Mises Daily Articles
How to Save the Dollar
The dollar has again hit a new low in recent weeks on the international currency exchange. The blame is falling from most sectors of public opinion on our legislature, with its debit spending at an all-time high. A few say that the Federal Reserve (FR) could do something about it, but they deny it. Greenspan himself, in his recent conference in Germany, explained once again that interventions are only temporary and ineffective.
He speaks correctly when he implies that interventionist attempts to manipulate the exchange rate or strength of the dollar are futile in the long run; but more importantly what he doesn't say, and may not even admit, is that the FR does play an important role in federal spending through its financing, and its decisions have a direct effect on both the foreign exchange market and the dollar's purchasing power within the United States.
There was a time when the value of a dollar, indeed of most currencies, was measurable on that yardstick called the gold standard. This meant that each currency unit was convertible into a fixed amount of gold and thereby retained a stable exchange value over the years. Back before the 20th century and up until 1913, the amount of dollars in circulation in our country was determined by regional commercial banks that had a pretty precise idea of what was needed.
Most were prudent in their transactions, holding a certain amount of gold as reserves, and issuing just enough currency to cover salable goods and services coming to market. If they issued too much, eventually paper dollar prices would rise, while gold dollar prices would remain more stable. Seeing this, customers would begin to turn in their paper dollars to the bank for gold at the previously fixed price, which had the effect of withdrawing the excessive paper dollars from circulation – an oversimplification, but accurate nonetheless.
However, in an attempt to allow for wider flexibility of money credit policy across state lines and to federalize the banking industry at the same time, in 1913 President Wilson signed into law the Federal Reserve Act, which took the issuance of currency away from regional banks. Whether inspired of good will or not, this was the opening of Pandora's box, the end of the sound dollar and the beginning of the fiat dollar, the external exchange value of which is determined abroad by the currency markets, and the internal purchasing value of which fluctuates according to the amount of money in circulation.
Both values (for now there are two) are allowed to float, and much of the time they do so relatively independently of each other. No more official gold price, no more measuring stick. Instead of a dollar being equal to, say, 1/400 of an ounce of gold all around the world, it is equal to one thing today, another thing tomorrow, and a third thing in Timbuktu. And amazingly enough, it seems to work, at least for a while.
Historically, even under the gold standard, wartimes have always been a source of trouble for the monetary unit, and inflation seems to be a temporary necessity during those times. Under gold standard conditions, the end of the war usually means a slight depression while the extra currency is extracted out of the economy. After WWI, the usual adjustments back to sanity were particularly harsh, probably due to the mischief caused by President Wilson's federalization of the monetary system. The resultant deflationary "morning after" crash started in 1929.
As economists searched frantically for a solution, British professor Keynes's demand theories came into vogue, and on his recommendation the government decided to increase the amount of dollars over and above commercial requirements, in order to "stimulate demand" and "get the country out of its economic depression." One theory maintains that, not only did their efforts backfire, but the goose was really cooked by the resultant Glass-Steagall Act of 1932 which, through a technicality, allowed the FR banks to inflate the money supply pretty much at will.
Reputedly because of its defects, but in reality because of ongoing British and other nations' mismanagement of their respective money supply, the gold standard was abandoned by all in 1933. Although this was viewed with some wariness at first, it didn't take long for the usual rationalization mechanism to evolve, and before you knew it, gold was named a "barbarous relic." The creation of the FR Board had given us a sense of confidence that someone was in the driver's seat; however, it also gave them a tool to manipulate the internal and external value of the dollar, and to inflate its purchasing power away if they so chose.
Just how do they accomplish this? A couple of the specific tools they use are familiar to us all: increasing or decreasing the discount and other short-term interest rates, supposedly to control inflation; however, since 1932, not only has the Fed not controlled inflation, but on the contrary, it has created a credit helium balloon. Why would they want to do that? To give us the impression that they were "solving" economic depressions; to decrease the relative size of the national debt and budget deficit by a few percent every year; to placate people into thinking that their usual pay raises were increasing their wealth to the expected degree when in reality inflation distorts this perception; and to reduce wages during business cycle slowdowns without actually having to decrease salaries. (Employers simply don't increase the salary and inflation does the rest for them.)
The only partial palliative is that today most of us prepare for inflation to some degree. However, the problems remain that some people do not, and it is destabilizing in several ways. It saps our confidence in the future and creates doubt and friction in the marketplace. It erodes our wealth. It can cause the collapse of nations. Keynes, inflation's best defender, once said, "In the long run, we'll all be dead." Well maybe he is, but we emphatically are not! No, the labeling of inflation as "legalized embezzlement" (catchphrase of E.C. Harwood, economist, founder of the American Institute for Economic Research and one of the rare successful contemporary debaters of Professor Keynes) applies just as much today as it ever did, and so the process goes on. Unfortunately, we are slow to wake, and generations pass.
Thus in real life, the Fed does have an enormous influence on many internal and external aspects of the dollar, and today that includes political ones, whether they like it or not, whether they admit it or not, and whether they control it or not. Today its role of fiscal puppeteer has expanded into both the international currency theater and the geopolitical stratosphere. Yes, it seems our central bank now has its own agenda, the details of which the rest of us ignore. It is a punctual one. Greenspan meets every week for breakfast at the White House. What happens there stays there, so like in Las Vegas, no notes are taken.
Now, not only must the FR attempt to control the domestic CPI inflation rate, but it regularly receives "suggestions" (we won't call them "orders," and indeed some are ignored) to bail out certain Latin American countries faced with debt default, maintain friendly relations with Asia (more recently with China), decrease the huge current account deficit (a similar but more elaborate gauge of the balance of trade), etc. – all according to the political expediency of the moment, and in complete disregard for (1) whether or not the FR can achieve the desired results, (2) whether the unavoidable concomitant change in US money supply is actually advisable for sound commercial purposes, and (3) the downstream effect on the American economy in the medium to long range. The fact is that the dollar cannot obey two masters, let alone three, or four or five; and it shows.
Morality aside, is the Fed getting the job done? As to the first layer of control, which is the internal US economy and the amount of currency in circulation, we have already seen that they do not take their role of controller of the currency very seriously, believing instead in their capacity to control the business cycle through Keynesian demand-side injections of credit when an economic slump appears. These doctoral interventions gives only illusory reprieve and are counterproductive.
Also, because they are no longer basing the production of currency on actual commercial need but rather on a kind of "taking of the pulse" of the economy and of the CPI, the FR's efforts end up being either too small, too late, or too large, too early; the end result is that they under- or overreact. Rate cuts end up creating too much currency, which can create speculative bubbles.
Eventually, to cure the bubbles, they must take steps to rein in the issuance of excess credit, so they raise rates. At the slightest hint of overreaction in the market, they ride both the brake and the inflation pedal at the same time, to smooth out the bumps.
Frankly, if the FR hadn't intervened in the first place, there may not have been as big a downturn in the second place; but they prefer to play a drunken psychological game of hide and seek, attempting to avoid bad press words like "depression" or "recession," even though the infamous binger's "morning after" must ultimately be faced. Was it Mme de Pompadour, Louis XV or the FR who said, "Après moi, le déluge!" So much for internal control of the money supply.
Add to the above a second layer of geopolitical tampering, for whatever "good" motives, plus a third factor, the Fed's financing of the irresponsible debt spending of the legislature with their wealth transfers, huge bureaucracies, corporate and bank bailouts, unwise loan guarantees, unfunded "trust funds" and general pork and centralist tendencies, and you have a looming financial abyss over which the little man is dangled to his death while the big players pull the strings.
These manipulations always hurt someone, and that someone is the unwary, main-stream, working man or woman who invests his or her hard-earned money in the bubbles that are the direct result of the Fed's fiddling. The insult spreads itself out over the whole market making it less perceptible – the old story of many being billed a little for the multiple follies of a few; but the cumulative toll is in the trillions of dollars' worth of our collective purchasing power.
Inflation becomes a chronic disease, to wit the 8-cent value of our dollar bill today, and falling. They have permitted our currency to lose 90 percent of its value in the last 90 years. It goes without saying that proper respect for and maintenance of the gold standard would have avoided this whole mess, but that is a game which takes at least two to tango, i.e. it would be better if the rest of the world played along.
Also, the consensus among a number of economists is that the numbers would require the world's recognition of the real weakness of our dollar to make a reinstatement of the gold standard feasible. (See here for an interesting discussion of this topic.) So what is our option today? Fasten our inflation seat belts; then sit tight, grin, and bear it. Unless of course the world is waking up "as we speak," in which case the resounding crash should be seen as a "golden" opportunity.