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Pass the Buck

Mises Daily: Thursday, December 02, 2004 by

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It is a sign of the times when the Chinese government, which was just granted market economy status by debt-laden Argentina, takes America to task over its gaping budget and trade deficits.

When interviewed by the Financial Times, published Nov. 22, Li Ruogu, deputy governor of the People's Bank of China, admonished Washington not to blame outsiders for its disorderly accounts, but instead put its own house in order. "The problem is that they spend too much and save too little," he says.

Similarly, when Fed Chairman Alan Greenspan publicly acknowledged in Berlin that, "Given the size of the current account deficit, a diminished appetite for adding to dollar balances must occur at some point," something is afoot.

Markets indicate that the fiat dollar era has arrived at an endgame. The greenback has fallen by more than 35% against the euro and 21% against the yen this year, setting record lows almost daily since spendthrift George W. Bush's re-election. As America's current account and budget deficits continue to bleed red unabated, traders all over the world are finally seeing red and dumping the dollar.


The precipitous fall of the leading fiat currency in the absence of a functioning gold standard is an inevitability predicted by adherents to the Austrian School at the outset of the disastrous Bretton Woods system that French economist Jacques Reuff referred to as, "a childish game in which, after each round, winners return their marbles to the losers." 

Bretton Woods I & II

The post Second World War monetary architecture crowned the dollar as the world's reserve currency, tying it to gold at a fixed sum and all other currencies fixed against each other. Under this pseudo gold standard, America's central bank would convert dollars to gold on demand for foreigners. However, U.S. policy-makers assumed that gold redemption would fail to materialize and the Fed could inflate without sanction because foreign central banks would retain the dollars as reserves on which to pyramid their own currencies.

The system worked fine, as far as America was concerned, until the 1960s when European countries replaced an inflationary bent with hard money policies. Assailed by rampant inflation, the Vietnam War, and staggering trade and budget deficits, the U.S. hemorrhaged gold at an accelerated pace, prompting President Nixon to close the gold window in 1971. The de facto declaration of national bankruptcy heralded the advent of free-floating currencies and the present stage of the dollar standard.

No longer constrained by even the nominal fetters of Bretton Wood's pseudo gold standard, America has been able to purchase imports with fiat money churned out by the Fed and uniquely finance its burgeoning indebtedness by issuing debt instruments in dollars. On the other hand, foreigners, stuck with unconvertible greenbacks since 1971, have had no choice but to adopt dollars, rather than gold, as the world's reserve asset.

Consequently, the dollar standard, in both the fixed and floating variants, has fostered an unhealthy economic relationship whereby most major economies excessively rely on exports to the U.S. and then funnel the greenback receipts back into America's credit-hungry public and private sectors. Repatriated dollars seep into America's financial system, furnishing banks a broader monetary base to pyramid credit upon, which can fund more U.S. imports, thus perpetuating the world's vicious economic cycle.[i]

Distortions Galore

Figures acutely illustrate the scope of the distorted international monetary system. Since 1982, the U.S. has run a current account deficit every year, save 1991. The IMF expects the 2004 total to exceed $630bn, substantially larger than the $531bn posted in 2003. Indeed, this year's expected current account deficit dwarfs the GDP of all but nine of the world's countries.

These persistent and widening trade imbalances, payable in dollars and U.S. debt instruments, have tremendously expanded the amount of the world's international reserves, presently estimated at $3.368 trillion.

Between 1969 and 1999 total international reserves, primarily consisting of deposits, currency, bonds, equities, and scarcely any gold, grew 20-fold,[ii] standing at roundabout $1.6 trillion. From January 2002 to July 2004 alone aggressive money creation by the Fed, coupled with insidious fractional reserve and central banking the world over, added a whopping $1.307 trillion to global currency reserves.

American indebtedness has burgeoned at a commensurately astounding clip. Total borrowing per annum (government and private sector) has grown from $89bn in 1969 to $1.673 trillion in 2003 and cumulative outstanding debt stands at $22.394 trillion compared to $1.332 trillion in 1969.[iii] As one would guess, the U.S. household savings rate declined from 10% in the 1980s to less than 1% today.

Put simply, the U.S. requires about $2bn per day from foreigners to appease its insatiable borrowing addiction.

However, when capital inflows begin to recede, because of diminished creditworthiness, "there will be a crisis that will result in rapidly rising interest rates and a rapidly depreciating dollar that will be very disruptive," said Robert McTeer, president of the Dallas Fed.[iv]

Fed and administration officials like to spin the abysmal current account deficit as a success story. The theory goes that foreign investors are keen to acquire American assets and reap the higher returns offered by the country's impressive productivity growth.

Conversely, foreign demand for U.S. assets has been flagging. Last year America imported twice as much capital a month as it needed to cover the trade deficit. The gap has narrowed; $63.4bn of capital was imported in September compared with a $51.6bn trade deficit that month. The abrupt upsurge in federal borrowing since 2001 has also quickened the gait of current account deterioration. As private investment has dwindled and lenders are now financing government and household consumption, rather than investment in productive ventures, foreign central banks have picked up the slack.

Kings of the East 

Enter East Asian central banks. China, Japan, and the Asian "tigers" have prospered by gearing their economies toward exporting to America. Recurring trade surpluses with the U.S. have been instrumental in boosting businesses, employment, and government revenues in these countries. Moreover, surfeit dollar receipts, when not plowed back into America, have financed the growing level of trade between the nations of East Asia.

Little wonder Asian governments have opted to use heavy purchases of dollar reserves to peg their currencies to the greenback at undervalued rates. Mean currency values keep Asia's exports competitive, supporting the rapid growth that underpins its economic success.

At the same time, acquisitions of U.S. Treasury bonds reduce American interest rates, which sustain spending and ensure that American consumers keep buying Asian wares. Without currency intervention by Asian central banks, America would not be able to finance its deficit without higher bond yields or a bigger fall in the dollar than what has already occurred thus far.

The downside of this policy is that as Asian central banks purchase dollars and dollar-denominated debt instruments in exchange for won, renminbi, yen, etc., it expands each country's domestic money supply, precipitating their own boom and bust sequences. Richard Duncan's book, The Dollar Crisis, best illustrates how asset price bubbles have burned Asian countries with sizable dollar inflows during the 1980s and 1990s and helps explain the boom in credit creation currently gripping China.

Presently, Asia holds 65% of the world's foreign currency reserves, or about $2.183 trillion.[v]Japan and China hold $820bn and $514.5bn of foreign reserves—mostly dollars—respectively. Asian countries have a delicate choice to make. Does each nation continue to finance America's spendthrift ways, courting boom and bust cycles of their own, or do they part with the dollar standard and permit their currencies to rise, thereby kicking the last leg out from under the dollar? 

Besides incurring a diminution in export competitiveness, the latter option threatens to wipe billions of dollars off Asian central bank balance sheets, as a declining dollar rapidly erodes the value of their vast stores of U.S. debt instruments. In effect, a steep greenback descent would constitute another de facto default by America, albeit differently from 1971 in that the world's biggest debtor will this time fail to pay on billions of central and fractional reserve banking produced dollars and debts.

Already, there are indications that Asian and other countries of the world are diversifying their holdings away from greenbacks. The dollar fell to $1.32 against the euro Nov. 23 when Russian central bank authorities hinted they might recalibrate the ratio of greenbacks to the European currency held in the bank's portfolio from 3 to 1 to 1 to 1. Jittery currency markets were jolted a day later when a respected Chinese economics professor and central bank committee member reportedly told his students that the central bank had reduced U.S. debt holdings.

China is the pivotal player in deciding the dollar's fate considering that Asia is almost, if not already, subject to renminbi ascendancy, rather than dollars. Should the Chinese government lose patience with the dollar and seek to move its foreign reserves into another currency, the rest of Asia will follow suit, precipitating a disorderly and calamitous rout of the greenback. The question is not if, but when, Asia will discontinue financing America's staggering profligacy, even if it entails a rise in the value of their currencies.

To underscore the voracity of the dollar's impending demise, the 27 November Edition of the Financial Times furnishes a telling account published in its letter-to-the-editor section. The writer, who just returned from a business trip to Vietnam, recalls how when a 7-year-old street urchin asked him for money, the child refused his offer of a dollar, instead specifying euros.[vi]       

A 100% gold standard, with its inherent price-specie-flow mechanism, would have precluded the tremendous accumulation of debt and annual trade deficits by America as well as the gross distortion of the international economy, whereby most major countries orient production toward exporting goods to America. As 50 years of the fiat dollar standard "boom" ends, the U.S. and the world will reap what they have sown.

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Grant M. Nülle is a Research Fellow with the Ludwig von Mises Institute.[email] Post comments on the blog.



[i]Duncan, Richard. The Dollar Crisis:  Causes, Consequences, Cures. 2003.

[ii]Ibid.

[iii]Federal Reserve. Flow of Funds Accounts of the United States. 4th Qtr. 2003.

[iv]"The Wolf at the Door."  The Economist. Oct. 28 2004.

[v]"Economies:  Imbalances Sweep Across the Pacific in Waves."  Financial Times. Nov. 19 2004.

[vi]"Euro Street Wisdom for Greenspan."  Financial Times. Nov. 27 2004.