A view from America …
The economic crisis we endure today is only the latest chapter in the century-long struggle to restore financial order in world markets — a struggle whose outcome is inextricably bound up with U.S. prosperity and the promise of the American way of life.
As we think through the consequences of financial disorder, what come to mind are the economic heresies of fascism and bolshevism, and the catastrophic world wars of the 20th century. These historical episodes compel us to remember that floating exchange rates and competitive currency wars became the occasion for violent social disorder and revolutionary civil strife in the first half of the 20th century. They remind us that natural resource rivalry, monetary depreciation, mercantilism, and war clouds have appeared together from time immemorial.
The monetary disorder and national currency wars of that era are now being repeated in our own time, and have again led to social disorder and pervasive civil strife. I cite only one example among legions. The recent “Arab spring,” a revolutionary upheaval of the suppressed Islamic poor and middle class, was triggered by a vast food and fuel inflation, transmitted to the dollarized world commodity markets by hyper-expansive Federal Reserve monetary policy during 2008-2011. Huge price increases for basic necessities penetrated into the heart of all subsistence economies — in this case, North Africa. Because the dollar is the official reserve currency of the world trading system, when the Fed creates excess credit to bail out the banks and the U.S. government deficit, it exports some of the excess liquidity abroad, igniting basic commodity inflation and the social strife this engenders. At home, the same rising prices of food, fuel, and other basic needs impoverish those on fixed incomes. Moreover, they lower the standard of living for the middle class, held back by wages and salaries that always lag rising prices.
Even more ominous, the surge of contemporary mercantilism and competitive currency depreciations — initiated by monetary authorities worldwide — brings to mind the national rivalries among the Great Powers between World War I and World War II. Amidst financial disorder, floating exchange rates, and beggar-thy-neighbor policies during the interwar period of 1918-1940, civilization witnessed the rise of imperial Japan, Mussolini, and Hitler. But the 1920s had begun with great hope, including overwhelming confidence in the primacy of central banking, led by Benjamin Strong of the Federal Reserve System and Montague Norman of the Bank of England. The unrestrained boom of the 1920s, rising on a flood tide of central bank credit — based on the reserve currency role of the dollar and the pound — led to the brief illusion of permanent prosperity. That “new era” ended in austerity, currency chaos, autarky, depression, and world war.
Thus, it becomes increasingly urgent, if we might learn from the past, to restore international monetary order now, with reforms to re-establish a stable dollar and stable exchange rates. The United States is still able to set the example for the world to emulate. Indeed, the major powers publicly endorse international monetary reform. All seem to sense that only with stable exchange rates can the world trading community rebuild global incentives for equitable, balanced, and growing world trade — and, with these incentives, create the conditions for global growth and rising standards of living.
Now comes the perennial question: How, precisely, does the United States once again establish a stable dollar? How do the United States and other countries get from “here” to “there” — that is, from the anarchy of floating-paper currencies to stable exchange rates based on an impartial, nonnational monetary standard? These questions have been debated at crucial junctures over the last century: before and after the creation of the Federal Reserve System in 1913; after the catastrophe of World War I; after Franklin Roosevelt in 1933 expropriated and nationalized all American citizens’ gold holdings; after Richard Nixon severed the last weak link between the dollar and its gold backing in 1971.
Recently, the same debate intensified after the Great Recession of 2007-2009, marked as it was by wild exchange-rate and currency instability. But it was the vast, inequitable financial subsidies — provided by the Federal Reserve system and the United States Treasury to an irresponsible, often insolvent, and cartelized world banking system — that sparked national outrage. In free markets, with responsible agents, insolvency should entail bankruptcy. Those who earn the profits in a free market must themselves endure the losses. Without the discipline of bankruptcy, crony capitalism must result — with the taxpayer providing the subsidies.
What lessons might we learn from American financial history? Consider the fact that from 1792 until 1971, the dollar was defined in law as a weight unit of gold (and/or silver). The last vestige of convertibility of the dollar into gold was abolished by President Nixon’s executive order on August 15, 1971. Since then, the dollar has depreciated dramatically, to the point that it is now worth a mere 15 pennies, adjusted by the CPI. After generations of manipulated paper — or credit-based floating currencies — which ignite the currency wars of our own era — it has become increasingly clear that free trade without stable exchange rates is a fantasy.
It is true that the post-World War II dollarized Bretton Woods system, inaugurated in 1944, gave rise to a new era of free trade; but it was free trade maintained and subsidized by the especially open market of the United States. After World War II, the United States controlled 50 percent of world output. Thus, the U.S. dollar became the sole acceptable reserve currency with which to conduct international trade — displacing gold by international agreement at Bretton Woods. The Bretton Woods system caused the dollar to become substantially overvalued as a result of worldwide excess dollar demand for transactions and foreign official reserve holdings. The overvaluation of the dollar was intensified by post-World War II currency depreciations and inflationary fiscal and monetary policies of other major countries.
The European currencies were finally stabilized and made convertible on current account in 1959 through the monetary reform of the European Payments Union. But the dollar remained overvalued as the sole official reserve currency of the Bretton Woods monetary regime (of 1944-1971). Overvaluation of the dollar was compounded by excessive Federal Reserve money expansion within the pegged currency system of Bretton Woods, thus systematically raising the cost and price level in America relative to other major countries. This happens because the Federal Reserve creates money to purchase Treasury debt securities, a process which finances the U.S. budget deficit. But the newly created money On behalf of Treasury spending is not associated with the production of new goods. Thus total demand exceeds total supply at prevailing prices. Prices rise (inflation), followed by rising costs. American goods thereby become incresingly uncompetitive in world markets. After the collapse of the dollar-based Bretton Woods system, floating-pegged exchange rates ensued (1973-2012).
Compared to the U.S., both developed and developing countries to this very day have aggressively protected their markets with undervalued currencies, quotas, high tariffs, and discriminatory regulations — China most egregiously in recent years, Japan earlier. This arrangement has characterized the world trading system not only under Bretton Woods but also amidst the floating-pegged currency arrangements of today. Successive American administrations, all committed to free trade, have made the U. S. open market an easy target for mercantilist nations worldwide. The good intentions of American free traders have never been fully reciprocated. As a result, developing countries have mobilized undervalued currencies with which to build growing export machines, and without giving commensurate trade reciprocity to the United States — the General Agreement on Tariffs and Trade (GATT) and World Trade Organization (WTO) notwithstanding.
The World Dollar Standard The dollar’s role as an official reserve currency
has enormously impacted the United States economy. Net U.S. investment abroad is the value of assets and claims held by U.S. residents and their government abroad, minus the assets and claims foreigners and their governments own in the U.S. In 1980, net United States international investment was 10 percent of GDP. In 2010, it was negative 20 percent of GDP. The empirical data show that the entire shift from positive to negative is accounted for by the official, accumulated, United States balance-of-payments deficit.
In a nutshell, since World War II, free trade has often been at the expense of United States business, manufacturing, and labor. The problem of dollar overvaluation was compounded not only by its reserve currency role, but also by the perennial United States budget deficit, increasingly financed by Federal Reserve money and credit creation. But the U.S. budget deficit is financed not only by the Federal Reserve and the banking system, but also by foreign government purchases of U.S. Treasury debt, which is held as official national reserves. China and Japan, two major beneficiaries of U.S. trade and budget deficits, hold official reserves equal to approximately $2 trillion of U. S. government related debt. The authorities, mesmerized by neo-Keynesian mythology, do not understand that the exponentially growing U.S. budget deficits absorb a huge fraction of domestic production, which would otherwise be available for export sales to the global market. Proceeds from these exports, growing faster than payments for imports, could then be used to settle U.S. balance-of-payments deficits, thereby reducing U.S. debt.
Let us remind ourselves that after World War I, the reserve currency system, based on the pound and the dollar, was liquidated in total panic (1929-1933), turning a cyclical recession into the Great Depression. Today we have relearned the lesson, as expansive Federal Reserve money creation has combined with the official reserve currency role of the dollar to cause massive credit, commodity, and general price inflation worldwide. (The purchasing power of the 1950 dollar adjusted by the CPI has declined over 90 percent.) But, like Banquo’s ghost, deflation and unemployment still haunt us, despite the Greenspan-Bernanke era of quantitative easing (often known as money-printing). That is because as soon as Fed money-printing slows down, prices tend to fall, with the threat of deflation and unemployment (2007-2012) coming to preoccupy the financial authorities. The inflation-deflation cycle is systemic, caused by perennial budget deficits and unhinged Federal Reserve stop-go monetary policies.
The scientific method and economic history teach us that under similar conditions, similar causes tend to produce similar effects. The saying makes the point: “History never repeats itself, but it often rhymes.” We know that reserve currency systems have been tested by the market, and that they have failed in the past (e.g., Sterling in 1931; the Bretton Woods dollar in 1971). And the timing of their collapse cannot be accurately predicted. But now is the moment to prepare a program of monetary reform.
How, therefore, may America now lead other nations toward an equitable world trading system based on a balanced monetary order, a disciplined Federal Reserve, balanced budgets, stable exchange rates, and reciprocal free trade to the mutual benefit of all? How do leading nations stage the resumption of a modernized true gold standard, ruling out the escalating debt and leverage engendered by the perversities of floating exchange rates and official reserve currencies?
America at the Crossroads
For the purpose of true monetary reform, we have an example from the only available laboratory of monetary policy: human history (surely a better source than abstract equations imported from the blackboards of Princeton or the University of Chicago). The empirical data show that the classical gold standard (1879-1914) had its imperfections, but was the least imperfect monetary system of the last two centuries, perhaps even of the past millennium. At the end of the entire period (1879-1914), the general price level was almost exactly where it began. Overall economic growth was the equal of any period since the birth of the Republic.
Given the gravity of world financial disorder, America must take one of two divergent roads. She may persist on the road of soft indulgence afforded by the unstable dollar’s official reserve currency role. It is true that the absolute dominance of the dollar has gradually diminished since World War II, given the rise of Asia and Europe. Still, the world dollar standard could continue for another generation because of the scale and liquidity of the dollarized markets across the globe. Consider the extraordinary fact that almost two-thirds of world trade, not including that of the United States, is still transacted in dollars. About 75 percent of world commodity markets are still settled primarily in dollars. U.S. dollar financial markets are the repositories for as much as 5 to 6 trillion of foreign reserves, not easily invested elsewhere. In the service of unrestrained U.S. politicians, the world reserve currency role of the dollar underwrites the twin budget and balance-of-payments deficits, as well as the exponential increase of United States debt — which must lead, in the absence of monetary reform, to national insolvency. This “exorbitant privilege” — that is, the dollar’s role as the world’s primary reserve currency — does mislead American authorities, policy makers, and academic economists to persist in rationalizing the reserve currency privilege of the dollar as a boon instead of a deadly economic malignancy.
On the other hand, far-seeing American leaders could acknowledge that the dollar’s official reserve currency role is an insupportable burden instead of a privilege. It is a burden because 50 years of supplying official reserves to the world necessarily entails the uncontrolled increase of dollar debt, ultimately financed by Federal Reserve credit expansion, foreign central banks, and the global banking system as a whole. Moreover, dollar deficits, monetized by the Fed and foreign banking authorities, are the fundamental cause of 50 years of global inflation. Let me repeat that the purchasing power of the post-World War II dollar has shrivelled to less than a dime. Finally, the steady dissipation of the U.S. international investment position — assets and claims in other countries owned by the United States, minus foreign liabilities — has led to the decline in American international competitiveness.
Recently, as much as 60 percent of the United States budget deficit has been financed by money and credit conjured into existence by the Federal Reserve. But these newly created dollars are not associated with new production of real goods and services. Under such market circumstances, total demand must exceed total supply, expressed by price increases in one sector of the world economy, such as oil and commodities (2003-2011), Internet stocks (1995-2000), or real estate (2004-2007). Fed credit expansion unassociated with the production of new goods and services — that is, the creation of demand without supply — is the hidden inflationary mechanism behind the world dollar disease. However, when the Fed tightens credit abruptly and substantially, as in 2006, the process is reversed with deflationary consequences (2007-2009).
Moreover, some Fed-created excess dollars flood abroad, sustaining the perennial United States balance-of-payments deficit. But the excess dollars going abroad are not inert. They are purchased by foreign central banks against the issue of their newly created domestic money, most prominently today by China in the form of new yuan. Global purchasing power is thereby augmented in this case by new issues of yuan — also unassociated with the production of new goods. The Chinese and other foreign central banks promptly reinvest the accumulated dollar reserves in U.S. Treasuries, financing the U.S. budget deficit; these foreign dollar reserves also finance the U.S. balance-of-payments deficit and the inordinate personal consumption debt of U.S. residents.
Because of the official reserve currency role of the dollar, everything carries on as if there were no United States deficits. There is little compelling incentive for the U.S. government — or its congressional budget masters, or the consumer holding the ubiquitous credit card — to adjust. In a word, the official reserve currency role of the dollar enables America to buy without paying. Worse yet, the necessary adjustment mechanism needed to rebalance world trade has been permanently jammed, immobilized.
If American leaders continue to choose rising debt and deficits financed by the Fed, the reserve currency dream world in the United States may carry on for many years before its collapse. But collapse is inevitable.
The choice is ours. Indeed, this election may be our last chance. If American leaders embrace true monetary reform, they will reject the siren song of the reserve currency’s exorbitant privilege. They will acknowledge the insupportable burden of the dollar’s official reserve currency role. They will plan now for the termination and windup of the dollar’s reserve currency role. They will plan to restore dollar convertibility, defining the dollar by statute as a certain weight of gold, and then propose gold as the missing and impartial global balance wheel by which to settle residual balance-of-payments deficits among nations and currency areas. A balanced budget amendment to the American Constitution should follow.
Moreover, such a monetary order, based on convertibility of the dollar to gold, free of government manipulation, provides an indispensable rule for the conduct of the Federal Reserve System, bringing to bear rule-based market discipline to stabilize the Fed’s monetary policy. Domestically, the institutional discipline of dollar convertibility would limit the Fed’s unrestrained discretion to print money, finance the government budget deficit, and bail out the cartelized banking system. Under dollar convertibility, if the Fed creates too much money, causing inflation, the people are free to redeem currency for gold at a price set by law. Too great a loss of gold would threaten the solvency of the banks. Thus, the Fed and the banking system would be forced to reduce the growth of money and credit, thereby maintaining convertibility and containing inflation. Conversely, deflationary tendencies could be contained by Federal Reserve credit — made available at market rates on high-quality collateral — without threatening currency convertibility.
To choose true monetary reform and balanced budgets is to embrace not only the American Constitution, but also the nation’s historic financial policy that led to world leadership. Article I, Sections 8 and 10 of the United States Constitution enabled the monetary reconstruction of the American Republic at the founding on the bedrock of a gold dollar. The Constitution mandates that only Congress has the power “to coin money and regulate the value thereof.” The Constitution prohibits the states from making anything but “gold and silver a legal tender.” Shorn of the crushing weight of trade disadvantages caused by inflation and the accumulating debt and deficits — originating in budgetary excess and the reserve currency role of the dollar — America could again become Prometheus unbound.
American economic reconstruction, grounded by the true gold standard, would lead to a resurgence of rapid growth, empowered by renewed confidence born of market expectations of a stable long-term price level. With American leadership, other nations would follow. By re-establishing an effective and equitable international adjustment mechanism, international monetary convertibility to gold would end perennial deficits, manipulated currencies, and the threat of currency wars among the major nations.
The true gold standard — that is, a dollar convertible by statute to a specific weight of gold, joined to the windup of the official reserve currency role of the dollar — would make vast sums of money available for long-term productive investment. With a stable long-term price level, speculators worldwide would abandon unproductive inflation hedges. This dishoarding would yield immense, liquid savings for productive investment in real goods and services. Equity and true capital investment would gradually displace debt and leverage. Under conditions of stable money and stable exchange rates, savings would be redeployed by entrepreneurs and investors in new and innovative plants, technology, and equipment — minimizing unemployment, as skilled and unskilled workers are hired to work the new facilities. The export production machine of the United States would be reoriented to produce for the world market, which would engage all the positive and equitable effects of economies of scale and free trade.
This is the true road of American monetary and economic reconstruction. Let us begin the great work before us.
This article was previously published in The American Spectator.
America must now take one of two divergent roads. First, America may persist on the road of soft indulgence afforded by the unstable dollar’s official reserve currency role—the enabler of ever-rising budget and balance-of-payments deficits, therefore of immense American foreign debt. Though the centrality of the world dollar standard may gradually decline, it may still continue for another generation because of the unique amplitude and liquidity of the dollarized financial markets, repositories for vast sums not easily stored elsewhere as official national reserves. Therefore, the “exorbitant privilege” of the dollar’s role as the world’s primary reserve currency may enable American authorities, policy makers, and academic economists to persist in rationalizing the misleading mask of this reserve currency privilege as a boon, instead of a deadly economic malignancy leading ultimately to national insolvency.
Or, second, American leaders may acknowledge the dollar’s world reserve currency role as an insupportable burden, instead of a privilege. It is a burden because decades of supplying dollar reserves to the world in the form of dollar debt has caused an exponentially rising burden of United States foreign and domestic debt. This process enables America to finance rising American budget and balance-of-payments deficits without institutional limits. These monetized deficits of the reserve currency country entail arbitrage mechanisms which cause inflation followed by deflation both at home and abroad.
If American leaders continue to choose option one—rising debt and deficits financed by the dollar’s reserve currency role—the reserve currency fantasy may carry on for several more decades before its complete collapse. Historians have analyzed the very same pattern of gradual reserve currency decline of the British imperial pound as it persisted after World War II—lingering as it did on life support for three more decades, then collapsing, finally making clear to the world the general collapse of British power.
If American leaders choose option two, they will reject the siren song of the reserve currency’s “exorbitant privilege.” They will acknowledge the insupportable burden of the dollar’s official reserve currency role. They will plan now for the termination and wind up of the dollar’s reserve currency role, restore dollar convertibility to gold, define by statute the dollar as a certain weight unit of gold, and propose gold as the sole international reserve currency, thereafter settling all residual balance-of-payments deficits in gold alone.
For America to choose option one is not unlike an intelligent, insouciant dare-devil, Icarus, who—well-suited for the leap—takes off from the fiftieth floor of his skyscraper, secure in the knowledge that he is feeling fine ten floors down, the street level still forty floors far below.
To choose option two is to choose the American Constitutional roadmap to monetary reconstruction on the bedrock of a stable dollar, shorn of the crushing weight of trade disadvantages and the accumulating dollar debt intensified by the reserve currency system.
American monetary and economic reconstruction on this historic basis will lead to a resurgence of rapid economic growth empowered by a sound and stable dollar and the renewed confidence and certainty born of market expectations of a stable long-term price level. These fundamental incentives will engender a vast increase of true savings available for long-term investment from current income—investable savings—and much more from dishoarding. The outpouring of savings will be redeployed by entrepreneurs in new and innovative plants, technology, and equipment, minimizing unemployment as skilled and unskilled workers are hired to manage the new facilities. The United States export production machine will be reoriented to the world market under free and fair trading conditions.
This is the true road of American monetary and economic reconstruction.
This article was previously published at The Gold Standard Now.
A view from America, previously published at The American Spectator.
The super-committee of Congress is the latest group to confess abject defeat by the Treasury budget deficit. Who can be surprised by this total failure? During the past generation Congress has made as many as fifteen legislative attempts to control government spending — aimed ultimately at a balanced budget. The most notable efforts were those sponsored by the all-time budget hawk, Senator Phil Gramm of Texas. But every administrative and legislative effort by the authorities, no matter how well-intentioned, has collapsed. Why is this so?
Nobel economist Milton Friedman believed the solution to the budget deficit problem was to deny Congress tax revenues. So he advised Congressmen and Presidents to oppose all tax increases — thereby denying bloated government the funds with which to increase spending. But Friedman’s advice has failed, too. We know this because marginal tax rates have been reduced from as high as 70% in 1964 to 15-20-39% in 2011 — depending on the type of income. But congressional spending has nevertheless increased every year — such that, today, only 60% of the Federal budget is financed by taxes, the remainder by Treasury debt. Total direct Federal debt is now about equal to total U.S. output.
The intractable budget deficit and the inexorable rise of government spending has a simpler explanation. Congress and the Treasury are in possession of several open-ended charge accounts — “permanent credit card financing” — with no limits. With its charge cards the Treasury can borrow new credit (money) from the banking system — much of what it needs every year to finance the ever-rising budget deficit.
A look at the current Federal Reserve Balance Sheet shows that the Fed has created about $1.7 trillion of new credit (money) with which to purchase Treasury debt. Foreign central banks have created about $2.7 trillion of new credit to purchase U.S. Treasury bonds. This global, electronic, money-printing exercise has financed almost 30% of the total direct debt of the U.S. Treasury. In 2002, Ben Bernanke, now Chairman of the Fed, did not mince words to describe this process:
[U]nder a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero…. [T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.
He might have added that these “no cost” dollars, printed by the Fed, are the enablers of the perennial U.S. budget deficit.
But the Fed is not the only credit card used by the Treasury to finance the budget deficit. Because the dollar is the world’s reserve currency, foreign central banks also finance U.S. budget deficits (as the custody account of the Fed balance sheet shows). Domestic and foreign commercial banks, too, supply vast amounts of new credit to the U.S. Treasury because domestic, foreign, and international bank regulators, such as the Basel authorities, define U.S. sovereign bonds as high quality assets for which bank reserves are not necessary. Therefore financial institutions can qualify their overleveraged balance sheets by loading up on Treasury Securities. Indeed, only 10-20% of the total direct debt of the U.S. Treasury is now owned by the non-bank, non-government private market. Given the reserve currency role of the dollar, the Federal Reserve and foreign central banks have been given every institutional incentive to finance the U.S. budget deficit. Beginning with World War I, every monetary discipline has been removed by domestic and international authorities, such that runaway government spending everywhere relies on the ultimate credit card — newly created money in the banking system.
The simplest solution to the government spending problem in Congress is “to tear up” its credit cards. The way to do this is not with ad hoc and unavailing administrative patchworks, all of which are nullified by world banking system credit made available to the U.S. Treasury. Instead, the effective democratic solution is authorized by the U.S. Constitution — in Article I, Sections 8 and 10: — whereby the control of the supply of dollars is entrusted to the hands of the people — where it stayed for most of American history, especially from 1792 to 1914. This was America’s longest period of rapid, non-inflationary, economic growth — almost 4% annually, with the budget under control except wartime.
Congress need only mobilize its unique, Article I, constitutional power “to coin money and regulate the value thereof.” From 1792 to 1971 Congress defined by law the gold value of the currency such that paper dollars and bank demand deposits were convertible to their gold equivalent — by the people (1792-1914) and/or by governments (1933-1971). Congress should exercise this constitutional power to restore dollar-gold convertibility, because of the proven budgetary and economic growth benefits of a dollar as good as gold.
First, the discipline of convertibility would automatically set the limit on Treasury access to its Federal Reserve credit card. If the Federal Reserve created more money than participants in the market wanted to hold, people would get rid of the inflationary excess by promptly exchanging paper and credit money for the gold equivalent. But under the true gold standard, the Fed and the commercial banks would be required by law to maintain dollar-gold convertibility at the statutory gold-dollar parity — or suffer insolvency. In order to maintain dollar convertibility to gold, the Fed and the commercial banks must reduce the quantity of money and credit, including credit to the Treasury — thus controlling government spending increases and inflation.
Second, the empirical evidence of American economic history also shows that convertibility to gold stabilizes the value of the dollar. The same evidence shows that a stable dollar also stabilizes the general price level over the long run. For example, under the gold standard, the price level in 1914 was at almost exactly the same level as it was in 1879 and in 1834. There was no long term inflation, even over an 80 year period! But from 1971 — Nixon’s termination of dollar-gold convertibility — until 2011, the purchasing power of the dollar (adjusted by the CPI) has fallen 85% in a 40 year period.
Third, gold convertibility of the dollar leads to a vast outpouring of savings from inflation hedges such as commodities, farmland, art, antiques — almost anything perceived to be a better store of value than depreciating paper currencies. Stable money also creates incentives to save from income. Combined with the global release of trillions of hoarded, inert, unproductive inflation hedges, convertibility triggers new savings which would pour into the productive investment market. The new investment would give rise to a general economic expansion — through new business, new products, new plant and equipment, creating thereby a renewed demand for labor to work the expanding production facilities.
The restoration of a dollar worth its weight in gold provides not only a missing and necessary brake on government spending, but a stable dollar supplies the missing steering wheel by which to guide the immense, hoarded savings into long-term productive investment. Dollar convertibility to gold is the simple, institutional financial reform which terminates the fear of rapid inflation — thus transforming unproductive, store-of-value hedges into real investment capital with which to inaugurate a new American era of rapid economic and employment growth.
China is an important trading partner of America. But it may also be a mortal threat. And not for the conventional reasons usually cited in the press. Ironically, it is a threat because China is in fact a financial colony of the United States, a colony subsidized and sustained by the pegged, undervalued, yuan-dollar exchange rate. Neither the United States nor its economic colony seems to understand the long-term destructive consequences of the dollarization not only of the Chinese economy but also of the world monetary system. While the Chinese financial system has been corrupted primarily by tyranny, deceit, and reckless expansionism, it is also destabilized by the workings of the world dollar standard. Neither the United States nor China has come to grips with the perverse effects of the world dollar standard.
The social and economic pathology of 19th century colonialism is well studied, but the monetary pathology of its successor, the neo-colonial reserve currency system of the dollar, is less transparent. In order to remedy this pathological defect, the United States must rid itself of its enormous Chinese financial colony, whose exports are subsidized by the undervalued yuan in return for Chinese financing of the U.S. twin deficits. Both China and the United States must also free themselves from the increasing malignancy of the dollar reserve currency system, the primary cause of inflation in both China and the United States.
In the end, only monetary reform, including an end to the reserve currency system, can permanently separate the dollar host from its yuan colony. Without monetary reform, the perverse effects of the dollar reserve currency system will surely metastasize into one financial and political crisis after another – even on the scale of the 2007-2009 crisis.
It is, of course, a counter intuitive fact that China has been financially colonized by the United States. But why is this a fact? Simply because China has chained itself to the world dollar standard at a pegged undervalued exchange rate, choosing therefore to hold the exchange value of its trade surplus – that is, its official national savings – in U.S. dollar securities. It is true that the dollar-yuan strategy of America’s Chinese colony has helped to finance a generation of extraordinary Chinese growth. But China now holds more than 3 trillion dollars of official reserves and more than a trillion dollars in U.S. government securities. These Chinese dollar reserves directly finance the deficits of the American colonial center. This arrangement clearly resembles the imperial system of the late 19th century. The value of a British colony’s reserves were often held in the currency of the imperial center, then invested in the London money market. Thus, the colony’s reserves were entirely dependent on the stability of the currency of the colonial center. While China is America’s largest financial colony, most other developing countries are also bound to neo-colonial status within the reserve currency hegemony of the dollarized world trading system.
China’s dollarized monetary system reminds us of nothing so much as the historic colonial financial arrangements imposed by the later British Empire on India before World War I – India actually remaining a financial colony of England long after its independence in 1947. How did the sterling financial empire work? The imperial colony of India, beginning in the late 19th century, held its official Indian currency reserves (savings) in British pounds deposited in the English money market; independent developed nations at that time, like France and Germany, held their reserves in gold. That is, France, Germany, and the United States settled their international payment imbalances in gold – a non-national, common, monetary standard – holding their official reserves, too, in gold. But the London-based reserves of colonial India were held not primarily in gold, but in British currency, helping to finance not only the imperial economic system, but also the imperial banking system, imperial debts, imperial wars, and British welfare programs. Eventually, as we know, both the debt-burdened British Empire and its official reserve currency system collapsed.
For more than a generation now, a similar process has been at work in China. China is America’s chief colonial appendage. The Chinese work hard and produce goods. Subsidized by an undervalued yuan, they export much of their surplus production to America. But, like the Indians who were paid in sterling, the exports of Chinese colonials are substantially paid in dollars, not yuan – because bilateral and world trade, and the world commodities market, have been dollarized. And thus it may be said that the world financial system is today an unstable neocolonial appendage of the unstable dollar.
China, like its predecessor the British colony of India, has chosen to hold a significant fraction of what it is paid in the form of official dollar reserves (or savings). These dollars are promptly redeposited in the U.S. dollar market, where they are used to finance U.S. deficits. Every Thursday night, the Federal Reserve publishes its balance sheet, and there we now read that more than $2.5 trillion of U.S. government securities are held in custody for foreign monetary authorities, 40 percent of which is held for the account of America’s chief financial colony, Communist China. It is clear that without financial colonies to finance and sustain the immense U.S. balance of payments and budget deficits, the U.S. paper dollar standard and the growth of U.S. government spending would be unsustainable.
It is often overlooked that these enormous official dollar reserves held by China are a massive mortgage on the work and income of present and future American private citizens. This Chinese mortgage on the American economy has grown rapidly since the suspension of dollar convertibility to gold in 1971. China – poor and undeveloped in 1971 – was at that time very jealous of its sovereign independence, sufficiently so to reject its alliance with the Soviet Union – even earlier to attack U.S. armies on the Chinese border during the Korean War.
In an ironic twist of fate, China surrendered its former independence and, as a U.S. financial colony, joined the dollar-dominated world financial system. China’s monetary policy is anything but independent. It is determined primarily by the Federal Reserve Board in America, the pegged yuan-dollar exchange rate serving as the transmission mechanism of Fed-created excess dollars pouring into the Chinese economic system. Perennial U.S. balance of payments deficits send the dollar flood not only into China but also into all emerging countries. The Chinese central bank buys up these excess dollars by issuing new yuan, thereby holding up the overvalued dollar, and holding down the undervalued yuan. Much of these Chinese official dollar purchases are then invested in U.S. government debt securities. So even though America exports excess dollars to China, China sends them back to finance the U.S. budget deficit – much like marionettes walking off one side of the stage, merely to reappear unchanged on the other side.
This is the little-understood arbitrage mechanism of the pegged exchange rate system by which Fed-created excess dollars are bought and held as reserves by the Chinese central bank, in exchange for which newly created yuan are issued, thereby supercharging inflation in China. The Chinese dollar reserves, which are reinvested in the United States, help to ignite inflation in the United States. It is clear that the workings of the official dollar reserve currency system cause spending power to be multiplied, or at least doubled, in both countries. But these central bank issues of new money are unassociated with the production of new goods and services during the same market period. Thus total spending exceeds the total value of goods and services at prevailing prices. When total demand exceeds total supply, the price level must rise.
But just as the subservient, colonial Indians were constrained not to sell their sterling reserves too quickly, so the Chinese are constrained-by politics, diplomacy, and self-interest not to dump their depreciating American dollars. The Indians had to consult their imperial bankers, even though the English were debtors to their Indian colony, because the Indians did not wish to anger the colonial center, nor to precipitate a sterling crisis. From time immemorial, creditors with too large a stake in an over-sized debtor often beg leave of their debtor to get their money back.
China is frustrated by circumstances similar to those of a colony of imperial Britain. Hostility has arisen in the debtor – the United States. Fear of setting off a dollar slide haunts the hostile creditor, China. The difficulty of finding a suitable portfolio of alternatives for a trillion dollars in U.S. government debt annoys the outspoken Chinese financial colony, as it calls for a new world monetary system. But there seems to be no genuine alternative to the very liquid dollar market. De facto illiquidity of official Chinese dollar reserves is enforced by political sensitivities, not by market salability. The debtor, as the saying goes, is “too big to fail.” Thus arises an unstable stalemate, a yuan-dollar pegged exchange rate regime constantly on the edge of a crisis.
The “exorbitant privilege” of the dollar is matched by the insupportable burden of America’s overvalued reserve currency role, which has tended to deindustrialize the colonizer, gradually increasing social inequality by reducing the standard of living of lower- and middle-income American families. The reserve currency country then feels compelled, as the Fed does today, to depreciate the dollar in the vain hope of eliminating the trade deficit and the balance of payments deficit – by becoming more competitive abroad as it becomes poorer at home.
The perversity of the official reserve currency system is endless as China now endures high inflation engendered by its colonial status in the world dollar system.
Which way out?
The floating, pegged exchange rate system based on the dollar has been slowly decaying since the end of World War II. But the dollar-based reserve currency system, because of the unmatched scale and liquidity of the dollar markets, could last another generation. When it will collapse cannot be predicted. That it will collapse, without systemic reform, I think inevitable. Few predicted the timing of the collapse of the pegged dollar system of Bretton Woods. But it did collapse in August of 1971, followed by America’s worst decade since the Great Depression.
Ultimately America, the leader of the unstable world financial system, must choose between two options.
The United States can wait for the eventual demise of the world dollar standard under chaotic
conditions, similar to the final sterling collapse and the subsequent collapse of Bretton Woods in 1971. This option is analogous to the intrepid daredevil who leaps from his 10th floor window, and takes heart that he is still unhurt two floors from the street level.
Or, America could take the lead in reforming the official reserve currency system based on the dollar. Such a monetary reform program would entail a careful windup, by agreement, of the world dollar standard. At the same time, America would reestablish by statute a dollar convertible to gold, i.e., a dollar defined in law as a weight unit of gold. Gold would replace the dollar as the world’s reserve currency.
The reform would, first and foremost, establish a tested, non-national, neutral monetary standard as the basis of a stable dollar-one which reasonable sovereign trading partners could accept. Gold would become the international settlements currency and thus would replace the dollar as the basis of world trade and finance. Inasmuch as monetary history shows that no unstable national currency can permanently serve as the crucial world reserve currency, it follows that neither can an unstable basket of national currencies, nor can a fiction such as the SDR – the reserve asset created by the International Monetary Fund to supplement member countries’ reserves.
But we are left with the question: what does the evidence of American history suggest as the basis for a stable dollar?
The stability of the U.S. dollar has varied widely in its history. This variation is explained by two factors: the monetary standard chosen for the dollar, and whether other countries have simultaneously used cash and securities payable in dollars as their own reserves, even as their monetary standard itself (i.e., official reserve currencies in place of gold).
The United States has alternated between two kinds of standard money: inconvertible paper money and some precious metal (first silver, then gold). The dollar was an inconvertible paper money during and after the Revolutionary War (1776-92), the War of 1812 (1812-17), the Civil War and Reconstruction (1862-79), and again from 1971 to present. The dollar was effectively defined as a weight of silver (and gold) in 1792-1812 and 1817-34, and as a weight of gold in 1834-61 and 1879-1971. The minted gold eagle, set equal to 10 dollars, and subsidiaries thereof, was provided for in the Coinage Act of 1792. The dollar was not used by foreign monetary authorities as an official monetary reserve asset before 1913, but the dollar has been an official “reserve currency” for many countries since World War I (along with the pound sterling). The dollar has been the primary official reserve currency for most countries since 1944.
Applying two criteria divides the monetary history of the United States into distinct phases. We can compare the stability of these monetary regimes by examining the variation in the Consumer Price Index (as reconstructed back to 1800) by two simple measures: long-term CPI stability (measured by the annual average change from beginning to end of the period of each monetary standard) and short-term CPI volatility (measured by the standard deviation of annual CPI changes during the period).
Weighting these criteria equally, the classical gold standard from 1879-1914 was the most stable of all U.S. monetary regimes.
After the failures of several generations of unhinged paper currencies, pegged and floating exchange rates, America should embrace a stable monetary system tested in the laboratory of human history – the cornerstone of which the elites have rejected for a century. It is now time to restore that cornerstone – the true gold standard, shorn of the economic pathology of official reserve currencies. Now is the time to restore the American monetary standard authorized by the Founders in the Constitution – Article I, Sections 8 and 10. Now is the historical moment for America to take the lead and again give the world a real money, the Founders’ gold dollar of the Coinage Act of 1792. What the Founders learned from the paper money inflation of the Revolution, the recent past has taught us again. America and the world need a monetary standard which, unlike the paper-credit dollar, cannot be created at zero marginal cost with which to dispossess the prudent and to subsidize the U.S. government and insolvent financial institutions at near zero interest rates.
For America to establish the gold standard would provide the least imperfect monetary solution to the problems of a century of financial disorder – engendered over and over by central bank-manipulated paper money, official reserve currencies, and floating pegged exchange rates. Only a stable dollar, a dollar defined by statute as a weight unit of gold, can pin down the long-term price level, restoring the incentive to save and ruling out extreme inflation and deflation. Such a dollar convertible to gold would reopen the road to confidence in the long-term value of the U.S. monetary standard. This is the durable road to economic growth and prosperity-financed by increased long-term savings, increased long-term investment, and rising demand for labor at rising real wages.
This article was previously published in The American Spectator and at Pravda.ru. We are grateful to Ralph Benko for bringing it to our attention.