What is a Flight from the Dollar?

A friend asked what a “flight from the dollar” looks like. I can certainly give my understanding expressed in easy-to-understand language.

A “flight from the dollar” happens when the citizens, or even the global financial system, rejects the dollar as a store of value. Here’s a little history to explain the context.

In the late 1800s, a dollar could be exchanged for 1/20.67 of an ounce of gold. This was the “gold standard,” whereby a dollar was “worth” (i.e. could be exchanged at any bank for) 1/20.67th of an ounce of gold. The banks accepted freely any amount of dollars in exchange for gold at that rate. The standard, as long as it remained in place and was respected, helped banks maintain a safe amount of reserves, a conservative amount of loans (made with real savings), and well-backed credit advances (i.e. credit creation based on commercial paper such as bills of lading and the like); and it kept the economy on a relatively even keel. The fact that every bank had to give out one ounce of gold for $20.67 in paper money kept them – and the dollar – honest, so to speak.

In 1913, the US created its first central bank, which became the arbiter, instead of private banks, of the amount of credit creation that would take place. The original rules applied by the central bank were pretty sound. Credit loans to banks were based only upon commercial paper. However, in the longer term the rules changed. Within a couple of years the central bank began to do what central banks have done for centuries, i.e. they began creating extra additional credit, which the government used to cover wartime and other expenses. 

The first episode of inflationary credit creation (what economist Edward C. Harwood labeled “inflationary purchasing media”) appeared during World War I. As the US central bank began to allow the expansion of credit above what was prudent (according to Harwood), the government spent it on the war effort. When the war was over, the central bank tried to contract that credit, which forced the country into something of a recession in the early 1920s. 

Then during the subsequent years Harwood noted that a lot of “inflationary purchasing media” had still not been cleared from the system, which was maintaining prices too high and encouraging bubbles in real estate (in Miami at the time), and in the stock markets. By 1928-29 he began to warn the public through articles published in financial journals that the previous monetary expansion was still in the system, which would probably end in another contraction. 

Indeed, a peak was reached in 1929. The central bank noticed the problem and tried to correct the imbalance by contracting the money supply. It was the right thing to do, because the excessive credit did indeed need to be withdrawn. Was the contraction too quick? Was the timing wrong? No one really knows, although multiple theories exist. At the same time, the government put in place some very strict trade policies that caused complications in the import-export markets, and we got the 1929 crisis, which extended several years into the 1930s.

In 1933 Roosevelt, in an attempt to save the gold standard, decided one day (literally) to force people to turn in their gold so that he could devalue the dollar down to 1/35th of an ounce. He explained that he didn’t want private “speculators” to profit from the devaluation. He also started the country on a centralizing-regulatory-socialist binge with his New Deal policies. Ownership of gold was outlawed. Much money was wasted in the various efforts, and the economy didn’t recover until the 1940s. By then the second world war was brewing. 

When the soldiers got home in 1945, they went right to work and got the place up and running pretty quickly, thereby probably absorbing the excessive credit created for the war effort. Given the difficulties experienced in the 1920s, the Western World decided that they needed to fiddle with the gold standard again. Global officials met up in Bretton Woods in New Hampshire and decided that the world would go onto a modified dollar-gold standard, i.e. the dollar would stay on the standard at 1/35th an ounce, and the rest of the world would use the dollar in international transactions. Somehow, they thought this would be better than a plain gold standard. 

This plan gave the US both a tremendous advantage and a tremendous disadvantage. The advantage is that nations needed to exchange their exports for dollars in order to do business, and some countries’ banks also bought tremendous quantities of US bonds as capital assets. Therefore the US could print just about whatever it wanted, and the dollars flowed around the world and never came home to roost. It's called “seignorage.” 

The disadvantage is that it is the equivalent of giving a credit card to a 16 year old.* 

It worked pretty well at first back in the early 1950s, but lavish money printing soon started again, creating another bout of creeping price inflation in the US. After all, it is not easy (or perhaps it’s impossible) for central bankers and politicians to determine with precision the amount of dollars that should be created and shared to maintain the Bretton Woods global monetary system. In around 1959, Harwood and others began to notice that in spite of the Bretton Woods fix at 1/35th of an ounce per dollar, the “price” of an ounce gold in dollars was increasing above $35 in certain markets. In other words, people were realizing that the dollar was losing its value. That’s when Harwood started getting people onto gold numismatic coins, gold stocks, gold “annuities,” and Swiss financial instruments, some of the very few ways to invest legally in gold and safe foreign assets.

This state of affairs lasted far longer than anyone thought possible, until 1971. France was getting wise about the loss of value of the dollar, and De Gaulle began asking for his nation’s gold at the official $35 price. Gold at $35 had become a good deal. It all came to a halt when Nixon “closed the gold window,” i.e. refused to pay out gold for dollars. (See this for a detailed explanation.) 

Since then, even though in the mid-1970s Americans could start owning gold again, the world has been on what is called a “fiat standard,” i.e. no standard at all. Over the rest of the decade, gold went from $35 to $800 in 1980, 23 times its previously fixed exchange rate. 

That’s a flight from the dollar.

Even though no longer in an official monetary role, gold still remains a good barometer of the value of currencies around the world. The dollar has continued to decline, and today the ounce of gold costs around $2,026. Yes, the gold exchange rate is “volatile.” But in fact it is not gold that is volatile. It is the paper currencies. After all, smart people watch economic policy and events, and when things start to get frisky, they start looking for ways to preserve the purchasing power of their money. The increased demand creates exaggerated swings in the “price” of gold. But in fact the one thing that remains constant is the underlying, on-average, longer-term stability of gold’s purchasing power. 

And the “price” of gold is one way you can measure the “lost value” of the dollar.

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* Today the US debt is over $34 trillion and climbing rapidly. This is WAY more than US production can sustain (about 145% of GDP). It is also especially dangerous when price inflation and cheap public borrowing sets in and when the Fed (rightfully albeit somewhat late) decides to take corrective action via higher interests rates. Over the past year or so, the yearly interest rate on the debt is now up to $500 billion, which is about 2/3 of the entire annual US military budget. (And here’s another interesting chart that I hadn’t seen before.)