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The
history of the U.S. dollar is closely linked to U.S. involvement in a series
of wars. The Bretton Woods Accord and the resulting world reserve currency
status of the U.S. dollar were both byproducts of World War II (1939-1945).
The Korean War (1950-1953) was followed six years later by the Vietnam War
(1959-1975) which led to the end of the Bretton Woods system. Unfettered by
the constraint of gold backing after 1971, the U.S. dollar became a weapon in
the Cold War (1945–1991) between the U.S. and the former Union of
Soviet Socialist Republics (U.S.S.R.). Each war corresponded with an increase
in the U.S. money supply. The Gulf War (1990-1991) was followed by wars in
Afghanistan, beginning in 2001, and in Iraq, beginning in 2003, and,
simultaneously, by the U.S.-led War on Terror that began in 2001. Like the
wars that came before them, the recent staccato of U.S. wars is correlated with
increases in the U.S. money supply. The Iraq war, for example, is estimated
to have cost as much as $4 trillion.
The
loss of value in the U.S. dollar caused by excessive expansion of the money
supply, together with rising demand for raw materials from emerging
economies, has led to permanently higher global commodity prices. Higher
crude oil prices, in particular, have put pressure on the U.S. economy, which
is putatively in a gradual recovery from the recession that began in 2007. At
the same time, international trade has begun to move away from the U.S.
dollar, threatening its world reserve currency status. Given the history of
the U.S. dollar, it seems likely that an eventual end of the U.S.
dollar’s reign as the world reserve currency will be marked by war.
U.S.
politicians are clamoring for war with Iran, the third largest oil exporter
in the world. Iran refuses to sell its oil for U.S. dollars. If Iranian oil
were traded in U.S. dollars, it would moderate the U.S. dollar price of crude
oil and ease pressure on the U.S. economy, as well as extend the world
reserve currency status of the U.S. dollar and give the U.S. economic
leverage over consumers of Iranian oil, which include China and India.
The
U.S. news media is preparing the American public for a war with Iran with
reports about the dangers of Iran becoming a nuclear power. Television news
reports have speculated that Iran would immediately wipe out Israel if it
obtained a nuclear weapon, despite the fact that a thermonuclear exchange
would wipe out Iran. It has also been reported that Iran might carry out
nuclear strikes on U.S. soil using intercontinental ballistic missiles
(ICBMs), although Iran possesses neither nuclear warheads nor ICBMs. In fact,
there is no evidence that Iran is currently building a nuclear weapon. One
concern that is valid, however, is that no nuclear power has ever been
invaded in a conventional war.
Forged in the Fire of War
The
approaching end of World War II led to the creation of the Bretton Woods
system in July 1944, although fighting in Europe and in the Pacific continued
into 1945. The U.S. dollar, which was convertible into gold, became the
dominant mechanism for international trade settlement. The price of gold was
set to the pre-war price of $35 per troy ounce, which was deflationary at the
time. There was nothing in the Bretton Woods Accord, however, that prevented
the U.S. from issuing more currency than was backed by gold other than the
threat of a run on U.S. gold reserves.
The
Bretton Woods system worked as intended for roughly 17 years. The London gold
market, which had been closed during World War II, reopened in 1954. By 1961,
upward pressure on the price of gold prompted the establishment of the London
Gold Pool by the U.S. Federal Reserve and major European central banks
(including the central banks of the United Kingdom, Belgium, France, Italy,
the Netherlands, Switzerland and West Germany). The London Gold Pool defended
the $35 per troy ounce price through interventions in the London gold market,
but upward pressure on the price of gold grew. In July of 1962, Americans
were forbidden by then president Kennedy to own gold abroad by Executive
Order 11037. In a 1965 press conference, then president of France, Charles de
Gaulle publicly denounced the U.S. for abusing the world reserve currency
status of the U.S. dollar. The London Gold Pool collapsed in March of 1968
after France withdrew from the group setting off a surge in gold demand that
caused the London gold market to shut down for a two week period.
By
1971, substantially due to the cost of the Vietnam War, the U.S. had
leveraged its gold reserves to the breaking point. The expansion of the U.S.
money supply caused the U.S. Consumer Price Index (CPI) to increase by more
than 6% in 1970 and it remained above 4% in 1971. When U.S. President Nixon
“closed the gold window” in August 1971 and instituted price
controls, the Bretton Woods system ended and an ad hoc floating exchange
system resulted. From their peak during World War II to 1971, U.S. gold
holdings fell from approximately 20,205 tonnes to approximately 8,134 tonnes.
In February 1973, the U.S. devalued the dollar and raised the official dollar
price of gold to $42.22 per troy ounce. By June of the same year, the market
price in London had skyrocketed to more than $120 per ounce.
Although
CPI inflation was below 4% at the start of 1973, it rapidly accelerated,
reaching 9% at the start of 1974. With the last vestiges of gold backing
having been removed from the U.S. dollar, Americans were once again allowed
to own gold as a hedge against inflation. Against a backdrop of runaway U.S.
dollar inflation, Arab members of the Organization of the Petroleum Exporting
Countries (OPEC), along with Egypt, Syria and Tunisia proclaimed an oil
embargo in October of 1974. Officially, U.S. support of Israel in the Yom
Kippur War was the reason for the embargo, but it was also a challenge to the
un-backed U.S. dollar’s position as the world reserve currency, i.e.,
as an exclusive medium for crude oil sales.
After
the end of the Yom Kippur War in 1974, OPEC members, including Iran before
the Iranian Revolution in 1979, began to accumulate hundreds of billions of
devalued U.S. dollars due to current account surpluses linked to rising oil
prices. Arab “petrodollars” were recycled into US Treasuries,
invested in financial markets around the world and loaned to commercial
banks.
By
1979, oil prices had roughly quadrupled and the price of gold was increasing
rapidly. Then Federal Reserve Chairman, Paul Volcker raised the Federal
Reserve’s funds rate to an average of 11.2% in 1979. Nonetheless, in
1980 CPI inflation soared to 13.5% and the stagnant U.S. economy also slipped
into recession. The price of gold hit $850 per troy ounce and the price oil
averaged $37.42 per barrel, more than ten times the average price of $3.60
per barrel less than a decade before in 1971.
In
a desperate bid to save the U.S. dollar, Volcker increased the funds rate to
an unprecedented 20% in mid 1981, pushing the prime interest rate to a
usurious 21.5% by the middle of 1982. Finally, Volcker’s radical
intervention slowed the rate of CPI inflation and restored confidence in the
U.S. dollar. It also brought the price of crude oil down and smashed the
prices of gold and silver.
The Committee to Flood the World
Post
Volcker, the Federal Reserve’s dilemma was how to bring down interest
rates while managing the CPI independent of increases in the money supply,
e.g., to neutralize the Triffin Dilemma (a conflict between domestic monetary
policy and the demands placed on a currency by international trade) and to
support U.S. federal government borrowing during the Cold War. The first key
to the solution was to look at inflation strictly in terms of its effects on
prices and not as an increase in the money supply, which is a function of
interest rates. When interest rates are low, prices tend to rise because the
money supply expands more quickly, thus the second key was to de-couple
prices and interest rates. The third and final key was to manage the
psychology of the consumer in terms of inflation expectations. While altering
the CPI to reflect relatively stable prices and managing consumer inflation
expectations were easily accomplished, de-coupling prices and interest rates
was a more difficult problem because the prices of global commodities were
not entirely under U.S. control. Ultimately, managing the CPI required
managing global commodity prices, especially the price of crude oil.
A
crucial breakthrough came in 1988. The article, “Gibson’s Paradox
and the Gold Standard” by Robert B. Barsky and Lawrence
(“Larry”) H. Summers in the Journal of Political Economy, showed
that the price of gold was inversely correlated to interest rates. Since gold
is not industrially consumed in significant quantities, the price of gold
changes relative to the value of major currencies. Specifically, the price of
gold had proven to be a barometer of U.S. dollar inflation after 1971. What
was more important was that the prices of gold and crude oil tended to
correlate. The implication of Gibson’s Paradox was that interest rates
could remain low as long as the price of gold did not rise. If interest rates
could remain low without causing an accelerating increase in the CPI, as had
happened in the 1970s, the money supply could be expanded indefinitely.
A
few years after Alan Greenspan took the helm as Chairman of the Federal
Reserve in 1987, interest rates were slashed and the resulting increase in
the U.S. money supply began to pull away from the increase in the CPI. For
roughly two decades, beginning with Volcker’s success in the early
1980s, the price of gold declined while oil prices remained relatively stable,
despite the fact that interest rates had come down.
The
innovations in U.S. monetary policy developed principally by Summers and
Greenspan helped to make it possible for the United States to up the ante in
the Cold War, which ended with the collapse of the U.S.S.R. in 1991. Setting
aside all other issues, the U.S.S.R. had arguably been spent into oblivion by
the U.S. The fall of the U.S.S.R. seemed to guarantee the hegemony of the
U.S. dollar for decades to come.
During
the 1990s, Greenspan, together with Larry Summers, who was Deputy Secretary
of the U.S. Treasury under Robert Ruben at the time, championed financial
deregulation. Confident in their ideas, the so-called “committee to
save the world” prevented regulation of over the counter (OTC)
derivatives and succeeded in effectively repealing the Banking Act of 1933
(the Glass–Steagall Act).
In
hindsight, Greenspan held interest rates too low for too long in the 1990s
resulting in the dot-com bubble. The bursting of the dot-com bubble was a
shot across the bow of the “committee to save the world” but the
warning went unheeded. The Federal Reserve moderated the downturn beginning
in 2000 by lowering interest rates and they remained low. U.S. banks took
advantage of deregulation and low interest rates to speculate and to increase
their leverage, especially in the mortgage market, while hedging the
additional risks in the fast growing OTC derivatives market. As the resulting
real estate bubble grew, the notional value of OTC derivatives exceeded $600
trillion on a global basis (more than ten times world GDP) and financial
services industry profits expanded to 40% of S&P 500 business profits.
The
price of gold had begun to move up after having made a historic low in June
of 2001 and, in 2006, the price of crude oil began to rise at an accelerating
rate revealing a fundamental flaw of de-coupling interest rates from prices.
The flaw was that the Federal Reserve had absolutely no control over the flow
of increased liquidity resulting from its policies. The “committee to
save the world” was flooding the world with cheap U.S. dollars.
Increased liquidity linked to low interest rates was fueling unprecedented
levels of financial speculation and increasing the risk and magnitude of
asset price bubbles, such as the dot-com bubble and the real estate bubble.
To make matters worse, excessive monetary expansion was weakening confidence
in the U.S. dollar.
Pressured
by rising oil prices, the U.S. economy began to roll over in 2007. As the
U.S. housing bubble began to burst, beginning with sub-prime loans, the price
of West Texas Intermediate (WTI) crude oil hit an all-time high of $145 in
June 2008. Roughly four months later, a financial crisis far larger than that
of 1929 began to take place, i.e., the bursting of the largest credit bubble
and monetary expansion in the history of the world. In October 2008 Greenspan
testified before the U.S. Congress saying “…I found a
flaw…in the model that I perceived is the critical functioning
structure that defines how the world works…”
Quantifying the Crisis
The
policy responses of the U.S. federal government and of the Federal Reserve
(under Chairman Ben S. Bernanke since 2005) to the financial crisis and to
the so-called Great Recession were radically inflationary. The Federal
Reserve loaned $16 trillion to financial institutions worldwide and $7.77
trillion to U.S. banks and corporations. The Federal Reserve also purchased
roughly $1 trillion worth of toxic mortgage backed securities (MBS) from
banks and monetized a total of roughly $800 billion of U.S. federal debt,
expanding its balance sheet from $900 billion before the crisis to $2.7
trillion.
In
the face of the most severe economic decline since the Great Depression, the
U.S. federal government embarked on a $700 billion economic stimulus plan,
despite the fact that tax revenues were falling. In addition to an initial
$800 billion bailout package, government sponsored entities Fannie Mae and
Freddie Mac were taken into receivership, making the U.S. federal government
liable for roughly $5 trillion of mortgage debt. In 2009, the total
liabilities of the federal government were estimated to be as high as $23.7
trillion by then Special Inspector General for the Troubled Asset Relief
Program (SIGTARP), Neil Barofsky. As a result, U.S. federal government debt
increased sharply and, in 2011, the U.S. credit rating was downgraded for the
first time in history.
Loss
of value in the U.S. dollar, caused by radically inflationary monetary
policies, set off a global currency war in 2009 and pushed global commodity
prices higher than they would otherwise have been. Higher crude oil prices,
despite lower demand, slowed economic recovery. At the same time, high debt
levels, bank bailouts, soaring government budget deficits and falling tax
revenues produced a sovereign debt crisis in Europe. Although the focus of
the still developing sovereign debt crisis remains on Europe, the
skyrocketing debt and unfunded Social Security and Medicare liabilities of
the U.S. federal government, estimated to be more than $63 trillion,
foreshadow a similar crisis in America.
The Trap of Financial Warfare
One
of the key reasons why the U.S. has yet to experience a sovereign debt crisis
is that the world reserve currency status of the U.S. dollar supports demand
for the U.S. dollar and for U.S. federal government debt. However, the U.S.
dollar is in the process of gradually losing its world reserve currency
status. Global trade is fragmenting into increasingly autonomous trading
blocks defined by currencies and trade relations, such as the BRIC nations
(Brazil, Russia, India and China), together with South Africa.
Demand
from emerging economies, particularly China, is placing steady upward
pressure on the price of crude oil. Higher oil prices resulting from a
combination of a weaker U.S. dollar and increased global demand threaten to
push the U.S. economy back into recession. Setting aside flat to declining
supplies of sweet light crude oil (Peak Oil), the fact that the price of gold
has risen roughly 500% in a single decade suggests much higher oil prices in
the future.
Iran,
which is the world’s third largest oil exporter and a major supplier of
oil to China, lies outside of U.S. control. Iran refuses to sell oil for U.S.
dollars, partly as a consequence of the overthrow of the democratically
elected government of Iran in 1953, orchestrated by the U.S. Central
Intelligence Agency, and partly as a consequence of current U.S. policies in
the Middle East.
In
March of 2012, the U.S. unilaterally removed Iran from the Society for
Worldwide Interbank Financial Telecommunication (SWIFT) system, effectively
cutting it off from world commerce. However, wielding the U.S. dollar’s
world reserve currency status as a blunt instrument could be
counterproductive in the current international climate. If the U.S. dollar
were to lose its world reserve currency status over a short period of time, a
U.S. sovereign debt crisis would be certain and a catastrophic collapse of
the U.S. dollar, i.e., hyperinflation, would be possible.
Having
taken a decision to act unilaterally against Iran, the U.S. may be forced to
resort to more extreme measures if the world reserve currency status of the
U.S. dollar begins to break down. Of course, the U.S. does not control the
oil trade solely through financial means. With Israel as a close ally, Iraq
and Afghanistan occupied by U.S. forces, close ties with Turkey, Saudi
Arabia, Kuwait, Qatar and other Middle Eastern countries, Iran is surrounded
by more than 40 U.S. military installations.
A
successful invasion of Iran would eliminate the largest non U.S. dollar oil
exporter, delaying the breakdown of the U.S. dollar’s status as the
world reserve currency. Although a war with Iran would cause a spike in oil
prices, U.S. control of Iran’s oil would increase the supply of oil
available for purchase in U.S. dollars, which would bring the U.S. dollar
price of oil down and enhance the ability of the U.S. to manage the price of
oil to meet the needs of the U.S. economy. Controlling a major supplier of
crude oil to China and India would give the U.S. additional leverage to support
the U.S. dollar and U.S. debt, as well as a means of influencing the policies
and economic growth of the two largest nations. The option of invasion,
however, may be time limited. If Iran were to eventually obtain nuclear
weapons, the risks involved in a U.S. invasion would escalate.
As
an alternative to invasion, a limited U.S. military action might involve
surgical strikes on Iranian nuclear research and power facilities, as well as
on Iranian military forces that pose a threat to the U.S. military.
Destroying Iranian nuclear facilities and suppressing potential
counterstrikes also suggests neutralizing Iran’s threat of disrupting
the oil trade by closing the Straight of Hormuz. Thus, a limited U.S.
military action would involve military operations on a scale not seen since
the invasion of Iraq in 2003.
A
limited U.S. military action might leave a weakened Iranian regime in place
after the conflict and reignite the moderate, pro-democracy Green Movement
that was brutally suppressed in 2009. Regime change from within might restore
democracy to Iran after twenty six years of U.S.-imposed monarchy and more
than three decades of quasi-democratic religious oligarchy. However, regime
change is unlikely to result in the sale of Iranian oil in U.S. dollars or to
extend the reign of the U.S. dollar as the world reserve currency. A
preemptive strike by the U.S. could also strengthen political support for the
current Iranian regime.
There
seems to be no political will in Washington D.C. to change course from a U.S.
military conflict with Iran, despite the fact that a U.S. attack on Iran will
increase anti-U.S. sentiment in the region and amplify the Islamic extremist
dimension of the U.S.-led War on Terror. The drumbeat to war in the U.S. news
media is loud and clear and, if history is any guide, the U.S. will soon,
e.g., after the 2012 presidential election, “cry havoc and let slip the
dogs of war”.
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