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If the love of money is the root of all evil, the
depreciation of money must be the mainspring of all shams and frauds. It
works silently and covertly, impoverishes many while it enriches a few, and
thereby inflicts great harm on social cooperation and international
relations.
A few economists are sounding the alarm about the
decline of the U.S. dollar. In recent months it fell visibly toward the euro
and Japanese yen and is likely to fall even lower. But most Americans refuse
to be alarmed as they are unaware of exchange rates and foreign exchange
markets. Why should they be troubled about the financial affairs of money
traders and dealers?
We may not be able to see the future but always can
learn from the past. Looking at the recent history of the dollar, this
economist perceives three distinct stages with various characteristics,
causes, and consequences. In the first stage from the end of World War II to
1971 the U.S. dollar was tied to a small anchor of gold. President Nixon cut
its ties and embarked on a wholly new road of fiat dollar management. Many
other countries readily accepted the new system acclaiming its flexibility
and manageability. At this time, in 2004, the world is still traveling this
road, but several countries are making preparations for leaving it and
proceeding toward a multiple standard system. It is not clear whether they
will depart in an orderly fashion or in crisis and contention.
The U.S. dollar has been the dominant world currency
for some 60 years. At the Bretton Woods international conference in 1944 it
was elevated together with the British pound sterling to the position of
"reserve" currency in which international payments could be made. It
was to be backed by gold and redeemable at $35 an ounce and sterling be made
readily convertible at $4.03 to the pound. With the Labour Party in power
pursuing a vigorous program of nationalization of industry and extension of
social services, the pound soon suffered frequent bouts of confidence; it was
devalued to $2.80 in 1949 and to $2.40 in 1967. Issued in ever larger
quantities and fettered by stringent regulations and controls it gradually
lost its position as reserve currency.
The U.S. dollar, in contrast, displayed great
strength and was traded at parity with gold. The recovery of European and
Japanese economies from the ravages of war increased their demand for a
reserve currency, the U.S. dollar. But soon after sterling had lost its
reserve position, the integrity of the dollar opened to doubt and controversy.
In the footsteps of the British Labour Party, the Kennedy and Johnson
administrations pursued policies of economic and social reform, incurring
growing budget outlays. President Johnson not only declared "war on
poverty" in order to create a "Great Society" but also
escalated American participation in the Vietnam War. His policy of both
"guns and butter" built on deficit spending and abundant credit by
the Federal Reserve.
In 1968 when the budget deficit reached World War II
proportions, the system came within an inch of disintegrating. U.S. balance of payment deficits and loss of
gold cast doubt on U.S.
solvency. In 1959 the U.S.
gold stock had still exceeded $20 billion. It fell sharply to $13 billion in
1965 and 1966, and now touched $12 billion, barely one-fourth of foreign
payment obligations. But President Johnson managed to buy time with a stopgap
arrangement, involving a two-tier pricing system for gold. The world's
central banks agreed to make payments at the fixed price of $35 an ounce
while all individuals could trade gold freely at market prices. And in order
to enlarge the world's currency base, the International Monetary Fund (IMF)
was empowered to issue Special Drawing Rights (S.D.R.s). There was widespread
agreement among monetary authorities that the influence of gold needed to be
diminished.
While the Federal Reserve was busily increasing the
dollar base and the U.S.
government was pursuing both wars, President Johnson decided to take
corrective action at home. In old Mercantilistic fashion, his administration
imposed a new tax on the purchase of foreign securities by Americans. It
hesitated to raise income taxes but chose to "jawbone" the people. It
ordered American businessmen to reduce their investments in foreign
operations and asked American banks to limit their loans to foreigners. The
Federal Reserve even raised its discount rate from 4 to 4½ percent,
which barely covered the inflation rate.
When President Nixon took office in 1969 he
immediately tried to slow down the galloping inflation by vetoing much new
social legislation and impounding funds for domestic programs which he
opposed. When the country fell into a recession and unemployment climbed to
six percent of the work force, he responded with new pump priming. In 1971
and 1972 the Federal budget headed for the largest deficits since the end of
World War II. Even the balance of trade fell deep in debt, and the chronic
deficits of the balance of payments filled the vaults of many foreign central
banks with dollars.
The year 1971 was to be a landmark in monetary
history. On August 15, the United
States government removed gold as the
foundation stone of the international monetary order and rescinded the
international agreements that had defined the system since the end of World
War II. In a nationally televised address President Nixon
simply announced that the United
States would no longer honor the
36-year-old commitment to pay international obligations in gold at the rate
of $35 an ounce. He imposed a 10 percent surcharge on imports into the United States.
And above all, he ordered virtually all wages and prices to stop and freeze. Violators
would be fined, imprisoned, or both. When management of the controls proved
to create frustrating problems, it underwent four "phases" of
adjustment to "problem areas" such as food, health care, and
construction.
The Bretton Woods standard survived neither the
Vietnam War nor the war on poverty. It was born of Keynesian thought and
buttressed with 18th century Mercantilistic beliefs; it died of basic
misconception of human action and behavior. John Maynard Keynes who had
helped to deliver the system at the Bretton Woods conference sought to
promote employment by government spending on public works. Most governments
have applied the Keynesian formula ever since. Old Mercantilistic notions and
doctrines found a ready home in the Keynesian economic system, pointing
toward favorable balances of trade and greater national productive efficiency
through a host of government regulations.
The new fiat dollar standard was a germane
derivative of the Bretton Woods order without its limitations. Liberated from
any gold reserve requirement or other quantitative restriction, it promised
to serve political needs as well as the Keynesian requirements for employment
and growth. Unfortunately, it proved to be even less stable than its
harbinger, more inflationary and, above all, more divisive and injurious to
American reputation and prestige.
The fiat dollar standard has profoundly affected the
economic lives of most Americans. Soon after the dollar's convertibility into
gold was rescinded the Federal Reserve accelerated its money creation. While
stringent controls were preventing goods prices from rising, the eurodollar,
that is, U.S. currency held in banks outside the United States and commonly
used for settling international transactions, commenced a steep slide and
U.S. trade deficits grew very large. They obviously reacted in anticipation
of ever more dollar inflation and depreciation; money markets tend to
anticipate future prices of goods and services. Mutual exchange ratios
between currencies tend to be determined by their foreseen purchasing power;
they always move toward purchasing-power parity where it no longer makes any
difference whether one uses this or that currency.
Withdrawal of American troops from Vietnam did not end the price and
wage spirals that were to mark the presidencies of Messrs Nixon, Ford and
Carter. The Federal Reserve duly supplied funds at single-digit discount
rates, bank credit expanded at double-digit rates, the U.S. Treasury suffered
ever larger deficits, and goods prices soared. The Fed occasionally would
"tighten" its reins but "real" interest rates always
remained relatively low or even below the rates of inflation. U.S. trade deficits increased erratically with
dollar funds flowing to Western Europe and Japan. But the. Their support
sustained the U.S. trade monetary
authorities in Europe and Japan
were determined to defend the existing dollar parity with substantial purchases
of dollars deficits and their own surpluses, which meant to bolster and
subsidize their own export industries. The abundance of dollar funds in
central banks throughout the world then facilitated an explosive growth of
money and credit in most industrial countries.
In 1974 and 1975 the fever of double-digit inflation
was briefly eclipsed by the chills of recession. Unemployment rose to 8.3
percent, a 33-year-high nationally, and much higher in construction and
manufacturing. It remained high although the chills of recession soon gave
way again to the fever of inflation. Money and credit were made to expand
again at double-digit rates, trade deficits set new records, and the U.S.
dollar deteriorated further in international markets. By the end of the
decade the country fell again in the grip of the twin economic evils of
recession and inflation. Unemployment rose again while GNP was falling. This
time, the Federal Reserve, under new management, meant to call a halt to the
turmoil. It raised its discount rate to 12 percent, the prime rate rose above
15 percent, and the eurodollar rate to 20 percent. President Carter even
imposed Federal temperature controls in public and commercial buildings,
setting minimum summer temperature at 78 degrees and maximum winter
temperature at 65 degrees. Many Americans keenly felt the effects of gasoline
rationing, waiting in long lines at gasoline service stations. Legislators
and regulators had a ready explanation for the crisis: the sheikhs and emirs
of OPEC had done it again.
In 1981 President Reagan took the helm of a deeply
troubled country. During his eight years in office he managed to lift the
spirits, changing the course and relaxing the reins of government. He rolled
back the Johnson Great Society but preserved the Roosevelt New Deal. He
rejected Keynesian formulas for managing economic demand and instead followed
"supply-side" prescriptions which aim to stimulate production and
investment by way of tax reduction and removal of some government controls. Mostly
at loggerheads with Congress, he insisted on rearming the country and
confronting Soviet aspirations. He steadfastly resisted Congressional efforts
to boost taxes significantly. With Congress raising social spending and the
President expanding military outlays, Federal budget deficits soon exceeded
two hundred billion dollars a year; the national debt doubled in seven years.
With the discount rate at 12 percent the quantity of
money and credit finally stabilized, allowing the economy to readjust to
actual market conditions. A 25 percent Federal tax cut over three years
brought some relief to business but tore big holes in the Federal budget and
capital market. After the removal of price controls the dollar regained some
strength and the American economy became again the engine of the world
economy. It slowed down after a spectacular Wall Street crash in 1987 which
reflected the international concern about the budget deficits and the chronic
trade and current account deficits of the United
States and the surpluses of Japan
and West Germany.
In ages past, the creditors would have demanded prompt payment in gold, which
would have forced the debtor to mend his ways or face insolvency. The fiat
dollar standard merely prompted contentious diplomatic exchanges - the
creditors pressing the debtor to live within his means and the debtor urging
his creditors to relax and stimulate their own economies with easier money,
larger budget deficits, or both.
The decade of the 1990s was akin to the 1980s. It
began with a recession, saw new acceleration followed by deceleration and a
"soft landing" in 1995. Great concern about the large balance of
payments deficits of the United
States led to a sharp decline in the value
of the U.S. dollar, especially versus the Japanese yen and the Deutsche mark
and other European currencies closely tied to it. Coordinated intervention by
foreign central banks was needed to stabilize the dollar. It rallied for a
while when several Asian currencies foundered in 1997. Large current-account
deficits led to sudden declines and devaluations of the Thai baht, the
Malaysian ringgit, the Indonesian rupiah, the Philippine peso, the Singapore
dollar, and the South Korean won. The International Monetary Fund (IMF),
working in cooperation with industrial countries, kept the Asian crisis from
spreading.
Throughout the 1990s the Federal government suffered
massive deficits although political spokesmen frequently boasted of budget
surpluses. In 1998, 1999, and 2000 the Clinton Administration waxed eloquent
about its surpluses which in time would retire the national debt. In reality,
the surpluses were deficits financed with Social Security money and other
government trust funds. They increased the national debt with Social Security
IOUs as much as Treasury bills, notes, and bonds sold to investors; payment
obligations to Social Security beneficiaries are as binding as those to
investors.
* * *
Throughout the decades a few economists always were
worried about the magnitude of the trade deficits and the vulnerability of
the American dollar. But their fears proved to be unfounded because they
underestimated the worldwide demand for dollars and the willingness of
foreign investors and central bankers to trust and hold U.S. dollars. After
all, until recently the deficits never exceeded three percent of GDP and
Americans still were net creditors in their foreign accounts. By now, in
2004, the dollar standard has reached a stage in which not only a few
economists but also some foreign creditors are beginning to question its
future. The Federal government is swimming in an ocean of debt. In its first
term the Bush administration increased the Federal debt by $2.2 trillion. Congress
raised the Treasury debt ceiling three times, by $450 billion in 2002, by
$984 billion in 2003, and by another $800 billion on November 19, 2004, to $8
trillion 184 billion. The ready willingness of Congress to finance such
deficits is a clear indication of the political and ideological mold and make
of most members of Congress and the public that elects them.
Foreign observers are drawing similar conclusions. The
Bank of Japan with more than $800 billion in dollar obligations already
announced its reluctance to increase its holding. China
with dollar reserves exceeding $500 billion is laboring under
"unsustainable U.S.
trade deficits." Asian banks altogether holding more than $2 trillion in
American obligations are suffering hundred-billion dollar losses in terms of
purchasing power. It is not surprising that the central banks of India and Russia
as well as some Middle East investors have
begun to sell dollar obligations.
According to some estimates, foreign banks and
investors are holding some $9 trillion of U.S. paper assets. They are
owning some 43 percent of U.S. Treasuries, 25 percent of American corporate
bonds, and 12 percent of U.S.
corporate equities. They obviously are suffering losses whenever the dollar
falls against their respective currencies; even if they are pegged to the
dollar they are incurring losses against all others that are rising.
The dollar standard surely would enter its third and
final stage of disintegration if its holders would panic and start selling
their American paper investments - their U.S. Treasuries, U.S. agencies, and corporate
bonds and shares. The crash would be felt around the world and neither
foreign sellers nor American authorities could be trusted to react rationally
in the fear and noise of the crash. The scene could be similar to the
political bedlam of the early 1930s.
There always is the hope that the primary creditors
will act in concert and once again bail out the debtor. The European Central
Bank, the Bank of Japan, the Bank of China, and the Bank of England may
decide to avert the unthinkable and support the dollar by mopping up huge
quantities. The mopping would stabilize the situation once again by inflating
and depreciating their own currencies; they would pass the depreciation
losses on to their own nationals. Optimists in our midst are hoping for this
scenario; they are convinced that the Bush administration will in time save
the situation by balancing its budget and the Federal Reserve will allow
interest rates to seek market levels. Such a policy would avert the dollar
dilemma although it would lead to a painful recession forcing all economic factors
to readjust to market conditions.
Pessimists in our midst cast doubt on such a
scenario. They point not only to the host of legislators and regulators who
cherish their position and power but also to public opinion and ideology
which call for government favors. They are prepared to proceed on the present
road and brace for the morrow. A few cynics even contend that a government
facing a financial crisis of such magnitude is prone to divert public
attention from its omnious path by embarking upon foreign adventures.
This economist is ever mindful that debts do not
fade or pass away. Individuals must face them, deal with them, or renege in
bankruptcy. Governments have an additional option: as the issuers of their
own currencies they may inflate and depreciate their debts away. The United States
government has done this ever since it cast aside the gold standard and
imposed the dollar standard. It undoubtedly will continue to do so as far as
the eye can see. It is an iniquitous road which individuals would soon be
barred from traveling but governments love to take, shedding their debts one
percent at a time. It is a road of the dollar standard designed at Bretton
Woods, built by the U.S.
government, managed by the Federal Reserve System, and financed largely by
creditor central banks in Europe and Asia. It
is a road on which the fall in dollar value has inflicted losses on all
foreign dollar holders each in proportion to the amount of dollars held. It
is the political road of debt default the magnitude of which amounts to
trillions of dollars, undoubtedly the largest in the history of international
relations. It will be remembered for generations to come.
It is unlikely that the Federal government and the
Federal Reserve will soon mend their ways, but it also is doubtful that
foreign creditors will continue their support indefinitely. The U.S. dollar
is bound to continue to depreciate and gradually surrender its role as the
world's primary reserve currency to a multiple reserve-currency system
resting on the euro, Japanese yen, Chinese renmenbi, and the American dollar.
The multiple-standard system is likely to perform more efficiently and
equitably than the dollar standard. Competition would avoid the abuses and
inequities of a monopolistic system. Confining the powers of the Federal
Reserve System and constraining the deficit aptitude of the U.S. Treasury, it
would ward off any further inundation of the world with U.S. dollars.
In idle reverie of years long past, this economist
is tempted to compare the gold standard with the dollar standard. Throughout
the long history of the gold standard the balance of payments of
gold-producing countries was usually "unfavorable." Since the birth
of the dollar standard the United
States has assumed the position of the
gold-producing countries; its balance of payments usually is unfavorable. Much
capital and labor were spent to find, mine, refine, and market gold; the United States
bears minuscule expense in the production of its money. The quantity of gold
coming to market was limited by market forces; the quantity of dollars
depends on the judgment of Federal Reserve governors who are appointed by the
President. In times of turmoil and war the quantity of gold mined does
decline; in such times the stock of fiat dollars tends to multiply and its
value depreciates quickly. The quantity of gold is limited by nature and its
value is enhanced by many nonmonetary uses; fiat and fiduciary moneys have no
such uses or limitations. They
are the sorry creation of politics.
Dr Hans F. Sennholz
www.sennholz.com
Dr. Sennholz is President of The Foundation for
Economic Education, Irvington-on-Hudson, New York and a consultant, author
and lecturer of Austrian Economics.
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