The SEERby Dr. Hans F. Sennholz
Hardly a year passes without a financial crisis. In 1998 the virtual collapse of the Russian economy led to serious losses on markets in Asia and Latin America. And the spectacular crack-up of a prestigious investment fund, Long-term Capital Management of Greenwich, CT, shook U.S. markets. The Federal Reserve felt compelled to move three times to stimulate economic activity by easing credit conditions to keep the U.S. economy from falling into a recession. The world monetary order which rests on the U.S. dollar as the most prominent reserve currency seems to be no stronger than the weakest link.
Last year's crisis passed, but the situation in many respects is more fragile today. There have been no fundamental reforms. The emerging countries are returning to their old free-spending ways and the United States, which for the last few years has been single-handedly sustaining the global system, may prove to be a shaky support. The downward pressure on the dollar -- stemming from the fact that U.S. asset prices no longer are rising and capital inflows are drying up -- highlights the fragility of the U.S. financial system and the vulnerability of the world economy. The dollar exchange rate is a barometer that may give early notice of the crises to come.
For more than half a century the U.S. dollar has been the primary reserve currency in the world of finance. It gained this eminent position as the most reliable currency among many, giving access to the world's largest economy with open capital and money markets. It emerged gradually with the decline of the British pound sterling during and after World War I. At the end of World War II it excelled and outweighed all other currencies with some 60 percent of the world's monetary gold as its backing in Fort Knox. This illustrious position of the dollar, however, provided an irresistable temptation for U.S. monetary authorities to inflate and expand credit in Keynesian fashion. During the 1950s and 1960s they expanded at various rates, which inevitably led to the loss of gold and to the first dollar crisis in 1971. Unable to make international gold payments of some $70 billion with just $11 billion of gold left in Fort Knox, President Nixon felt it necessary to default. The world has been on a dollar standard ever since.
It is a fiat standard, not backed by gold or silver, and not redeemable in anything but government paper. It was born in default and crisis and, to this day, has suffered five major international crises, which inflicted much economic hardship and brought social upheaval and political turmoil to many developing countries. The next financial crisis ... may prove to be the knell of the dollar standard.
The history of the dollar standard since 1971 has been an exciting chapter of several ups and downs and makes and breaks. By 1978, with double-digit inflation at home and flooded dollar markets throughout the world, the U.S. dollar faced its first major crisis as foreign financial institutions began to liquidate their dollar holdings. Thirteen months later, raging inflation and a world-wide flight from the dollar forced the Federal Reserve to raise its discount rate to 13 percent with a three percent surrate for banks in New York and Chicago. The rate boost brought a halt to the credit expansion and saved the dollar standard, but cast the American economy and jointly the world economy into deep recession.
By 1981 and 1982 the U.S. crisis became an international crisis with a number of foreign countries unable to make interest and principal payment on their debt. Mexico, Argentina, Venezuela, and some 40 smaller Latin-American and African countries were forced to reschedule their foreign indebtedness to governments and banks. Even countries that were not facing severe liquidity problems, such as Brazil and South Korea, suffered painful economic effects. There was widespread fear that the crisis would lead to a chain reaction of financial failures with serious effects on the U.S. banking system.
During the 1980s the United States government embarked upon unprecedented deficit spending which was financed primarily out of domestic and foreign savings. Attracted by relatively high interest rates, the influx of foreign capital helped to cover both the budget and foreign account deficits. As long as a sufficient flow of funds from abroad was maintained, it proved to be possible to run large deficits and, at the same time, assure an appreciation of the U.S. dollar. But by 1987, the stock market crash of October 19, which spread to securities exchanges in other major countries, shook the financial structure to the core. The international value of the dollar fell precipitously while the currencies of Japan and Germany rose significantly.
The 1980s also saw Japan emerge as the world's largest creditor nation. Its high rates of saving together with massive credit creation facilitated and encouraged Japanese investments all over the globe. When in 1989 and 1990 the Bank of Japan finally raised its rate five times to deflate "the bubble of speculation" the Japan miracle began to fade. A crisis gripped the financial markets with the Nikkei stock average dropping precipitously and the banking system developing serious problems as a result of growing numbers of loan defaults due to declining property values and stock prices. The banking crisis ushered in economic decline and recession which numerous "stimulus packages" by several successive administrations managed to aggravate and prolong.
The stimulus packages in the form of mammoth fiscal deficits and painful tax boosts fashioned Ã la John Maynard Keynes kept the economy in turmoil throughout most of the 1990s. Uncertain about Japanese economic conditions and facing minuscule interest returns, many Japanese investors looked upon the United States as a safe harbor and dependable source of revenue; they helped to stoke a Wall Street boom.
The recent weakness of the U.S. dollar versus the Japanese yen reflects a new confidence of Japanese as well as international investors in the Japanese economy. Output finally is expanding again in contrast to last year when it was contracting. Corporate stock prices have risen by more than one third in recent months. Japanese investors are restructuring their portfolios as are foreign investment funds that had been avoiding yen assets. Since the yen strength and the dollar weakness are driven by fundamental considerations, it is likely that the yen will remain rather strong.
The 1990s brought two major financial crises. The "Christmas crisis" of 1994 was triggered by the collapse of the Mexican peso which transmitted shock waves throughout the Western hemisphere. The Mexican economy contracted painfully; goods prices rose more than 50 percent. Tens of thousands of small- and medium-sized businesses collapsed, and some one million workers lost their jobs. When the U.S. Congress refused to approve the Clinton rescue plan, the President worked with the U.S. Treasury, the International Monetary Fund, and European governments to devise a bailout estimated at nearly $50 billion. While American and European taxpayer funds were pouring into Mexico to keep the crisis from spreading, private capital sought refuge in American financial markets. U.S. stock and bond markets saw "the largest increase in market wealth in history."
In 1997, finally, the world was caught in the grip of the most serious financial crisis since the 1978 and 1979 flight from the dollar. Starting in Thailand and spreading quickly to Indonesia, Malaysia, and the Phillippines as well as affecting South Korea, Hong Kong, and Singapore, it posed a direct threat to U.S. finance and the world dollar standard. By the end of 1997 the Asian currency depreciation averaged 50 percent against the U.S. dollar, contributing to Japan's slide into deep recession and causing the yen to plummet. A deep depression settled over parts of Asia, causing severe economic hardship and leading to social unrest and political upheavals.
The new Asian crises augured the bursting of various financial bubbles -- just as the Japanese bubble had broken eight years earlier. It revealed huge malinvestments in industrial capacity and property, and caused massive wealth destruction through the collapse of asset prices, creating mountains of bad loans and leaving behind an illiquid and vulnerable banking system. The crises affected other countries around the globe as liquid capital sought to escape the troubled areas and find safe havens in Europe and the United States. The influx of frightened foreign funds added more fuel to the U.S. bubble.
Since the beginning of this year (1999) the bubble has come under new pressure which is bound to increase in the future. Annoyed by the hegemony of the U.S. dollar in world markets and fearful of its precarious base of debts and deficits, many Europeans would like to withdraw from the world dollar standard by creating a currency system of their own. Eleven European countries launched a common currency, the euro, to replace their national currencies. In time it may create a continent-wide economy very much like that of the United States, and challenge the dollar as the world's primary currency. The Euroland of eleven is as large as the United States, conducting more trade with the rest of the world than the U.S., has larger foreign exchange reserves, and enjoys a much stronger foreign trade and finance position than the U.S.
Europeans may soon finance their trade in euros rather than U.S. dollars, which may result in a huge shift from dollars to euros around the world. It would signal a shift from dollar hegemony or dollar standard to a bipolar monetary world. The transition may depress the exchange rate of the dollar, boost the prices of all imports, and generate an upward pressure on inflation and interest rates. It could trigger a dollar crisis, burst the Wall Street bubble, and usher in a deep recession.
The American bubble is at extreme risk; it is the mainstay and supporter of all others. As the dominant reserve currency of the the world, the U.S. dollar is in world-wide demand, which has given the dollar authorities the ability and power to inflate and create credit at astonishing rates. The demand allows the U.S. to suffer huge trade deficits and export some of its excesses in the form of dollar loans to business and governments around the globe. The U.S. dollars held abroad then serve as an ever expanding basis on which foreign governments and central banks build their own bubbles. They are resting their credit pyramids on a dollar base which itself is a giant pyramid of leveraged credit and debt.
The visible marks of the U.S. bubble are not just egregious malinvestments, especially in the telecommunication and media industries, but also a great stock market boom. Taking advantage of the stock euphoria, investment bankers underwrite new stock and bond issues nearly every day. Corporate mergers and acquisitions proceed unabated, facilitated by lofty stock prices and easy credit. Feverish issuance of mortgage-backed and asset-backed securities bolsters a residential housing boom. Fannie Mae, the publicly owned and government-sponsored banking corporation, alone holds more than one trillion dollars of new mortgages. Syndicated bank lending exceeds even this amount. Outstanding credit card debt is growing at double-digit rates, while personal savings are declining. There is leverage upon leverage as never before, as securitization is vying with banking as the primary source of credit. Countless trillions of dollars worth of derivatives are supposed to sustain the lofty pyramid. Global outstanding interest rate swaps, currency swaps, and interest rate options alone now exceed $100 trillion. According to Alan Greenspan, the derivatives market carries some $80 trillion of most short-term debt, world-wide, with U.S. banks holding $33 trillion of this debt.
If some of the debtors should ever default because of an unexpected decline in financial markets, the banks will be holding worthless IOUs, which would cast doubt on their solvency. Surely, the Federal Reserve will want to come to their rescue, but it is inconceivable that it can create trillion-dollar credits or print trillion-dollar notes. Any such attempt would seriously damage the U.S. dollar, lead to rampant price inflation, and irreparably ruin the world dollar standard. It is more likely instead that the federal government will declare bank holidays and impose a myriad of controls on the people. The controls in turn will generate a financial underground which will develop standards of its own.
The Federal Reserve still wields great power because part of the stock of money consists of bank deposits; and banks are forced to keep reserves at the central bank. But this Fed power may prove to be rather hollow because the evolution of electronic means of payment in recent years deprives the Fed as well as the member banks of all leverage. The proliferation of non-bank credit reduces the power of central banks because bank credit is steadily contracting as a proportion of total credit. Moreover, even where commercial banks still issue loans, these may be "securitized," which means that they are sold to non-bank investors who are not subject to reserve requirements. In short, the demand for bank money is eroding as is the Fed power to manipulate the people's money and credit.
In these waning days of the dollar standard and the exciting new world of electronic means of payment, it is difficult to foresee the shape and color of the coming financial order. We cannot say what the rate of inflation will be, nor can we know whether national authorities will find new ways of controlling the people's money. Most economists are convinced that we will have to return to the financial systems of the past. Surely, the monetary authorities of the world will want to reassert their position through new controls over their subjects and new international agreements and treaties. But it is difficult to see how political machinations can redirect the electronic national and international monetary flows.
In the end, the standard of value in which international prices are quoted and contracts denominated will be neither the U.S. dollar nor the euro. It will not be measured in terms of a unit of account defined in terms of a basket of goods because the international authorities will never agree on the content of the basket. We are convinced that the future standard of value will be gold again, as it has been for more than 2,000 years throughout the Western world. The political authorities will fight it unrelentingly and mercilessly, but gold undoubtedly will prevail in the end.
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At this time a gold standard has few friends and advocates. It limits the power of politicians and officials to manage and manipulate the stock of money. It denies them the means to "stimulate" economic activity and renders deficit spending rather difficult. The remarkable stability of gold serving as money lends stability to economic life, which made it the monetary standard throughout the ages. In fact, gold has been wealth and money since the dawn of civilization. Most of the gold won from the earth during the last 5,000 years can still be accounted for in man's possession today. There is no shortage of gold.
The world monetary system is about to change again. It is difficult to foresee the form and structure of the coming order. Clinging to their powers, the monetary authorities of the world will want to repair the old order with restrictions and regulations. But their failure to prevent the numerous crises, which put nearly all countries in serious jeopardy, is casting serious doubt on their credibility and ability. The precarious condition of the very dollar base and chronic foreign account deficits of the United States at the expense of all creditor countries are discrediting the dollar authorities. This explains why governments and central banks throughout the world are becoming ever more reluctant to grant the U.S. government a permanent monopolistic position in matters of world money. In crisis and despair the world may choose gold.
by Dr. Hans F. Sennholz
October 28, 1999
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