To evaluate the history of the Federal Reserve System, we cannot help but wonder, whither the Fed? and to consider wherefore its reform—even what and how to do it. But first let us remember whence we came one century ago.
The End of the Classical Gold Standard
No one knew better than Jacques Rueff, a soldier of France and a famous central banker, that World War I had brought to an end the preeminence of the classical European states system and its monetary regime—the classical gold standard. World War I had decimated the flower of European youth; it had destroyed the European continent’s industrial primacy. No less ominously, the historic monetary standard of commercial civilization had collapsed into the ruins occasioned by the Great War. The international gold standard—the gyroscope of the Industrial Revolution, the common currency of the world trading system, the guarantor of more than 100 years of a stable monetary system, the balance wheel of unprecedented economic growth—was brushed aside by the belligerents. Into the breach marched unrestrained central bank credit expansion, the express government purpose of which was to finance the colossal budget deficits occasioned by war and its aftermath.
The Rise of Discretionary Central Banking
With the benefit of hindsight we can see that quantitative easing (QE) was actually inaugurated with World War I. We can see also that discretionary central banking in the United States coincided with the founding of the Federal Reserve System. After the banking panic of 1907, the Federal Reserve Act of 1913 was designed to provide “an elastic currency” but also to reinforce the international gold standard. Thus, Federal Reserve sponsorship of floating exchange rates in 1971 would become one of the great ironies of American monetary history.
To interpret the financial events associated with the Great War and their effect on the ensuing 100 years, my colleague John Mueller and I have highlighted two crucial events of 1913. First, of course, was the establishment of the Federal Reserve System, and second, the publication by the young John Maynard Keynes of his book, Indian Currency and Finance. The inauguration of the Federal Reserve and the intellectual foundation provided by the monetary ideas of Keynes, taken together, soon gave rise to a perfect intellectual and financial storm—a storm which would last a century.
Lately we have been engulfed by headlines reporting financial turmoil on every continent, in almost every nation, large and small. The commissars of central planning who so marred the history of the 20th century have been replaced by central banks in the 21st. In Cyprus, the new leadership now dares to confiscate citizens’ wealth with a one-time tax of up to 60 percent on bank deposits above 100,000 euros. Self-interested prime ministers blame continental monetary policies for instigating the currency wars that they themselves surreptitiously carry on.
Central banks worldwide, led by the U.S. Federal Reserve, mint new money ceaselessly to bail out insolvent governments, insolvent banks, and insolvent but politically powerful corporations and labor unions. This new money goes first to insiders in the financial sector, who exchange the cheap credit for commodities, stocks, and real estate at ever-rising prices. This is the so-called carry-trade, monopolized by a financial class that uses free money from the Fed to front-run the authorities for insider profits.
From the beginning of the American republic until not long ago, dollars could be exchanged for gold at a parity established by congressional statute (1792–1971, but from 1934–1973 convertible by foreigners alone). Currency convertibility to gold, enforced by law, established a finite limit to the money supply. Inflation—caused by the issue of excess money and credit—would lead citizens to promptly cash out for gold, thus reducing the money supply and ending the rise in prices. In a sense, the system was self-regulating.
With an unlimited money supply, the insolvency of national banking institutions has become an endemic global problem. Depositors are at risk of loss or arbitrary confiscation by panicked political authorities, as in Cyprus. Taxpayers are involuntarily dragooned in to bail out the banking system, as at the start of America’s recession. And if the central bank credit bubble collapses, systemic deflation will be the profound and destructive consequence.
A winning agenda for a political party must simultaneously satisfy the requirements of economic effectiveness and political success. Ronald Reagan had such an agenda in the 1980s. Subsequent Republican presidential candidates have not. The opportunity now is great. Far from having a free hand after reelection, President Obama is constrained by the same economic and political realities as everyone else. This is why his first act of 2013 was to sign into law a tax code in which the top rate on labor income is about twice the rate on property income, disappointing the dominant faction of his own party.
The four basic principles of successful American political economy may be summarized simply:
1. Current peacetime government consumption of goods and services should be funded by current taxation, not money creation—thus limiting peacetime government borrowing to an amount equal to government-owned investments of the same or lesser duration. This principle was first enunciated and implemented under President George Washington.
2. Current consumption of true public goods (such as national defense and administration of justice) should be funded with an income tax levied about equally on labor and property income. This principle was first implemented under Abraham Lincoln.
3. More narrowly targeted “quasi-public” goods, which benefit many but not all citizens, should have dedicated funding. Social benefits for specified individuals (Social Security, Medicare, and Medicaid, primarily) should be financed by payroll taxes on individuals, not by income or property taxes. This principle was first applied under Franklin D. Roosevelt at the insistence of his Treasury secretary, Henry Morgenthau.
The counterpart to this policy is that subsidies to property owners (e.g., tax-advantaged savings accounts and product, corporate, and banking subsidies) should be financed by taxes on property income (such as interest, dividends, rents, or capital gains), not payroll or income taxes.
4. Government’s size and methods should be strictly limited in order not to displace private jobs, or cause general unemployment or disinvestment in people and property. This was attempted by Ronald Reagan (with its success limited by factors we will describe).
President Obama chose to deliver his State of the Union address this year on the 204th anniversary of the birth of Abraham Lincoln. It was a good selection of a significant date. As Steven Spielberg makes clear in his epic film "Lincoln," Americans of all backgrounds and political persuasions can learn much from the character and presidency of the 16th president.
With regard to human rights and economic liberty, Lincoln adhered to two fundamental principles. First, that every person was entitled to the fruits of his or her labors, and no one had an unrequited claim (i.e., slavery) to the fruits of the labors of others. What so troubled Lincoln about slavery was that it was theft—pure and simple. Lincoln ran for president on a platform to stop slavery's spread. As president and commander in chief, he struck against slavery in the rebellious states through the Emancipation Proclamation. Then he pressed for slavery's permanent abolition by constitutional amendment—in both rebellious and loyal border states—because no man may steal the fruits of the labor of others.
The second principle that guided the Republican president was that every person, regardless of the circumstances of his birth, should be able to climb as far up the economic ladder as his talents may take him. Historian Richard Hofstadter called Lincoln the "greatest dramatist" for upward mobility the nation ever produced, and for good reason.
Under Lincoln's watchful eye and skillful leadership, the 37th Congress enacted more economically significant legislation than had any of its predecessors. The underlying theme of Lincoln's economic initiatives was that by providing ordinary people with incentives to use their own skills and labor, the entire nation would prosper. Very little of what Lincoln signed into law could be declared, in the present-day idiom, "entitlements" or "redistribution."
Who caused the financial collapse? Just about everyone.
To appreciate this landmark work it is necessary to know a bit about the author’s background.
John Allison is not only a banker-entrepreneur; he is also a recognized intellectual leader of American business. Moreover, Allison’s financial expertise is a product of his personal biography: In a mere two decades, he built BB&T (Branch Banking & Trust Co.), a comparatively small Southern bank of $4.5 billion in assets, into a $152-billion financial enterprise, making it one of America’s largest and most profitable banks. But unlike many overpaid, underperforming CEOs, Allison focused his leader-manager skills—at modest compensation—on behalf of his employees, customers, and shareholders.
Briefly stated, Allison’s core principles begin with an unapologetic dedication to customer-oriented banking and carefully managed risk-taking as sound and effective means to long-term profitability and high returns on capital. BB&T deploys an uncommon means to sustain the bank’s dedicated corporate culture: continuous, serious, systemic employee education aimed at the formation of leaders, executives, and well-trained employees at every level. A core goal of every employee must be to focus on making every client profitable and successful on a risk-adjusted financial basis—that is, through conservative banking. False financial products were neither fabricated nor widely distributed during the bubble years (such products having been an important cause of the financial crisis). Monthly employee readings in philosophy and economics are mobilized to reinforce the core principles.
At the center of this banking philosophy is the development of the full potential of each employee, and each client, of the bank: This strategy, Allison argues, is the optimum path to shareholder, customer, and employee enrichment. Many firms pretend to such a strategy; Allison earned a national reputation because he actually carried it out, and successfully, in a banking system engaged during the bubble years in a “race to the bottom.”
In a free-market society, it is hard to exaggerate the importance of such a corporate culture. And in business, the individual conscience, dedicated to long-term rational self-interest, is the indispensable condition of a minimally regulated free market. It is striking that Allison’s strategy was vindicated by good returns on capital; it is equally striking that BB&T’s corporate culture was proven right in the financial crisis and Great Recession, as BB&T experienced not a single quarterly loss during the financial earthquake of 2007-2009.
It is necessary to know all this in order to understand the importance of The Financial Crisis and the Free Market Cure. As the head of a major American bank, Allison was witness to the decisions of government, Federal Reserve leaders, and banking CEOs that led to a huge speculative bubble and the collapse of the financial system, including Fannie Mae, Freddie Mac, virtually the entire cartel of big banks and brokers, and major companies. Allison guides us, with a gimlet eye, through taxpayer-subsidized bailouts of these wards of the state, focusing on a reckless, insolvent, privileged financial oligarchy—subsidized by a feckless Fed, a dilatory Treasury, and a politicized FDIC. The coercive power of the federal government, and the moral hazard of excessive regulation, is dissected and debunked.
“The problems that exist in the world today cannot be solved by the level of thinking that created them.” – Albert Einstein
EVERY DAY WE WAKE UP hoping for good economic news: lower unemployment numbers, more jobs created, stronger growth. But we miss the forest for the trees. Our markets, for the past 100 years, have been engulfed in perennial financial crises.
Many of these crises have been associated with major Federal Reserve credit expansions and contractions. Upon examination, these volatile market episodes almost always lead to major moves in non-durable commodities, primarily oil and food.
But first, some historical background.
How do we mark the onset of the age of financial disorder, or, if you will, the Age of Inflation? The starting point was the volcanic eruption in 1914 at the epicenter of the Western world. World War I brought to an end the preeminence of the classical European states system; it decimated the flower of European youth; it destroyed the European continent’s industrial primacy, making Europe a debtor and America a creditor. The classical gold standard was suspended everywhere by the belligerents. The monetary gyroscope of the Industrial Revolution collapsed along with the world trading system into the anarchy of total war.
To interpret the financial events associated with the Great War —and their effect on the ensuing hundred years—let us highlight two crucial occasions of 1913: the establishment of the Federal Reserve system and the publication by the young John Maynard Keynes of his book Indian Currency and Finance. Neither event by itself would probably have created a barrier to resumption of the long period of monetary stability and economic growth under the prewar classical gold standard. But the inauguration of the Federal Reserve and the monetary ideas of Keynes, taken together, created the perfect storm.
As originally conceived, the Federal Reserve system, a government-dominated central bank, was designed to strengthen American participation in the classical international gold standard, even while making the U.S. currency and banking system more “elastic,” so it would be able to deal with crises like the panic of 1907. As the lender of last resort, the Fed was also tasked with issuing Federal Reserve notes and commercial bank deposits against collateral convertible on demand into gold. (By collateral here, we mean things such as the liquid, short-term, high-quality commercial paper of solvent firms used to finance goods in the process of production.)
Statement and Testimony of Lewis E. Lehrman Chairman, The Lehrman Institute Prepared for September 21, 2012 Hearing
... Now we are able to formulate an authentic, bipartisan program to restore 4 percent American economic growth over the long term. Tax rate reductions with an enlarged tax base, government spending restraint aimed at a balanced budget, simplification of business regulation designed to empower entrepreneurial innovation -- these reforms can be made effective for America and the world by a modernized gold standard and stable exchange rates. This is the very same platform which uplifted 13 impoverished colonies by the sea in 1789 to leadership of the world in little more than a century.
Gold, a fundamental, metallic element of the earth’s constitution, exhibits unique properties that enabled it, during two millennia of market testing, to emerge as a universally accepted store of value and medium of exchange, not least because it could sustain purchasing power over the long run against a standard assortment of goods and services. Rarely considered in monetary debates, these natural properties of gold caused it to prevail as a stable monetary standard, the most marketable means by which trading peoples worldwide could make trustworthy direct and indirect exchanges for all other articles of wealth.
The preference of tribal cultures, as well as ancient and modern civilizations, to use gold as money was no mere accident of history. Nor has this natural, historical, and global preference for gold as a store of value and standard of measure been easily purged by academic theory and government fiat.
Gold, by its intrinsic nature, is durable, homogenous, fungible, imperishable, indestructible, and malleable. It has a relatively low melting point, facilitating coined money. It is portable and can be readily transported from place to place. Gold money can be safely stored at very low cost, and then exchanged for monetary certificates, bank deposits, and notes—convertible bills of exchange that efficiently extended the gold standard worldwide.
Like paper money, gold is almost infinitely divisible into smaller denominations. But paper money has a marginal production cost near zero. Producing gold money, like other articles of wealth, requires real labor and capital.
Mitt Romney has articulated the choice we will make in November. We can choose President Obama and a European future—i.e., high unemployment, demographic winter, big government commanding over 50 percent of future output, a welfare state engineered and manipulated by the Washington bureaucracy, the end of American leadership, and, ultimately, national insolvency. Or we can embark once again on the road to rapid economic expansion, through pro-growth tax reform, smaller government, a balanced budget, and sound money. What we need, Romney argues, is an entrepreneurial economy based on the free price mechanism, free markets, free and fair international trade. For Romney the goal of rapid economic growth is full employment, a strong national defense, and a rising American standard of living. These policies are necessary. But are they sufficient?
Romney’s analysis emphasizes the character of presidential leadership, the need for hands-on White House direction of national economic policy. Workable economic policies require not only the right goals but also a strong president capable of leading Congress and the nation in a new direction—away from Obama’s backward-looking statism, and forward to pro-growth tax policies, budgetary equilibrium, and sound monetary policies. Regulations must be radically simplified. The tax code must be comprehensively reformed—with a larger base, fewer loopholes, and lower rates.
In his 2010 book Seeds of Destruction, Glenn Hubbard, a top economic adviser to Romney, summarizes the entrepreneurial spirit underlying Romney’s approach. “First and foremost, it will mean putting unemployed Americans back to work. Second, it will mean stabilizing the housing market and housing prices. Third, it will mean increasing the productivity of the American worker and making U.S. industry more competitive in international markets so that wage and economic growth can once again boost purchasing power. Fourth, it will mean reducing America’s dependence on increasingly expensive oil. Finally, it will mean creating a strong and stable dollar so that our import bill remains manageable.”
On this last point, Romney has criticized the Greenspan-Bernanke Fed—the ultimate cause of the stock market bubble of the 1990s and the subsequent crash and recession (2000-2002); the ultimate cause also of the real estate bubble, its collapse, and the Great Recession (2007-2009). Romney argues in almost every economic speech that Obama’s stimulus policies are poorly planned and ineffective, and that Obama has been AWOL on major legislation, defaulting to a pork barrel Democratic congressional majority on economic and health care policy in 2009-2010, when he had a majority in both the Senate and the House.
In private and public comments, Romney and Hubbard have suggested that hyper-expansive Fed policy and quantitative easing—repressing interest rates to zero—is a recklessmonetary approach that in the past has led to bouts of inflation, followed by deflation and recession.
I embrace much of this analysis and many of Romney’s proposals. His program is necessary, but it may not be sufficient.
Papering over U.S. debts and trade imbalances will take bills than we can print.
The Consequences of Disorder
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 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 of 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 increasingly 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, 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, non-national 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 currencies. 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, 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.
The dollar’s role as an official reserve currency has enormously impacted the United States economy. Net U.S. investment abroad is the value of assets and claims held by U.S. residents and their government abroad, minus the assets and claims foreigners and their governments own in the U.S. In 1980, net United States international investment was 10 percent of GDP. In 2010, it was negative 20 percent of GDP. The empirical data show that the entire shift from positive to negative is accounted for by the official, accumulated, United States balance-of-payments deficit.
In a nutshell, since World War II, free trade has often been at the expense of United States businesses, manufacturing, and labor. The problem of dollar overvaluation was compounded not only by the reserve currency role of the dollar, but also by the perennial United States budget deficit, increasingly financed by Federal Reserve money and credit creation. But the U.S. budget deficit is financed not only by the Federal Reserve and the banking system, but also by foreign government purchases of U.S. Treasury debt which is held as official national reserves. China and Japan, two major beneficiaries of U.S. trade and budget deficits, hold official reserves equal to approximately $2 trillion of U.S. government related debt. The authorities, mesmerized by neo-Keynesian mythology, do not understand that exponentially growing U.S. budget deficits absorb a huge fraction of domestic production, which would otherwise be available for export sales to the global market. Proceeds from these exports, growing faster than payments for imports, could then be used to settle U.S. balance of payments deficits, thereby reducing U.S. debt.
Let us remind ourselves that after World War I, the reserve currency system, based on the pound and the dollar, was liquidated in total panic (1929-1933), turning a cyclical recession into the Great Depression. Today we have relearned the lesson, as expansive Federal Reserve money creation has combined with the official reserve currency role of the dollar to cause massive credit, commodity, and general price inflation worldwide. (The purchasing power of the 1950 dollar adjusted by the CPI has declined over 90 percent.) But, like Banquo’s ghost, deflation and unemployment still haunt us, despite the Greenspan-Bernanke era of quantitative easing (often known as money-printing). That is because as soon as Fed money-printing slows down, prices tend to fall, with the threat of deflation and unemployment (2007-2012) coming to preoccupy the financial authorities. The inflation-deflation cycle is systemic, caused by perennial budget deficits and unhinged Federal Reserve stop-go monetary policies.
The scientific method and economic history teach us that under similar conditions, similar causes tend to produce similar effects. The saying makes the point: “History never repeats itself, but it often rhymes.” We know that reserve currency systems have been tested by the market, and that they have failed in the past (e.g., Sterling in 1931; the Bretton Woods dollar in 1971). And the timing of their collapse cannot be accurately predicted. But now is the moment to prepare a program of monetary reform.
How, therefore, may America now lead other nations toward an equitable world trading system based on a balanced monetary order, a disciplined Federal Reserve, balanced budgets, stable exchange rates, and reciprocal free trade inuring to the mutual benefit of all? How do leading nations stage the resumption of a modernized true gold standard, ruling out the escalating debt and leverage engendered by the perversities of floating exchange rates and official reserve currencies?
America at the Crossroads
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 thatthe 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 balance-of-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, and the reserve-currency dream world in the United States may carry on for many years before its collapse. But collapse is inevitable.
The choice is ours. Indeed, this election may be our last chance. If American leaders embrace true monetary reform, they will reject the siren song of the reserve currency’s exorbitant privilege. They will acknowledge the insupportable burden of the dollar’s official reserve currency role. They will plan now for the termination and windup of the dollar’s reserve currency role. They will plan to restore dollar convertibility, defining the dollar by statue as a certain weight of gold, and then propose gold as the missing and impartial, global balance wheel by which to settle residual balance-of-payments deficits among nations and currency areas. A balanced budget amendment to the American Constitution should follow.
Moreover, such a monetary order, based on convertibility of the dollar to gold, free of government manipulation, provides an indispensable rule for the conduct of Federal Reserve System monetary policy -- bringing to bear rule-based market discipline to stabilize the Fed’s monetary policy. Domestically, the institutional discipline of dollar-convertibility would limit the Fed’s unrestrained discretion to print money, finance the government budget deficit, and bail out the cartelized banking system. Under dollar convertibility, if the Fed creates too much money, causing inflation, the people are free to redeem currency for gold at a price set by law. Too great a loss of gold would threaten the solvency of the banks. Thus, the Fed and the banking system would be forced to reduce the growth of money and credit, thereby maintaining convertibility and containing inflation. Conversely, deflationary tendencies could be contained by Federal Reserve credit -- made available at market rates on high-quality collateral -- without threatening currency convertibility.
To choose true monetary reform and balanced budgets is to embrace not only the American Constitution, but also the nation’s historic financial policy that led to world leadership. Article I, sections 8 and 10 of the United States Constitution enabled the monetary reconstruction of the American Republic at the founding on the bedrock of a gold dollar. The Constitution mandates that only Congress has the power “to coin money and regulate the value thereof.” The Constitution prohibits the states from making anything but “gold and silver a legal tender.” Shorn of the crushing weight of trade disadvantages caused by inflation and the accumulating debt and deficits -- originating in budgetary excess and the reserve currency role of the dollar -- America could again become Prometheus unbound.
American economic reconstruction, grounded by the true gold standard, would lead to a resurgence of rapid economic growth, empowered by renewed confidence born of market expectations of a stable long-term price level. With American leadership, other nations would follow. By re-establishing an effective and equitable international adjustment mechanism, international monetary convertibility to gold would end perennial deficits, manipulated currencies, and the threat of currency wars among the major nations.
The true gold standard -- that is, a dollar convertible by statute to a specific weight of gold, joined to the windup of the official reserve currency role of the dollar -- would make vast sums of money available for long-term productive investment. With a stable long-term price level, speculators worldwide would abandon unproductive inflation hedges. This dishoarding would yield immense, liquid savings before productive investment in real goods and services. Equity and true capital investment would gradually displace debt and leverage. Under conditions of stable money and stable exchange rates, savings would be redeployed by entrepreneurs and investors in new and innovative plants, technology, and equipment -- minimizing unemployment, as skilled and unskilled workers are hired to work the new facilities. The export production machine of the United States would be reoriented to produce for the world market, which would engage all the positive and equitable effects of economies of scale and free trade.
This is the true road of American monetary and economic reconstruction. Let us begin the great work before us.
Lewis E. Lehrman is a senior partner of L.E. Lehrman & Co. and chairman of the Lehrman Institute.