Asset allocation with crashing dollar: Independent investment advice
Posted by Don Martin on Fri, Mar 04, 2011 @ 02:57 PM
Investors worry that the dollar will go down and so they seek a safe haven to invest in. The fear is that Bernanke will create inflation leading to a decline in the value of the dollar. So let’s review the three ways that inflation may be created.
First: The 1970’s type of inflation was caused by an increase of the money supply from bank lending combined with a tight unionized labor market during a pre-globalization era. The type of labor market that existed then is different by 180 degrees. Today we have ruthless globalization and deunionization and most importantly plenty of excess capacity.
Second: The Federal debt is monetized by the Federal Reserve. This would involve increased deficit spending by congress during a time when the Treasury had trouble selling Treasury bonds. To get to that point would require a Congress that wants to increase spending instead of cut spending. It remains to be seen as to whether or not Congress will be able to cut spending during the next two to four years. It is possible that Congress will make drastic cuts in spending rather than have the Fed monetize newly issued debt.
Third: The Fed manages to increase the money supply using Quantitative Easing, leading to the dollar gradually become devalued, thus making imported goods more expensive, which would incite domestic inflation. This is difficult to do because other countries want to have a competitive devaluation so the U.S. attempts to devalue may not succeed. Further, since imports are 17% of total consumption then a 20% devaluation would be only a one-time inflation surge of an extra 3.4%. The best data set to examine is the history of the dollar’s value for 35 years.
So if inflation is subdued and no worse than other countries then how can the dollar be devalued?
Except for the Volcker Fed era from 1979-87 and the dotcom bubble of 1997-2000 the dollar index has been relatively close to a range of about 80 to 90 and is now at 76.4. It got in the low 70’s in 2008 and then went up.
I have written about the risk of a dollar collapse here.
Independent investment advice is needed to understand the risks of dollar devaluation.