BEST OF MICHAEL BERRY

May 6, 2008

Curse of the paper Dollar

"The dollar is once again bouncing around its all-time lows of 1980 and 1987 as it is driven down by Washington’s deliberate depreciation of the currency. Why the dollar bashing? The answer is that contemporary mercantilism is practiced behind a smokescreen of unrestrained monetary policies. Managed exchange rates are exploited to subsidize exports and tax imports in very much the same style as the Smoot Hawley tariffs of yesteryear.

Under floating exchange rates the US economy has suffered unprecedented financial instability for nearly 20 years. Between 1971 (when President Nixon destroyed the Bretton Woods exchange-rate agreement) and 1974, Americans endured four phases of wage and price controls, while the free-floating dollar plunged in value. Then came the "energy crisis", sustained double digit inflation and interest rates that topped 15% - double the level that prevailed during the Civil War when it wasn’t clear that there would be a United States very much longer. International banking has been in turmoil since 1982, and the banking crisis of 1990 is only the latest consequences of Federal Reserve sponsorship of prolifigate U.S. banking practices.

Many observers blame the world’s present financial disorders not on floating exchange rates, but on the U.S. budget and trade deficits. The U.S. budget deficit and trade deficit are indeed at the heart of the world’s fundamental economic problems. Bu the deficits are the symptoms not the causes, of monetary disorder.

It has been so long since the world has enjoyed stable money that we have forgotten what it looks like. Neither the post-war Bretton Woods system nor the fixed-rate system of the 1920s and 1930s were stable exchange rate systems based on an independent monetary standard. Rather they were International monetary systems largely based on "reserve currencies," the pound sterling and the dollar. Under a reserve -currency system, central bank reserves consist not only of gold and domestic claims but also of claims in the currency of the major financial power.

These reserve currencies become international currency and lead to over-extension of their issuer’s domestic banking systems. In the 1920s the dollar and the pound sterling were the reserve currency; under Bretton-Woods the dollar alone. The dollar remains the dominant reserve currency today making the Federal Reserve, in effect, the world’s central bank.

This sort of exchange rate system faces one big risk: What if the country issuing the reserve currency decides to inflate its currency? As the reserve currency – in that case the dollar – floods into the international markets the world’s central banks must at some point purchase and hold these dollars. If they don’t the value of the dollars decline making the making the other countries’ exports more costly in the U.S. It was this feature of the reserve currency system that helped cause the collapse of the interwar financial system in 1930 -32 and also the Bretton Woods regime of 1971.

After the collapse of Bretton Woods foreign central banks continued buying dollars. For the most part they have been left to lie at the Fed in the form of Treasury securities. Last month these reserves exceeded $250 billion. The long decline of the dollar against the Yen and other major currencies has coincided with the rise of official dollar reserves held by foreign central banks.

There is no adequate adjustment mechanism to discipline a reserve currency. As the dollar declines, rising foreign dollar reserves are re-deposited in the Eurodollar market and in the US, where they finance the budget deficit , or finance more imports or finance domestic consumption of goods that would otherwise be exported at competitive prices to re-establish equilibrium in the international balance of payments.

But the inflation of the reserve currency is not ultimately sustainable. The foreign demand has a limit. When that limit is surpassed foreign holders will unload the dollar and it will begin to fall rapidly. The reserve-currency country will then be forced, as the U.S. is today, with pressure to raise interest rates at the very moment that the real economy is weak.

This article was not written by me but by Mr. Lewis Lehrman and published in the Wall Street Journal November 6, 1990. This is only part of his essay. It is a must read. His questions are poignant. It is obvious that after almost 20 years and 9 major financial failures (Stock Market Crash of 1987, S&L Crisis, Orange County Crisis, Mexican Currency Crisis, Russian Default, LTCM Meltdown, Kidder Peabody, Dot Com Bubble, Global Real Estate Bubble) nothing has changed with respect to the floating rate currency regime in the world. As it was in the 1930s, it is still ultimately a "beggar thy neighbor" system. Listen to Lehrman’s prescient entreaties from two decades ago:

1. "It has been so long since the world has enjoyed stable money that we have forgotten what it looks like."
2. "This sort of exchange rate system faces one big risk: What if the country issuing the reserve currency decides to inflate its currency?"
3. "The long decline of the dollar against the Yen and other major currencies has coincided with the rise of official dollar reserves held by foreign central banks."

    

4. "But the inflation of the reserve currency is not ultimately sustainable. The foreign demand has a limit. When that limit is surpassed foreign holders will unload the dollar and it will begin to fall rapidly."
5. "The reserve-currency country will then be forced, as the U.S. is today, with pressure to raise interest rates at the very moment that the real economy is weak."
6. "There is no adequate adjustment mechanism to discipline a reserve currency."

So here we sit in 2008, 18 years after Mr. Lehrman’s WSJ essay. Monetarists and Keynesians paid no attention to his suggestions because in traditional hubris of the Economist (the dismal science) we have assumed that such leaders will make the expedient decisions to assure a high quality of life. Take a quick look at the fate of the dollar (trade-weighted Major Currency Index) from the St Louis Fed since 1990. As you can see it has declined irreparably allowing mom and pop to continue to consume. It has declined irreparably since President Nixon cut its ties to gold.

Now take a look at the Fed’s inflation that Mr. Lehrman refers to over this period.

Inflation has been a constant companion and insidious silent tax imposed on mom and pop over this timeframe. As Mr. Lehrman suggests the reserve currency country (The US) decided to inflate.

Finally during Mr. Lehrman’s time the US with its reserve currency had sent $250 billion overseas. At the end of March 2008 $2 trillion dollars were held by our trading partners in Treasuries. China held $414 billion (19% and growing), Japan $615 billion (29%), and OPEC $112 billion or 5%. Restating Mr. Lehrman’s question, what happens when these countries (and others) decide to unload?

What do we know today?

1) There is no adequate adjustment mechanism to discipline a reserve currency.

2) The US (the reserve currency country) is now forced to raise rates (if it wishes to defend its currency and retain its status) "at the very moment the real economy is weak." Given the accelerating housing demise this is the real conundrum that the Fed faces today. That is why the Fed will be forced to lower rates further in the future, likely in the third quarter.