Remember that eye-watering day just last week - May 24 when the spot future Gold price in New York plummeted by $US 36.20? The following day, 321Gold posted a piece by Peter Schiff titled: Higher Interest Rates Won't Help The Dollar. He's right, they won't. What Mr Schiff's contention actually illustrates is a typical brain disconnect in the "thinking" of investors and monetary "authorities" alike. On the face of it, this seems an historical contradiction. There was a definite instance when higher US interest rates DID save the Dollar. They were resorted to only in extremis, at the end of a decade in which the purchasing power was steadily declining and during which every other economic and political "cure" had been tried and had failed. The decade in question is, of course, the 1970s. At the end of the decade, the Fed took their hands off all their interest rate controlling mechanisms and US interest rates spiked to 20 percent plus and remained there for the best part of three long years.
This spike in interest rates began in late 1979 and ended - with a declaration of bankruptcy by Mexico - in mid 1982. The beginning of that period saw the price of Gold soar to $US 850, a level which remains its all time high to this day. The end of that period saw the beginning of the great paper asset bull market when the Dow took off in August 1982.
In the interim, the US economy went through what was then and still remains the worst recession it had suffered since the 1930s depression. It had no "choice" in the matter. For a decade, the US had been running a regime of negative REAL interest rates. By that we mean that the level of interest rates in the US was insufficient to compensate foreign and domestic holders of US Dollars and Dollar-denominated instruments for the loss of purchasing power of the US Dollar. The only way to induce Dollar holders to refrain from dumping their Dollars on the exchange market floor was to end this regime of negative REAL rates. That's what the Fed did under Paul Volcker in late 1979.
The effect was to first slow and then stop the decline of the Dollar, and then to reverse this decline into a Dollar bull market as the recession bottomed out and the perceived risk of holding Dollars was overcome by the returns available from holding them.
At the beginning of the 1980s, the US economy went into deep recession but it did not collapse. The US was still by far the world's biggest external net creditor. It was still, despite the inroads of the Asian nations and Japan in particular, the world's manufacturing powerhouse. It was perceived universally as the essential bulwark against the predations of the USSR and its satellite nations. And the rest of the world had already, by 1980, made too big a bet on the future of the US currency as the world's reserve currency to stand by and watch it fail.
For all these reasons, and many others, the US economy weathered the deep recession of 1979-1982 and the US Dollar did too. The US Dollar was rescued using one part of the IMF's recipe for "rescuing" any nation in financial distress, by means of (by all US historical precedent) sky high interest rates.
Fast forward to 2006. You will probably remember that up until mid-May and especially during the period when Gold was soaring from $US 540 to $US 720, more and more articles were appearing in the mainstream financial media harking back to the late 1970s and early 1980s. The major catalyst for this sudden interest in events which happened more than a quarter century ago was the simple fact that $US Gold prices were reaching levels not seen since that period more than a quarter century ago.
But almost every report or analysis which harked back to the period of the last BIG US recession hastened to state somewhere within it that times are different now and just because Gold is at levels not seen since 1980 does NOT mean that the financial and economic situation bears any similarity to what it was in 1980. After all, it was reported over and over again, "inflation" and interest rates are much lower now than they were then.
In 2006, the Bush Administration piles up a monthly deficit which equals or exceeds what the Carter Administration piled up in a YEAR in the late 1970s. In 2006, government funded debt is almost ten times what it was in 1979. In 2006, the US is "celebrating" its 21st year as an international net debtor and has very long since become the biggest international net debtor in history. The US was still a HUGE international net creditor in 1980. Yet official measures of "inflation" are less than HALF of what they were in 1980, and rates on US Treasury debt are less than ONE QUARTER of what they were then.
This is the problem. By any sane measure, REAL inflation - THE INCREASE IN THE TOTAL STOCK OF MONEY - is running at huge multiples of its rate during the height of the "inflationary 1970s". By any equally sane measure, US interest rates high enough to compensate foreign and domestic US Dollar holders for the POTENTIAL loss of purchasing power of the US Dollar now would have to be multiples of the level that rates rose to at the end of the 1970s when the Fed got out of the way and let the market determine US rates.
But given the gartantuan levels of debt owed at all levels - public and private - right across the US economy, interest rates are already at a level where the servicing of debt is threatening to collapse the US economy. The US economy stood 20% rates in 1980. Today, it could not stand even 10% rates and is stretched to extremis even to stand the current 5% level of the Fed Funds rate. Today, higher rates cannot help the US Dollar because the US economy would utterly collapse beneath them.
If you doubt it, consider the yield curve on US Treasury debt paper. Since late last year, that yield curve has flattened out almost completely. Indeed in February 2006, the spread between the yield on two-year and ten-year paper was negative. Right now, that spread is a mere 8 basis points (0.08%).
On top of that, since late last year, and with the exception of the recently reinstated 30 year bond, the yield curve on US Treasuries has remained at or even below the prevailing Fed Funds rate. Take a look at the yield curve on Treasuries on June 2 (Privateer subscribers only). You can see that with the exception of the yield on 30-year paper, the yield curve is at or below the current Fed Funds rate of 5.0%. The yield on "T-Bills" (three-month paper) is a HUGE 20 basis points below the Fed Funds rate.
On June 2, yields on Treasuries dived right across the board. The "reason" given was a bad US employment report, and the attendant mood swing on Wall Street that maybe the Fed wouldn't be raising rates when they meet at the end of June after all. The thing that Wall Street recognises is that higher interest rates will kill the US economy stone dead. The thing they resolutely refuse to recognise is that if the Fed DOES stop raising rates, the US Dollar is in GRAVE danger of collapse.
In fact, the US Dollar as it is presently constituted as the "reserve currency" of a global fiat money system will collapse in any interest rate scenario. If the Fed lowers rates, the cost of holding Dollars will break the economic back of the foreign central banks which have amassed so many. If the Fed continues to raise rates, the cost of servicing the already overwhelming levels of US denominated debt will decimate the US economy. If the Fed stands pat, they will signal the intention to "save" the US economy at the expense of the US Dollar. They will end up saving neither.
As Mr Schiff says: "Higher Interest Rates Won't Help The Dollar". In the short term, nothing will help the US Dollar except a sudden and draconian cut in government budget deficits coupled with an equally sudden trade and current account surplus to begin to repair the current immense net international debt. The first is unlikely to the point of absurdity. The second is quite literally impossible, unless the US almost ceases to import altogether.
A currency based on nothing but a promise to pay which has been abused like the US Dollar has for the best part of four decades is NOT salvageable by ANY economic and/or political combination of action or events. Savaging the price of Gold expressed in that currency will do nothing but delay the day of reckoning. Interest rate manipulation will do nothing but delay the day of reckoning. Even getting out of the way and letting market forces take over the setting of interest rates(for a while) - as was done at the end of the 1970s - will do nothing but delay the day of reckoning.
At the end of the 1970s, the day of reckoning was delayed for more that three decades. And throughout that period, the growth of the stock of money accelerated and the debts piled up. Now, all that is left is to keep on delaying - for a week or a month. The savaging of the Gold price we have seen over the last three weeks illustrates just how severe the situation is. So does the perverse performance of US Treasury yields.
In 1980, enough remained in the economy of the US from the days of a Gold-backed (however imperfectly) currency to allow it to weather a regime of high interest rates. Twenty-six years of rampant inflation and even more rampant credit creation later, none of that remains. Nothing can save the US Dollar now - except GOLD.