Friday, July 31, 2009

A Brief and Contemporary History of the Dollar

Most Americans are ignorant of America's financial history and how things have gotten to the way we are with last year's market crash and subsequent government intervention meant to help the economy recover. I hope to give a short primer into what has brought us to this point and to give some understanding of the complexity of our financial system.

For most of American history our currency was based on a gold and silver standard. This meant that gold and silver were monetary instruments—meaning they acted as money. Paper currency was labeled as a gold or silver certificate. This meant that you could request gold or silver in exchange for your paper currency. There are a few primary consequences of the gold standard, these include:

  • Most global currencies were also denominated in gold or silver, so there was (and still is) a limited supply of both metals. This meant that the money supply was essentially fixed and could not be inflated without the public becoming aware of it.
  • Because most national currencies were denominated in gold or silver, currency exchanges were basically fixed and easily completed.

Prior to 1913 the Federal Reserve did not exist. This meant that interest rates were controlled by commercial banks and would fluctuate based on market forces. Bankers and the public had been clamoring for a banking reform to "provide a ready reserve of liquid assets in case of financial panics and would also provide for a currency that could expand and contract as the seasonal U.S. economy dictated."

The Federal Reserve Act became "the lender of last resort," meaning that it would and did lend money to banks as they required funds. The Federal Reserve became essential to maintain the fractional reserve banking practices that had become commonplace.

Fractional reserve banking means that banks must only have cash for a set amount of their deposits, rather than having the full amount. A full reserve bank would have cash or gold in a 1:1 ratio for all deposits in the bank. Fractional reserve banking allows banks to have cash or gold for only 1/10th of the bank's deposits. This realization led to bank runs in the 1930s—banks did not have the reserves to be able to fulfill all their customer's demands for cash or gold after the market crash. This led directly to President Franklin Roosevelt declaring bank holidays and gold confiscation.

We still operate on a fractional reserve standard, though the Federal Deposit Insurance Corporation (FDIC), enacted in the Glass-Steagall Act of 1933, has guaranteed to protect all cash deposits in participating banks up to $100,000. This has led to the illusion of safety and soundness, though the FDIC has recently warned "the deposit insurance fund could become insolvent this year."

Prior to FDR's gold confiscation, one ounce of gold was worth $20.67. The Federal Reserve paid $20.67 for each ounce of gold. The gold standard was still in effect, at least internationally, as FDR re-priced gold at $35 per ounce. So while American citizens were prevented from "hoarding" gold, international governments could still receive gold for their dollars at $35 per ounce. This price was stable until 1971 when Richard Nixon "closed the gold window," terminating the exchange of dollars for gold internationally.

In the years that followed FDR's gold confiscation the world changed dramatically in a very short period of time. While FDR was spinning his New Deal in America, Adolf Hitler was consolidating power in Germany and reclaiming lands lost through peace negotiations after World War I. World War II led to even greater debt across the globe.

Britain abandoned the gold standard after World War I and, "was soon followed by the other countries of Europe." (Rothbard, Murray. What Has Government Done to Our Money, p. 92) This left America as the dominant financial power of the time. However, World War II and the debts incurred from it led to The United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire in 1944. The Bretton Woods meeting resulted in the creation of the International Monetary Fund and ultimately led to the U.S. dollar becoming the world's reserve currency. I will believe this confluence of events has accelerated the undoing of America and will lead to its ruin.

Murray Rothbard writes, "the system could "work" for a while because all the world's currencies returned to the new system at their pre-World War II pars, most of which were highly overvalued in terms of their inflated and depreciated currencies... Since the dollar was artificially undervalued and most other currencies overvalued in 1945, the dollar was made scarce, and the world suffered from a so-called dollar shortage, which the American taxpayer was supposed to be obligated to make up by foreign aid. In short, the export surplus enjoyed by the undervalued American dollar was to be partly financed by the hapless American taxpayer in the form of foreign aid."

He goes on to argue that due to this imbalance, we took advantage of the situation pursuing inflationary policies—fueled by trade deficits with most European nations which had returned to hard money policies, forced European nations into, "keep piling up their reserve, and even use these dollars as a base to inflate their own currency and credit." (Rothbard, Murray. What Has Government Done to Our Money, p. 96-97)

Rothbard, of course, is worth following here:

But as the 1950s and 1960s continued, the harder money countries of West Europe (and Japan) became restless at being forced to pile up dollars that were now increasingly overvalued instead of undervalued. As the purchasing power and hence the true value of dollars fell, they became increasingly unwanted by foreign governments. But they were locked into a system that was more and more of a nightmare… American politicians and economists simply declared that Europe was forced to use the dollar as its currency, that it could do nothing about its growing problems, and therefore the United States could keep blithely inflating while pursuing a policy of "benign neglect" toward the international monetary consequences of its own actions.

But America's trading partners had not forgotten that their dollars were convertible into gold at $35 per ounce, which is what more and more countries began to do. As a result, "the United States gold stock dwindled over this period from over $20 billion to $9 billion." (Rothbard, Murray. What Has Government Done to Our Money, p. 97) Naturally this led to a dollar crisis and finally in 1971 President Nixon closed the gold window—the dollar was no longer tied to gold at all. The U.S. dollar became a fiat currency. But the dollar remained the world's de facto reserve currency—America's trade deficit continued to be funded by foreign investment—creating a massive distortion in the world markets.

As America continued to inflate the dollar, America continued to prosper. Foreign capital continued to pour into the country, and the distortion continued to grow. America ran a trade deficit every year from 1976 on. Normally this should not occur since dollars paid abroad should all be returned in imports. But due to the dollar's reserve currency status, we allowed foreigners to hold dollars in cash and in bonds. The arrangement generally worked, as America's credit was strong and we were viewed as the engine for growth. The Federal Reserve continued to expand the money supply fueled in large part by foreign investment in U.S. bonds and cash reserves. The imbalance became distorted further, as the Federal government was being given access to the credit of the world to fund its massive growth, not to mention the private sector's easy access to foreign investment.

The graph below shows the trade deficit from 1991-2005. Notice how it becomes grossly distorted in the late 1990s and continues unabated through the early years of this decade. Anecdotally, I can't help be wonder if there is a correlation to the tech bubble and later the housing bubble.

Whether there is a correlation or not, the consequences of this enlarging trade deficit reduced incentives toward manufacturing and capital production. It became significantly cheaper for manufacturing to be done in foreign markets and the money followed the trail. After all, the economy seemed to be booming despite a shrinking manufacturing base. This was heralded as a new era—a service economy as opposed to a manufacturing one. The general view became that a manufacturing economy is a third world economy. The longer this distortion continued, the deeper it became ingrained in our sensibilities and the deeper in debt we became.

The fact that this distorted system lasted as long as it did means that the correction will take a long time to unwind. America grossly abused its privilege as the world reserve currency, and that status will be lost at some point. America is on an unsustainable path of fiscal insolvency.

In conclusion, our national financial system has been on a crash course since 1913 as the Federal Reserve Act set this series of events, interventions, and reactions in place. Of course it would have been a different story had not money been within the monopoly power of the federal government, but that is a tangent for another time.

The U.S. dollar which at one time had inherent value because it was redeemable for silver or gold became a debt instrument—paper worth only as much as the promise of the federal government to repay its massive debt. The dollar's prestigious position as world reserve currency allowed America to fuel an inflationary boom bigger than the world has ever seen. Of course now we're in the middle of the biggest boom the world has ever seen. Do not be fooled into believing that a crisis of this magnitude can be resolved in the matter of months. Empire America is crumbling and life in America will not ever return to what it was like for the last decade.

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