My Two Cents - "Dollar Standard Destruction"

12/08/2006

It is always easy to tell if I’ve struck a chord with a commentary by looking at my inbox in the days following its release. And even though my previous issue had almost nothing to do with the dollar, my inbox runneth over this past week with comments, questions and complete frustration over the latest dollar rout. Highlighted was amazement at the utter lack of concern displayed by many in the financial press and government. Perhaps a history lesson is in order.

During the Cold War in the 1970’s and 80’s the doctrine of ‘mutually assured destruction’ was often echoed in corridors of government, and coffee shops across America. Generally speaking, the term related to both the US and USSR stockpiling nuclear weapons, enough to destroy the world many times over. Everyone knew that if one side launched, the other side would launch and oblivion would quickly ensue. Because each side knew this, no one launched. This doctrine was popularized in the movie ‘War Games’.

The post-WWII economic environment relied on a powerful nation to run it. The United States more than adequately filled that role. We had a huge industrial base and were able to supply the world with high-quality, low-cost goods while still maintaining a high wage base. We achieved this partly because of our strong currency and partly due to our productive capacity.

After the war, the United States was the only major industrialized country whose infrastructure wasn’t ravaged by the war. Much of Europe and Japan lay in ruins. China and India had not yet begun their climb to prominence. Clearly, this gave us a competitive advantage and we assumed the role of the world’s largest creditor nation. The Bretton Woods agreement, signed in 1944 bound the participating countries to fix their currency exchanges within a 1% range and price their currencies in gold. Another important aspect of the agreement was that all international debts could be redeemed for gold. This suited the United States just fine because we had large reserves of gold, gold-backed dollars and an undamaged industrial base. For nearly 20 years, we made loans to the world and accumulated even more gold reserves. We were able to aid in the development of the European and Japanese economies and even open our doors to their imports without seriously threatening our position of dominance.

In the 1950’s and early 60’s, the praise of the American public and the world fueled a machine that became all consuming. Started potentially out of political guilt, and corporate pressure we compromised our position and sold off the industrial base that was the core of our economy. Our machine, tool, clothing, and steel industries were sold at rock bottom prices; sold on promises and empty handshakes. Perhaps at some point down the road, President Nixon will be remembered for abolishing Bretton Woods and initiating this downturn rather than the comparatively meaningless Watergate scandal.

We soon found ourselves mired in the Vietnam War and this endeavor placed our gold reserves under considerable strain as they were needed to finance the enormous costs of the war effort. By 1968, foreign central banks were worried about holding too many dollars and were rushing to redeem them for gold. By 1971, our gold reserves had reached a critical level and in August of that year, President Nixon ‘closed the gold window’ and our foreign obligations were no longer settled in gold and the gold-dollar ceased to exist. Prior to this final cutting of the apron string, the dollar had already undergone several painful devaluations to stop the bleeding.

Once Bretton Woods was broken, the dollar was backed by nothing but the full faith and credit of the US government. We still had the productive capacity, but had lost our strong currency and gold reserves. The government, however, quickly began to appreciate the power of debt and deficits; especially because the dollar had the preferred status of being the world’s reserve currency. The problem lies in the fact that the dollar assumed this role because of a genuine strength and comparative advantage; once those were gone, the dollar still maintained the role mainly due to the lack of a viable alternative.

Once the gold-dollar ceased to exist, the United States began to rack up deficits and has never stopped. The aforementioned sell-off of our industrial base followed soon after and continues to this day. The debts resulting from current account, trade and budget deficits were used to bind the rest of the world to the dollar standard. The formerly agreeable arrangement became one of hegemony or force as the United States pounded its chest and pointed to the fact that it was the peacekeeper of the world in order to cajole other countries into continued acceptance of a now intrinsically worthless currency.

In the decades since the end of Bretton Woods, foreign central banks have repeatedly debased their local currencies, albeit to a lesser extent than the US, to support the broken dollar standard. This debasement unleashed global inflation, devoured the savings of much of the free world, and caused a massive redistribution of wealth. Today, the dollar standard operates under the doctrine of mutually assured destruction. The world is now buried under an avalanche of dollars and the general consensus seems to be that pulling the plug on the US will pull the plug on the rest of the world along with it. Don’t be too sure of that.

It is oxymoronic, is it not, that those who supposedly support the world’s economy have to borrow from the world’s savers in order to do it?

Keep in mind the Austrian notion that he who produces gets to consume. Those who produce will eventually consume their own goods, rather then sending them to us only to be paid with IOU’s, the value of which is shaky at best. Since the rest of the world in effect lends us their savings so we can consume their products, it follows that they could simply consume their own products does it not? Most certainly, this paradigm shift will require a temporarily painful adjustment for the rest of the world, but at the end of the day our ‘wealth’ will become theirs and out of our ruins a more efficient economic system can be born.

Graham Mehl is a pseudonym. He is not an ‘insider’. He is required to use a pseudonym by the policies of his firm when releasing written work for public consumption. Although not an insider, he is astonishingly bright, having received an MBA with highest honors from the Wharton Business School at the University of Pennsylvania. He has also worked as an analyst for hedge funds and one G7 level central bank.

Andy Sutton is a research and freelance Economist. He received international honors for his work in economics at the graduate level and currently teaches high school business. Among his current research work is identifying the line in the sand where economies crumble due to extraneous debt through the use of economic modelling. His focus is also educating young people about the science of Economics using an evidence-based approach.