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EXECUTIVE SUMMARY
America's Deficit, the Dollar & Gold

by Tim Congdon
World Gold Council Reserch Study No.28

Professor T. G. Congdon, CBE is one of Britain's leading economic commentators. He was a member of the Treasury Panel of Independent Forecasters (the so-called "wise men") between 1992 and 1997, which advised the Chancellor of the Exchequer on economic policy. He founded Lombard Street Research, the City of London's leading economic research and forecasting consultancy, in 1989, and is currently its Chief Economist. He has recently been appointed to a research professorship at Cardiff Business School, where he will be writing a book on The Monetary History of the UK, 1945 - 2001. He is also a visiting professor at City University Business School. He has written a number of books on monetary policy, contributes widely to the financial press, and makes frequent radio and television appearances. He was awarded the CBE for services to economic debate in 1997.

EXECUTIVE SUMMARY
America's Deficit, the Dollar & Gold (click here for full commentary)

Introduction: Can the dollar remain the world's dominant currency?

Trends in the USA's external payments
-- Summarizing trends in the USA's external payments since 1945

Is a big fall in the dollar needed?
-- Policy options
-- Heavy fall in dollar is inescapable

Can the coming slide in the dollar be reconciled with its status as the world's dominant reserve currency?
-- Why do nations hold foreign exchange reserves?
-- The coming slide in the dollar: how will it affect the demand for the dollar as a reserve asset?
-- Will gold become more attractive as a reserve asset?

---

Introduction: Can the dollar remain the world's dominant currency?

With the USA accounting for over a quarter of global output, American economic leadership is an established feature of the international financial scene at the start of the 21st century. The dollar is accepted as the world's main currency, and it dominates both governments' reserve holdings and trading on the foreign exchanges. But in one key respect the dollar looks vulnerable. In the last few years the USA has run a vast current account deficit on its balance of payments. The deficit has been the largest in money terms, and the highest as a share of gross domestic product, in American history; it has also dwarfed the largest deficits incurred by other nations, including nations that have been a byword for financial mismanagement and bankruptcy.

The story of the USA's external payments since 1945 is one of a remorseless slide, from a massive trade surplus and a commanding status as the world's biggest creditor in the late 1940s, to the erosion of the surplus and the emergence of a trade deficit, to an increase in overseas obligations, and finally to the unprecedented trade deficits and the position of the world's biggest debtor today.

A vital question raised by the USA's external debt and deficits is, "can the dollar remain the world's dominant currency, and in particular the favourite asset in government holdings of foreign exchange reserves, while the USA continues to build up external liabilities at the recent rate?" Further, if the dollar's pre-eminence is weakened by the USA's external imbalances, "what other reserve asset can compete with it?" These questions have become more relevant with the introduction of the single European currency, the euro. Several leading European statesmen have said -- openly and in forthright terms -- that one aim of the euro is to supplant the dollar as the world's principal currency.

The dollar's prospects are also fundamental to the future monetary role of gold. Gold has diminished sharply as a share of international reserves since the 1970s. Although many explanations could be provided for the reduced official demand for gold, undoubtedly important have been the decline in inflation and the restoration of respect for paper currencies. Are the USA's large external deficits a sign of a weakening of anti inflationary resolve? Do they foreshadow a collapse in the dollar? And would a collapse in the dollar not only benefit the euro's international prestige, but also renew gold's monetary role?

The questions are not new. Indeed, an argument could be made that they have been inherent in the post-war international financial system. The USA has been expected to create easily traded financial instruments, including large and ever-growing dollar balances, to meet the world's rising demand for liquidity. But to create such balances it has to incur external deficits and the deficits undermine the dollar's credibility. This tension -- between the need for deficits to provide the world with claims on the USA and the risk that such deficits makes the claims unattractive to hold -- was brilliantly described in Triffin's Gold and the Dollar Crisis. The book emphasised "the Triffin paradox", that the USA could not indefinitely expand the world's dollar holdings and maintain the convertibility of the dollars into gold as the fixed price of $35 an ounce.

Of course, the situation today is very different from that in the late 1950s and early 1960s when Triffin was writing, but a link remains between the quality of the USA's management of its currency and the appeal of non-dollar assets, including gold, to international investors. As this study will demonstrate, the scale of the USA's external deficits in recent years has undoubtedly given new relevance to long-standing questions about the dollar's international role.


Trends in the USA's external payments

In 1945 and the immediate post-war years the USA enjoyed a huge economic advantage over the rest of the industrial world. Because the USA had generally recorded a surplus on the current account of its balance of payments in the first half of the 20th century, its overseas assets dwarfed those of other countries. The United Kingdom -- which had been similarly placed only 40 years earlier -- had been forced to sell the bulk of its overseas assets in order to cover heavy external deficits in the two world wars. Negotiations between the USA and the UK about the institutional framework of post-war international relations took it for granted that the USA was the world's dominant creditor nation. In the resulting Bretton Woods system the dollar and the pound sterling were the two reserve currencies, but in reality the dollar was pre-eminent.

Some rebalancing of the world economy over the next two or three decades was to be expected, as Europe and Japan returned to pre-war levels of output. The scale of the American lead in the late 1940s was exceptional and could not last. In the event economic growth in Europe and Japan in the 25 years from 1950 ran at an unprecedented rate, removing much of the initial gap between them and the USA in output per head and living standards. The post-war liberalizations of trade and payments encouraged nations to specialize in areas of comparative advantage, which reduced the diversity of their production as they concentrated on products to be sold in foreign markets. The reduction in tariff barriers by the USA was an important part of the wider process and stimulated rapid growth in its imports.

In fact, the USA's imports of goods grew far more than its exports -- with only occasional cyclical interruptions -- throughout the period of Europe's post-war economic renaissance.

Although the USA remained a big creditor nation in 1971, the erosion of the current account position since the early post-war years undermined international confidence in the dollar. The USA's money supply growth had also been rather high in the late 1960s, so that the world economy arguably had "too many dollars." As the world's central banks wanted to increase the proportion of their assets in gold, they asked the US Government to exchange their surplus dollars into the precious metal. The consequent drain on the USA's gold reserves forced it to suspend the convertibility of the dollar into gold, removing a foundation stone of the Bretton Woods structure. The episode demonstrated the relevance of trends in the USA's external payments to international perceptions of the dollar, both against other currencies and against the ultimate reserve asset, gold.

The apparent entrenchment of a trade deficit was accompanied by unconvincing monetary policies, with the USA's Federal Reserve overshadowed by the German Bundesbank and the Swiss National Bank in the commitment to sound money. The dollar lost half its value against the Swiss franc between 1973 and 1979, and also fell heavily against the German mark and the Japanese yen. High inflation rates around the world hit confidence in paper money. The dollar price of gold -- still officially $35 an ounce in early 1971 -- averaged $614.50 in 1980 and briefly touched $850 in January 1980. Gold was favoured as an investment vehicle because in several industrial countries the rate of inflation exceeded the interest rate on deposits, implying a negative real return on money balances.

Mr. Paul Volcker was appointed Chairman of the Federal Reserve Board in 1979, with the task of curbing American inflation. In the year to December 1979 the USA's consumer price index rose by 13.3%. Volcker recognized that a sharp rise in interest rates was needed, both to restore a real return to savers and confidence in paper money, and to dampen excessive growth of credit and money. The Federal Reserve limited the quantity of reserves supplied to the US banking industry, letting the critical fed funds rate find a market-clearing level. In 1980 and 1981 it bounced around from month to month, but was typically in the teens. US banks' prime rates stayed at over 20% for most of 1981.

Despite the clear adverse trends in international flows of both trade and investment income, the late 1990s was a period of great investor enthusiasm for American assets. This enthusiasm owed much to the success of American entrepreneurs in developing new computer, telephone and information technologies, which encouraged talk of a "New Paradigm" of endless prosperity. Heavy capital inflows into the USA reflected investor excitement about the New Paradigm and made it easy to finance the current account deficit. The spread of American investment banks and news media around the world reinforced the image of the USA as the dominant participant in the world economy.

American leadership was obvious, even obtrusive, in the summer of 1997. A severe financial crisis erupted in South-East Asia, following the failure of the Bank of Thailand to prevent a devaluation of the baht in July. Share prices fell heavily around the world, and for a few weeks in October and November the bond market was virtually closed as a source of corporate funding. Mr. Greenspan decided that the USA had to act as "importer of last resort" to the world economy. The Federal Reserve cut interest rates to boost demand in the USA. The deliberate intention was to stimulate purchases from the over-indebted countries of South-East Asia and Latin America, and so to overcome their balance-of-payments difficulties.

But the result was to widen yet further the USA's trade and current account deficits. Indeed, the slide into deficit in the late 1990s was far more rapid than at any other time in the post-war period. The monthly trade deficits by mid-2000 were as large as the quarterly trade deficits only three years earlier. The wider trade deficit added to the current account deficit, while the sequence of large current account deficits increased foreign claims on the USA. Inevitably, the deficit on investment income also became larger.

Summarizing trends in the USA's external payments since 1945

This narrative account of trends in the USA's external payments in the second half of the 20th century has identified a persistent erosion of the creditor position held by the USA in the immediate post-war years. In the late 1940s the USA had a surplus on trade in goods, and a larger surplus on trade in goods and services. Further, because it had acquired substantial foreign assets in the first half of the 20th century, it had a surplus on international investment income. The overall surplus on the current account -- the sum of the trade surplus and the surplus on investment income (only slightly qualified by a deficit on transfers which reflected the USA's great power role) -- appeared structural in nature. It was self-reinforcing year by year because the assets bought with the surplus implied increased surpluses on the investment income account. Further, there was a powerful economic justification in the world's most technologically advanced nation spreading its expertise to other countries by investing in them and acquiring claims on their future output. In 1950 the USA's creditor status seemed impregnable.

Over the next 50 years everything changed. Between 1950 and the early 1970s imports grew faster than exports, with only occasional cyclical interruptions. 1973 was the last year that the USA had a surplus on trade in goods and services. The slide in this part of the international accounts was nevertheless largely offset by a healthy and growing surplus on investment income, and even in the early 1980s the current account was roughly in balance. A possible sustainable outcome would have been for the USA to stabilize both the trade deficit and the surplus on investment income as proportions of GDP. Instead extraordinarily high interest rates were required to restore faith in the dollar as a sound currency, after the shock of double-digit peacetime inflation rates in the 1970s. The resulting dollar over-valuation hampered US exports, and the gap between exports and imports widened again. A deficit on the current account -- as well as on trade in goods and services -- became the norm.

Inevitably the sequence of current account deficits caused the USA's foreign liabilities to overtake its assets. By 1998 its payments of international investment income also exceeded its receipts; by early 2000 the deficit on investment income was running at an annual rate not dissimilar to the typical surpluses recorded on this item in the previous 20 years.

To summarize, over 50 years a surplus on trade in goods had become a deficit, a surplus on trade in goods and services had become a deficit, a surplus on investment income had become a deficit, a persistent current account surplus had become a persistent deficit, and a substantial excess of foreign assets had been replaced by a substantial excess of foreign liabilities. Whereas in the middle years of the 20th century the USA was the world's dominant creditor nation, by the century's end it was the biggest debtor nation. Moreover, no signs of a stabilization of the payments position had yet emerged. At mid- 2000 the USA's current account deficit exceeded 4% of GDP and was by far the highest figure on record. At the start of the 21st century it is realistic to forecast that the USA will soon register a current account deficit of almost 5% of GDP.


Is a big fall in the dollar needed?

How will the USA tackle its external deficit? Will the emphasis be on expenditure-reduction rather than expenditure-switching, on demand restriction rather than devaluation, or will policy-makers be indifferent to the question and take no active policy steps whatsoever?

The first type of policy -- known as expenditure-reducing -- takes it for granted that imports are a reasonably stable proportion of expenditure. If so, policy can reduce imports only by cutting domestic expenditure. Expenditure-reducing policies include tax increases to lower disposable income, retrenchment in public expenditure and increases in interest rates. In principle, expenditure-reducing policies could eliminate an external deficit without a change in the exchange rate.

The second type of policy response is "expenditure-switching." The classic type of expenditure-switching policy is a devaluation, a sudden, once-for-all and policy-determined change in the exchange rate. But a milder version of the same basic strategy is a gradual decline in the exchange rate unimpeded by foreign exchange intervention and blessed by policy-makers. Tariffs are also sometimes included in the armoury of expenditure-switching weapons, although nowadays their use is restricted by international agreements.

Policy options

The option of total indifference -- or of "benign neglect" -- should not be dismissed out of hand. There is at least an argument that policy-making politicians and bureaucrats cannot know the deep-seated determinants of payments deficits and surpluses between nations, just as they cannot know the ultimate causes of corporate and personal financial deficits and surpluses within nations. However, governments do have to be concerned about sharp changes in the international demand for their debt and in the repercussions for their banking systems of abrupt swings in international sentiment towards their currencies. The Asian crisis of 1997 showed that a sudden loss of confidence may interrupt the banking flows -- notably loans from the international banks -- which have previously financed a large current account deficit. Given the scale of the USA's external deficit, it would be foolhardy for American policy-makers to ignore it altogether.

The three studies considered here had different approaches to the subject, but one common message emerged. It was that sustainability -- however defined -- could not be easily restored by policy actions which ignored the exchange rate. The Papaioannou and Yi paper implied this result in a simple and compelling way. If the boom of the late 1990s was not the main cause of the widening of the trade gap, something else had to be the culprit. Their paper was cautious in its even-handed references to three "non-cyclical forces," but in reality surely only one such force -- the strong dollar -- had to take much of the blame. The analyses by Obstfeld and Rogoff, and by Mann, were more frank in their comments on the exchange rate. While acknowledging that the scale of the downward exchange rate move could be moderated the longer the adjustment period, Obstfeld and Rogoff mentioned dollar depreciations in the 12% - 45% range. Mann conceded the dependence of her results on the divergence between the income elasticities of demand for the USA's exports and imports, but her base case without devaluation was obviously unsustainable and even a 25% devaluation was insufficient in the long run.

When three separate research exercises arrive at the same broad view, that view becomes difficult to challenge. The conclusion has to be that expenditure-reducing policies cannot, by themselves, take the USA back to external sustainability. The three studies were published at different times -- in September 1999, in August 2000 and February 2001 -- but events soon confirmed their message. In 2001 the USA suffered a sharp slowdown in the growth of domestic demand, with numerous media references to "the recession" by late in the year. The slowdown reduced the current account deficit somewhat, but it was not enough to bring the deficit down to the levels generally regarded as sustainable. With the bounce-back in the economy in early 2002, the trade and current account deficits again started to widen. No doubt expenditure-reducing measures could work if they were on the necessary scale, but this might involve a big recession and serious damage to the world economy as well as to the USA. The verdict has to be that expenditure-switching action will have to occur sooner or later. More concisely, the dollar will have to fall in value against other major currencies.

Heavy fall in dollar is inescapable

It may be that the adjustment lasts over a decade and that the fall in the dollar is only 10% or 20% from its level in early 2002. But a more plausible assessment is that the adjustment will occur in under a decade and require the dollar to fall by between a quarter and a half (against competitor currencies, on a trade-weighted basis) from its peaks.


Can the coming slide in the dollar be reconciled with its status as the world's dominant reserve currency?

Why do nations hold foreign exchange reserves?

Any discussion of the future of the dollar has to be set within the broader context of financial geopolitics. An argument can be made that -- in a world of floating exchange rates -- governments do not need to hold reserves of foreign exchange and gold at all. The underlying thought is that changes in exchange rates will ensure that payments between nations balance, without the need for official purchases or sales of foreign exchange. As such purchases and sales are therefore unnecessary, so also is a government-owned stock of gold and foreign currency. The world today has a hybrid currency system, with the currencies of big countries and the European currency area floating against each other, while the currencies of small countries are sometimes fixed against a big-country currency and sometimes floating. There is good evidence that the small countries' reserves tend to be mostly in the currency of the big country to which their own currency is linked, or with which they have close trading and financial ties. Nevertheless, virtually all governments -- including the governments of big countries with floating exchange rates -- hold reserves. Clearly, the nature of the international currency system cannot be the only determinant of their demand for reserves.

Insight is gained by recalling the historical development of international financial arrangements and the geographical distribution of reserve holdings today. The salient feature of the historical record is that -- until the late 20th century -- governments' international reserves were dominated by gold. In the 19th century this was a necessary and inevitable by-product of the gold standard, which was managed by the principal trading nation, Britain. In the early 20th century British decline implied the absence of a global hegemon and considerable geopolitical instability. This instability was evidenced not only in two world wars, but also by severe restrictions on trade and financial flows between nations in the inter-war period. Because of the prevailing uncertainties, the governments and peoples of different nations were unwilling to build up large paper claims on each other. Quite simply, they were afraid that debtor nations -- or even debtors in creditor nations -- would not pay up. Gold had the key virtue that it had intrinsic value; its credibility in payment did not depend on the promise of a particular nation or government. In extreme circumstances, when nations were at war or faced trade embargoes, gold was a reliable international money. Unlike paper money, it could be expected to serve as a cross-border store of value and medium of exchange at all times.

In other words, governments held monetary reserves not merely to protect a particular exchange rate, but because of geopolitical instability. In times of national emergency, and in particular when war was threatened or had broken out, these reserves could be mobilized to buy weapons and essential imports, such as food and oil. In the polycentric world economy of the early 20th century -- when several powers were striving for leadership -- gold was the most basic reserve asset.

The greater part of world output is produced in North America and Europe, but countries in these two continents do not hold most of the world's foreign exchange reserves. Instead Asian countries are by far the largest holders. The discrepancy between their share of world output and their share of world foreign exchange reserves is striking. A possible explanation is the recent Asian crisis, which reminded nations such as South Korea and Thailand that their governments ought to have foreign exchange reserves in order to facilitate the servicing of their private sectors' international debts. But this cannot be the whole story. Asian countries had a disproportionately high share of total foreign exchange reserves well before the beginning of the crisis with Thailand's devaluation of the baht in July 1997. Moreover, as Table 5.1 shows, the most sizeable foreign exchange reserves are held in Japan, China and Taiwan, two of which (Japan and Taiwan) are international creditors. Singapore also has unusually ample foreign exchange reserves for a small country, particularly in view of its massive net foreign assets apart from its reserves.

Table 5.1: The composition of the world's foreign exchange reserves, end-2001

Why, then, does Asia have such a large demand for foreign exchange reserves? A case can be made that a vital underlying factor in these countries' demand for foreign exchange reserves is continuing diplomatic instability in East Asia and, more specifically, the unpredictability of China. China is not only the world's most populous nation, but also potentially a leading economic power, yet its policies remain hard to read. By holding large quantities of dollars deposits and US Treasury bonds, other Asian governments may believe they have diplomatic clout in Washington. In the extreme, they may believe these holdings give them the means to apply pressure on US policy.

The coming slide in the dollar: how will it affect the demand for the dollar as a reserve asset?

The message of the last section may be summarized by saying that nations' need to hold foreign exchange reserves and their demand for particular reserve assets are influenced by both economic and non-economic considerations. Reserves are held for economic reasons -- to give governments some power over exchange rates (particularly if the exchange rate is fixed), to facilitate the servicing of external official debt and to provide support to the banking system in the servicing of its external debt. But they are also held for non-economic reasons, particularly to reinforce governments' diplomatic and military capability in an uncertain geopolitical environment.

How much would the international demand for the dollar as an international reserve asset be undermined by a large and protracted fall in its value? The answer depends partly on the relative importance of the economic and non-economic considerations in the demand to hold it. A fair comment is that the non-economic demand to hold the dollar -- the demand based on geopolitical imperatives -- may be little affected by a fall in its value. The diplomatic and military motives for holding dollars may be insensitive to exchange rate fluctuations. (But that may not be entirely comforting for the USA. By bringing the role of non-economic factors in the Asian demand for dollars more to the fore, the USA's perhaps unwilling involvement in a major theatre of international tension is clearly anticipated.)

On the other hand, the economic demand to hold the dollar in foreign exchange reserves seems certain to be undermined by a decline in its value. This economic demand for reserves seems to be the relevant one for most European and Latin American nations. A dress rehearsal for the possible future foreign exchange dramas was provided in the 1960s and 1970s, when the appreciating deutschemark and yen gained ground relative to the two traditional key currencies, the dollar and the pound, as reserve assets. The fall in the international value of both the dollar and the pound must have affected their appeal to official holders of foreign exchange. If the dollar were again to lose over a quarter of its value (as suggested at the end of Chapter 4), these holders could not be indifferent. They would want to have another asset of more stable and predictable value.

The euro has been widely canvassed as an alternative to the dollar. The combined GDP (about $7,000bn) of the eurozone's members is smaller than the USA's GDP (over $10,000bn) at current prices and exchange rates (May 2002), but the difference between them is a gap, not a chasm. At present the euro's weight in the world's foreign exchange reserves is much less than implied by the eurozone's and the USA's relative economic size. If the dollar were to plunge heavily in value against the euro, an adjustment to a more balanced pattern of reserve holding would be logical. (Similar remarks might also be ventured about the yen, but Japan's economic difficulties over the last few years appear to disqualify it from an expanded reserve currency role for the time being.)

However, the euro has two fundamental weaknesses as a reserve currency. The first is that it is a most unusual construct, the currency of an area with 12 national governments. No other example can be cited of significant sovereign nations sharing a single legal-tender currency. The debate about the relationship between monetary union and political union is far from settled, and a case could be made that the 12 "governments" are members of a de facto political union. But they continue to think of themselves as national governments, with responsibilities for banking supervision, deposit protection, debt management and so on. The extent of these responsibilities, and in particular the demarcation of their roles relative to the European Central Bank's, are questions of great institutional complexity and political difficulty. But these questions are also important to governments and central banks in Asia, Latin America and the rest of the world, when they decide the currency denomination of their reserves. A fair comment is that -- unless a fully-fledged political union emerges in Europe -- the euro will be handicapped in its competition with the dollar. The dollar would have to be extremely weak over a long period for the euro to overcome the unattractiveness inherent in the circumstances of its birth.

The euro's second weakness is more deep-seated. The nations of the Eurozone face an unprecedented economic and social challenge in the early 21st century from demographic trends. Not only will the number of old people be rising relative to the working-age population, but the working-age population will be falling in most of the eurozone's members. From the late 2010s the fall will exceed 1% a year in some countries, severely restricting economic growth. The contrast with the USA, where immigration seems likely to cause labour force expansion more or less indefinitely, is marked. Their different demographic patterns imply that the USA will increase in economic importance compared with the Eurozone in the opening decades of the 21st century.

Will gold become more attractive as a reserve asset?

A reasonable case can therefore be made, on institutional and strategic grounds, that the euro will not rival the dollar as a reserve asset in coming decades. Yet this study has argued that dollar has to fall heavily against other leading currencies, with its exchange rate down by perhaps between a quarter and a half, to facilitate a resource shift of 4% - 5% of GDP into the USA's balance of payments. On the one hand, the dollar seems irreplaceable; on the other hand, it looks thoroughly unattractive. How is the conundrum to be resolved? And is this where gold can make a comeback?

Much will depend on the return on dollar assets. It is worth emphasising that the dollar may be losing value relative to, say, the yen, but dollar bonds could still give a better overall return than their yen-denominated alternatives because they have a higher yield. If the yield on dollar assets rises to persuade international money managers to keep them, dollar assets will remain worthwhile investments even in a weak-dollar environment. Gold has the serious disadvantage that, by itself, it offers no yield. It is true that an income return can be secured nowadays by gold loans in the derivatives market, but the return is modest compared with that available in dollar bonds. Gold could overcome this drawback only if the real return on dollar paper assets were to be hit by rapid inflation. If inflation were to exceed the interest rates on dollar deposits and bonds (as it did in the 1970s), the negative real return on dollar assets would cause wealth-holders around the world -- including governments and central banks -- to reconsider the investment merits of gold. If the gold price were rising in line with or faster than the general price level, the return on gold would be above that on dollar paper assets. Gold would again be a more attractive reserve asset.

The key issue here is whether dollar depreciation is associated with high American inflation. As the double-digit annual inflation rates of the 1970s came as a shock to savers, it took them time to catch up with the different investment context. Interest rates lagged behind inflation and real interest rates became negative, creating the ideal conditions for rising prices of gold and other so-called "hard assets" (oil, real estate, commodities). No one can say for certain whether the dollar's coming fall will be accompanied, once again, by an upturn in inflation. Crucial will be central banks' -- and particularly the Federal Reserve's -- attitude towards the causes of inflation. The intellectual underpinnings of Volcker' assault on inflation in the early 1980s, that inflation is caused by excessive growth of the quantity of money, is now profoundly unfashionable in the USA and other English speaking countries.

Perhaps the greatest imponderable of all is whether the global political and economic stability of the 1990s will prove to be transient or more lasting. Tension between Western values and Islamic fundamentalism has been a background theme in much geo-political discussion for many years, but the events of 11th September 2001 made the subject more urgent and problematic. The Middle East has traditionally been a significant importer and holder of gold, and the demand for gold in jewellery remains stronger in Saudi Arabia and the Gulf states than in other societies with a similar level of income per head. If these nations were to weaken their military and economic alliances with the USA, there could be a reduction in the official reserve demand for the dollar as well as an increased private sector interest in gold as a safe haven asset.

At any rate, it must be true that a sudden collapse in the dollar's external value is likely to feed back to the USA's domestic inflation rate. (4) As Preeg has warned in The Trade Deficit, the Dollar and the US National Interest, the most serious threat from the payments deficits is "the familiar syndrome of financial markets tending to overshoot equilibrium levels when reacting to perceived imbalances," with the result being "an excessively large decline in the dollar". (5) Although policy-makers around the world accept that exchange rates are set by market forces and are understandably reluctant to meddle with currency fluctuations, they need to be alert to the dangers of continued large American payments deficits. They cannot avoid the message that such deficits will have to be countered -- sooner or later -- by a fall in the dollar; they also cannot deny that, if the dollar's fall is too large and compressed into too short a time-scale, it will raise American inflation and shatter the confidence in paper assets built up in the 1980s and 1990s.

Table 1: Global reserve changes (end-year; SDR bn)

by Tim Congdon
September, 2002

Reprinted by USAGOLD by kind permission of the author, Tim Congdon of Lombard Street Research (www.lombardstreetresearch.com), and the World Gold Council (www.gold.org). Further use without consent is prohibited.

Copyright © 2002. All Rights Reserved.
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