Would King Midas Hold American Dollars?

I read an article in yesterday's Financial Post that set off some alarm bells in my brain. A large number of investors globally are buying gold on the speculation that OPEC could replace the American Dollar as their trading currency. China holds trillions of American dollars in investments and has to be nervous of a potential collapsing of the dollar. The fear being that if the Chinese were nervous enough about a dollar collapse, they might try to sell all their holdings out ahead of the collapse to minimize loses. This action would help lead to a collapse of the dollar, or of course China can work to help save the dollar. There is some evidence today that Asian markets are trying to save the dollar. Other countries have suggested that the US Dollar should be replaced as the world's "reserve currency" (which would be bad for the dollar, possibly good for the world).

The tricky thing about telling you what will happen next is that if there were a catastrophic decline in the value of US dollars, we really don't know how that will affect global financial markets and economic output. We can speculate, as many experts are, but truthfully every doom and gloom scenario is just an educated guess. If the dollar collapses, all bets are off.

One of two things are true.

1) The rising price of gold is forecasting a decline in the dollar

2) Investors are over compensating for news stories and are buying too much gold

The answer is probably somewhere in the middle, but I wanted to distinguish these two scenarios. First, "futures" values of precious metals or other commodities can lead real time events. If I think it is going to be a cold winter, I can go make a bet on higher natural gas prices. If enough investors have a reasonable belief of an upcoming event and act collectively, the value of the related commodity goes up before the event occurs. Also people with insider information on upcoming events can buy a commodity and nudge the price up. For example, how much do you want to bet that "people in the know" in the Middle East bought large quantities of gold prior to Hezbollah's military operation into northern Israel? Knowing that such an operation could provoke Israel into a large regional conflict, you would want to hold gold as the safe investment. That James Bond: Casino Royale touches on this subject of making money off of terrorism.

Investors collectively may not be behaving entirely rationally. This is possible. I'm almost willing to bet that Glenn Beck holds most of his investments in precious metals. He's been singing about the potential collapse of the dollar for a few years now. A number of other experts have also forecast the decline, which sends day traders scurrying to the trading floor to hedge against the potential bad news. As the value of gold then climbs, other investors want to get in on it to "surf the trend”. This then creates a bubble. A golden bubble. If we have learned anything of bubbles, they eventually pop. That pop can sting a little bit, but they are also good because they purge bad business and bad ideas. It is part of the evolutionary process. The strong survive and the weak shall perish.

I am not prepared to forecast a decline in the American dollar, although I did recommend to my father in February that he transfer his retirement savings from the American market to the Canadian market (I know, Peter Mansbridge would be horrified by that statement). If the Democrats in Washington pass these absurdly ambitious spending projects at a time when they have no money to spend, they may very well collapse the dollar without any help from OPEC. It could be that OPEC watches the Glenn Beck Show, believe it, and want to change their trading currency before "Obama can destroy America".

Really, I don't know what is going to happen. It could break either way but if I had to make a bet, I'd say King Midas is blowing a bubble...