Potential Dollar Scenarios
Never before in recent history have monetary and fiscal policies been as "stimulative" as today, and yet, the American economy remains weak and vulnerable. The Federal budget deficit for the 2003 fiscal year was posted at $555 billion, some six percent of GNP; it may continue to rise in coming years when new tax reductions add their weight. The Federal Reserve System has opened its flood gates and reduced all interest rates to their lowest levels since the 1950s. Its basic rate now stands at just one percent permitting the stock of money in all its forms to soar at frightening rates. Government and Federal Reserve officials are convinced that this combination of stimuli is bound to facilitate an annual growth rate of 3.75 to 4.75 percent, just like that of the late 1990s.
The fact that this opinion is widely held by many officials and economists is no evidence that it is accurate; indeed, in our age of inflation and economic manipulation, an official pronouncement is more likely to be political than sensible. With the gates wide open, the rush of liquidity is bound to inflict serious harm not only on the American economy but also on global conditions. The Federal Reserves utter disregard of the market rate of interest, which guides the efficient employment of all factors of production according to consumer choices, is bound to do great harm to the economic structure. It causes severe maladjustments and imbalances which market forces sooner or later are bound to correct.
Record-low interest rates encourage present consumption and generate massive debt. In just five years, total financial as well as non-financial American debt has surged by 51 percent or $10.9 trillion to more than $32 trillion, three times the annual Gross National Product. The Federal government itself is chafing under $6.8 trillion debt and adding $1.6 billion a day every day. At present interest rates, this debt alone commands charges of $300 billion a year, or more than $1,000 per man, woman, and child. It may be no concern for officials and politicians who, like Franklin D. Roosevelt, reassure us that internal debt merely is a debt by the nation to the nation and interest payments just are payments to ourselves. But it frightens this observer. It may soon distress millions of households which, tempted by low mortgage rates, converted their housing equities into consumer goods and new debt. During the last quarter alone American households added $397.6 billion in mortgage debt and another $40 billion in credit card debt. The annualized rate amounts to more than $1.5 trillion or approximately fifteen percent of GNP. If it is true that the living standard of Americans has been stagnant for years, we must draw the startling conclusion that this boost in debt was needed to maintain it. If the rate of new indebtedness should ever decline, or the people should choose to repay some debt, living standards would surely plummet.
Facing the mountain of debt, even President Roosevelt would be frightened today as nearly one-half of the U.S. Treasury debt is held by foreigners. The Bank of Japan alone owns $440 billion of Treasury securities, the Bank of China some $122 billion and more every day. Other Asian governments hold $166 billion. They have become major creditors because U.S. trade deficits, which are a direct consequence of the super stimulation, now exceed $500 billion a year. Yet, U.S. dollars do not readily plunge in foreign exchange markets, as other currencies would, because they are special, they are the primary reserve currency of the world. Central and commercial banks and millions of individuals all over the world hold and use them; some central banks eagerly purchase them in order to assist their own export industries. In Keynesian fashion, they promote employment by weakening their own currencies.
"A small debt makes a man your debtor, a large debt makes him your enemy." If this old saw holds true also for governments, the U.S. government must have countless enemies and be making more every day. Foreigners are financing the American purchase of goods and services, half a trillion dollars worth every year, which visibly sustain American standards of living. Foreigners are investing in U.S. Treasury obligations and dollar assets, trusting in the continuing integrity of the U.S. dollar. But with the stock of dollars rising incessantly and American debt soaring at disturbing rates, their trust is wearing thinner every day. By now, they may be considering the following scenarios.
No central bank on earth, not even the Federal Reserve System, can continually inflate its currency and defy market rates of interest without harming both its currency and the economy. Inflation tends to accelerate and ultimately destroy the currency and cripple the economy. And no government whatsoever can suffer budget deficits of half a trillion dollars annually without impairing its standing with its creditors. Piling debt on debt undermines their trust and raises the crucial question of debt resolution.
Important foreign creditors nevertheless may choose to stay the course in the hope that their debtor will bring his house into order. They may continue to peg their currencies to the U.S. dollar, as the government of China has been doing with persistence, and to enjoy the influx of dollars. It not only has given employment to millions of Chinese workers producing goods and services for the American market but also attracted much American capital and technology enabling them to leap from 19th century economic conditions to contemporary high-tech capability and productivity. They obviously will not make haste to increase the value of their currencies, which would depress their sales and curb the flow of American capital. They may even be prepared to bear the costs of a sudden devaluation of their large dollar holdings, if the U.S. dollar should finally fall under the growing weight of foreign indebtedness.
Other foreign creditors who are dismayed by the soaring trade and budget deficits of their giant debtor may quietly reduce their holdings of U.S. Treasury obligations. The recent fall of the U.S. dollar from some 120 yen to just 108 may signal a change in Japanese attitude and policy. At the same time the American dollar fell more than ten percent toward the euro. The European Central Bank may not have reduced its dollar holdings, but many European investors and traders undoubtedly did. They may be frightened by the soaring American deficits or merely seek higher interest returns in European capital markets. Growing foreign reluctance to continue to cover American trade deficits and help finance U.S. Treasury deficits is bound to affect American financial markets and economic activity. All interest rates must rise although the Federal Reserve may want to offset foreign reluctance with its own willingness to support Treasury obligations. But such Fed reaction may alarm many foreign creditors who may react by liquidating more U.S. Treasury obligations; it surely would trigger a financial crash and launch a world-wide recession. Fear is the driving force of all crashes.
Both U.S. Treasury and Federal Reserve officials seem to underrate the growing international dangers to both the dollar and the economy. But even if they were cognizzant of the true situation, their choices of action would be rather limited. A few academic advisers favor instant removal of the prime causes of the predicament; they would halt the Federal Reserve credit expansion forthwith and balance the Federal government budget with due haste. They would allow interest to find its market rate and capital and labor markets to readjust freely to the preference and choices of the people. In short, they would stabilize the U.S. dollar and release economic life from its most harmful constraints. But they are fully aware that such a solution would be rejected summarily not only by the policy makers but also by the American people. Under the sway of the policy makers and their spokesmen, most people are unaware of the cause-and-effect relationships of monetary policies and their portentous effects. And even if they were more knowledgeable in monetary matters, they probably would reject a sudden, resolute stabilization of the dollar which would painfully reveal the full extent of the damage inflicted by the fiscal and monetary stimuli. After many years of maladjustment the withdrawal would usher in a painful recession which probably would be long and severe due to numerous institutional barriers impeding or even thwarting the necessary readjustment. Few Americans are likely to place their trust in these advisers and opt for such a scenario.
The pessimists in our midst envision a truly calamitous chain of events. They are convinced that present policies will continue year after year until inflation will accelerate and finally destroy the dollar, as it has so many other currencies in the past. Federal spending is scheduled to head ever higher not only to meet existing military commitments in Iraq and Afghanistan but also to expand Medicare, the Federal healthcare program for the elderly. Both political parties are eager to include prescription drugs, which are estimated to cost $400 billion over the next decade. The real bill, of course, would be much higher. Pessimists brace for ever greater instability and prepare for another Great Depression with declining world trade and commerce and falling standards of living around the globe. These augurs now portend political consequences that may follow the economic upheaval.
This economist cannot envision the total destruction of the American dollar, the primary world currency. Surely, it will continue to depreciate at various rates and the American economy will remain sluggish and unstable. The dollar may even have to share its eminent position as the world reserve currency with the euro which itself suffers from massive deficit spending by the three largest member countries: Germany, France, and Italy. The dollar may even face a crisis similar to that in 1979 when the rate of inflation soared to 13.5 percent, the prime rate to 15.75 percent, and the mortgage rate to 14 percent or more in some parts of the country. Financial life ground to a halt in two dozen states which had usury laws prohibiting credit transactions at such rates. The Federal Reserve, under new management, finally broke the inflation fever by raising its basic rate to 12 percent. The subsequent readjustment was long and severe, especially in the housing market. A similar turning point may be reached in coming years when the Federal Reserve, under new management and in a crisis, will raise its rate to market levels and allow the American economy to readjust. And once again the Fed may succeed in stabilizing a smaller dollar. We cannot foresee the number of rescues needed in coming years, but we believe that, in the end, the fiat dollar will need the support by a commodity dollar which served this country rather well throughout its history.
A few pessimists who are ardent friends of the enterprise order justify their gloomy outlook with references to the surge of protectionism in the United States. Scarcely a day passes without some well-known politician or newsman denouncing America's foreign trade partners for amassing unwarranted trade surpluses. China which prides itself in its trade with the U.S. is the favorite target of disapproval and censure. Protectionists would impose a steep surcharge on all imports from China and other countries with large surpluses. They may even call for legislation that would take the U.S. out of the World Trade Organization.
The United States government sought to protect "infant industries" from the beginning of national history. Its chief instrument was the protective tariff. Even after American industries had grown to a position equal to all others, they were said to need protection from cheap foreign labor. Protectionists still raise their voices whenever the rate of unemployment rises for any reason. They are loudest in industries with militant union labor suffering high rates of unemployment.
An American slide into protectionism unfortunately would have grave consequences not only in the United States but also throughout the world. It would not alleviate the very causes of the present imbalance: the Federal Reserve stimuli and Treasury deficits. In fact, it would aggravate the situation as new import restrictions would cause goods prices to rise, consumption to be curtailed, and levels of living to fall. It would slash various sources of government revenue, which in turn would boost budget deficits and make matters worse. Moreover, the government of China and other countries hurt by American tariffs undoubtedly would retaliate with similar restrictions on American goods. In American footsteps, they would not hesitate to hurt their American trade partners and, in interventionist fashion, impose even more restrictions on their own people.
A more optimistic scenario would be a gradual abandonment of the monetary policies and an orderly readjustment to unhampered market conditions. The Federal government would balance its budget in the next few years by holding the line on both transfer spending and military outlays. The Federal Reserve System would allow the market rate of interest to resume its basic function, the efficient allocation of economic resources in the course of time. A painful readjustment process would commence immediately; interest rates would rise, calling a halt to misguided spending patterns and encouraging saving and capital formation. Boom industries soon would suffer withdrawal symptoms while others would revive from several years of stagnation. At the same time China and other creditor countries hopefully would allow their currencies to rise and the U.S. dollar to decline gradually, which would trim America's trade deficits, raise goods prices, and depreciate all dollar debt at home and abroad. With the Federal budget in balance and interest rates at market levels, the dollar would continue to function smoothly as the primary world currency.
Such a scenario would tell the truth about the international state of affairs. In world money markets a dollar depreciation of 30 percent would reduce the financial as well as non-financial American debt of $32 trillion by that percentage, which would approximate one year's GNP. It would diminish the three-trillion-dollar international debt burden of the U.S. government by one trillion dollars. Goods prices would rise at lesser rates, which undoubtedly would bring relief to all debtors while it would diminish the wealth of creditors. There are many ways of cheating a creditor. The United States government would use an old political ruse, the depreciation of its currency.
It is unlikely that present policymakers will soon see the urgent need for basic changes; they like the present system. In contrast, the political opposition, ever eager to take the place of the present team, may recognize the need some day and advocate the return to solvency and integrity. When the electorate finally recognizes the urgent necessity and elects and empowers the opposition to correct the course, the dollar may stabilize. It will need much courage and leadership to endure the pains of readjustment and hold the course.
Our favorite scenario builds on a gradualist adjustment which, in democratic societies, is the only realistic outline of changes. When the electorate finally realizes that the U.S. dollar moves from crisis to crisis at ever shrinking value and purchasing power it may want to retrieve the old anchor of all currencies, the gold standard. The world abandoned it in 1971 when President Nixon defaulted in international gold payment obligations and made the fiat dollar the only available medium of exchange. Since then the world has moved from crisis to crisis, suffering from ever increasing maladjustments.
The East Asian crisis of 1997 may have special significance because it may point to important changes to come. Five currencies which were pegged to a basket of currencies suddenly collapsed after years of current-account deficits. In time, the Malaysian ringgity was devalued by 25 percent, the Indonesian rupiah 33 percent, the Philippine peso 23 percent, the Singapore dollar 9 percent, and the South Korean won 35 percent. Asian bankers and politicians readily laid the blame for the crisis on foreign capital, especially the U.S. dollar, on its massive influx and ready flightiness. The crisis demonstrated anew the vulnerability of the present monetary system and the need for a more stable and just monetary order.
Many Asians are convinced that they experienced the currency crisis as a result of the international U.S. dollar policy. The dollar system exports massive inflation, instability, and unsustainable debt around the world, and the oil-producing countries of Asia exchange strategically important and diminishing assets for paper dollars. It is hardly surprising that the subject of their increasing concern is the role of gold in international trade and financial exchanges. In Muslim countries such as Malaysia, Indonesia, and the states of West Asia and North Africa monetary stability is an important issue, but equally important is the issue of justice. An international system based on gold is believed to address both these issues. In 2001 the United Arab Emirates apparently made a beginning toward what they believe to be a more equitable world order; they issued gold dinar coins. A public statement by the Islamic Mint even made a fervent religious point in favor of a new gold standard: "The reintroduction of gold money can be expected to be a significant milestone in the changing tides of the world economic and social situation . . . there is no doubt that this work puts behind it a century of suffering and defeat for Muslims and opens the coming age to a powerful and revived Islam."
We may challenge such prognoses of a powerful and revived Islam; power and revival require more than a gold dinar. But there cannot be any doubt that a gold dollar would restore justice in international relations and reassert American power and leadership. It would clear away much conflict and strife and pave the way toward a more equable and peaceful world order.