Why the dollar is doomed

The FTSE 100 hit another new post-credit crunch high yesterday, rising to its highest point since last October.

Markets around the world seem unstoppable. It's partly down to the broadly positive noises coming from the mouths of central bankers in recent days, particularly one Ben Bernanke, head of the Federal Reserve.

But talking a good game is one thing. At some point soon, central bankers are going to face some tough decisions. And we can have absolutely no faith that they'll make the right choices

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Central bankers can have their cake and eat it

Central bankers are in a real sweet spot right now. They're able to have their cake and eat it. They can talk vaguely about recovery, but also warn that the economy isn't yet strong enough for them to remove the 'stimulus'. In other words, disaster has been averted, but they still get to hand out free money.

In case you didn't know it, handing out free money is a great job, particularly when it's not your own money you're handing out. Everybody loves you for it. Bankers get to throw the free money at risky assets, prices shoot up, and everyone feels richer.

And the central bankers are loving it. Just look at Bernanke. The other day at the annual central banking shindig in Jackson Hole in the US, he declared that the credit crunch was caused by silly-headed investors panicking, and that it was only through his "speedy and forceful" actions and those of his colleagues that "we have avoided the worst".

Not a mention of the fact that interest rates had been kept far too low for far too long by his predecessor Alan Greenspan. No acknowledgement of his consistent denials that there was any housing bubble, or the fact that he regularly argued that the sub-prime collapse would have little impact on the wider US economy. As Edward Hadas put it on Breakingviews.com, "those who spread kerosene should not take too much credit for putting out fires."

Now, maybe Bernanke is just talking his book. He's got a job to fight for after all (although it looks as though his reappointment in January is now in the bag after he received Obama's backing). But I suspect he believes what he's saying. And that's scary. Because what's unfolding now is the same response that followed every bubble under Greenspan's regime.

The pattern is clear. Create a bubble. Deny the bubble exists. Then, when it pops, argue that your only responsibility is to clean up the mess. You do this by making money ever cheaper, encouraging careless lending and inflating another bubble.

If the system is working, what's the worry?

Economist Hyman Minsky whose theories broadly predicted the credit crunch argued that stability breeds instability. Basically, when human beings find a system that works, they'll keep pushing at its boundaries until it breaks.

You might have thought the system had hit breaking point this time. But it seems not. An unfettered financial sector, fuelled by a never-ending supply of free money, seems once again to be our chosen route out of this bust and on to the next bubble. The one financial group that looks most at risk of punitive legislation is the hedge fund sector arguably the only genuinely free market rivals to investment banks, and one of the few financial sectors that turned out to be pretty much blameless in the credit crunch.

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But why worry, if the system works? Herein lies the problem. It doesn't work. The economy is still very fragile, so deflationary forces are severely crimping the ability of central bankers to reflate the economy. But as Professor Nouriel Roubini pointed out in the FT yesterday, Anglo-Saxon central bankers' and politicians' jobs are about to get a lot harder.

Basically, they're between a rock and a hard place. If the economy starts to recover, they're going to have to pull some of that 'stimulus' out of the economy (by raising interest rates or stopping printing money) and start dealing with the massive deficits their governments have racked up. If they do that, they might derail the recovery.

But if they don't start withdrawing the stimulus early enough, long-term interest rates will rise (as investors demand a higher return on government debt) and it'll become more expensive to borrow throughout the economy, and the currency will weaken as fewer investors want exposure to it. Which could also derail the recovery. Given the natural bent of central bankers to err on the side of inflation, I suspect the second scenario is more likely.

The dollar's fate is in China's hands

Roubini's not the only worrier. Warren Buffett warned last week that the dollar is likely to be devalued in the longer run. He's right. And it may happen sooner than we think. One of the main reasons that investors still see the dollar as a safe bet, is the fact that China holds so many Treasury bills in its reserves. If the dollar devalues, China loses a lot of money.

But maybe it won't care. I read an interesting point recently from Eric Kraus, a fund manager in Russia. Kraus writes very entertainingly and articulately about matters of Russian politics, finance and macroeconomics. He has an original take on things if you're at all interested in Russian investment, you should look at his website (www.nikitskyfund.com).

He has this to say about China and the dollar: "The exit from this seemingly illogical trade [lending money to America to buy Chinese goods] will leave China sitting atop a pile of devalued assets, but also, possessed of a world-class industrial infrastructure and having gone a long way towards hollowing out and undermining the economy of its sole strategic competitor."

In other words, China has already spent large quantities of recycled dollars on upgrading its infrastructure (the country already has nearly as many miles of motorway as the US does) and cornering the market in various commodities (rare earth metals, for example). In the meantime, it has managed to manoeuvre itself into a position where it holds the fate of its biggest rival's currency in the palm of its hand.

Does that sound like an equal relationship to you? Me neither.

The end of the dollar's status as reserve currency may be a long time coming. But I suspect it will arrive more quickly and with more upheaval, than anyone realises. I'm not suggesting you dump your dollar assets it's a good idea for sterling investors in particular to have a good spread of international exposure right now, and the dollar may well rise in the near-term if investors take fright again. But it's certainly a good reason to have a chunk of your portfolio (about 10% say) in gold. The yellow metal may not go anywhere from here for some time but it's worth having it as insurance for when support for the dollar finally collapses.

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