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Volume 16, Number 5
Perils of the Dollar Standard
by Jeffrey M. Herbener
Winter's economic crisis in Asia was blamed on "go-go capitalism"
and "crony capitalism," but those explanations don't get to the root
cause. The Asian meltdown stems from structural defects deep within the world monetary
system itself. These are defects that no amount of bailouts, exchange controls, IMF power,
or even U.S. monetary discipline can repair.
Crushing price inflation in Indonesia most dramatically illustrates the
monetary dimension. From the summer 1997 to early 1998, the rupiah lost 75 percent of its
purchasing power against the dollar and domestic prices for basic necessities skyrocketed.
Rice was up 36 percent, cooking oil 40 percent, milk 50 percent, and electricity 200
percent. This sparked runs on stores, a drought of investment, growing exodus of
businesses, a collapse of the banking system, massive layoffs, violence and riots, soaring
interest rates, and sinking stock and real estate markets.
The Suharto regime froze prices for basic foodstuffs, mandated wage
increases, allowed a few bank mergers, sent troops into the streets to quell unrest, and
suggested a debt moratorium. The IMF pressed Indonesia to raise taxes to balance its
budget, adopt American-style bankruptcy laws, and bail out bad debt to the tune of $43
billion. But this Suharto-IMF onslaught only aggravated a desperate situation by
short-circuiting market forces.
If it hasn't helped Indonesia, what is the point of the IMF plan? It
is designed to enforce the international dollar-reserve system deemed essential to U.S.
interests. U.S. banks and companies will be relieved of some of their losses by the
massive bailout. But more importantly, the IMF is part of the attempt to maintain American
monetary and economic hegemony by ensuring that the ravages of price inflation stay far
from America's shores.
This is no mean feat considering the massive monetary and credit expansion
engineered by the Federal Reserve in the 1990s "global" boom. From the end of 1990 to the end
of 1996, the Fed used its open
market operations to increase the monetary base (MB), which is currency plus bank
reserves, by 55 percent. Currency itself increased 60 percent.
Only a corresponding increase in money demand can forestall price
inflation once monetary inflation of this magnitude has been set in motion. But growth
rates of the American economy--not high by historical standards--have been insufficient to
absorb this monetary inflation and bring about
the current low, and even falling, rates of price inflation. The greater money demand has
come overseas as the U.S. has asserted the dollar's status as the world's
The dollar-reserve system of the "global economy" of the 1990s is the resurrection of the
Bretton Woods system without gold.
Under the "gold-reserve" system of Bretton Woods, each
country's currency had a fixed exchange rate against the dollar and foreign
governments could redeem the dollar at the U.S. Treasury for gold at the fixed rate of $35
The arrangement forced a coordinated monetary and credit inflation among
the member countries at a rate determined by the Federal Reserve. Any rogue nation intent
on excessive monetary inflation would be punished by devaluation and domestic price
inflation, and the attendant problems now being suffered by the Indonesians. Just the
threat of such a catastrophe was normally sufficient to induce the profligate nation to
curtail its liberal monetary inflation.
The linchpin of the Bretton Woods agreement was the fixed rate of
redemption between the dollar and gold. The Fed broke this link by accelerating monetary
inflation in the 1960s to help finance expenditures for the Great Society and Vietnam war.
From the beginning of 1960 to the end of 1964, the Fed increased the money base 3 percent
per year, but from the beginning of 1965 to the end of 1970, the Fed more than doubled the
rate of increase to 6.3 percent. The average annual rate of price inflation went from 1.3
percent in the earlier period to 4.2 percent in the latter one.
Recognizing that the monetary inflation was reducing the purchasing power
of the dollar sufficiently to make the fixed rate between the dollar and gold untenable,
foreign governments began to cash in dollars at the U.S. Treasury for gold.
When Nixon reneged on the U.S. promise to exchange dollars for gold to
foreign governments at $35 an ounce in 1971, foreigners dumped dollars in anticipation of
an official devaluation to bring the dollar's official exchange rate in line with
its, much lower, market-determined purchasing power.
The sudden reduction in money demand brought devaluation and, as the
dollars were repatriated, domestic price inflation. By 1973, the dollar had devalued 18
percent and annual price inflation rates averaged 6.8 percent from 1971 to 1974. As the
dollar lost its purchasing power, interest rates rose to compensate lenders for the
reduced value of dollars they would receive in the future. The 3-month Treasury bill rate
went from 4.1 percent in 1971 to 7.9 percent in 1974; the 10-year Treasury bond rate
jumped from 6.1 percent in 1971 to 8 percent in 1975.
Higher interest rates caused capital values to collapse and the ensuing
losses led to bankruptcies and rising unemployment. From late 1972 to late 1974, the Dow
fell 45 percent; unemployment rose from 3.5 percent in 1970 to 8.5 percent by late 1975.
The Nixon administration responded to the crisis with price controls, changes in bank
regulations and bankruptcy laws, and more Fed inflation.
After increasing the monetary base 8.7 percent per year from 1971-1974,
the Fed accelerated the rate to 10.4 percent from 1975 to 1981.But after the debacle of
the first half of the 1970s, it was difficult to convince foreigners to hold more dollars
as reserve. Accelerating monetary and credit inflation by the Fed led immediately to
severe domestic price inflation (average annual rates of 11.2 percent), soaring interest
rates (peaking in 1981 at a 14 percent 3-month), collapsing capital values (from 1976 to
1982, the Dow lost 22 percent and stood at 774 in 1982), and higher unemployment (peaking
at 9.7 percent in 1982, a rate not seen since 1941).
This entire scenario is precisely the reverse of the American economy in
the 1990s. From 1982 through 1990, the dollar began to regain its status as the
world's reserve currency. The Fed expanded the monetary base 11 percent per year in
the 1980s, but the demand to hold dollars overseas helped soak up the monetary inflation
and the American economy experienced economic growth with low levels of price inflation.
The annual rate of price inflation was only 5.9 percent. But the improved performance of
the economy in the 1980s was only a foretaste of the renaissance of dollar dominance in
American supremacy in the wake of the collapse of communism allowed the
Fed to fully exploit the international dollar reserve system. The new system opened up a
vast new vista for overseas dollar holdings. From Russia and Eastern Europe to China and
East Asia, the governments of former communist countries began to soak up dollars to hold
as official reserves as they became part of the American, "global" system. From the beginning of
1991 to the end of 1996, the Fed increased the MB 9.1 percent per year, while price
inflation ran only 3.6 percent annually.
The new regime differs from Bretton Woods in the absence of a link between
the dollar and gold. Without the fetter of gold reserves and redemption commitments of
dollars for gold binding it, the Fed has no objective constraint in determining the rate
of dollar inflation.
But like Bretton Woods, the new regime depends on foreigners'
willingness to hold dollars and use them as the basis for their own domestic monetary
inflation and credit expansion. Only with harmonized monetary policies can the system
Any country trying to take advantage of the fixed exchange rate of its
currency against the dollar by excessive domestic monetary inflation and credit expansion
will be punished, as under Bretton Woods, with devaluation and domestic price inflation.
But therein lies the great danger of the system to the American economy. A
rogue nation will be tempted to defend its currency, and stave off devaluation, by
spending its dollar reserves. Any significant disgorging of dollars would threaten to
ignite price inflation in America if the dollars were repatriated. Significant domestic
price inflation would, at best, bring a repeat of the 1970s, and, at worst, a
This danger explains the U.S. interest in promoting IMF austerity policies
and bailouts. The bailouts are intended to soften the blow of devaluation and price
inflation. In exchange for taxpayers subsidizing banks and large corporations, and other
key beneficiaries of the system, the IMF can use the bailout money as leverage to impose
conditions favorable for the future of the dollar-reserve system.
One condition the IMF has imposed across Asia is for the recipient country
to establish an "independent" central bank, i.e., one
independent of local political control, and therefore at liberty to harmonize monetary
policy with the Federal Reserve. Other conditions concern fiscal policy consistent with
much lower rates of domestic monetary inflation, ones that allow stable exchange rates
between domestic currencies and the dollar: raising taxes, restricting spending, balancing
budgets. The remaining conditions address the hemorrhaging bankruptcies and collapsing
financial systems across Asia.
In the last three years, the system has faced a $50 billion bailout of
Mexico, a $57 billion bailout of South Korea, $43 billion for Indonesia, $18 billion for
Thailand, for a total of $118 billion in Asia (some estimate that it will eventually rise
to $160 billion) to fend off its own destruction. But by delaying the day of reckoning
with bailouts, the international mountain of dollars and debt grows, making the inevitable
collapse all the more devastating.
Will the system be able to prevent disgorging of dollar reserves to fend
off Asian-style financial debacles in China, South America, Russia, and a repeat
performance in Mexico? If the euro becomes the common currency of the EU, what will happen
if its members replace their dollar reserves with euros? And if Japan recovers, what will
happen if the yen becomes the reserve currency across Asia?
The Fed has overseen the best of times for the American economy in the
1990s, a period of rapid monetary inflation and credit expansion with current benefits of
low interest rates, high earnings, soaring capital values, low unemployment, and steady
economic growth. It has come courtesy of foreigners who have absorbed enormous quantities
of dollars and, in so doing, kept U.S. price inflation at bay.
If Fed and Treasury officials seem tired and hypersensitive about their
every remark these days, maybe they realize the worst of times must be the future cost to
be paid when U.S. dollar hegemony wanes.
Jeffrey Herbener teaches economics at Grove City College.