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December 29, 2004

Shades of the Dollar Standard
by Hans F. Sennholz

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.

Hans F. Sennholz
www.sennholz.com

Copyright © 2002-2007 Hans F. Sennholz

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