Betting Against the Dollar Jude Wanniski December 2, 2003

With gold now over $400 and the euro nudging over $1.20, the dollar bears are looking smart these days. Warren Buffett and George Soros are making news with their bets against the dollar. According to Barron’s, Goldman, Sachs expects the euro at $1.44 next year. The old twin-deficit hypothesis supposedly lies at the root of dollar weakness, the  culprits being the $500 billion trade deficit on current account and the $500 billion federal budget deficit. Advocates of the idea suggest the only cure for the dollar’s slide are dramatic increases in the national saving rate, so Americans will buy fewer goods from abroad. If Americans will not save, the government should tax more of their incomes and save for them. This will help with the other deficit, if the receipts of the higher taxes are used to reduce the deficit and not to increase spending. This twin-deficit theory occupied serious economic thought in the 1970’s, with the added neo-Keynesian wrinkle that a weak dollar was also good for the economy because it would make American goods cheaper and the Japanese would buy more of them (and sell fewer of their more expensive goods to Americans). As Establishment doctrine, the twin-deficit hypothesis lasted until it ran into the Reagan Revolution, when tax cuts coincided with rising budget deficits and falling interest rates. Also coincident was a 50% decline in the gold price in 18 months, the dollar strengthening in the forex market, and the trade deficit persisting here while the trade surplus persisted in Japan. 

The classical supply model explained these apparent inconsistencies with the argument that while fiscal and monetary events influence each other, they are in the first instance separate and distinct. That is as true today as it was then. There is an optimum monetary policy, an optimum tax policy, an optimum spending policy and an optimum regulatory policy. Politics is all about trying to locate these optimums through the institutions that have arisen over the ages with those tasks in mind. Polyconomics is all about trying to keep track of the variables and make educated guesses on a host of questions, including the direction of the dollar and whether to bet with it or against it. So are Buffett and Soros right, or will they be unhappy with their bets against the dollar? Let’s think about that.

One of the things that make analysis in our classical model easier than it is for others is our starting assumption that there is always an optimum dollar price of gold. In the absence of a gold standard that would keep gold constant, its price does move around. Since 1971, it has been as low as $35 per ounce and as high as $850. But if you know where it is optimum and fix it at that spot, you could leave it there for decades, even centuries, and it would remain optimal. Taxes and spending and regulatory policies are a different matter because they MUST be altered continuously to take into account the changing circumstances of the national economy, including the demographics of the population. As the President and the Congress fiddle with these considerations, their decisions have an impact on the dollar price of gold and, ipso facto, the dollar’s relative position against forex. To complicate matters, every foreign currency is moving according to the fiddling its government is doing with tax, spending and regulatory policies. 

In our framework, there are still forces at work pulling gold down and working to strengthen the dollar against the Euro and yen, and these should get help early next year when Congress gets back to work on the WTO’s problem with the Foreign Sales Corporation. With Medicare off his plate, House Ways&Means chairman Bill Thomas should have something ready for the President by March. Wall Street will like what it sees, and so will the exchange economy. If this had cleared Congress this year, we believed it would have hastened the stock market’s advance to a DJIA of 10000 and at the same time increased the demand for liquidity to help last spring’s tax cuts on capital strengthen the dollar against gold and forex. Another positive force has been the regime change in California, with it now more likely that steps will be taken to stop the erosion of its capital stock with obtuse tax and spending policies. 

There are plenty of negatives in the mix, however. The Sarbanes/Oxley corporate governance legislation does not seem to have lightened up, with regulators every day finding new, creative ways to levy cash fines on the business community. The Patriot’s Act is clearly another regulatory tax on the dollar’s international utility in ways Congress never intended, pushing some multinational transactions out of the dollar, which helps explain the 1.20 euro; we continue to track this problem and will report on it with new developments. 

Still another drag is the President’s protectionist thrust with steel, textiles and now Chinese television sets. It may be my imagination, but one of the reasons Karl Rove has been finding it so easy to raise $200 million for the Bush re-election campaign are these trade maneuvers. We’re now told the administration will lift the steel tariff in order to head off WTO penalties, but meanwhile the Commerce Department is handing out myriad exceptions to companies that can’t compete unless they can import cheaper foreign steel. Both political parties play at this game and have been for decades, but it is now endemic to big-ticket presidential campaigns. It doesn’t help that mega-billions are being spent on Iraq and Homeland Security, with government contracts making lots of businessmen happy to make political contributions. These factors also weigh on the demand for dollar liquidity, but should recede as the economy continues its slow expansion and the labor market tightens further. 

The twin deficits are of course horrendous, but because they are primarily the residues of the monetary deflation now behind us, they have probably peaked in this range and will begin to recede going forward. The trade deficit is certainly no problem, as it is the direct result of capital inflows from the rest of the world, which is responding to the much improved economic climate in the USA arising from the tax cuts on capital. The administration has been yelping about China’s bilateral trade surplus with the US, but China is now in trade balance with the rest of the world and should soon run sizeable trade deficits as the capital inflows swamp export earnings. If China follows Russia’s lead with a flat tax, which is the buzz in Asia, the media will be filled with complaints that we are exporting precious capital to a Communist country, i.e., running a bilateral trade surplus with the PRC. This was the outcry in the 1950s when Japan ran sizeable trade deficits with the US as its economy began its post-war boom. 

At $400 gold, it will be some time before other prices catch up, with some commodity prices still inching their way back to equilibrium with $350. If it stays in this range, it would take years as contracts unwind to translate into a serious rise in the CPI. Think of 1971 when gold was at $35. If it had stopped at $40 instead of soon going to $120 when Nixon took us off the gold standard, inflation would have been so slight and gradual it would have only been a mild irritation. Think of gold at $1400, four times $350, and you will appreciate the difference between then and now. The WSJ Monday ran a piece on how “the Inflation Monster” may be coming back. So far, it is more like an “Inflation Mouse,” and there are no economic reasons on the horizon feeding it while there are some likely to starve it. Always excepting some unexpected bolt from the geopolitical blue akin to 9-11, by mid-2004 the dollar should be under $400 and the euro should be under $1.20. If you happen to run into Warren Buffett or George Soros, tell them for me there are now better things they can do with their money than place bets against the dollar.