Fight The Fiat

Papering over U.S. debts and trade imbalances will take more bills than we can print.

By From the July - Aug 2012 issue

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 in creasing ly 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 increasingly 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.


Like this Article

Print this Article

Print Article
About the Author

Lewis E. Lehrman is a senior partner at L. E. Lehrman & Co. and chairman of the Lehrman Institute.