by Steve Forbes
You had to exchange your Belgian francs for French francs, German marks, or Dutch guilders, paying a commission to a money changer. Exchange rates were in constant flux, which meant that traders had to hedge exchange risks at a cost that also was passed on to consumers. And competition across borders, which was the point of the Common Market from its infancy, was inhibited by the fact that there was no single standard of value.
Robert Mundell and other advocates of the euro hoped that the European currency would provide shelter from post–Bretton Woods volatility. Little did they realize that Europe would behave as badly as the United States.
Why the Dollar Will Remain the Leading Currency—for Now
We’re more optimistic about the euro than some of its critics. But the European Union’s currency—or for that matter, the Chinese yuan, also known as renminbi—are still light-years away from becoming the dollar’s equal. No question that the dollar has suffered a loss of prestige, but it is still unlikely that it will lose its leadership position in the global marketplace. We say this because of the nature and meaning of money. History has shown that capital flows to countries with a stable currency. The United Kingdom became a financial power after the founding of the Bank of England in the seventeenth century spurred the development of capital markets and eventually led to the adoption of a gold standard.
The dollar became the currency of global business not as a result of the Bretton Woods conference, or of any conference. It is the world’s foremost currency because it arose from the market, as real money always does. People around the world use dollars because the U.S. economy is the biggest in the world and its capital markets are the deepest, the most liquid, and the most innovative. If you’re a government, a corporation, or a major investor, you wouldn’t want to do business with Fiji dollars, Argentine pesos, Brazilian reales, or for that matter Russian rubles. You probably wouldn’t even want the yuan. Those currencies offer far less opportunity to invest your money on a major scale.
The global business community still prefers the dollar because there is no better alternative. An estimated two-thirds of existing $100 bills reside outside the United States. Since the banking crisis, U.S. currency holdings outside the United States have not decreased; instead, they have dramatically increased. Before 2008, about 56% of U.S. currency resided outside the United States. After the financial crisis, that percentage actually rose to around 66% in 2012.
Many contracts today between non-U.S. parties are denominated in dollars.
Countries that do well, such as Switzerland, Singapore, and Hong Kong, have (by today’s standards) generally sound money fixed to the dollar or to a basket of currencies.
For a variety of reasons, China’s idea of an artificial reserve currency—even one called paper gold—is not likely to succeed in the global market. Remember our definition of money: it is a tool that arises from real-world transactions. Paper gold did not. Like the bitcoin, SDRs were artificially created. Pegged to a collection of fluctuating currencies, paper gold derives its worth not from real-world transactions, but from bureaucratic fiat.
Could a new monetary order emerge within the next decade, when some predict China will become the world’s largest economy? Possibly, but China has problems: an overbearing government, widespread corruption, the lack of financial markets to fund small businesses, and a weak legal system.
The U.S. economy continues to be a magnet for foreign investment not only because of its size but also because of its business environment: historically, the United States has offered a pro-market climate based on reasonable taxation, the rule of law, and a court system that can be relied upon to enforce contracts and protect property rights. These things are taken for granted in the United States, but they are often not found even in many developed countries. Investors and entrepreneurs in America generally have not had to contend with the kinds of problems often encountered with capricious governments.
America’s debt/GDP ratio has risen alarmingly. But, as we noted, it is worse in other developed countries, including, most notably, Japan.
The fear that the United States is destroying its traditional advantages with the federal government’s high spending and regulatory onslaught is well founded. It is certainly true that the Federal Reserve and the U.S. Treasury Department have badly mismanaged the dollar. But the other major central banks have done no better. For now, the dollar wins by default.
There Would Be No Dilemma with a Stable Dollar
The Chinese and others are right to worry about the consequences of today’s runaway U.S. debt and an ever-weakening dollar. The root of the problem, though, is that the United States and most other countries do not appreciate the importance of sound money—and what it takes to maintain it.
The doomsday scenarios that we mentioned earlier in this chapter could be avoided with a stable dollar. Dangerous as they may be, today’s sky-high levels of government debt are not unprecedented. Great Britain, for example, had a huge debt after the War of Spanish Succession in the early 1700s: 260% of GDP. That nation also took on enormous debt during the subsequent Seven Years’ War, and later, as a result of the 20-year war with Napoleon. Yet Great Britain was able to emerge in the nineteenth century as the greatest industrial power in the world because of its stable currency and capital markets. Both facilitated economic activity and produced a growing revenue stream for government that was not frittered away with reckless spending. In this way, Great Britain was able to grow its way out of a giant debt burden. In the century before World War I, its debt as a percentage of GDP went from 200% to 27%.
The Monetary Base: A Tool for Stability
The dollar may be more vulnerable today than it has been at any other time in recent history. But most of today’s problems could be solved by a return to stable money. Even if, before a return to gold, the dollar were to come under attack in a currency war, it is possible to defend against the kind of assault that brought down the Thai baht and endangered other Asian currencies. The Russians showed this when they successfully defended the ruble in 2009. Unlike the Thais, they didn’t buy currency on the foreign exchange market and then unload it back into their economy. They reduced the monetary base, in addition to raising interest rates.
If the Fed continues to taper and scale back on quantitative easing, the United States does not have to be on a collision course with hyperinflation. Respected Stanford University professor Ronald McKinnon proposes that the Fed taper by announcing a schedule of gradually increasing short-term interest rates. With rates higher than zero, banks would have more of an incentive to resume lending. In this way, the Fed could carefully funnel money back into the economy—with a watchful eye trained on commodity indicators to avoid releasing too much.
The problem would be most swiftly remedied, of course, if the dollar were relinked to gold. The United States demonstrated this during the early years of its existence: America’s finances were in a state of disarray after the wild inflation resulting from massive money printing during the American Revolution. Then, thanks to the efforts of Alexander Hamilton, the young country reformed its finances. Along with raising revenue from tariffs and excise taxes, the government adopted a gold-based monetary system. Soon international capital from the Dutch and other investors started to flow into the young republic, fueling its historic growth.
We should also not forget that the United States had an even more staggering debt ratio than exists today after World War II: 122% of GDP. But at the same time the economy had stable money. By the end of the 1960s, debt as a proportion of GDP had fallen sharply to 34% of GDP.
Debt is not a death sentence, if you get the economy right and if you understand money.
THE NUGGET
The only real deficit is not enough trade.
CHAPTER 4
Money Versus Wealth
Why Inflation Is Not a Good Thing
It isn’t the gold we have that makes us rich. It’s what we make, our know-how, our productivity. So long as th
is country produces more and better, the world will continue to want what we make.
—MALCOLM FORBES
IN NOVEMBER 2013, JANET YELLEN, WHO WAS SOON TO succeed Ben Bernanke as head of the Federal Reserve, testified at her Senate confirmation hearing about her views of the economy, the role of central banks, and recent Fed policies, including the gargantuan monetary expansion known as quantitative easing (QE). The job of chairman of the Fed, the leading central bank, is probably the most powerful nonelected government position in the world. Its actions have a major impact on the lives not only of Americans but also of people throughout the world.
The media covered the hearing with only tepid interest, as though Yellen were just another midlevel bureaucrat. The real focus that week was the disastrous rollout of President Obama’s Affordable Care Act (popularly known as Obamacare). For weeks, controversy had raged over what had gone wrong with the government’s new health insurance initiative and what was needed to fix it. Even media long supportive of Obama were proclaiming that the program wasn’t working.
Little such media indignation, however, was directed at another government failure mentioned at the Yellen hearing, one with implications more far-reaching than Obamacare: the inability of the Fed’s historic monetary stimulus, quantitative easing, to restore the economy.
This massive injection of liquidity, the largest monetary expansion ever, was a disaster more momentous than the launch of Healthcare.gov. Five years and three rounds of quantitative easing had produced miserably feeble GDP growth of just under 2%, about half the level of a decade earlier. The biggest monetary stimulus ever had produced the weakest recovery from a major downturn in American history.
Combined with the zero interest rates of the past several years, quantitative easing should have delivered a charge to the economy sufficient to revive Keynes himself. Since QE started in late 2008, the Federal Reserve had increased its balance sheet from $900 billion to $3.7 trillion in 2013. Around the time of Yellen’s confirmation hearing, required bank reserves had already reached $124 billion. Excess reserves—the money above and beyond the required reserves that banks are allowed to lend—were a staggering $2 trillion and rising, many times the normal level.
The problem was that QE also involved the arcane strategy of suppressing interest rates known as Operation Twist. As mentioned, the Fed normally lowers—or raises—short-term interest rates. But under Operation Twist, it was buying bonds to suppress long-term rates as well. The real “twist” was that instead of stimulating job creation, Operation Twist was doing the opposite. It was directing credit to certain sectors of the economy—the federal government, large corporations, and the housing sector—away from the small businesses that have traditionally been the economy’s job creators. Because of postf–inancial crisis legislation, the Fed was also paying banks to hold on to their excess reserves.
In other words, QE was working against a recovery. Job creation was at its worst level since the 1930s.
Yet because the media and policy makers are uncomfortable with the subject of monetary policy, there was little of the robust questioning and debate about QE that swirled around the Affordable Care Act. There have been no headlines like “Federal Reserve Stimulus Disaster” or “QE Rollout a Miserable Failure.”
Monetary Obesity Is Not Healthy
We need food to live. But too much food leads to unhealthy obesity. The same applies to money. We need money for commerce. But just as too much food can be bad for your health, an oversupply of money can undermine the health of an economy.
If expanding the monetary base was the way to economic vitality, Zimbabwe would be the richest country in the world. When that country first became independent in 1980, the Zimbabwe dollar was worth more than the U.S. dollar. In the early 2000s, after redistributionist reforms led to the destruction of the country’s agricultural economy, the Zimbabwe government responded to the crisis with a manic printing of money. The result was a hyperinflation second only to that of Hungary after World War II. By 2011, Zimbabwe was printing 100-trillion-dollar bills that became a hot novelty item among collectors. Eventually it had to abandon its currency and start over.
The story of monetary expansion is not a story of wealth creation but rather of wealth destruction. History contains countless examples: from the eighteenth-century French debacle of the Mississippi Bubble, described later in this chapter, to the wild colonial inflations preceding the American Revolution to the German hyperinflations of the early 1920s and after World War II to the 1970s U.S. stagflation. Over the past decade, reckless monetary expansion has rocked countries like Venezuela and Argentina. In the United States, it led to the collapse of the housing market, the 2008 financial crisis, and subsequent global stagnation.
Keynesians and monetarists are on the wrong side of history. Increasing the supply of money cannot create prosperity because that is not how wealth is created. Wealth and growth come from innovation. Henry Ford’s mass production of the automobile, for instance, transformed society by creating jobs in entirely new industries, from fast food to auto repair and even to home building. (Car ownership made the suburbs possible.)
Over the last several decades, we’ve seen this kind of job creation as a result of the personal computer. Twenty years ago, there were no jobs in “social media” or in designing Internet sites, or in retail stores devoted to selling things like iPads.
Keynesians, however, are convinced that monetary expansion spurs economic activity and employment. There may be a growth spurt. But much of the activity, like the feverish home buying and mortgage lending that took place as a result of the cheap dollar in the early 2000s, is artificial. And as we saw with the housing market, it ultimately collapses.
Excess liquidity also slows growth by distorting credit markets and impeding capital creation. Expanding the money supply encourages the misallocation of resources.
When governments destroy the value of money, one can no longer trust prices. People make bad decisions. Like misguided hikers who have been given a bad map or a corrupted GPS device, the economy can end up wandering in circles, stagnating like Spain in the Middle Ages or the United States in the 1970s. Or, as in Weimar Germany or Zimbabwe, the economy can go over a cliff.
Why Hasn’t There Been More Inflation?
Keynesians and monetarists largely dismiss today’s fears of the inflationary effects of QE and the weakening dollar. Economist Paul Krugman, with his usual note of negativity, accuses advocates of stable money of “inflation hysteria.” In her Senate testimony, Janet Yellen deflected concerns with bureaucrat-speak, insisting that “at this stage, I don’t see risks to financial stability” from current Fed policies. It is true that despite the immense injection from QE, the United States has yet to see severe, across-the-board rises in the cost of living. According to the Consumer Price Index, the rate of increase in 2013 got as low as 1.1%.
CPI numbers, however, don’t reflect the price rises people have been experiencing. Meat prices are the highest they have been in about a decade. Gas prices have come down from their very highest highs, but the price of a gallon of gas is about double what it was less than 10 years ago. Consumers are also seeing plenty of price hikes in other places. Financial analyst Michael Sivy wrote in Time magazine that he was shocked to discover the price of ink cartridges for his printer increased by 25% in less than one year.
He and others believe that prices are rising faster than government statistics indicate because of changes in methodology that have caused the Consumer Price Index to understate the rate of inflation. CPI metrics change so frequently that measurement methods, in the words of investor and financial commentator Peter Schiff, bear “scant resemblance” to what they were just a few decades ago.
Schiff created a market basket of essential goods needed for daily living—such as eggs, milk, gasoline, and bread—and compared their price changes to CPI statistics for the same period. Between 2002 and 2012, the CPI reported a total of 27.5% inflation. But the prices
of goods in Schiff’s market basket increased more than 44%.
What would inflation be today if CPI statisticians were using the old metrics? John Williams, economist and founder of American Business Analytics & Research, features charts using CPI methods of the 1970s and 1980s on his website Shadow Stats.com. He comes up with an annual inflation rate that ranges from as low as 5% to as high as 10%.
Prices rise and fall, as we’ve noted, for any number of reasons—from changes in supply and demand to increases in productivity. To what extent do the recent price increases have to do with the weakening of the dollar? The best place to look for the answer is gold prices. Gold is the purest indicator of the dollar’s value because the supply and demand of the precious metal do not vary dramatically from one year to the next. Gold is not vulnerable to weather like agricultural commodities or to sudden surges in supply or demand that affect oil and gas prices.
Gold prices, as we all know, have increased to stunning levels in the past several years. They have come down some, but in early 2014 the price of gold was three times what it was in 2003; it took 200% more dollars to buy gold than it did a decade ago. In other words, our money is worth much less.
Commodities have also risen sharply. The Thomson Reuters Continuous Commodity Index (CCI) measures six categories of commodities, including energy, grains, meats, and precious metals. From December 2008 to November 2013, the CCI increased from around 370 to 506, an increase of nearly 37%.
