Sunday, September 28, 2014

Be Careful What You Wish For

In what I found to be a most interesting article, Jared Bernstein, a former Obama and Joe Biden economic adviser, wrote an op-ed in the New York Times advocating the removal of the U.S. dollar as the world’s reserve currency.

He claims that the balance of payment deficit engendered by the dollar’s reserve status is costing the U.S. jobs. These job losses are the result of foreign demand to hold the reserve currency, pushing the dollar too high relative to other currencies making production in the U.S. too costly. He reckons that the downside of losing reserve status for the dollar would be an increase of just 1% in the CPI rate of inflation.  This, he thought, would be an acceptable, low cost, trade off.

As someone who thinks that the U.S. would experience acute pain from seeing the dollar lose its reserve status, I thought that I should attempt to explain why I feel this way.

Let me start by referencing another article that I found to be most fascinating over at

Dante Bayona referenced an old tale about Salvador Dali:

There is a story about the great Catalan surrealist painter Salvador Dali. It is said that in the last years of his life, when he was already famous, he signed checks knowing that they would not be submitted to the bank for payment. Rather, after partying with his friends and consuming the most expensive items the restaurants had to offer, he would ask for the bill, pull out one of his checks, write the amount, and sign it. Before handing over the check, he quickly turned it around, made a drawing on the back and autographed it. Dali knew the owner of the restaurant would not cash the check but keep it,put it in a frame, and display it in the most prominent place in the restaurant: “An original Dali.”

It was a good deal for Dali: his checks never came back to the bank to be cashed, and he still enjoyed great banquets with all of his friends. Dali had a magic checkbook.

But what would have happened if one day art collectors concluded that Dali’s work really did not capture the essence of surrealism, and therefore that his art was not of great value? If that had happened, every autographed check would have come back to the bank (at least in theory), and Dali would have had to pay up. If Dali had not saved enough money, he would have had to find a job painting houses.

Bayona, in using this story, is  warning that the U.S. has been writing an excessive number of checks that it clearly believes will never be cashed. As long as the dollar remains the world’s reserve currency those dollar-based IOUs held overseas will remain there, uncashed.

But just what would happen if the dollar lost its reserve status and those checks had to be honored? I propose that we look at a similar situation that played out for the U.S. between the end of WW II and, roughly, 1980.

By way of quick background, in 1944 the world agreed to adopt the Bretton-Woods monetary system. Everyone agreed that both dollars and gold would be counted as reserves. The U.S., at the time possessing something on the order of 70% of the world’s monetary gold, would see its currency and IOUs held by foreigners, counted as official reserves. The U.S. also promised to honor a gold exchange ratio for foreigners of $35/oz. and currency ratios would all be fixed.

The one thing that no one counted on at Bretton-Woods was the idea that the U.S. could start to run balance of payment deficits. After all, the U.S. was going to emerge from WW II as the economic colossus of the globe. It was impossible to imagine the U.S. as an emerging debtor, but that is exactly what happened.

                          U.S.                                        U.S.
            Short Term Liabilities              Gold Stock
Year           to Foreigners            @$35/Oz.        Tonnes

1955             $11,895                    $21,753           19,331
1960             $18,701                    $17,804           15,822
1965             $25,551                    $13,806           12,268
1968             $31,717                    $10,892             9,679
1971 *          $55,417                    $10,206             9,069
1974 *          $95,000                    $11,803            10,489

($ in millions)
*      Bretton-Woods gold conversion was abandoned in 1968 and gold was then no longer fixed at $35/oz.
Source: The War on Gold, Anthony Sutton, 1977

As we can see above, the U.S. had managed to accumulate debts to foreigners of $18.7 billion by 1960, and this was after settling a further $3.5 billion in foreign claims by shipping 3,500 tonnes of gold overseas. That is, dollars were starting to flow back towards the U.S. The checks that the U.S. had written, never expecting them to be cashed, were being presented for payment.

The problem was that by 1960, the U.S. no longer had enough gold, if valued at $35/oz., to settle its debts to foreigners. The U.S. either had to revalue gold higher (a default), continue to ship gold overseas or adjust its economy so that is ceased allowing excessive money and credit growth so that the gold outflow was stemmed.

For a time, until 1968, the U.S. chose to stay the course, to continue to allow excessive money and credit growth and to cap the gold price at $35.

Foreigners during this period continued to send dollars back to the U.S. in exchange for gold even as dollar claims to foreigners continued to explode due to easy money policies in the U.S.

By 1968 it was clear to the U.S. that they were about to lose all of their gold and they defaulted on their obligations, refusing to honor the $35/oz. pledge of Bretton-Woods. By 1971, the fixed currency portion of Bretton-Woods was also ended, burying the Bretton-Woods system forever.

In 1960, the first year where U.S. obligations to foreigners exceeded its gold holdings, the U.S. GDP figure was $543 billion. The foreign obligations of the U.S. then amounted to just 3.4% of GDP. This was enough to destroy the monetary system of the day.

By 1974, with inflation picking up, U.S. GDP had nearly tripled to $1,548 billion and foreign liabilities had jumped to 6.1% of GDP.

Between 1955 and the end of the U.S. honoring its $35/oz. gold obligation, foreigners sent back well over $11 billion dollars to the U.S., and this clearly intensified inflationary pressures in the U.S.

In the following graph we can see that post WW II the velocity of money in the economy started to accelerate, particularly after 1955:

Part of the increase was initially driven by a normalization of the economy following the war, but the acceleration in velocity was increasingly driven, in my opinion, by the loss of confidence in the dollar's reserve status.

 As the dollar started to lose its reserve currency status and dollars that were expected to remain overseas permanently flowed back to the U.S., CPI inflation picked up dramatically as a consequence of the increase in velocity. From a sub 2% rate in the late 1950s, CPI inflation was over 6% by 1969 before completely exploding in the 1970s.

My point is that foreign obligations of somewhere between 3-6% of GDP created, in the end, massive CPI inflationary problems as many of the dollars flowed back to the U.S. Faith, of course, wasn’t just lost by foreigners, it merely kick started the process of a loss of confidence in the dollar inside the U.S. as well, forcing velocity and CPI inflation much higher.

I would stress that the imbalances of the Bretton-Woods period pale in comparison to the imbalances created by the reckless monetary policies of the Fed and other central banks of the past couple of decades.

The IMF’s Composition of Foreign Exchange report (COFER) alone details nearly  $12 trillion of foreign exchange reserves held by global monetary authorities. Perhaps 60% of this is held in U.S. dollars, roughly $7 trillion. This amounts to 40% of current GDP for the U.S. The Fed’s balance sheet now stands at 26% of GDP. These numbers dwarf the imbalances that kicked off a flow of overseas dollars back to the U.S. under Bretton-Woods, resulting in the start of CPI inflation in the 1960s.

More importantly, Russia and China appear to have been forced by U.S. actions in the form of inconsequential returns on their dollar based holdings and interference in their historical spheres of influence to push for a removal of the dollar from center of the global economy. This just may give Mr. Bernstein his wish, the removal of the dollar as the world’s reserve currency.

Unfortunately, unlike Salvador Dali’s experience, the checks that the U.S. has written over the years, checks they expected to never see cashed due to the dollar’s reserve status, will come home again. The result should be massively higher CPI inflation. Dali actually provided those who took his checks with something of great value in the form of his art. The U.S. cannot say the same as its current rate of savings and growth in output cannot hope to cover the number of checks it has been writing.

It won’t be pleasant as it happens, but such an outcome is a necessary precursor to returning to sustainable growth.

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

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