The world economy always has an official reserve currency, or “final money.” Is this important?
A reader of day-to-day commentary on the financial crisis would almost certainly guess the answer to be an emphatic “No.” Occasionally the role of the American dollar as the world’s predominant final money is mentioned, but usually in the context of warning that a stronger currency like the euro or yen might supplant it. Given everything else going on in the American economy, this would appear to be the least of the country’s worries.
Yet a reader of textbooks that deal with economic history might develop a twinge or two of doubt. Debates and crises over such issues as gold, silver, bimetallism, convertibility, and devaluation pockmark economic history until fairly recently. Repeated runs on the French franc in the 1940s and 1950s helped lead to one of the last military coups to take place in Western Europe, the Gaullist-led overthrow of the Fourth Republic in 1958. The post–World War II decline of the pound is frequently cited in textbooks as a key symptom of the end of Britain’s status as a global power. In 1979, a worldwide run on the dollar caused Pres. Jimmy Carter to push aside his handpicked chairman of the Federal Reserve, William Miller, and replace him with Paul Volcker, a respected former Treasury official who had served in administrations of both parties. After a widely praised eight years at the Fed, Volcker retired in 1987, but has recently reappeared as senior economic counselor to President Obama.
Even though Volcker was tapped to take over the Fed in the midst of a dollar crisis, he is remembered as a tamer of domestic inflation rather than as savior of the dollar. Of course, by their nature these two things have a lot of overlap. But economists of all stripes — Keynesians, monetarists, neoclassicists, supply-siders — will tell you that the structure of the global currency regime has mattered little since the Nixon administration took the world off the Bretton Woods gold-dollar-exchange standard in 1971.
What if all these economists are wrong?
They’re sure about little else: No one can adequately explain the financial meltdown (which few predicted), and no one is very sure any solution or set of solutions will work. Joe Biden was only hinting at the uncertainty in today’s Washington when he said there is a 30 percent chance that the administration’s economic policy will turn out to be dead wrong.
So it is worth asking: If the role of the dollar as the world’s final money did matter, in what ways would it matter? Here are three:
‐ The world money supply would be determinable by adding the U.S. monetary base to the holdings of interest-bearing U.S. public debt by foreign central banks that use the dollar as their final money (almost all of them). You don’t have to contact 100 or more central banks to get the numbers; the Federal Reserve keeps track of most foreign central-bank holdings and publishes the total every Thursday afternoon as a footnote in its balance sheet.
‐The trend in the global money supply would give you a good ballpark estimate of the trend of the U.S. economy about a year from now.
‐It would give you an even better estimate of the global price of oil two and a half years from now. Other commodity prices are broadly predictable with similar or lesser lags. This is because commodities are not a national or regional phenomenon, but are globally traded and settled internationally in dollars, which is the final money of the world.
Assuming for the sake of argument that these points are correct, the U.S. recession may be ending this spring or summer, earlier than almost anybody expects. Though the recovery will have relatively little to do with the stimulus package or the bank bailout, and mostly to do with Fed chairman Ben Bernanke and his Federal Open Market Committee, the Obama administration will receive a measure of credit for the recovery.
But this same bout of aggressiveness by the Fed will cause a bout of global inflation that will begin in late 2011 and early 2012. Having gotten the credit for turning around the Bush meltdown, Obama will get the blame for a spike in inflation just as he is entering his reelection year.
FINAL MONEY IN HISTORY
So much for the near-term future. What about the recent past? Is there anything about the monetary dominance of the dollar that helps explain the boom and bust in mortgage-backed securities? What about such earlier boom/busts as the tech/Internet bubble of a decade ago?
When something of intrinsic value is the final money of the world, as gold was in the generation before World War I, the supply of money grows at a reasonably steady rate, based on a global demand for increased monetary reserves.
What are dollars? Today the small print on a dollar bill says, “This note is legal tender for all debts, public and private.” The dollar, in other words, is a fiat currency — a debt instrument backed only by the full faith and credit of the U.S. government. This wasn’t always the case. Until 1933, any owner of a dollar could exchange it for a bit of gold or silver from the U.S. government; until about 40 years ago, foreign central banks could still convert dollars to gold.
Before the fiat dollar, when a growing world economy demanded more money, gold miners went to work a little harder. Today, the Fed fills greater demand for money by buying U.S. public-debt securities, either with domestic money the Fed has created itself or with money created by foreign central banks. Either way, the Fed is increasing the global supply of final money and the credit line of the United States simultaneously. This has a number of results.
First, over time, the dollar declines gradually in value against other top-rank convertible currencies, such as the euro and the yen.
Second, foreign central banks typically react to a bear market in the dollar in a way opposite to that of private investors: They buy interest-bearing, dollar-denominated U.S. public debt in order to prevent the currencies of their more export-dependent economies from rising against the dollar.
Third, because of the foreign central banks’ need for dollar-denominated debt, the U.S. can run budget and trade deficits with a painlessness not available to any other country. Our role as sole producer of the final money of the world, U.S.-backed debt, gives us an ability, over time, to consume beyond our ability to create wealth.
These effects were readily apparent in the first decade or so after fiat money supplanted the gold-convertible dollar. The world went through two frightening bouts of double-digit inflation, in the mid-1970s and in 1979–80. But then, American policymakers and central bankers seemingly learned how to manage the dollar standard: Carter’s appointment of Volcker in 1979 and the policies of Ronald Reagan after 1980 brought inflation to a halt, ushering in an era of disinflation and strong, nearly unbroken U.S. and global growth in the years between 1983 and 2007.
In this two-decade-plus era of disinflation, U.S. interest rates steadily declined. Chairman Alan Greenspan and his Federal Open Market Committee were able to lower the federal-funds rate on overnight money to 3 percent to help pull the U.S. out of the 1990–91 recession — which seemed like dangerously easy money to those who had lived through the high interest rates of the 1980s — and no extended inflation seemed to result. To pull the U.S. out of a milder recession after 2001, the Greenspan Fed lowered the fed-funds rate to 1 percent. There was subsequent energy inflation, but that was widely attributed to post-9/11 warfare and instability in the Middle East, not to central bankers.
FINAL MONEY AND THE WORLD OF INVESTMENT
But final money, and the extremely low interest rates that accompanied it in our years of plenty, can explain many of the problems we’ve seen lately in the world of American investment. Hedge funds were the first to figure out that “hot money” — seemingly bottomless dollar liquidity brought in-house at low interest rates — enabled them to leverage market momentum and reap huge profits in any market that was headed up. The favored market could be in bonds, foreign currencies, Internet and tech stocks, or mortgage-backed securities issued by U.S. public agencies. If one bubble burst, another would come along.
The role of leverage in pushing up hedge funds’ performance did not escape the attention of the rest of Wall Street, eventually including the big banks. If anything, the indulgence in mortgage-backed securities was conservative in comparison with the Internet-stock craze of the 1990s. U.S. home prices, after all, had rarely suffered an extended bear market in the decades since World War II.
Almost two years ago, the previously booming (or bubbling) U.S. residential-real-estate market turned suddenly south when foreign monetary authorities sharply reduced their scooping of U.S. debt, threatening many highly leveraged positions. The suddenness may have had something to do with congressional rejection of immigration reform and the subsequent Bush-administration policy of aggressive workplace raids against illegal workers, which noticeably contracted the demand for homeownership in some of the nation’s most booming residential markets.
But that is at most an issue of timing: The residential-real-estate market, pushed sharply upward by “hot money”–leveraged investment at every level from marginal subprime borrowers to the elite of Goldman Sachs, had become a bubble waiting to burst.
Only now the whole investment world was involved.
And “world” in this instance is more than metaphor. If America has the flu, the rest of the moneyed world is in a near-coma. This includes foreign central banks that added mortgage-backed securities to their monetary base on the understanding that these Fannie and Freddie instruments, almost like Treasury securities, had the tacit but full backing of the U.S. government. The unwinding of these holdings, often with deflationary results, proved a handy offset to the Bernanke Fed’s virtual abolition of short-term interest rates and accompanying explosion in the domestic monetary base.
Now, with nearly a third of privately held American wealth gone, we will return for a while to more normal market swings. “Capitalism” will continue to get a black eye, bank and investment executives who responded to the incentives they saw in the markets will be demonized to compensate for the glory they enjoyed such a short time earlier, and “federal regulator” will be the growth profession of the Obama era.
The global economy, badly wounded, will remain a system with U.S.-backed government debt as its final money. Should they ever be asked, informed and credentialed economists will confirm that this is true, but they will quickly add that the dollar’s dominant global role is of little or no importance. Won’t they?
– Jeffrey Bell, a visiting fellow at the Ethics and Public Policy Center, is a principal of Capital City Partners, a Washington consulting firm.