The dynamics driving the dollar down


by Alasdair Macleod, GoldMoney:

This article examines the currency imbalances between US dollars and the other currencies and concludes that should foreign holders decide to reduce their dollar exposure, the consequences for its value would be dramatic.

The dollar’s problems should be laid at the door of the wishful thinkers who think the state knows better than free markets. It is that which has led to currency imbalances. Central banks attempting to manage economic outcomes by manipulating interest rates and “stimulating” economic activity have acted in defiance of Say’s law, which defines the relationship between production and consumption, and the true role of a medium of exchange. 


By dismissing this fundamental truth, the US authorities have made a rod for their own backs. Their determination to replace gold as the highest form of money with the fiat dollar has led to extraordinary levels of dollar accumulation about to be unleashed onto unsuspecting markets. A break below 100.50 on the dollar’s trade weighted index will probably be the signal. It currently stands at 101.50.

Say’s law says it simplest

John Maynard Keynes did the world a disservice with his offhand dismissal of Say’s law. Consequently, economists have lost the true relationship between production and consumption. And we have lost our understanding of the true role of currencies as a medium of exchange. Nearly all our economic errors have flowed from this dismissal. 

In order to understand the seriousness of it with respect to the dollar today, the denial of Say’s law is no less than a denial of the division of labour. Yet, plainly, the division of labour is the basis of all human economic activity. Without having something to sell, we cannot buy the things we need which we are unable to provide for ourselves efficiently or easily. Where we differ from other animals is that we develop our personal skills to maximise the value of our specialised production so that we can increase our wider consumption for the greatest relief of our needs and desires. Our individual skills are the key that provides our wealth. And it is the role of currency as a medium of exchange which allows us to turn our production into our consumption.

Several things follow from this truism. One is that if we reduce our total production, we reduce our total consumption, because the former leads to the latter. No, say the Keynesians, who put it the other way round. They say that if we reduce our consumption there will be a general glut of goods on the market and then prices will fall, leading to unemployment. The error is to not understand that first we must produce in order to consume, so that there cannot be a general glut, only changes in the level of productive output which are broadly matched by changes in overall consumption.

Surely, this can be easily understood even by non-experts. But this deliberate error — for that is what it can only have been — has led to a misunderstanding of the role of the medium of exchange. It provides the means to exchange goods of unequal value: for example, a cobbler makes shoes and boots, whose unit value will be greater than the individual food items he requires daily to feed his family. It also provides producers with the credit required to finance production, paying costs incurred before a final product is sold and creditors repaid.

This is the essence of trade. And so long as transacting individuals only produce to consume, the expansion and contraction of the sum total of money and credit purely in connection with that trade cannot alter their value in terms of goods and services generally. Not so, say Keynes’s macroeconomists, now joined in chorus by the monetarists. They claim that expansion of money and credit alters the general price relation. Both believe in manipulating credit to this end.

Again, a child should be able to understand the flaw in this argument. The general price relation is only altered when additional currency is introduced by central banks for purposes other than the credit required for the settlement of trade in free markets.

This is in defiance of the sole function of a medium of exchange, which is to act as the agent for turning our production into consumption. But it does mean that if excess currency accumulates in the form of credit additional to its use as a trade settlement medium, its purchasing power is undermined because it does not originate from the need to turn production into consumption. It is important to understand that it is this excess that changes the price relation, not changes in the level of credit per se. And this is the case with respect to international trade, where currency balances have accumulated.

When a foreigner holds unspent dollars, that person or entity can be said to be “owed” US domestic goods and services. This logically follows from the unbending precepts of Say’s law. But the majority of foreign owned dollars have actually been exchanged for product of a sort. On US Treasury TIC figures, approximately $24.5 trillion are invested in long-term US Treasuries, corporate bonds, and equities. These constitute incorporeal wealth and are therefore classed in the owners’ minds as assets, just as if they were corporeal wealth, such as property, farmland, livestock, and factories, which are similarly valued in dollars. All these assets represent consumption of the fruits of production.

It is the unspent dollars held in the correspondent banking system, together with short term Treasury and commercial bills instantly realisable, totalling some $7.2 trillion which represents the unspent balance of foreign production. It arises because foreigners have accepted dollars in payment for their goods and have yet to spend them on US goods and assets.

What are their alternatives? They can of course hang on to their dollars, spend them on US production (presumably by increasing their ownership of financial and non-financial assets valued in US dollars), sell them to acquire non-American production and assets, or exchange them for the ownership of their own or other currencies of account.

The altered character of the US economy

It will not have escaped the reader’s attention that over decades the US economy has reduced its production of corporeal goods relative to the incorporeal. This means that foreigners cannot buy much in the way of semi-manufactured and manufactured goods with their dollars, but overwhelmingly incorporeal assets in the form of securities and services. Accordingly, the US economy is said by some to have been hollowed out.

Putting services to one side, this means that by acquiring US securities, which have accumulated to a figure larger than US GDP, foreigners are committing to receive continuing dollar income streams. It is an important distinction from spending dollars on physical goods, which are not so immediately exposed to currency risk. 

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