The Age of Instability

Unprecedented policies always bring unintended consequences. Weidentify these hidden fractures. There are many at the moment, and we’ll be writing to you about those in the months ahead.

The ongoing currency war is not new. In fact, the war has been raging since 2010. That’s when President Obama announced the National Export Initiative (NEI) in his Jan. 27, 2010, State of the Union.

The president declared that it was the goal of the United States to double exports in five years. Of course, the U.S. could not become twice as productive or twice as populous in five years. The only way to double exports was to trash the currency, and that’s exactly what happened.

Although it was not widely noticed at the time, the NEI was the start of a new currency war. This was the most momentous development in international economics since Nixon abandoned the gold standard on Aug. 15, 1971. The repercussions are still being felt, and the potential impact on your portfolio has never been greater.

To understand the importance of this raging currency war, some history is needed.

From the Bretton Woods conference in 1944 until Nixon abandoned gold in 1971, the international monetary system operated on a gold standard. All major currencies in the world were pegged to the dollar at fixed exchange rates, and the dollar was pegged to gold at $35 per ounce.

Because of these pegs, non-dollar currencies were indirectly pegged to gold, and to each other. The International Monetary Fund could allow the currency pegs to be adjusted, but it was a laborious and protracted process. (But some countries had already broken their pegs prior to 1971.)

Still, on the whole, it was a fixed-rate system with the dollar and gold as its anchors. This system cracked up in 1971. It was not immediately replaced with a new system. From 1971–79, the world muddled through first with a new gold peg (at $42.22 per ounce), then with floating exchange rates and then with the first efforts at a European monetary system (called “the snake”).

None of this was stable.

The world experienced multiple recessions and borderline hyperinflation, which reached a crescendo in January 1980. At that point, annual dollar inflation reached 15%, interest rates hit 20% and gold spiked to $800 per ounce — a 2,200% increase from the old $35 level.

The international monetary system was collapsing. The world was spinning out of control.

Then, on the brink of total collapse, two individuals stepped in to save the system. One was Paul Volcker, chairman of the Federal Reserve. The other was President Ronald Reagan. Volcker took interest rates as high as needed to kill inflation. Reagan cut taxes and regulation to encourage growth in the U.S. economy.

It worked.

Inflation came down, growth went up and soon the U.S. became a magnet for savings and investment from around the world. The Age of King Dollar had begun.

From 1980–2010, the world was not on a gold standard, but it was on a de facto dollar standard. Under the leadership of Treasury secretaries James Baker (Republican) and Robert Rubin (Democrat), the U.S. told the world that the dollar was a stable store of value. Trading partners could not anchor to gold, but they could anchor to the dollar.

This new “dollar standard” prevailed through the Plaza Accord (1985), the Louvre Accord (1987), the Mexican Peso Crisis (1994) and the Asian-Russian Crisis (1998). U.S. leadership under Presidents Reagan, Bush 41 and Clinton were resolute. The strong dollar was the new gold standard, and it was here to stay.

Yet nothing lasts forever, especially in international economics. The Global Financial Crisis of 2008 put an end to the Age of King Dollar and gave rise to a new currency war.

Wars have an official start date (when someone fires the first shot), but they are usually years in the making. The new currency war is no different.

The war process started with the G-20 leaders’ summit in Pittsburg in September 2009. It was at that meeting that Mike Froman (a key economic adviser to President Obama and now U.S. trade representative) devised a global “rebalancing” plan.

Froman got Obama to convince world leaders of the need for rebalancing inside the major economic zones. He did this to jump-start the global recovery from the worst recession since the Great Depression.

- Source, Jim Rickards via the Daily Reckoning