Looking at the dollar the old-fashioned way

When the Bretton Woods system was cracking in the early 1970s the price of a troy ounce of gold, in dollar terms, was raised in two steps from $35 (Dh128.73) to $42.22. This was, in effect, a devaluation of the dollar.

The authorities then still thought it worth expressing the shift in terms of bullion, rather than against another currency like the Japanese yen or French franc. In the 1930s Franklin Roosevelt had a specific policy of devaluing the dollar against gold, pushing the price from $20.67 to $35 in the belief this would push commodity prices (and thus farm incomes) higher and reduce the burden of debt service.

Nowadays the price of gold is set by the market rather than by official diktat. When explaining shifts in the bullion market people tend to think in terms of supply and demand. Perhaps, however, they should view gold-price movements in terms of investors' confidence in the dollar, and in paper money in general.

Great moderation

After gold was set loose in 1973 its price rose at a rapid rate for the rest of the decade, peaking at $850 an ounce in 1980. In other words the dollar had lost around 90 per cent of its value since the demise of Bretton Woods. The 1970s was a period when economic policy in the developed world seemed to be in disarray, with inflation and unemployment high, and confidence in central bankers low.

The appointment of Paul Volcker as chairman of the Federal Reserve in 1979 appeared to be a turning-point. He broke the inflationary spiral in the early 1980s, albeit at the cost of a double-dip recession. From 1982 onwards developed economies seemed to enter the "great moderation": inflation was low or falling, and recessions were rare and mild. The authorities developed the knack of delivering stability with paper money, thanks to independent central banks committed to a low inflation target. Gold fell from $850 to $253 by 1999. With confidence in economic policy restored, the dollar was revalued by 236 per cent over almost two decades. By the late 1990s, however, belief in the eternal wisdom of central bankers was nearing its peak: Maestro, Bob Woodward's portrait of Alan Greenspan, came out in 2000. The dotcom and housing bubbles led to a reappraisal of Greenspan's career.

The credit crunch also laid bare a conflict in central banking that goes back to the days of the gold standard. As well as safeguarding the value of the currency, central banks act as lenders of last resort. When push comes to shove the latter duty seems to outweigh the former, and the bankers turn on the monetary taps. The result has been a loss of confidence in the dollar. Gold's rise since 1999 in effect means a near-80 per cent devaluation of the dollar over the past decade.

Three swings

What is striking about the history of the past 40 years is that these three swings in the value of the dollar (ranging from a rise of 236 per cent to a fall of 90 per cent) are huge by previous standards. But they have not been noticed because the dollar is now compared with other paper currencies — like the euro and yuan — where shifts have been nothing like as extreme.

This raises a further puzzle. One reason why countries tried so hard to maintain the gold standard and the Bretton Woods system was to reassure creditors that they would be repaid in sound money. Since 1971 most countries have had the right to repay creditors in money they could print at will. The likes of America and Britain are now perceived as "lucky" because they, unlike Greece, can devalue their currencies and default in real terms.