Monday, May 11, 2009

How to Lose Friends with Monetary Policy

The unforeseen evil consequence of our government’s constant meddling with monetary affairs extends to causing increased animosity with our trading partners. Of course, America is not alone in this regard, for all governments today feel that it is their right and duty to manipulate their nations’ money supply, interest rates, and banking laws for the benefit of the nation. America, however, is in the (temporarily) unique position to force its trading partners bear much of the cost of such manipulation, due to the use of the dollar as a reserve currency. Since international trade settlement, especially for big-ticket items like oil, is conducted in dollars, each nation must hold more dollars than it would otherwise. This situation is a carry-over from the unique position of the United States at the end of the Second World War. At that time America held the most above ground gold reserves in the world and our nation’s infrastructure had escaped the destruction of war. The Bretton Woods agreement of 1944 enshrined the dollar as a reserve currency. America agreed that it would tie the dollar to gold at thirty-five dollars an ounce; all the rest of the world’s currencies would be tied to the dollar at some agreed-upon exchange ratio. Foreign governments could hold dollars instead gold to satisfy the necessary settlements of trade. This arrangement was called the "gold exchange standard".

The gold exchange standard certainly seemed to be a more efficient system than transporting gold from one central bank to another in order to settle accounts, something that the anti-gold clique, headed by John Maynard Keynes, harped about constantly. As long as America kept its dollar-to-gold ratio in tact, every currency would be subject to the discipline of the gold standard without all the fuss of handling the physical commodity itself. And therein lay the problem—America did not keep its dollar-to-gold ratio in tact. Almost before the ink was dry on the agreement America started printing more dollars. Within three decades America was forced to abandon the Bretton Woods Agreement, because we could not honor the redemption claims of foreign governments. Few Americans understood the full impact of this shameful action, but it was not lost on our trading partners. One of the first foreign statesmen to call the world’s attention to America’s dishonorable failure to uphold Bretton Woods was President Charles de Gaulle of France.

Charles de Gaulle was perhaps the only statesman of the modern era who understood economics, especially monetary affairs. His long-time economic confidante, Jacques Rueff, was a highly regarded Austrian School economist. De Gaulle was skeptical of the Bretton Woods Agreement. Having witnessed a large percentage of his countrymen collaborate with the enemy during the war, he well knew the weaknesses of men when placed under extreme pressure, either to save their necks or exercise political power. Therefore, he placed more confidence in the discipline of gold than the promises of men. Why hold dollars as surrogates for gold when the real thing was readily available? Nevertheless, this is the so-called system that the world had adopted when he came out of retirement in 1958 to save France from the insurrection of the Algerian officers and re-write France’s constitution to form the Fifth Republic, still the constitutional order of France. (This episode itself bears the hallmark of an adventure story played upon the world stage in which one man, by force of personality alone, saves his country from disaster for the third time. He saved French honor during the war—the Petain government in Vichy was a Fascist puppet and Germany was forced to occupy France as a conquered nation--and from a communist takeover immediately after France’s liberation.)

After de-colonizing French Algeria, de Gaulle turned his attention to France’s economy. In his presidential memoirs, cut short by his death in 1970, de Gaulle gave as clear an explanation as any textbook in explaining how the United States had managed to export inflation to its trading partners by failing to keep the dollar-to-gold ratio at the level agreed upon at Bretton Woods. One must read selected passages in de Gaulle’s own words in order to understand the international political damage that had been done:

"…there was the monumentally over-privileged position that the world had conceded to the American currency since the two world wars had left it standing alone amid the ruins of the others…the world’s entire stock of gold was piling up in the United States. The countries of the West…had no choice but to accept…the ‘gold exchange standard,’ according to which the dollar was automatically regarded as the equivalent of gold. It was so, in fact, as long as the Federal Government limited its issue of banknotes in direct proportion to its gold reserves…But the vast sums lavished by Washington…had drawn America into a process of galloping inflation…Moreover, America carried sufficient political and economic weight for the International Monetary Fund…not to insist that it be maintained….In France itself, the surplus dollars…since this foreign currency was converted into francs on the spot…resulted in an artificial increase in our total money supply."

In 1963 the French government demanded that America redeem eighty percent of what it owed France in gold. Eight years later America reneged on its promise to redeem the dollar for gold. Bretton Woods collapsed, unleashing government profligacy funded by unprecedented currency debasement.

One of our largest trading partners, China, has pegged its currency to the dollar at a fixed exchange rate, meaning that the Bank of China buys dollars with yuan, which American companies then spend in China. Resisting downward pressure on the dollar, which would mean exchanging fewer yuan for each dollar than the market would command, China has imported American inflation just as did France in the years after Bretton Woods. One could insert "yuan" for "franc" in the quote above, for the process is exactly the same. What can China do with its depreciating dollars? It should float the yuan and accept the recession that this would bring to the Chinese economy, an economy that is much too dependent upon exports, as witnessed by the government’s reluctance to end supporting the dollar at its currently high value. Its only other course of action is to exchange dollars for hard assets before the world recognizes what it is doing. It could buy gold internationally, and there is some indication that it is doing this at a slow process so as not to panic the markets, or it could buy American assets…not treasury bills, but real American assets such as land and companies. Repatriating massive amounts of oversees dollars would cause hyperinflation in the U.S., says Professor Jorg Guido Hulsmann of the University of Angers, France. The scenario from such an action is hard to fathom, but the possibility exists for chaos with our country and instability abroad. Who said the study of economics was dull?

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