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Why Gold and the Dollar May Both Rise From Here

 November 13, 2012 10:43 AM

Executive Summary

  • Triffin's Paradox leads to four principal conclusions that indicate why the U.S. dollar may well continue to strengthen from here
  • Why the euro's troubles have been good for the price of gold
  • Why the dollar can strengthen despite the United States' wishes
  • Why the future may well see the price of both gold and the U.S. dollar rise

If you have not yet read Part I: Gold & the Dollar are Less Correlated then Everyone Thinks, available free to all readers, please click here to read it first.

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In Part I, we examined the commonly offered correlations between the dollar, gold, interest rates, and the monetary base, and found no consistent correlations between any of these and the domestic economy.  Clearly, the trade-weighted value of the dollar and the value of gold have at best marginal impact on the domestic economy. 

Perhaps the dollar's primary impact is on the international economy, as suggested by Triffin's Paradox, which begins with the premise that the needs of the global trading community are different from the needs of domestic policy makers.

Prior to 1971, the dollar was backed by gold, which acted as a supra-national anchor to the dollar's reserve status.  As the U.S. monetary base expanded while gold remained artificially pegged at $35 an ounce, roughly half of America's gold reserves were shipped overseas before the policy was jettisoned.

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Here is the Wikipedia entry on Triffin's Paradox:

The Triffin paradox is a theory that when a national currency also serves as an international reserve currency, there could be conflicts of interest between short-term domestic and long-term international economic objectives. This dilemma was first identified by Belgian-American economist Robert Triffin in the 1960s, who pointed out that the country whose currency foreign nations wish to hold (the global reserve currency) must be willing to supply the world with an extra supply of its currency to fulfill world demand for this 'reserve' currency (foreign exchange reserves) and thus cause a trade deficit.(emphasis added)

The use of a national currency (i.e. the U.S. dollar) as global reserve currency leads to a tension between national monetary policy and global monetary policy. This is reflected in fundamental imbalances in the balance of payments, specifically the current account: some goals require an overall flow of dollars out of the United States, while others require an overall flow of dollars in to the United States. Net currency inflows and outflows cannot both happen at once.

This leads to some startling conclusions that many have great difficulty accepting...

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