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Gambling with the dollar

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Thursday, November 12, 2009

One of the many television commercials exhorting viewers to buy gold says solemnly that it is an asset whose value "has never dropped to zero," a boast that surely sets a record for minimalism. Still, the world's appetite for gold as an investment option is intensifying. Last month, India purchased 200 tons of gold at $1,045 an ounce, before the price topped $1,108 on Monday. China, too, may increasingly diversify from paper -- i.e., bonds -- into gold, the price of which, some experienced investors believe, could soar to $2,500 an ounce in three to five years. One reason for all this is U.S. behavior.

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India's 2008 gross domestic product was $1.2 trillion, so its $6.7 billion purchase was small beer. It may, however, be a large portent: Gold increasingly looks to investors to be a more reliable store of value than governments' bonds are, especially U.S. bonds as the U.S. government threatens to pile a mammoth health-care entitlement onto the nation's Ponzi welfare state, increasing the nation's debt and borrowing.

The fiscal 2009 budget deficit, triple that of 2008, was 10 percent of GDP. Lawrence Lindsey says probable policies will produce deficits of 7 percent of GDP for a decade. Ronald Reagan's worst deficit was 6 percent of GDP and for only one year.

Lindsey -- a former member of the Federal Reserve board of governors and director of George W. Bush's National Economic Council (2001-02) -- says Americans' net worth has dropped at least $13 trillion since the recession began in December 2007. What is to be done?

Americans could suddenly begin saving substantially more, but this would deepen and prolong the recession. Alternatively, America could reflate the value of its assets by printing money. Lindsey says it is already doing that -- printing bonds promiscuously and lending money to banks at negligible rates, money that banks can use to buy the bonds. This sharply increases the money supply, which sets the stage either for inflation -- too much money chasing too few goods -- or for recovery-snuffing higher interest rates to try to prevent inflation. Or for something like Japan's lost decade -- banks pouring money into government bonds rather than the real economy.

America, says Lindsey, will not be Weimar Germany, where hyperinflation caused people to rush to stores with satchels of rapidly depreciating currency. But, he adds, no country has successfully behaved the way the United States is behaving.

Suppose, he says, you owned some U.S. Treasury bonds or other dollar-denominated assets, and you were sitting in front of two buttons, one marked Buy More, the other marked Sell. Which button would you push? Obviously, Sell.

Fortunately, Lindsey says, there is so much U.S. paper circulating that not every owner can hit Sell at the same time. But if enough people, institutions or nations sell, others will not buy unless U.S. interest rates rise substantially, which can ignite a vicious cycle -- killing economic growth, thereby depressing revenue and increasing the deficit and borrowing. Irwin Stelzer of the Hudson Institute notes that China, America's largest creditor, has increased its dollar holdings 20 percent this year, so China has increased its interest in not having the dollar devalued by mass selling. But, Stelzer adds, China thinks geopolitically as well as economically and might have noneconomic reasons for encouraging a controlled flight from the dollar.

A cataclysmic event -- say, an interruption of the flow of Middle Eastern oil -- could, Stelzer says, cause the world to flee to the safety of even a depreciating dollar. But absent such an event, the world will be carefully watching a U.S. government that has a powerful incentive to try to use controlled inflation for the slow-motion repudiation of some of its mountain of new debt.

It is, however, hubris -- something abundant in Washington -- to think inflation can be precisely controlled, like an oven's temperature. It is hubris cubed to think inflation can be unleashed just short of provoking a flight from the dollar.

Perhaps Federal Reserve Chairman Ben Bernanke knows how to sop up the trillions of new dollars before inflation ignites. But will he? He knows about "the recession within the Depression" that occurred in 1937, perhaps as a result of premature confidence in a recovery.

Furthermore, he may feel duty-bound to try to use loose money to help reduce unemployment. But although the Fed has suddenly assumed stupendous powers, it still has one sovereign duty -- to preserve the currency as a store of value.

georgewill@washpost.com



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