(This essay was written in collaboration with Benjamin Harnwell, Secretary General of the Working Group on Human Dignity, European Parliament)
Many economists, both inside and outside of government, are very worried that foreign governments may dump their dollar holdings, touching off massive price increases in the U.S. and possibly bringing down our financial system. It is a real danger.
According to the U.S. Treasury Department’s own figures, as of June of 2008 foreigners hold over $10 trillion as currency reserves. China and Japan each hold $1.2 trillion. The U.K. holds $.8 trillion. Tiny Luxembourg and Ireland hold $.6 and $.4 trillion respectively! Even Russia holds huge amounts of dollars—over $.2 trillion.
Contrast these overseas dollar holdings with the Fed’s official tally of the domestic money supply as of April 2009. M1 (currency and other checkable deposits) totaled $1.6 trillion. M2 (M1 plus savings, money market funds, and small time deposits) totaled $8.3 trillion. So even compared to the most expansive measure of the domestic U.S. money supply (M2) foreigners hold more dollars than domestic holders.
If any country with significant dollar holdings decided to dump them for some other currency, the result would be inflation in the U.S. on par with the worst days of the Carter administration and, if panic sets in and others join, hyperinflation and the destruction of our economy.
Jorg Guido Hulsmann explains the process with this example in The Ethics of Money Production. (Just insert the name "China" or "Japan" for his hypothetical country Ruritania.)
"If we assume that Ruritania is a very large country with substantial dollar reserves even by world standards, then the mere announcement that the Ruritanian government will switch to the euro standard might incite other member countries of the dollar standard to do the same. This could precipitate the dollar into a spiraling hyperinflation. The dollars would sooner or later end up in the United States, the only country where people are forced to accept them because of their legal-tender status. Here all prices would soar, possibly entailing a hyperinflation and collapse of the entire monetary system." (Pages 232/3)
As Hulsmann explains, the "leadership of the U.S. Federal Reserve is aware of this situation." (Page 233) OK. That’s reassuring. But if U.S. officials are concerned about the terrible consequences of a POSSIBLE dumping of dollars on the U.S. market, why are they UNCONCERNED about the consequences of their own efforts to stimulate the economy, which involves the same mechanism that they so fear from foreign actions; that is, massive expansion of the money supply?
The government has taken two actions that will expand the money supply every bit as much as possible foreign actions to dump the dollar--expansion of the monetary base by the Federal Reserve Bank and the Obama administration’s spending spree. Currently excess reserves held by banks in their accounts at the Fed total close to $1 trillion. Reserves are the building blocks of the money supply. Through their lending actions, commercial banks can create money up to many multiples of their reserves…a good rule of thumb is ten times. So the money supply could be increased by a factor of ten or more when the banks start lending, as surely will happen over time. Furthermore, the Obama administration’s stimulus package of $.8 trillion is funded entirely by fiat money; that is, money printed from thin air. Compared to the current level of M1 at $1.6 trillion, this action alone will expand the money supply by 50%.
None of this makes sense from the perspective of economic fundamentals. Ah, but it makes perfect sense from the perspective of expanding government power and control!
Through its stimulus program, the government can shower funds on its friends. It can buy votes. It can reward labor unions by bailing out the very industries that union action did so much to destroy. It can create bureaucratic jobs for its sycophantic hangers-on. Finally, the resulting budget deficits become justification for punishing ones enemies through tax increases.
If foreigners dump their dollars, the government will have no control over where they will enter the American money supply, and, therefore, the government will not be as able to direct the influx of money to politically connected friends. This is the only difference. The American price level will rise tremendously, regardless of the source, and hyperinflation and economic chaos are real possibilities.
Of course, no nation would be in this predicament had it remained on the gold standard. Money spent on overseas goods (imports) would have reduced the domestic money supply, lowering domestic prices, and causing a reversal of the gold flow (via exports) as that country’s products became bargains on the international market. But under the fiat money supply, by which the supply of money is limited only by the prerogative of the monetary authorities—which means that there is no real limit—the domestic money supply can continuously expand even as dollars are sent overseas for decades, accumulating in the coffers of foreign central banks until the dam bursts, so to speak.
The U.S. must take three actions immediately to prevent hyperinflation. Number one, it must rescind the stimulus package. So far less than five percent of the stimulus package has been released. Good! Rescind the rest of it. Number two, the Fed must take back the $1 trillion in excess reserves before the banks start lending. It can do this buy raising the interest rate through open market operations, offering to sell the banks its huge holding of government bonds at reduced prices. Number three, the U.S. must reform its monetary system—it must peg the dollar to gold, abolish the Fed, and prosecute fractional reserve banking. This will end the politicization of the money supply.
With a gold dollar, inflation and deflation will become things of the past along with the boom/bust business cycle that credit expansion, not based upon true savings, is the primary cause. Unable to monetize its debt, the government will be forced to control its budget. We will return to a limited rather than an activist, destructive government. Our Founding Fathers will look down upon us with approval.