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November 3, 2006

When Sterling Bowed
to the Dollar

by Ann Berg

As writers 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 debt burdens.

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 85 million 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 its trickle-up policy working brilliantly, the administration stands by its slogan that "deficits don't matter."

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 mechanism."

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.


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Ann Berg has spent a 30-year career in commodities and capital markets as a trader, consultant, and writer. While a commodity futures trader and Director of the Chicago Board of Trade, she advised foreign governments, NGOs (the United Nations, World Bank), think tanks (Catalyst Institute), and multinational and foreign corporations on a variety market-related issues. She was also a frequent conference speaker at international derivatives markets forums. In recent years, she has contributed articles to several commodities/capital markets publications, including Futures Magazine, Traders Source, Financial Exchange, and the Financial Times editorial page. Berg is also an artist. She is currently working on a body of work entitled The Unknown Unknowns – The Things You Don’t Know You Don’t Know, which explores U.S. national security policy.

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