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

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 balanceof- 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 shriveled 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 reservecurrency dream world in the United States may carry on for many years before its collapse. But collapse is inevitable.


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About the Author

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