Kuwait kicks sand on the dollar

But as long as the dinar was pegged to the U.S. dollar, there was very little Kuwait's central bank could do to fight inflation. For example, raising interest rates, a standard tool used by the U.S. Federal Reserve to fight inflation, was out because an increase in Kuwaiti interest rates would have sent the dinar soaring and broken the dinar-dollar peg. Breaking the peg put monetary control back in the hands of the Central Bank of Kuwait.

But the bank may have just traded one problem, inflation, for another -- currency speculation. In the weeks before Kuwait went off the peg, speculators had been buying dinar hand over fist in anticipation of the move. If the dinar soared in price, they'd make a huge profit on their currency holdings. In an effort to beat back those speculators and to prevent the dinar from the kind of rapid increase in price that is often followed by a wrenching plunge, the central bank on May 28 suspended sales of short-term central bank certificates of deposit. The country's banks use these CDs as a place to park short-term funds, and the suspension had the effect of driving short-term interest rates in Kuwait to 4.125% from 5.1875% a few days earlier.

Fallout in the U.S.

This all leaves the U.S. dollar in a very uncomfortable position. On the one hand, we are seeing a gradual move away from the dollar by the world's central banks in favor of baskets of currencies. This puts gradual downward pressure on the price of the dollar and leads to a gradual increase in U.S. inflation and U.S. interest rates, as well as a gradual decline in relative U.S. standards of living and U.S. financial market performance.

As in Kuwait, where such a move resulted in a 25% shift away from the U.S. dollar in favor of other currencies, I don't think the result is a stampede out of the U.S. dollar. The dollar balloon isn't about to burst. But we are witnessing the air gradually leak out of the currency.

I think this reflects global fundamentals. The U.S. economy is less dominant in the global economy today, with the rise of China, India and the European Union, than it was in, say, 1980. The size of the U.S. trade deficit also argues for a gradual depreciation of the dollar in order to bring global trade flows closer into balance.

On the other hand, it's clear that some countries in the world are quite happy to preserve as much of an unofficial dollar peg as they can. It's to the benefit of a country with an export driven economy like China, which uses what I'd call an unofficial, mostly-dollar-peg monetary policy, to keep their currencies pegged to the dollar. That way their own currency doesn't appreciate, and their exports retain a price advantage in the marketplace. Saudi Arabia, which has an official dollar peg, falls in that category because that country is trying to build up value-added, export industries to diversify its economy. Russia, a country with an aging industrial base that wasn't globally competitive to begin with, certainly doesn't want to see the ruble appreciate so that the country's exports become even less competitive.

The combination seems to be heading toward a jury-rigged global monetary system. This system doesn't rely on market mechanisms to adjust the relative value of currencies. Instead, individual countries opt in and out of those market mechanisms as they choose with their policy moves designed to maximize their own return from the rules of the market.

This system as a whole relies upon a touching faith that enough countries will play by the rules of the market, so that the market will continue to function with rules that can be exploited as national self-interest dictates.

Interesting concept. Don't think I'll sell my position in gold stocks just yet.

New developments on past columns

"China's Olympian stock-market sprint": It was a huge overreaction -- which just shows you exactly how big the speculative bubble is on China's Shanghai stock market. The Shanghai Composite Index fell 6.5% on May 30 as investors reacted to news that the Beijing government had raised the tax on stock trades. How big was the increase in what is called the stamp tax? Well, it went from 0.1% up to a whopping 0.35%. On a $10,000 trade, that's an increase from $10 to $30 in taxes.

By itself the tax increase won't change a thing on the Shanghai market -- an increase of $20 won't stop the speculators or individual Chinese who see the stock market as the best route to wealth from trading. But I'd read the tax increase as another warning from Beijing to the Shanghai market of the government's intention to act when the time is right (in my opinion, after the Beijing Olympics in August 2008). Judging from the market's drop, traders in Shanghai got the message.

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