The Daily Reckoning PRESENTS
The greenback still reigns supreme, holding sway over all other paper currencies - for now. Justice Litle explains how the dollar is still holding on as the world’s reserve currency...

There are only a few ways for the bull market in gold to play out, and supposedly a fixed ending in all cases. The yellow metal’s dollar price will violently launch into orbit at some point, arc into a near vertical crescendo and ultimately burn itself out supernova style. Either that or a long, drawn-out grind - a steady sloshing higher over the course of years, punctuated by occasional hiccups and countertrends to keep us on our toes. Or perhaps a combination of both, in homage to the disco era - a multiyear rise capped off with a blaze of glory.

But no matter how it happens, gold will eventually return to Earth. The fixed ending is a return to normalcy, which in gold’s case equates to dormancy. After all, what goes up must come down. Right? It’s only logical. That is what everyone expects. Yet what if, this time, the future doesn’t look like the past? What if gold were to climb to new highs, breaking the $1,000 an ounce barrier, and never return from whence it came? With apologies to Thomas Wolfe, what if the bankers can’t go home again?

Now that would be something.

It is usually the case that the greater the stake in a specific outcome, the less freedom one has to connect the dots. But the ability to foresee a wide range of possibilities, including the extreme and the unexpected, is a hallmark of the exceptional trader or investor. When asked what traits made him so successful, legendary hedge fund manager Bruce Kovner observed, “I have the ability to imagine configurations of the world different from today, and really believe it can happen.” In that spirit, we lay the groundwork for our golden scenario... and one cannot hardly discuss the outlook for gold without first considering the dollar.

In spite of all the pessimism and diversification talk of recent years, IMF figures show that dollars still make up roughly two-thirds of the world’s foreign exchange holdings. Eat your heart out, Charles de Gaulle. It’s good to be king.

So why is the dollar so popular? What gives America free reign to settle debts in its own currency, print more of it at will and impose its fiscal whims on the rest of the world? There are five elements currently supporting the dollar as world reserve currency. We will now discuss each in turn.

The first critical element is security, provided in the form of military and economic dominance. Charles and Louis-Vincent Gave, of research house GaveKal, theorize that the world’s reserve currency is primarily held as a form of insurance in the event of crisis. Based on this theory, GaveKal has come up with four key requirements, as follows:

Attribute #1: “The issuing country must be dominant militarily. And here the logic is simple: One holds a reserve currency for random crisis events. Wars are random crisis events. One wants to ensure that, in case of a war, one is able to buy the best possible weapons... and be sure that the weapons will be delivered.”

Attribute #2: “The issuing country must be dominant technologically (see above).”

Attribute #3: “The issuing country must be dominant agriculturally so that in case of a random crisis, reserves can be morphed into food to feed local populations.”

Attribute #4: “The issuing country must be mature financially (i.e., have developed financial markets) so that in a random crisis, the afflicted country has the ability to raise money in the financial markets.”

By this reckoning, the dollar is more than just a paper liability of the U.S. government; it is backed by the best-in-class physical strength of the U.S. military and the best-in-class financial strength of the U.S. economy. This provides a sense of security to smaller countries facing greater exposure to the dangers of political unrest, military conflict or economic shock. When the local unit of exchange is being buffeted this way and that like a dinghy in a hurricane, it is good to have a stash of dollars on hand.

The security factor also underlines why the euro, the yen and the yuan are all pretenders to the throne. While they have sufficient economic heft, Europe and Japan do not have the ability to project military power of any real significance, let alone the capability to challenge the U.S. militarily. And while China is making headway on the military front, the Middle Kingdom’s financial structure and capital markets have nowhere near the depth, breadth and stability that would be required to support reserve currency status for the yuan.

The second element underpinning the dollar as world’s reserve currency is universal acceptance. One could accurately rehash the old credit card slogan: “Greenbacks - they’re everywhere you want to be.” Whether you are a tax accountant in Togo, a spice merchant in the Maldives or a drug runner for the Albanian mafia in Montenegro, you probably accept American money. There is no greater testament to the dollar’s widespread acceptance than the enthusiastic endorsement of organized crime. Got a hundred dollar bill in your wallet? It probably has traces of cocaine on it. The dollar also acts as a go-between for parties who would have trouble conducting transactions otherwise. If I have shekels and you have kopeks, it might be tough to do a deal - I cast a dubious eye on your medium of exchange, and you on mine. If we make the transaction in dollars, however, our problems are solved. The dollar thus acts as a go-between for less liquid currencies, greasing the wheels of world trade.

The third element supporting the dollar is the network effect, where the value of something increases in proportion to the number of users. The more widely circulated dollars become, the more people are willing to use them, reinforcing their competitive advantage as a medium of exchange. Eventually, the dominance of the marketplace is so strong that it becomes very hard, if not impossible, for competitors to find a real foothold. The phenomenon can be described in slang terms with the expression, “Them that has, gets.”

Fourth in the dollar hit parade is America’s willingness to act as spender of last resort. You have probably heard pundits refer to the United States as the “engine of growth to the world.” Issuing the world’s reserve currency gives America huge privileges, chief among them fiscal autonomy, and with those privileges come responsibilities. In times of gloom, the leader is expected to step up, running deficits if necessary, until global growth gets back on track. Those who see America’s current account deficit as benign argue that this is exactly what the United States has been doing of late: spending more to make up for anemic demand elsewhere. Just being a responsible global citizen, thanks very much. A large chunk of America’s spending power is due to creative financial innovations and deep capital markets; Europeans, on the other hand, are not nearly as adept at turning their homes into spending cash while still living in them. As more exporting countries rely on the prodigious appetite of the United States, more and more dollars find their way into global circulation.

Last but not least, a significant element propping up king dollar’s throne is plain old inertia. When things have been done the same way for a very long time, it is hard to introduce change. An example that immediately comes to mind is the popular engineering anecdote entitled “standards last forever,” in which specifications for the space shuttle are traced back to the wheel spacing on a Roman war chariot. So many essential goods and services are priced in dollars today, and so many transactions are conducted in dollars by tradition, that it would be nearly impossible to coordinate a mass switchover.

So how might the king be toppled? There is precious little to work with in terms of past example. The Economist observes the last regime change:

“The pound was king during the era of the gold standard. But in the years after 1914, Britain switched from net creditor to net debtor, and by the 1920s, the dollar was the only currency convertible to gold (although the pound returned to gold in 1925). Two costly wars and two episodes of currency devaluation in Britain later, the dollar was unchallenged as the world’s chief reserve currency.”

It arguably took two world wars and a global depression to dislodge the pound. That is a fairly tall order; no wonder the consensus belief is that king dollar will maintain his throne. But for all the elements working in its favor, the reign of America’s world-beating currency has a large strike against it: The profligate policies of America itself. While it took a series of extraordinary events over the space of decades to dislodge the pound, Britain never spent others’ money with the wild abandon America has shown.

To put it bluntly, the United States has taken a jackhammer to its financial credibility. The U.S. consumer is happily in hock up to his eyeballs, betting on further housing appreciation to bail him out, while the accelerating pace of U.S. government spending boggles the mind. The current administration appears to have less grasp of financial responsibility than a 16-year-old girl set loose with her father’s credit card.

Regards,

Justice Litle
for The Daily Reckoning

P.S. Still, if the final-straw event (or combination of events) has not yet arrived, the hour is surely coming, and Katrina may have hastened it.

But you can protect yourself - and even profit - from this scenario. Find out how here: Energy = Wealth
http://www.agora-inc.com/reports/OST/WOSTF420

© 2005 Justice Litle, Outstanding Investments
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Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall)

Justice Litle is also a member of an elite group that meets occasionally to debate and discuss the new trends in the financial world and investment ideas - among other things. This monthly gathering includes the cream of the crop of financial minds - and for a limited time, the Agora Financial Reserve is open to the public at a 98% discount. Get your invitation here: The Birth of an Elite Club http://www.agora-inc.com/reports/AFR/WAFRF972 

You can sign up for a free subscription to the Daily Reckoning here: http://www.dailyreckoning.com. This essay was originally published in The Daily Reckoning.