Monday, November 25, 2013

This Time, There Is No Sorcerer to Save Us

In the previous post, I traced the trend in this country away from the hard money we started with -- gold and silver coins -- to their replacement with paper promises (called Federal Reserve Notes). This trend occurred despite the complete absence of any grant of power to Congress in the Constitution to print paper money.

Well, strictly speaking, of course, it isn't Congress that prints the Notes. The Federal Reserve authorizes their issuance, and it is the Bureau of Engraving and Printing that does the job. But the Federal Reserve acts with the statutory authority of Congress, and it is Congress who declared the Notes to be "legal tender for all debts, public and private." Its power to do so was resolved long ago, in a series of decisions known as The Legal Tender Cases.

The course away from hard to paper money followed by the United States has been the same as that followed by the rest of the world. And the reasons for adopting paper money schemes have been almost uniformly the same, in country after country: to pay the costs of war.

The last time the world was on a true hard money (also called "commodity money") system lasted from 1879 to 1914. The United States, which had mostly redeemed in specie all of its "greenbacks" issued to finance the Civil War (nota bene), went back on the gold standard in 1879 (and joined Britain, France, Germany, and many other countries in doing so).

But World War I disrupted the finances of the European powers, and one by one they went off the gold standard. The United States continued to redeem (domestically) its money for gold until 1933, when FDR thought he could help the country out of the Great Depression by massive deficit spending. (It is a little-known and -appreciated fact that President Hoover had already embarked on a similar course in 1930. Just like FDR, however, he was unable to put people back to work solely by increasing government spending. The difference is that the electorate held Hoover accountable, while it reveled in FDR's machinations.)

The United States continued to exchange dollars for gold, and vice versa (at the new FDR-established price of $35 per ounce), internationally. (By Executive Order, FDR forbade Americans from holding gold; Congress did not lift the ban until 1975. That was what Americans thought of gold all those years -- while one by one, the domestic gold mines shut down, as after about 1950 they could no longer produce the metal and make a profit at only $35 per ounce.)

Before the Second World War was over, in July 1944, delegates from all 44 Allied countries gathered at Bretton Woods, New Hampshire to work out the form of a post-War international monetary system. A return to the gold standard was unworkable, because the United States (as a result of the War) held most of the world's gold reserves, due to its having steadily bought gold since 1933 at $35 per ounce.

Under the leadership of Britain's Sir John Maynard Keynes, America's Harry Dexter White, Henry Morgenthau, and others, the delegates created the so-called Bretton Woods system that governed international trade and finances from 1945-1971. All foreign currencies were pegged (within a fluctuating range of ten percent) to the U.S. Dollar, and the United States agreed to convert Dollars to Gold at the official rate of $35 per ounce. At the time, it is estimated that the United States held approximately 20,000 metric tons in gold reserves (the bulk of it in New York and at Fort Knox, Kentucky), or 75% of the world's then total.

The Bretton Woods system worked until Lyndon Johnson decided to fight two wars at once: the Vietnam War, and the War on Poverty. By 1968, he had to ask Congress to remove the last requirement for sound currency: at that time, the Federal Reserve was required to keep a gold reserve equal to 25% (reduced from 100% in 1913) of all dollars in circulation. But President Johnson needed more dollars for his programs, and so Congress obligingly removed the requirement that they be backed by gold.

One should take note of what President Johnson told Congress when he made his request (my emphasis added):
Speculation generated by the strains on the international monetary system has caused further drains of gold from international reserves--much of it from our own. As a result, U.S. gold reserves have declined to about $12 billion.
Our commitment to maintain dollar convertibility into gold at $35 an ounce is firm and clear. We will not be a party to raising its price. The dollar will continue to be kept as good as or better than gold.

I am therefore asking the Congress to take prompt action to free our gold reserves so that they can unequivocally fulfill their true purpose--to insure the international convertibility of the dollar into gold at $35 per ounce.
  • The gold reserve requirement against Federal Reserve notes is not needed to tell us what prudent monetary policy should be -- that myth was destroyed long ago.
  • It is not needed to give value to the dollar -- that value derives from our productive economy.
  • The reserve requirement does make some foreigners question whether all of our gold is really available to guarantee our commitment to sell gold at the $35 price. Removing the requirement will prove to them that we mean what we say.

I ask speedy action from the Congress -- because it will demonstrate to the world the determination of America to meet its international economic obligations.
Congress obliged, in March 1968. The drain on U.S. gold reserves continued as inflation mounted everywhere, but the price of gold stood fixed at $35 per ounce. And thus, just three years after Johnson's message to Congress, President Nixon closed the international gold window, in August 1971.

That was a momentous change -- not just for the United States, but for the entire world.

First, the price of gold was no longer a constant; it floated higher with fears of inflation, and soon soared to over $800 per ounce.

Second, because gold could float, so now could the dollar -- and eventually, so could all of the other national currencies that tried to remain pegged to the dollar. This began a new era of "currency wars," from which we still have not emerged.

Third, and perhaps most consequential, the Federal Reserve now had no restraint on its ability to print and circulate its dollar notes and credits, as it monetized more and more of America's debt (check the huge rise in M2 since 1980 in the chart shown in the previous post, as well as the corresponding rise in total credit [debt] since 1971).

But there was a fourth, and unforeseen, consequence of freeing the dollar from its backing in gold. As countries exported their goods to the United States, their exporters received payment in dollars, which they could not use in their own country -- they needed to exchange them at their banks first.

All of those dollars coming into a foreign country, however, could not be exchanged on the open market without causing a spike in the exchange rate of that country's currency against the dollar. (It is the old law of supply and demand -- if suddenly everyone wants to exchange dollars for francs, pounds, marks or lira, then the price of those currencies relative to the dollar will go up.)

If the exchange rate, say, for the franc increased, then French wine would become more expensive in the United States, England and other wine-consuming countries, and France would export less of it. This would hurt French wine producers, and the politicians and central banks were determined not to let that happen.

In order to prevent any increase in their exchange rates, the central banks of each country printed more of their own money to exchange for the flood of dollars coming in. By doing that, they artificially held down the exchange rate, and kept the price of their exports low for other countries.

The money so printed was, however, central bank money -- so it was just printed without any backing of any kind, and it increased the (domestic) supply of each country's own currency, which over the longer run was inflationary for that country.

And what did the central banks do with the dollars that they received in exchange? They invested them -- in the only markets where huge amounts of dollars could be invested -- in the United States. These dollar investments from abroad balanced the trade deficits that the United States was running with many foreign countries, and helped to fund our government's deficit budgets, as well as push up the price of both equities and bonds (which meant that interest rates, which moved opposite to the price of bonds, fell lower).

Now contrast this post-Bretton Woods situation with how things worked during Bretton Woods: if the United States ran a trade deficit with, say, France, then the French did not have to print new money to offset the effect of the new dollars flowing in, because they could immediately exchange all those dollars for gold. Because of its gold backing, the exchange rate of the dollar for the franc remained relatively constant (depending on the vicissitudes of France's own fiscal and monetary policies).

Thus the biggest and least foreseen consequence of the United States going completely off the gold standard was the huge, inflationary increases in foreign currencies that resulted from central banks' attempts to keep their currencies from appreciating against the dollar. A recent estimate of the amount of new paper money added to the world economy in this way is $11.7 trillion. And so long as China, for example, keeps running a trade surplus with the United States while artificially holding down the yuan, there is no end of this paper money inflation in sight.

The $11.7 trillion of new foreign money has to be added to the trillions of new dollars being created by the Federal Reserve -- now more and more through so-called Quantitative Easing.

The result is that the world is awash in paper money, with nothing to back it except people's willingness to continue to accept it in exchange for goods and services.

Moreover, the world does not need all this new paper money, because its economies have not grown in tandem with their money supplies.

How can any Keynesian or monetarist continue to defend such a system? Both of those theories were developed when gold backing imposed a restraint upon the creation of new paper money. And now all restraint is gone -- it's not unlike the tale of the sorcerer's apprentice (in the version with porridge, rather than Goethe's poem, employing a broom and water -- though either version will suffice to make the point).

We know how that tale ends -- the sorcerer comes back, spanks his apprentice and stops the endless production of porridge from his magic pot. The village cleans up the mess, and life goes on as before.

Unfortunately, there is no "sorcerer" this time to wave his magic wand. Our elected representatives continue to operate the country without any kind of a budget, and our monetary authorities continue to enable their irresponsible actions. And the supply of money and credit just expands and expands ...

How can this all end? In the next post, we will take a look at some likely scenarios.

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