doomed. Now that the Fed Chairman Bernanke has rolled out the printing presses for QE2, many believe the Dollar will soon be worth less than a square of toilet paper. The argument goes that this is an unwarranted expansion of currency.

The Hypothetical Gold Standard

To accept the theory that expansion of currency is unwarranted, you must believe that the more dollars in circulation, the less each dollar is worth - therefore, the value of all Dollars must add up to some imaginary value expressed in gold, or some international monetary currency baseline.

In other words, this theory requires you to believe the Dollar's value is determined as if it were still on the gold standard (fixed value against gold).

These theorists point to the drop in value of the dollar as proof QE2 and the printing presses are destroying the value of the Dollar. No doubt, printing of money cannot be considered something that enhances the value of a currency. The value of a currency against other currencies (or an independent baseline) has many factors. But the overwhelming worth of a currency to its users is the ability to invest and profit from that investment, and its value relative to gold is secondary.

Currency Valuation by Market Determination

The long term value of the US Dollar is determined by the potential of the Dollar's users to make money using that currency.

The marketplace determines the value of the dollar. Higher demand for dollars than competing currencies cause the dollar to strengthen. Today, money is flowing out of dollars for a variety of reasons - carry trade and investment opportunities top the list of reasons. Carry trade allows business to borrow in cheap Dollars, and buy another currency to invest and profit offshore.

QE2 has serious side effects with its heavy targeting of the 2-1/2 to ten year treasury range - it has sent a clear signal to the world that the USA will hold down interest rates for a real long time. Not only will it put off investors seeking yield both inside and outside the USA, but it signals both USA and foreign based business that they can borrow money at real low interest rates for a real long time. This borrowed money will be used to make money anywhere in the world.

QE Leakage

The primary intention of QE2 is to create a low interest environment for USA economic expansion - but has instead caused a flight to invest in parts of the world where investment is more profitable. Foreign investors do not need to buy dollars if they are investing in India or China. Americans seeking higher fixed yields have been driven to other currencies - in doing so are selling dollars and buying foreign currencies. Leakage of the expanded U.S. currency into the rest of the world was discussed last week.

Domestic Damage

No one seems to mention the huge number of retired Americans who depended on social security check supplemented by the proceeds from their CD's. CD's offered a low risk, fixed return - something retirees could bank on. There are no return on CD's in 2010 primarily due to the Federal Reserve low interest policy - and the Fed has signaled there will be no return on CD's in 2015 also. These retirees are abandoning CD's and moving money to higher risk bonds, or moving money to relatively safe banking accounts in other countries.

Abandoning a Strong Dollar

When money is moved from the U.S. to other countries, that causes selling pressure on the Dollar - and it drives the relative value of the Dollar down. There are no current dynamics in play which point to an end to the long term decline in the dollar. It is not a secret that the USA is no longer espousing a strong dollar policy despite protesting statements by Treasury Secretary Geithner to the contrary.

“We will never seek to weaken our currency as a tool to gain competitive advantage or grow the economy.”

The game plan is to make American products relatively cheaper than offshore products by making the Dollar worth less.

One reason given by pundits for soaring gold prices is that there is an exodus from the Dollar to a commodity that stores value. Some view gold as a currency even though only $5 trillion dollars of gold has been mined by mankind to date. Is it illogical that gold in a fiat world should act as a currency? Is it any more logical that people should accept a piece of paper (fiat currency) as a store of value? If it quacks like a duck, and acts like a duck - it is a duck - Gold is acting like a currency based on its recent pricing movements.

It was not too long ago when the investment banks used predatory policy to constrain gold prices. Today, gold is trading in a less manipulated environment - and without some of the predatory headwinds, gold likely will make up for some of the past constraints.

Gold is not Currency

Even though gold is acting like a currency, it is not a currency. Gold is not a direct exchange medium. You cannot buy your groceries with gold or fill your gas tank with gold money. Investors try for "double pops" - investing in a country with a strengthening currency. This gives you a chance to profit both from the currency AND the investment. You cannot do this with gold. Buying gold directly gives the investor only one swing at the cat.

Every investor needs to question whether they need to diversify out of dollar based investments. Gold is only one option. Many avenues to broaden investing exist including interest bearing deposits in relatively safe banking countries, direct purchase of foreign stock, and ETF's based on foreign market indexes.

Currency is a Medium of Exchange

There is one other note worth making about the value of the Dollar. That requires that we recognize the ultimate use of the Dollar as a medium of exchange - an IOU presented in return for the delivery of goods and/or services. The relative value of the IOU has a relationship to how much a country is buying and selling. When buying and selling are not nearly equal, the result is a trade imbalance.

Trade imbalances can exist without producing currency dislocations only for a short period of time, a few years. The U.S. trade deficit has been building for decades, driven primarily by two factors: (1) imports of energy and (2) manufactured goods from China. Monetary theory states that such endemic trade imbalances are corrected with an appreciation of the relative value of trade surplus currencies and depreciation of value for trade deficit currencies. Thus the value of Chinese currency should rise in value with respect to the value of the U.S. Dollar.

These currency adjustments, which would occur naturally in a free market, would make the exports of the surplus countries more expensive to the deficit countries and imbalances would be corrected. The result in the deficit countries would be inflation with respect to imported materials, goods and services until the trade imbalances corrected. To the extent that the imported goods and services could be replaced by domestic items, the inflation could be mitigated. In so doing, however, the costs of the domestic items would experience pricing pressures as well, with a competition between lowered standard of living through lower labor and production costs on one hand and through inflation on the other hand.

There is the two handed economist again, but in this case both hands deal pain to the people in countries with long standing trade deficits.

The standards of living in the trade surplus countries tend to improve as the relative valuations of currency take place.

The free market process has not been operative. Currencies are not freely traded on an open market in all cases. Some currencies are "pegged" to other currencies. An example of this is the Chinese Yuan. It is defined to have a fixed exchange rate with the U.S. Dollar. This allows trade imbalances to grow without market interference, creating ever increasing tension due to a stretching imbalance. Like a rubber band, these imbalances can stretch further and further. The question is will these tensions eventually snap like a rubber band or can they be relieved in a more controlled manner?

Economic News this Week:

The G20 meeting ended without any concrete agreements. Having lived and worked in Asia, if there was no concrete results - then no real agreement exists. Asians have a nice way to tell you no. They never say "no" - but if there is no "yes" then the answer is no. This amounts to a fundamental rejection of USA economic and monetary policy - specifically sovereign debt growth and quantitative easing. With open economic borders, USA monetary policy alone is ineffective unless all countries cooperate.

The four week moving average for initial unemployment claims dropped below 450,000 this week to the lowest level since September 2008.

click to enlarge

There has been no real trend in 2010 on initial unemployment claims, although there has been a gentle down trend since August 2010. This same down trend pattern occurred between January and March - but that trend reversed. There are some indications that this gentle down trend will remain in play through the rest of the year.

The forward indicator (the WLI from ECRI) rose slightly this week -5.7% from -6.5%. Six months ago, the WLI began its negative trend towards negative numbers - and over the last 2 months has gently been drifting upward from the -10% levels to this weeks -5.7%. The WLI is saying the economy will be relatively worse in six months but the rate of being worse is decreasing.

A summary of other economic activity this week - please follow the hyperlinks for the analysis.

Weekly Economic Release Scorecard:
Southern Asia Infrastructure Crisis
Home Foreclosures Fewer foreclosuresHousing outlook worsens
Trade Balance U.S. deficit decreasedBest export September in history
Consumers Consumer Index may be bottoming
Diesel Use Third month of slowdownOctober diesel decline indicates economy slowing
Wholesale Sales and Inventory Inventories RisingInventories Normal
Home Prices Declined in October
Rail Transport Still strong
Equities Investment Outlook Poor
Cause of the Great Depression France may have caused Great Depression by hoarding gold
Do tax cuts increase revenue?No

Bankruptcies this Week: Ambac Financial Group, Visual Management Systems

Failed Banks this Week:

Disclosure: Author owns gold, gold miners, and options relating to gold and miners.

Source: A Case for Divesting Dollars