So far in the US-China trade war, China’s been the one taking it on the chin. Its stock market’s plunged over 20%, and the Yuan, the Chinese currency, is down nearly 8% against the US dollar. On the other hand, equity markets in the US, as measured by the Nasdaq 100, S&P 500, and Russell 2000, are up ~10% year to date, and the US Dollar (USD), as measured by the US Dollar Index, is also up, about 3.5% YTD (year-to-date). Let’s dig a little deeper into the Dollar Index, how it came to be, and how President Nixon put America on a path to $21.4 Trillion of debt.
What is the US Dollar Index? The US Dollar Index measures the value of the US dollar against a basket of foreign currencies. The Intercontinental Exchange is a private company that publishes the US Dollar index. It also lists a futures contract on the US Dollar Index. A futures contract is a derivative of some underlying index. Futures contracts allow traders to speculate on the future value of the US Dollar index.
According to ICE (InterContinental Exchange), the US Dollar Index is a geometrically-averaged calculation of six weighted currency exchange rates versus the US Dollar. Those currencies, and their respective index weighting, are:
- Euro 0.576
- Japanese Yen 0.136
- British Pound 0.119
- Canadian Dollar 0.091
- Swedish Krona 0.042
- Swiss Franc 0.036
Notice the Euro has the largest weight. The reason for this is the Dollar should be valued against its major trading partners, since ultimately, the majority of currency exchange is done in the course of international trade. The current weighting is only valid if US-European trade is substantially higher than with any other partner. This is not entirely accurate, and therefore, according to Investopedia, change is coming for the way the US Dollar Index is calculated:
“In the coming years, it is likely currencies will be replaced as the index strives to represent major U.S. trading partners. It is likely in the future that currencies such as the Chinese yuan and Mexican peso will supplant other currencies in the index due to China and Mexico being major trading partners with the United States.”
The US Dollar Index was originally developed in 1973 by the US Federal Reserve. What was significant about 1973? It was the year the US Dollar was floated. By that we mean the value of the USD was no longer determined by the Gold Standard.
WHAT IS THE GOLD STANDARD?
In 1934, the US Government passed a law that said $1 was equivalent to 1/35 oz of gold; in other words, gold was valued at $35 per ounce. This USD/Gold exchange rate lasted until 1973. Prior to 1934, the exchange rate had been $20.67 per ounce of gold. Taking the value of gold from $20.67 to $35 dramatically devalued the dollar; specifically, it was a 69% devaluation. This meant an ounce of gold could get you 69% more US dollars than pre-devaluation; if you thought you had $1000 worth of gold, you suddenly had $1,690. Many exchanged their gold for dollars with this realization, which was exactly what the Federal Reserve wanted. The reason this was done was to stimulate commerce and revive the economy. The stock market crash of 1929, World War I, and the Great Depression, had put European, US, and other governments, in large debt, and stifled economic growth. Governments needed ways to to raise and spend more money, but at the time, the growth in gold supply was not keeping up. Governments figured that devaluation would not be harmful. They figured war, industrialization, and the rise of real estate and stock markets had created value in the economy prior to the Great Depression, that had not been extracted into currency. In other words, gold supply had not kept up with economic growth. After 1934, something interesting started happening. Smaller countries around the world, instead of keeping gold in reserve, started keeping US Dollars in reserve. They also used the British pound as a reserve currency. What did these two countries have in common? They were the global industrial and military superpowers of the day. This was extremely significant; industrial and military (especially naval) power, was suddenly a determinant of paper money value. With fewer countries keeping gold, gold ownership was greatly consolidated, into British and American hands. The devaluation of 1934 had another consequence: a surge in gold mining; by 1939, that surge in gold production meant there was enough gold to replace all the currency in circulation in the world.
The end of World War II sealed the US Dollar’s destiny as currency king. The Bretton Woods Agreement made that official before the war even ended. Bretton Woods took place in July of 1944, before World War II had ended. D-Day had occurred a month earlier, on June 6th, 1944. D-Day was so significant, it set in motion the process for the US Dollar to become the world’s reserve currency. Even the Soviet’s were at Bretton Woods. By 1944, the US had stockpiled 75% of the world gold supply. No other currency was able to compete; owning dollars was essentially the same as owning gold. Any country that owned dollars could count on US gold reserves as guarantor of value; the effect trickled down, making sense for countries to build dollar reserves rather than seek out their own gold reserves. Since the world would need massive amounts of money to rebuild after the war, the US became the world’s banker, providing dollar denominated loans and grants; think Marshall Plan. The Bretton Woods agreement also declared that no currency, except US Dollars, could be redeemed for gold. This meant the US had cornered the gold market.
PRESIDENT NIXON DETHRONES KING DOLLAR
Of course, leave it to a politician to mess up a good thing. By 1968, the dollar was on the decline. With all those US dollars being minted to pay for loans, grants, Lyndon Johnson’s Great Society, and wars like Korea and Vietnam, the US now had an inflation problem. GDP (economic) growth stayed strong, until 1970, when a major recession hit, and real GDP growth disappeared, going negative by the 4th quarter of 1969. The economy was shrinking.
How did this happen? Well, one reason was that Gold was still priced at $35 per ounce, more than 30 years after the price was set. That meant anyone who wanted gold, could still go buy it from the Federal Reserve for the same price as 1934. Markets clearly thought gold was worth more. Why? Because inflation eats currency for lunch, and there was a lot of inflation. By 1968, the Federal Reserve only had $15 Billion of gold reserves left, while 3x that, $45.7 Billion of paper money, was held by foreign countries. Yikes! That’s not even counting domestic circulation of USD, which is a concept we won’t get into, but is worth reading about here. The Federal Reserve did not have the means to meet demand for gold if foreign dollar holders wanted to convert. As a result, there was a run on the bank, where the bank was the US Federal Reserve. To fight this run, the Federal Reserve raised interest rates, and raised interest rates, and raised them even more, to encourage people to keep dollars and earn interest. By 1969, the Federal Funds effective rate, which is a short term interest rate, was up near 10%. You can also see in the same below chart, that a recession predictably hit the United States in 1970 (the grey shaded areas indicate recessions). The recession was the worst possible scenario for the United States, because it combined very high inflation with no economic growth; this is called Stagflation. The US had printed far too much money, and it neither had the Gold nor the economic value (in terms of business and industry) to support it.
Crises have a way of turning people off to capitalism, and turning them on to socialism; government grows in times of crisis; people expect Big Brother to come to the rescue. The Nixon government was no exception. Nixon’s first step: price controls! Price control was his answer to inflation. The government began dictating the price of everything from wages and commodities to finished goods and consumer staples. As this article from The Balance puts it,
“Wage and price controls don’t work in a free market economy. That’s because workers can no longer get raises, giving them less money to buy goods and services. That lowers demand. Businesses can’t lower prices to boost demand. Neither can they raise prices, even though the cost of their imported materials increase. They can’t lower wages, so they reduce hiring and therefore demand.”
Price controls are for communist/socialist/Marxist nations. Nixon clearly felt capitalism had failed. With that said, Nixon saved the most monumental of his blunders for last. Upon taking office for his second term in 1973 (yes, shockingly, he was re-elected, primarily because of his promise to end the Vietnam War), he ordered the Federal Reserve to cease redeeming dollars for gold. It was an event of historic proportions. The price of gold immediately shot up to $120 per ounce; the day before, the Fed had been selling it for $42 an ounce (Nixon had devalued from $35 to $42 earlier in 1973). Nixon’s actions caused people to realize, there was not enough Gold to have the Dollar’s back. The value of the dollar was now a mystery. Inflation soared as a result; no one knew what the dollar was worth anymore, and so they played it safe, and undervalued. In the US, inflation hit 11% in 1974, and 13.5% in 1980! Federal Funds (short term interest rates) peaked at 12.5% in 1974, and then near 20% in the early 1980’s!
These numbers are unfathomable today; Federal Funds today are (August 2018) 2.5% in the US, and inflation is slightly less, at 2%. 1974 and 1975 saw US GDP shrink for 3 consecutive quarters, as seen from the above, at one point shrinking 4.8% in 1975! It was even worse in 1980, when GDP shrunk by 8% in the second quarter. For comparison sake, it was just as bad in the 2008 Great Recession, when GDP shrunk by 8.4% in the fourth quarter.
The horrible thing about inflation is not actual inflation, it’s inflation without growth. If economies are growing, then new economic value can offset inflation; simply put, if you’re making more money, you can pay more money. If you’re paying more, yet making less, you’re screwed. That causes recessions, and worse, depressions. 1980 saw the worst recession since the Great Depression. With interest rates at 20%, mortgage rates would have been closer to 25-30%. The economy was strangled by these high interest rates; loans were impossible to get. The 1970’s were a lost decade.
The 1980’s saw the last effects of the Nixon Gold standard catastrophe cleaned out of the system. The 1980’s represented the beginning of a new era that continues to play out today. That era is known as the era of debt, the funding of the private sector with public debt. As a result, since the 1980’s, financial crises have become more and more common; it’s quite simple after all: debt is ok, as long the bill gets paid every month. When payments are missed, it’s a huge problem, especially when debt pays for other debt, which pays for other debt. With each new crisis came an opportunity for socialist reform and government power grab. The gold standard had been a solid anchor for currency value, and a solid anchor for how much paper currency should be printed. With it gone, the US government offers only its “full faith and credit” as backing for the US Dollar. With the US National Debt at $21.4 Trillion and counting, how much credit it has left is anyone’s guess.