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Dollar Flood

September 3, 1998

Tags Financial MarketsGlobal EconomyMoney and BanksU.S. EconomyMoney and Banking

Investor's Business Daily
September 3, 1998

"Dollar Contrarians"

The Federal Reserve says that more than half of all U.S. currency is now held overseas. The dollar has now become the currency of choice for much of the world. And it has replaced gold as the global financial standard. That has some economists worried.

"What happens if all that money starts flooding back into the U.S.?" asked Jeffrey M. Herbener, an economist at Grove City College.

For an answer, look back a little more than 25 years, Herbener suggests.

In ‘71, Nixon reneged on a U.S. pledge to swap a fixed number of dollars for gold for foreign governments.

Seeing that the dollar was about to be devalued, foreigners dumped them. That weakened the dollar even more than Nixon had intended.

And when those dollars tarted coming back home, they added fuel to a growing fire of price inflation during the ‘70s.

Could something like that happen today? Herbener things so.

"One scenario would be that nations facing devaluation would spend their dollar reserves to defend their own currency," Herbener said.

"We've also got to ask what will happen if the euro becomes the common currency of the European Union," he said. "Will its members replace their dollar reserves with euros?"

A big rush of dollars back to the U.S. could kick off price inflation, unless the Fed hiked interest rates sharply. And this underscores a dangerous fact, say some economists. The U.S. has become addicted to a policy of easy money, they say.

The U.S. monetary base, currency plus bank reserves, has grown by 74% since ‘90. It's 6% larger now than it was just a year ago.

M2, the base plus checking accounts, has grown 30% since ‘90. It's now 7% larger than it was a year ago.

Ordinarily, monetary inflation would bring price inflation, but America so far has been able to avoid that.

But, Herbener warns, it may not be able to do so forever.

New money doesn't enter the economy evenly. It gets injected into credit markets, making credit look cheaper than it should be.

Total bank loans and investments have been growing at an almost 10% annual rate for nearly a year now.

Federal Reserve Chairman Alan Greenspan earlier this year warned that banks may be cutting their lending standards in order to push out the money they are awash in.

Meanwhile, total household debt has climbed from 68% to 95% of personal income over the last 10 years.

Of course, many people are worried that U.S. monetary policy is too tight, not too easy. They want the Fed to cut interest rates and boost the money supply.

Those who think there are too many dollars disagree.

"I don't see a lack of liquidity out there," said Lawrence White, an economist at the University of Georgia.

Nor does White think interest rates are terribly out of line.

The rate of a 30-year Treasury bond is less than 5.5%. Take into account a consumer inflation rate of about 2%, and that leaves real interest rates at about 3.5% .

"That's not off the mark, historically speaking," White said.

Nor do falling commodity prices mean that deflation will sweep the U.S., he adds.

"With particular goods, prices are determined by complex forces of supply and demand," he said. "Before I worry about deflation, I'd want to see falling prices in a wider index of goods, such as the consumer price index."

The CPI continues to rise, but slowly.

But Greenspan and some other members of the Fed's Open Market Committee warned about the dangers of inflation as recently as a few weeks ago.

With all of the economic turmoil sweeping the world, this probably isn't the time to tighten up on money, White admits.

"But I'm also not convinced that we should start inflating the money supply," he said.

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c) copyright Investor's Business Daily, 1998

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