Shades of the Dollar Standard
Hans F. Sennholz
by Hans F. Sennholz
the love of money is the root of all evil, the depreciation of money
must be the mainspring of all shams and frauds. It works silently
and covertly, impoverishes many while it enriches a few, and thereby
inflicts great harm on social cooperation and international relations.
few economists are sounding the alarm about the decline of the U.S.
dollar. In recent months it fell visibly toward the euro and Japanese
yen and is likely to fall even lower. But most Americans refuse
to be alarmed as they are unaware of exchange rates and foreign
exchange markets. Why should they be troubled about the financial
affairs of money traders and dealers?
may not be able to see the future but always can learn from the
past. Looking at the recent history of the dollar, this economist
perceives three distinct stages with various characteristics, causes,
and consequences. In the first stage from the end of World War II
to 1971 the U.S. dollar was tied to a small anchor of gold. President
Nixon cut its ties and embarked on a wholly new road of fiat dollar
management. Many other countries readily accepted the new system
acclaiming its flexibility and manageability. At this time, in 2004,
the world is still traveling this road, but several countries are
making preparations for leaving it and proceeding toward a multiple
standard system. It is not clear whether they will depart in an
orderly fashion or in crisis and contention.
U.S. dollar has been the dominant world currency for some 60 years.
At the Bretton Woods international conference in 1944 it was elevated
together with the British pound sterling to the position of "reserve"
currency in which international payments could be made. It was to
be backed by gold and redeemable at $35 an ounce and sterling be
made readily convertible at $4.03 to the pound. With the Labour
Party in power pursuing a vigorous program of nationalization of
industry and extension of social services, the pound soon suffered
frequent bouts of confidence; it was devalued to $2.80 in 1949 and
to $2.40 in 1967. Issued in ever larger quantities and fettered
by stringent regulations and controls it gradually lost its position
as reserve currency.
U.S. dollar, in contrast, displayed great strength and was traded
at parity with gold. The recovery of European and Japanese economies
from the ravages of war increased their demand for a reserve currency,
the U.S. dollar. But soon after sterling had lost its reserve position,
the integrity of the dollar opened to doubt and controversy. In
the footsteps of the British Labour Party, the Kennedy and Johnson
administrations pursued policies of economic and social reform,
incurring growing budget outlays. President Johnson not only declared
"war on poverty" in order to create a "Great Society" but also escalated
American participation in the Vietnam War. His policy of both "guns
and butter" built on deficit spending and abundant credit by the
1968 when the budget deficit reached World War II proportions, the
system came within an inch of disintegrating. U.S. balance of payment
deficits and loss of gold cast doubt on U.S. solvency. In 1959 the
U.S. gold stock had still exceeded $20 billion. It fell sharply
to $13 billion in 1965 and 1966, and now touched $12 billion, barely
one-fourth of foreign payment obligations. But President Johnson
managed to buy time with a stopgap arrangement, involving a two-tier
pricing system for gold. The world's central banks agreed to make
payments at the fixed price of $35 an ounce while all individuals
could trade gold freely at market prices. And in order to enlarge
the world's currency base, the International Monetary Fund (IMF)
was empowered to issue Special Drawing Rights (S.D.R.s). There was
widespread agreement among monetary authorities that the influence
of gold needed to be diminished.
the Federal Reserve was busily increasing the dollar base and the
U.S. government was pursuing both wars, President Johnson decided
to take corrective action at home. In old Mercantilistic fashion,
his administration imposed a new tax on the purchase of foreign
securities by Americans. It hesitated to raise income taxes but
chose to "jawbone" the people. It ordered American businessmen to
reduce their investments in foreign operations and asked American
banks to limit their loans to foreigners. The Federal Reserve even
raised its discount rate from 4 to 4½ percent, which barely
covered the inflation rate.
President Nixon took office in 1969 he immediately tried to slow
down the galloping inflation by vetoing much new social legislation
and impounding funds for domestic programs which he opposed. When
the country fell into a recession and unemployment climbed to six
percent of the work force, he responded with new pump priming. In
1971 and 1972 the Federal budget headed for the largest deficits
since the end of World War II. Even the balance of trade fell deep
in debt, and the chronic deficits of the balance of payments filled
the vaults of many foreign central banks with dollars.
year 1971 was to be a landmark in monetary history. On August 15,
the United States government removed gold as the foundation stone
of the international monetary order and rescinded the international
agreements that had defined the system since the end of World War
II. In a nationally televised address President Nixon simply
announced that the United States would no longer honor the 36-year-old
commitment to pay international obligations in gold at the rate
of $35 an ounce. He imposed a 10 percent surcharge on imports into
the United States. And above all, he ordered virtually all wages
and prices to stop and freeze. Violators would be fined, imprisoned,
or both. When management of the controls proved to create frustrating
problems, it underwent four "phases" of adjustment to "problem areas"
such as food, health care, and construction.
Bretton Woods standard survived neither the Vietnam War nor the
war on poverty. It was born of Keynesian thought and buttressed
with 18th century Mercantilistic beliefs; it died of basic misconception
of human action and behavior. John Maynard Keynes who had helped
to deliver the system at the Bretton Woods conference sought to
promote employment by government spending on public works. Most
governments have applied the Keynesian formula ever since. Old Mercantilistic
notions and doctrines found a ready home in the Keynesian economic
system, pointing toward favorable balances of trade and greater
national productive efficiency through a host of government regulations.
new fiat dollar standard was a germane derivative of the Bretton
Woods order without its limitations. Liberated from any gold reserve
requirement or other quantitative restriction, it promised to serve
political needs as well as the Keynesian requirements for employment
and growth. Unfortunately, it proved to be even less stable than
its harbinger, more inflationary and, above all, more divisive and
injurious to American reputation and prestige.
fiat dollar standard has profoundly affected the economic lives
of most Americans. Soon after the dollar's convertibility into gold
was rescinded the Federal Reserve accelerated its money creation.
While stringent controls were preventing goods prices from rising,
the eurodollar, that is, U.S. currency held in banks outside the
United States and commonly used for settling international transactions,
commenced a steep slide and U.S. trade deficits grew very large.
They obviously reacted in anticipation of ever more dollar inflation
and depreciation; money markets tend to anticipate future prices
of goods and services. Mutual exchange ratios between currencies
tend to be determined by their foreseen purchasing power; they always
move toward purchasing-power parity where it no longer makes any
difference whether one uses this or that currency.
of American troops from Vietnam did not end the price and wage spirals
that were to mark the presidencies of Messrs Nixon, Ford and Carter.
The Federal Reserve duly supplied funds at single-digit discount
rates, bank credit expanded at double-digit rates, the U.S. Treasury
suffered ever larger deficits, and goods prices soared. The Fed
occasionally would "tighten" its reins but "real" interest rates
always remained relatively low or even below the rates of inflation.
U.S. trade deficits increased erratically with dollar funds flowing
to Western Europe and Japan. Their support sustained the U.S. But
the trade monetary authorities in Europe and Japan were determined
to defend the existing dollar parity with substantial purchases
of dollars deficits and their own surpluses, which meant to
bolster and subsidize their own export industries. The abundance
of dollar funds in central banks throughout the world then facilitated
an explosive growth of money and credit in most industrial countries.
1974 and 1975 the fever of double-digit inflation was briefly eclipsed
by the chills of recession. Unemployment rose to 8.3 percent, a
33-year-high nationally, and much higher in construction and manufacturing.
It remained high although the chills of recession soon gave way
again to the fever of inflation. Money and credit were made to expand
again at double-digit rates, trade deficits set new records, and
the U.S. dollar deteriorated further in international markets. By
the end of the decade the country fell again in the grip of the
twin economic evils of recession and inflation. Unemployment rose
again while GNP was falling. This time, the Federal Reserve, under
new management, meant to call a halt to the turmoil. It raised its
discount rate to 12 percent, the prime rate rose above 15 percent,
and the eurodollar rate to 20 percent. President Carter even imposed
Federal temperature controls in public and commercial buildings,
setting minimum summer temperature at 78 degrees and maximum winter
temperature at 65 degrees. Many Americans keenly felt the effects
of gasoline rationing, waiting in long lines at gasoline service
stations. Legislators and regulators had a ready explanation for
the crisis: the sheikhs and emirs of OPEC had done it again.
1981 President Reagan took the helm of a deeply troubled country.
During his eight years in office he managed to lift the spirits,
changing the course and relaxing the reins of government. He rolled
back the Johnson Great Society but preserved the Roosevelt New Deal.
He rejected Keynesian formulas for managing economic demand and
instead followed "supply-side" prescriptions which aim to stimulate
production and investment by way of tax reduction and removal of
some government controls. Mostly at loggerheads with Congress, he
insisted on rearming the country and confronting Soviet aspirations.
He steadfastly resisted Congressional efforts to boost taxes significantly.
With Congress raising social spending and the President expanding
military outlays, Federal budget deficits soon exceeded two hundred
billion dollars a year; the national debt doubled in seven years.
the discount rate at 12 percent the quantity of money and credit
finally stabilized, allowing the economy to readjust to actual market
conditions. A 25 percent Federal tax cut over three years brought
some relief to business but tore big holes in the Federal budget
and capital market. After the removal of price controls the dollar
regained some strength and the American economy became again the
engine of the world economy. It slowed down after a spectacular
Wall Street crash in 1987 which reflected the international concern
about the budget deficits and the chronic trade and current account
deficits of the United States and the surpluses of Japan and West
Germany. In ages past, the creditors would have demanded prompt
payment in gold, which would have forced the debtor to mend his
ways or face insolvency. The fiat dollar standard merely prompted
contentious diplomatic exchanges the creditors pressing the debtor
to live within his means and the debtor urging his creditors to
relax and stimulate their own economies with easier money, larger
budget deficits, or both.
decade of the 1990s was akin to the 1980s. It began with a recession,
saw new acceleration followed by deceleration and a "soft landing"
in 1995. Great concern about the large balance of payments deficits
of the United States led to a sharp decline in the value of the
U.S. dollar, especially versus the Japanese yen and the Deutsche
mark and other European currencies closely tied to it. Coordinated
intervention by foreign central banks was needed to stabilize the
dollar. It rallied for a while when several Asian currencies foundered
in 1997. Large current-account deficits led to sudden declines and
devaluations of the Thai baht, the Malaysian ringgit, the Indonesian
rupiah, the Philippine peso, the Singapore dollar, and the South
Korean won. The International Monetary Fund (IMF), working in cooperation
with industrial countries, kept the Asian crisis from spreading.
the 1990s the Federal government suffered massive deficits although
political spokesmen frequently boasted of budget surpluses. In 1998,
1999, and 2000 the Clinton Administration waxed eloquent about its
surpluses which in time would retire the national debt. In reality,
the surpluses were deficits financed with Social Security money
and other government trust funds. They increased the national debt
with Social Security IOUs as much as Treasury bills, notes, and
bonds sold to investors; payment obligations to Social Security
beneficiaries are as binding as those to investors.
the decades a few economists always were worried about the magnitude
of the trade deficits and the vulnerability of the American dollar.
But their fears proved to be unfounded because they underestimated
the worldwide demand for dollars and the willingness of foreign
investors and central bankers to trust and hold U.S. dollars. After
all, until recently the deficits never exceeded three percent of
GDP and Americans still were net creditors in their foreign accounts.
By now, in 2004, the dollar standard has reached a stage in which
not only a few economists but also some foreign creditors are beginning
to question its future. The Federal government is swimming in an
ocean of debt. In its first term the Bush administration increased
the Federal debt by $2.2 trillion. Congress raised the Treasury
debt ceiling three times, by $450 billion in 2002, by $984 billion
in 2003, and by another $800 billion on November 19, 2004, to $8
trillion 184 billion. The ready willingness of Congress to finance
such deficits is a clear indication of the political and ideological
mold and make of most members of Congress and the public that elects
observers are drawing similar conclusions. The Bank of Japan with
more than $800 billion in dollar obligations already announced its
reluctance to increase its holding. China with dollar reserves exceeding
$500 billion is laboring under "unsustainable U.S. trade deficits."
Asian banks altogether holding more than $2 trillion in American
obligations are suffering hundred-billion dollar losses in terms
of purchasing power. It is not surprising that the central banks
of India and Russia as well as some Middle East investors have begun
to sell dollar obligations.
to some estimates, foreign banks and investors are holding some
$9 trillion of U.S. paper assets. They are owning some 43 percent
of U.S. Treasuries, 25 percent of American corporate bonds, and
12 percent of U.S. corporate equities. They obviously are suffering
losses whenever the dollar falls against their respective currencies;
even if they are pegged to the dollar they are incurring losses
against all others that are rising.
dollar standard surely would enter its third and final stage of
disintegration if its holders would panic and start selling their
American paper investments their U.S. Treasuries, U.S. agencies,
and corporate bonds and shares. The crash would be felt around the
world and neither foreign sellers nor American authorities could
be trusted to react rationally in the fear and noise of the crash.
The scene could be similar to the political bedlam of the early
always is the hope that the primary creditors will act in concert
and once again bail out the debtor. The European Central Bank, the
Bank of Japan, the Bank of China, and the Bank of England may decide
to avert the unthinkable and support the dollar by mopping up huge
quantities. The mopping would stabilize the situation once again
by inflating and depreciating their own currencies; they would pass
the depreciation losses on to their own nationals. Optimists in
our midst are hoping for this scenario; they are convinced that
the Bush administration will in time save the situation by balancing
its budget and the Federal Reserve will allow interest rates to
seek market levels. Such a policy would avert the dollar dilemma
although it would lead to a painful recession forcing all economic
factors to readjust to market conditions.
in our midst cast doubt on such a scenario. They point not only
to the host of legislators and regulators who cherish their position
and power but also to public opinion and ideology which call for
government favors. They are prepared to proceed on the present road
and brace for the morrow. A few cynics even contend that a government
facing a financial crisis of such magnitude is prone to divert public
attention from its ominous path by embarking upon foreign adventures.
economist is ever mindful that debts do not fade or pass away. Individuals
must face them, deal with them, or renege in bankruptcy. Governments
have an additional option: as the issuers of their own currencies
they may inflate and depreciate their debts away. The United States
government has done this ever since it cast aside the gold standard
and imposed the dollar standard. It undoubtedly will continue to
do so as far as the eye can see. It is an iniquitous road which
individuals would soon be barred from traveling but governments
love to take, shedding their debts one percent at a time. It is
a road of the dollar standard designed at Bretton Woods, built by
the U.S. government, managed by the Federal Reserve System, and
financed largely by creditor central banks in Europe and Asia. It
is a road on which the fall in dollar value has inflicted losses
on all foreign dollar holders each in proportion to the amount of
dollars held. It is the political road of debt default the magnitude
of which amounts to trillions of dollars, undoubtedly the largest
in the history of international relations. It will be remembered
for generations to come.
is unlikely that the Federal government and the Federal Reserve
will soon mend their ways, but it also is doubtful that foreign
creditors will continue their support indefinitely. The U.S. dollar
is bound to continue to depreciate and gradually surrender its role
as the world's primary reserve currency to a multiple reserve-currency
system resting on the euro, Japanese yen, Chinese renmenbi, and
the American dollar. The multiple-standard system is likely to perform
more efficiently and equitably than the dollar standard. Competition
would avoid the abuses and inequities of a monopolistic system.
Confining the powers of the Federal Reserve System and constraining
the deficit aptitude of the U.S. Treasury, it would ward off any
further inundation of the world with U.S. dollars.
idle reverie of years long past, this economist is tempted to compare
the gold standard with the dollar standard. Throughout the long
history of the gold standard the balance of payments of gold-producing
countries was usually "unfavorable." Since the birth of the dollar
standard the United States has assumed the position of the gold-producing
countries; its balance of payments usually is unfavorable. Much
capital and labor were spent to find, mine, refine, and market gold;
the United States bears minuscule expense in the production of its
money. The quantity of gold coming to market was limited by market
forces; the quantity of dollars depends on the judgment of Federal
Reserve governors who are appointed by the President. In times of
turmoil and war the quantity of gold mined does decline; in such
times the stock of fiat dollars tends to multiply and its value
depreciates quickly. The quantity of gold is limited by nature and
its value is enhanced by many nonmonetary uses; fiat and fiduciary
moneys have no such uses or limitations. They are the sorry creation
Hans F. Sennholz [send him mail]
was professor and chairman of the department of economics at Grove
City College. See his website.
2005 Hans F. Sennholz