note, the Suez Canal
crisis 50 years ago marked the last hurrah of the British Empire. Significantly,
it also spelled the demise of the pound sterling. When it broke away from the
gold standard in 1931, the pound was the reserve currency throughout half the
world. After Britain's failed
attempt to prevent Egypt's nationalization of the Canal in 1956, the pound
cratered and the dollar rose to undisputed supremacy.
Will history repeat itself for the greenback?
Although rarely remarked upon, the number of monetary systems the world has
seen in the past one hundred years has totaled no less than five – the gold
standard, dirty floats, pound sterling, Bretton Woods, and floating or sometimes
pegged (1) fiat currencies. Every one of these systems (except
the last) collapsed because of war and war debt. The main argument for the continued
reign of the dollar, despite the prolonged, costly invasion and occupation of
two countries, is the strength of the U.S. economy. But logic and history suggest
otherwise: dollar hegemony prevails because the dollar-centric fiat monetary
system and the rapid rise of third world economies have insulated America from
After World War II, as the holder of 80 percent of the world's monetary gold,
the U.S. crafted a quasi-gold standard by linking the dollar to gold at $35
an ounce. It pegged all other currencies to the dollar, making them indirectly
convertible to gold. This Bretton Woods system solved the pesky problem of bank
runs that had created a wave of global bank failures between 1931 and 1933 (starting
in Austria) by making gold strictly a balance-of-payments mechanism. (Roosevelt
outlawed gold coin ownership with the threat of imprisonment in 1933.) Although
the initial problem of the dollar-centric system was a dollar shortage, the
Marshall Plan spurred the dollarization of Europe and Japan. The rapid economic
revitalization of these regions fueled exports, resulting in their accumulation
of dollar reserves.
When Britain, France, and Israel invaded Egypt, Britain was already in decline.
Two wars had decimated its balance sheets, forcing it to cede its colonial possessions.
Its costly embrace of wage supports, entitlements, and nationalization policies
ruined its manufacturing and coal mining industries. The pound, fixed in 1924
to gold and the dollar at $4.82, declined in value to $2.80 by 1955. A month
after the Suez debacle, the pound fell to $2.30. When Britain slapped currency
controls on third-country
financing, it put the last nail in the coffin for its currency; a rising
wave of dollars in European banks gave birth to the eurodollar
market. That market, deemed a flash in the pan by some, allowed dollar deposits
to be loaned domestically and internationally without burdensome regulation.
Today, it reigns as the largest credit market the world has ever known.
Bretton Woods ended in 1971. War (in Southeast Asia) and welfare (Lyndon Johnson's
Great Society Program) caused U.S. foreign liabilities to exceed gold reserves
by five to one, more than reversing the postwar position of one to three. When
France demanded bullion redemption for dollars, Nixon shut the gold window.
Since 1971, currencies have been unmoored from their golden anchor.
Although intended to function similarly to the gold standard system by balancing
trade and allocating investment capital, the fiat monetary system does neither.
As experts note, "capital runs uphill" (i.e., emerging countries finance
the debts of developed countries), and trade flows have never been more unbalanced.
Nobel Prize winner Robert Mundell, a Canadian economist and advocate of fixed-rates
systems, described the system on the eve of the euro's launch as follows:
"The present international monetary system neither manages the interdependence
of currencies nor stabilizes prices. Instead of relying on the equilibrium produced
by [gold's] automaticity, the superpower has to resort to 'bashing' its trading
partners which it treats as enemies." (2)
Referring to the dilemma of the dollar's reserve currency status at the time,
he declared, "The United States can't fix its dollar! To what would it
fix?" The observation explains why, in its currency battle with China,
the U.S. can't unilaterally devalue the dollar against the yuan in order to
"correct" its massive trade deficit with the Asian power. (3) Instead,
it must rely on protectionist threats to compel China to raise the yuan.
How the dollar got so big is no mystery. Once freed from the discipline of
backing dollars with gold in 1971, the money supply increased thirteen-fold
– an event forewarned by economists. One reason why this inflation doesn't show
up in the Federal Reserve's numbers is that the U.S. exports much of its inflation.
(China holds probably $600 billion in dollar reserves.) Without the rest of
the world's absorption of dollars, which recirculate via cheap goods and low
interest rates, the U.S. would have seen runaway inflation. Also the Federal
Reserve – the supposed inflation watchdog – ignores a host of data signaling
price appreciation. Spending more for food and energy? Too volatile to consider.
Did your real estate tax just double? Doesn't count. Your new car more expensive
than the last one? It's really cheaper due to the extra pleasure it affords.
In other words, the Fed disregards about 40 percent of what the normal person
spends money on.
The Fed also turns a blind eye to asset inflation. Ownership is good, even
if increased valuations in stocks, bonds, and real estate are merely the result
of the pumped-up supply of greenbacks. How does the Fed create extra money?
In a magical act called "deficit-backed financing," (4)
it buys Treasury notes from banks or other institutions and simply makes an
offsetting credit to them out of thin air. (5) Thus, an
anointed committee, creating money and poring over spending data gleaned from
consumers' diaries, has replaced gold's automaticity with a sugar-coated economy
that keeps the consumer spending and foreigners financing both public and private
debt. The dollar, as much as any politician, lobbyist, or mercantilist, is the
silent accomplice to the unaffordable pursuits of conquest.
However, the dollar's fault lines are showing.
The booming housing market that supported $600 billion in extra spending last
year is coming to an abrupt end. Soft landing? Never have home buyers been more
leveraged, procuring homes just by paying interest on the debt. Recently, California
foreclosures were reported up by 170
percent from last year.
New jobs are
increasingly coming from nontransferable service sectors at the low end of the
pay scale. Cosmeticians, hairstylists, and nurses are the new American economy.
Pension liabilities and uncompetitive labor inputs are forcing companies to
"buy out" their workers. Like the agricultural programs that paid
farmers to set aside land, which resulted in the rapid export of U.S. soybean
and wheat acreage to South America, Eastern Europe, and Asia, these programs
accelerate America's decline as a productive economy.
Educational standards are rapidly sliding downhill. Some estimate that one-third
of all high school seniors won't
graduate this year.
Asia is quickly increasing its consumption, meaning fewer dollars can be recycled
into Treasury debt. This will cause interest rates and import prices to rise.
Finally, the whole structure of capital is changing. Corporations have record
profits, but are keeping the money close to the vest, often buying back their
own shares. As real investment opportunities are declining, the banking and
financial houses have spawned a quadrillion-dollar industry around derivatives
trading, enticing investors to hop onboard the commodity boom. However, as any
trader knows, derivatives trading is a zero-sum game, and unlike capital formation,
it produces nothing (other than profits and losses). Therefore, money flows
are becoming increasingly cannibalistic.
Structurally, this era has no precedent. Before the fall of Bretton Woods,
except during the brief postwar spending boom, households saved. Mortgages were
30 years fixed and credit cards barely existent. The extended-time payments
that snag a third
of Americans in revolving debt today were not introduced
until 1987. In a reversal of WWII, when slick promotional campaigns enticed
Americans to invest in war bonds, the U.S. simply draws the excess capital
from its dollarized manufacturing colonies to fund its global adventures. U.S.
citizens, virtually unaware of the treasure being wasted in catastrophic wars,
spend freely, pumping earnings into corporate coffers. Carefully marketed by
the departmental arms of government, spending is now a civic and patriotic duty.
This will only change when consumers run out of money, interest rates choke
them, or foreigners ratchet up their consumption. In the meantime, watching
policy working brilliantly, the administration stands by its slogan that
Unlike the pound in 1956, the dollar is too ubiquitous to fold overnight. In
addition, there is no currency large enough to replace it. However, if faith
in the dollar were to slide precipitously, it is conceivable that the world
powers would devise another monetary scheme to prevent the world from plunging
into chaos, as in the 1930s.
A euro-dollar fix is possible, primarily because Europe couldn't abide a drastically
cheaper dollar. (6) Other than the
lone crusader, politicians dismiss a possible return to sound money such
as a gold or bi-metal system. Ironically, when asked in his debate
with Milton Friedman
on what toppled the gold standard, Mundell offered a societal explanation, "Democracy
killed the gold standard … [it] led to drastically inflated expectations of
what government could do for people and led to increased government spending
and budget deficits that often had to be financed by money creation." It
leaves one wondering whether this brand of "democracy" and the dollar
haven't just about exhausted their course.
1. The Chinese yuan is a currency that is closely pegged
– but not fixed – to the dollar by government intervention.
2. David Hume in 1752 first described gold's ability to
balance trade among nations as follows: As net exports increased, causing a
nation's bullion reserves to rise, the prices of goods in that country would
also rise. The increase in domestic prices due to the gold inflow would discourage
exports and encourage imports, thus automatically limiting the amount by which
exports would exceed imports. The process was called the "price-specie-flow
3. A higher yuan relative to the dollar would make Chinese
exports more expensive.
4. All money is created from debt issued by the Treasury
to fund the government's operations. The national debt is now $8.57 trillion.
5. By holding this interest-earning debt, the Fed netted
$22 billion in profits last year, twice as much as Wal-Mart.
6. A much cheaper dollar would harm the competitiveness
of European exporters already suffering from cheap Asian imports.