Time to Dump the Dollar Standard

Posted October 3, 2008

The torrent of dollars unleashed by the U.S. trade deficit fueled ever larger bubbles around the world as credit expanded without limit. A crisis too big to be inflated away has inevitably arrived.

Why is the global economy in danger of collapse? So far explanations have focused on the proximate causes, like banks’ imprudent mortgage lending and use of complex financial instruments. But behind these missteps lie deeper problems with the world’s financial system, flaws that made a crisis of this magnitude inevitable.

The recent rapid growth of international trade and investment was built on foundations made of paper money. Over the last four decades, the global economy has prospered thanks to the greatest expansion of credit in human history.

When the money was flowing freely it was easy to forget that throughout history, whenever the link between money and gold has been severed, disaster soon ensues. And so it is again today.

The events of September 2008 represent nothing less than the breakdown of the credit-driven Anglo-Saxon economic model. The consequences for the global economy will be dire. Having benefited most during the boom, Asia may well suffer most in the bust.

Rise of the Dollar Standard

The Anglo-Saxon economic paradigm today is very different from the one under which capitalism developed in the 18th and 19th centuries. This fundamental point is little understood either in Washington or abroad. The economic orthodoxy that guided policy from the time of Adam Smith to the outbreak of World War I was premised on the principles of balanced government budgets and sound money fully backed by gold. The 21st-century Anglo-Saxon economic model bears hardly any resemblance whatsoever to the earlier one. In fact, in many ways, it is its complete antithesis, due to its dependence on massive government budget deficits financed with loans denominated in a debased currency.

The origin of the current Anglo-Saxon model can be traced back to 1971, when the dollar standard became the new international monetary system by default. Its predecessor, the Bretton Woods system, had been a modified gold standard in which the U.S. dollar was pegged to gold and all other currencies were pegged at a fixed exchange rate to the dollar. That system had begun to weaken in the late 1960s under the weight of the large U.S. budget deficits required to fund the Vietnam War and then President Lyndon B. Johnson’s Great Society programs simultaneously. It ended on Aug. 15, 1971, when President Richard Nixon closed the “gold window” at the Treasury to stop the flood of gold leaving the United States as other countries sought to convert their dollar holdings into gold.

Once the Bretton Woods system collapsed, the U.S. quickly discovered it was able to run large trade deficits and finance them with debt denominated in its own currency. During the four decades that followed, those deficits grew so large they destabilized the global economy.

The principal difference between the gold standard and a fiat money regime (money not backed by precious metal or other assets) is that the former limits the amount of money (and credit) a government can create. The latter removes those limits, making credit creation potentially limitless. Today, the global financial system is collapsing because the unfathomable amount of credit that has been created since 1971 cannot be repaid by the private sector. If the system survives, it will be because the U.S. government assumes responsibility for repaying billions, or more probably, trillions of dollars worth of credit losses. But this will not be the last crisis.

When President Nixon opened Pandora’s dollar box, the consequences were felt almost immediately. Global commodity prices skyrocketed, precipitating a severe recession in 1974 and a 15% inflation rate by 1979. Then U.S. Federal Reserve Chairman Paul Volcker (currently one of the only U.S. policy makers with his reputation still intact) crushed inflation by pushing bank lending rates to above 20%. However, that victory came at a high price. The U.S. experienced 11% unemployment and the worst recession in 50 years. Abroad, the price came in the form of what is now known as the Third World debt crisis of the early 1980s.

As the U.S. trade deficit grew, it began to destabilize the countries in surplus, beginning with Japan. The Bretton Woods system, and the gold standard that preceded it, both contained inherent adjustment mechanisms that made large-scale trade imbalances impossible. The dollar standard does not, and that is its greatest flaw. In the 19th century, if England had a large trade deficit with France, it would have had to pay for its deficit by shipping its gold to France. That would have caused England’s money supply (i.e., gold) to contract and that would have caused England to fall into recession with unemployment rising and prices falling. The opposite would have happened in France. The inflow of gold would have caused the economy to boom and employment and prices to rise. Soon, the rich French would have bought more products from England and the poor English would have bought fewer products from France until the balance of trade was restored.

The Bretton Woods system worked more or less the same way. When it broke down, however, the U.S. began to run very large trade deficits, initially with Japan. As the Japanese exporters repatriated their dollar earnings from the U.S. to Japan, the Japanese economy boomed (as with France in the example above) and property prices skyrocketed. The U.S. did not deflate as it would have under a gold standard, however, because it did not have to pay for its deficits with gold, but instead could pay with paper dollars, which it could create at will. Consequently, the imbalance persisted and blew the Japanese economy into a bubble.

This imbalance in trade between the U.S. and Japan was the beginning of a trend. Again and again, countries that experienced unusually large inflows of dollars blew into bubbles that destabilized their economies before later imploding.

Over the 1990s, the convulsions in the global economy became ever more extreme, with the rise and fall of one credit bubble after another. In response to the recession of 1991, the U.S. budget deficit hit a new record of $329 billion in 1993. The budget deficit stimulated the economy, but that pulled in imports and caused a new deterioration in the trade deficit. China devalued its currency by 50% in 1994, making matters worse. The Mexican peso crisis erupted in 1995, followed by the Asian financial crisis in 1997. Russia, Brazil and Long Term Capital Management went to the wall in 1998. To prevent a global crash, the Fed responded by flooding the global economy with ever larger amounts of paper money.

Fuelled by that liquidity, the Nasdaq bubble inflated and then imploded in 2001, throwing the global economy back into a recession that nearly saw a return of deflation for the first time since the 1930s. The policy response? What else? Large budget deficits and an aggressive monetary response that took the Fed funds rate down to 1%.

It worked by creating an even greater bubble, this time in the U.S. housing market. By this time the pattern was well established. The policy response to one crisis simply sowed the seeds for the next, with each cycle becoming more extreme. By 2006, equity extraction from homes allowed Americans to consume so much that the U.S. trade deficit exploded to $800 billion (6.2% of GDP). Soaring U.S. imports created a global economic bonanza, with the global economy growing at the fastest pace in 30 years during 2004 and 2005. Meanwhile Wall Street ran amok, originating subprime mortgages and securitizing them into toxic debt.

Twenty-first-century Anglo-Saxon capitalism just might have survived the subprime catastrophe were it not for one thing. That crisis was overlaid and interlaced with $600 trillion of derivatives contracts, equivalent to almost $100,000 for every person on Earth. Imprudent? Undeniably. But Citigroup’s then CEO Chuck Prince explained it like this: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

The music stopped playing in the third quarter of 2007. By the third quarter of 2008 the global financial sector was in systemic crisis. The Fed and other central banks reacted by injecting something approaching a trillion dollars of liquidity into the capital markets, but had little to show for it. In September 2008, credit markets froze. Within two weeks, Fannie Mae, Freddie Mac and AIG were nationalized, and Wall Street’s investment banking industry ceased to exist. A nightmare scenario began to unfold. All the equity in the global financial system was at risk of being completely destroyed. That danger forced the Bush administration to beg Congress to come to the rescue of the capitalist system with a $700 billion government bailout. Ironically, the plan was put together by Treasury Secretary Hank Paulson, who had amassed a stunning fortune during his career at Goldman Sachs before resigning his position there as chairman in 2006.

It is far from certain that the Paulson Plan can succeed. It is anyone’s guess how high the losses will mount in the $600 trillion derivatives market. Even a 1% loss rate would amount to $6 trillion. If this unregulated market miraculously does not blow up and the plan is successful, it will likely be at the cost of trillions of dollars of new government debt. Already, most of the U.S. mortgage market and much of the financial sector have been nationalized. . . .

To read this essay in its entirety, subscribe here.

If you already subscribe to the REVIEW, click here.


Richard Duncan is the author of "The Dollar Crisis: Causes, Consequences, Cures" (Wiley, 2003) and a managing director at Blackhorse Asset Management.