How money creation threatens hyperinflation

In order to understand the relationship between money creation and the price level, we first need to get some definitions straight.

To Austrians the terms inflation and deflation refer to money and not prices. There is no doubt that money has experienced unprecedented inflation. In February of 2010 base money was $2.1 trillion. Four years later it was $3.8 trillion. In the same time frame, M1 has increased from $1.7 trillion to $2.9 trillion. M2 has gone from $8.5 trillion to $11.7 trillion. Excess reserves have doubled from $1.2 trillion to $2.4 trillion. (Please keep in mind that prior to 2008 excess reserves seldom were more than a few BILLION dollars, which is effectively zero and represented mostly the aggregate of excess reserve cash in thousands of community bank vaults.)

To Austrians changes to the price level, what the public incorrectly calls inflation and deflation, are the result of changes to the aggregate demand for consumers' goods and the aggregate supply of consumers' goods. Think of a simple ratio with the numerator representing demand and the denominator representing supply. Notice that an increase in supply will cause the price level to fall. Aren't we all happy with this? I am. Or a decrease in demand will cause the price level to fall. There can be many causes of a decrease in demand--a fall in the money supply due to bank failures, a change in subjective time preference to save more, or a rational desire to hold more cash during times of uncertainty. None of these are bad for the economy per se. Whatever the cause, the antidote to a fall in demand is falling prices. The relationship between supply and demand must be re-established.

The point I am trying to make is that it is fruitless to attempt to prop up prices with more money creation, as the unprecedented increase in all categories of money in recent years has shown. In fact, excess reserves represent the potential for a massive increase in the money supply. The ratio of mandatory reserves to M1 is around 3%. The ratio of mandatory reserves to M2 is around 1%. Just do the math to find out the mathematical potential increase in the money supply should the banks eventually be able to convert excess reserves into mandatory reserves via the lending process. Keep in mind that this is exactly what the government WANTS banks to do; i.e., make more loans to supposedly stimulate the economy. An increase in the demand for goods of this magnitude, the numerator of our simple equation, would cause the price level to skyrocket perhaps to hyperinflation levels.

Therefore,digging even deeper into our problem, one finds that legal tolerance for fractional reserve banking is at the heart of the problem. Fractional reserves allow banks to create money out of thin via the lending process. Instead of funding an increase in loans by an increase in real savings, loans are "funded" by...well...nothing. This triggers the Austrian business cycle. Production, the denominator in our simple equation, falls. When supply falls, prices rise. Creating even more money will not help the situation, only exacerbate it.

Hyperinflation is a cancer that lurks in our monetary structure. Time to surgically remove it before it metastasizes.

My letter to the NY Times re: New Pay Day Loan regs will hurt the working poor

Re: Agency wants to rein in payday loans

Dear Sirs:

Often payday lenders are the last tool of the working poor to forestall having utilities cut off, having a car repossessed (which can lead to losing one's job), or even going to jail for falling to pay a parking fine. There are two remedies for those who believe that current payday lenders charge too much. Number one, make it easier for new entrants to the payday lending market. Competition will drive down costs and increase service. Number two, those who believe that payday lenders are charging too much must believe that they have identified a profitable business opportunity. They should enter the payday lending market themselves and offer their services at lower prices. Furthermore, no one should believe the specious excuse that new regulations are needed that would "...require lenders to make sure that borrowers have the means to repay them." There is no better or quicker way to lose money than to lend it to people who cannot pay it back.

My letter to the NY Times re: Setting the record straight on changes to the price level

Re: Eurozone Business Growth Nears 4-year High, by David Jolly

Dear Sirs:

Once again one of your reporters repeats the mantra that there is a "...problem of declining consumer prices...in the eurozone...". Problem for whom? Changes in the price level are the result of changes in the ratio of the aggregate demand for consumers' goods and the aggregate supply of consumers' goods. Think or the demand for goods as the numerator and the supply of goods as the denominator in a simple equation. Notice that an increase in the supply of consumers' goods MUST cause the price level to FALL! A reduction in spending in favor of savings also will cause the price level to fall, which is necessary to re-establish the market clearing price for goods. Measures to prop up prices will result in unsold inventories. However, the only way the price level can rise is for the supply of consumers' goods to fall and/or spending to rise. Spending can rise only from an artificial increase in the money supply or a reduction in savings in favor of spending. Neither of these causes of a rising price level are to be celebrated.  In conclusion, either falling prices are the result of economic progress--i.e., an increase in the supply of goods--or the market clearing antidote to a decrease in spending in favor of saving.

A Waste of Time

From today's Open Europe news summary:

Bundesbank proposes new European fiscal authority to replace European Commission

Germany’s Bundesbank proposed in its monthly report yesterday to create “a new European fiscal authority which, in the style of independent national fiscal councils, is bound by a clear mandate to only assess budget developments with a view to complying with fiscal rules.” This new fiscal authority would replace the role of the European Commission as it would run less risk to “agree to inappropriate compromises at the expense of budget discipline.”

Source: Frankfurter Allgemeine Zeitung

The Germans desperately want to believe that somehow they can instill fiscal discipline into the sovereign nations of Europe through something other than normal commercial relationships. They cannot. Every nation Europe has figured out that it can spend more than it makes and cover up its disastrous socialist policies with fiat money from the ECB. As long as the money flows from the ECB, these socialist governments will never have a mandate to reform. The Bundesbank is fooling itself and the German people. Its proposal to form a new entity that is "bound by a clear mandate to only assess budget developments with a view to complying with fiscal rules" is a waste of time. No nation, with the exception of Germany, is complying with the existing fiscal rules, because there is no need to do so and no one can force any nation to do so. A new oversight agency does not change this fact.

At a minimum Germany must leave the European Monetary Union (the eurozone) and reinstate the Deutsche Mark. It may as well recognize that the European integration idea is doomed. There can be no integration of sovereign countries, only free trade of goods, services, and capital. Since free trade requires no supranational organization, Germany should leave the European Union, too. Naturally, other nations will howl that Germany is "abandoning Europe", when in reality it is saving Europe by forcing all nations to adopt sustainable economic policies or go bankrupt.

My letter to the NY Times re: Time for an editorial board reassessment

Re: Japan's Recovery Is Complicated by a Decline in Household Savings, by Jonathan Soble

Dear Sirs:

Mr. Soble (and your editorial board, I'm sure) can't seem to make up his mind whether Japan should spend its way to prosperity or adopt policies that will return it to the savings culture that financed its post WWII economic miracle. Mr. Soble comes very close to breaking with what I am sure is NY Times policy and Keynesian dogma that increasing aggregate demand will do the trick. Japanese households spend every last yen as it is, and the government's debt to GDP is the highest in the industrialized world. So just where will this increased demand originate? Please don't bet too heavily on the BOJ's all-in QE program, which has done zip-a-dee-doo-dah so far, unless you count adding even more zeroes to the government's debt. This is the time for an editorial board reassessment. Does the Times continue with Paul Krugman and his mindless "print money until it's worthless" mantra, or does it open its mind to other explanations? The Austrian school has the answers, and you have one of the world's primary Austrian school monetary scholars right in Manhattan--Dr. Joseph Salerno at Pace University. I'm sure he would be happy to take Krugman's place. Does the Times want to lead the world away from the monetary abyss or does it want to follow the lemmings? Time for a change.

My letter to the NY Times re: Mr. Kuroda has put the cart before the horse

Re: Japan's Central Bank Warns of Temporary Return to Deflation

Dear Sirs:

BOJ governor Kuroda and his supporters should question the very foundation of their beliefs that inflation is "...crucial to rekindling growth..." and that "a 'deflationary mindset' is behind many of Japan's economic woes" as evident in "weak consumer spending and a reluctance by investors and businesses to take financial risks..." This chain of beliefs that falling prices reduce aggregate demand and lead to a vicious downward spiral in the economy is nonsense. Falling prices actually spur spending as households' real income rises. Higher prices, as championed by Mr. Kuroda, destroy household purchasing power and leads to business retrenchment and higher unemployment. Mr. Kuroda needs to let the Japanese people alone for a few years in order for them to rebuild household balance sheets, which will lead to an expanding economy. Mr. Kuroda and his supporters have put the cart before the horse.

The Federal Reserve Bank Must Be Destroyed!

"Delanda est in Susidium Foederatum Bank"

(The Federal Reserve Bank Must be Destroyed)

by Patrick Barron

During the years of the Roman Republic, Cato the Elder ended every speech with the phrase "Delanda est Carthago" (Carthage must be destroyed). Rome had fought two wars with Carthage, yet the threat to the Republic remained. Cato saw Carthage as an existential threat and concluded that Rome would not be secure as long as Carthage existed. So fervently did he hold this view that he ended every speech, even about completely different subjects, with the famous phrase. I believe that we Austrians need to adopt a similar phrase to remind the American people that the US faces an existential threat from the machinations of the Federal Reserve Bank. "Delanda est in Susidium Foederatum Bank"...The Federal Reserve Bank must be destroyed. Like Carthage, the Federal Reserve Bank cannot be controlled or restrained. Either it or our republic will survive, but not both. For the sake of our nation, the Fed must be destroyed.

Founding the Fed Instead of Ending Fractional Reserve Banking

The Fed was founded under false economic premises--to prevent bank runs by providing temporary liquidity to banks which found themselves unable to redeem their certificates and demand deposits for cash and/or specie. The real cause of illiquid banks--fractional reserve banking--was never seriously addressed. It was assumed that banks had the legal right to invest their customers' demand funds in loans and that runs were caused by over indulging in this practice. But as Murray N. Rothbard explain in What Has Government Done to Our Money?, loaning demand funds instantly places  the bank in an insolvent position, for it cannot redeem all of its demand accounts for cash or specie. Through the process of lending demand funds, the banks have created fiduciary media out of thin air, reducing their reserve ratio below one hundred percent. If the banks do this on a very modest basis, the public may not be aware of the fraud. However, once the rumor starts that the bank is illiquid, there is a literal "run" to the bank to withdraw demand funds. In such a case, even a bank that only modestly lent its demand funds might find itself unable to honor all withdrawal claims and would be forced to close its doors.

(NOTE: Central Banking was established to legitimize counterfeiting fraud, aka - Fractional Reserve Banking)

The Federal Reserve Bank, as the lender of last resort, was supposed to prevent such occurrences by providing temporary, penalty rate loans to struggling banks. Note that there is nothing that a central bank could provide that could not be provided by another private bank. In fact the banking panic of 1907 was stemmed by private bank interventions led by J. P. Morgan. However, Morgan realized that such private bailouts were very risky and presented a case of moral hazard; i.e., that bankers, confident of a bailout by the Morgan banking empire, might  book riskier, higher yielding loans. So rather than face the real cause of banking crises and lobby to outlaw fractional reserve banking, the Morgans, Rockefellers, etc.--who did not want to forego the financial benefits of lending demand deposits--lobbied instead for government to create a lender of last resort, a central bank, which we named the Federal Reserve Bank.

Fed Policy Causes Depressions and Then Prevents Recovery

Over time this entity, new to Americans, would expand its role in fruitless attempts to cure crises caused by ITSELF. The Fed caused and exacerbated crises by allowing, facilitating, and expanding the practice of fractional reserve banking. In the 1920's the Fed began to expand the money supply to prevent prices from falling, justifying its new role as one of maintaining a stable price level. But printing money to prevent falling prices caused malinvestment in the structure of production and led to a depression by the end of the decade.

Rather than do nothing and allow the purging of bad investments and liquidation of malinvestment, which would re-establish a sustainable structure of production, as it had done at the beginning of the decade in the depression that no one remembers, the Fed intervened monetarily to pump up reserves while the Hoover administration intervened fiscally to prevent price deflation and maintain high spending levels. All this is well documented in Murray N. Rothbard's America's Great Depression.

Yet even an interventionist Fed could not prevent the massive bank failures of the 1930's, due to many factors which included restrictive bank branching laws. But the primary cause of the bank failures was *again* the banks' adherence to fractional reserve banking practices which resulted in  their inability to honor all demand deposit redemption requests for specie and/or cash.

In the Roaring Twenties fractional reserve banking had expanded the money supply well beyond the ability of banks to stem all the runs. Again the banks and the politicians refused to dig deeper into the real cause of the problem. Rather than separate banking into deposit and loan functions--the former would require one hundred percent reserves and the latter would require strict asset-liability management to ensure that loans matured on the same schedule as time deposits, what is commonly known as funding loans out of savings--the government suspended specie redemption and eventually formed the FDIC to "ensure" bank deposits.

However, the FDIC's "insurance" program was nothing more than an explicit promise that the Fed would print enough money to redeem all ensured deposits, thus insuring the continuation of fractional reserved banking, the very problem that was used as the excuse to establish the Fed; the very problem--bank instability--the Fed was sold to the public to solve. So, once again, a solution to cure a problem caused by the Fed itself resulted in even more power for the increasingly government run banking system.

The Monetary Genie Was Out of the Bottle

Once the politicians realized that the Fed could print money at will, the genie was out of the bottle. Money growth did expanded at a modest rate for a few decades, due mainly to the efforts of prudent men such as Fed Chairman William McChesney Martin (1951 to 1970) and fiscally conservative politicians such as President Dwight Eisenhower (1953 to 1961). However, it was inevitable that less prudent men, such as President Lyndon Johnson and all Fed chairman with the exception of Paul Volcker, would rise to power on their promises to fund all manner of government programs with what was now seen to be unlimited money.

This was the key revelation!

Money printed in unlimited quantities could cure all ills, or so it was claimed, and to its everlasting shame the economics profession provided sufficient "academic" cover to support these spurious assertions. Now everyone understood that the Fed could monetize--i.e., purchase government debt itself--any amount of government spending. The economics profession refused to consider the inevitable consequences of these irresponsible monetary policies. Instead it cherry picks historic price data to prove them to be non-inflationary and endorses changes to unemployment calculations to prove them to be fiscally sound, too. These whores, these house economists have their eyes glued to the rear view mirror of spurious government statistics as the race car of state hurtles toward an economic cliff of depression and perhaps even hyperinflation.

Money Production and Banking Subject to Commercial and Criminal Law

It matters not who is in charge of the Fed or what rules Congress may insist that it adopts. Once money printing, via fiat or fractional reserve credit creation, is seen to be both feasible, justified, and legal nothing and no one can stop it. The political pressure to fund government programs will be irresistible. Everyone knows that the Fed seemingly has the ability to solve their problem by monetizing the federal debt. Should it refuse to do so, we would see riots in the streets similar to what is happening in Europe as protesters target the European Central Bank.

The only solution is to destroy the monster that makes it all possible, the Fed. Without the ability to sell its debt to its own central bank, government would be forced to live within the means set by the will of the people through their elected representatives. The scales would eventually fall from the eyes of both politicians and public as its becomes clear that what government spends comes at the expense of the private economy. The public would no longer be fooled by government propaganda that its spending spurs the private economy, when it is clear that the only way government can spend is to tax the people or suffer the crowding out effect of private investment by government borrowing. Money production must be moved to private hands that are subject to normal commercial and criminal law, where money printing is nothing more than counterfeiting. Banks, too, must be subject to normal commercial and criminal law, which requires them to treat a demand deposit as a bailment for which they must keep one hundred percent reserves. Loan banking would be subject to the normal principles and well understood practices of sound asset-liability management, whereby loans are funded by real savings and the maturities of both loans and deposits must be coordinated in order for lending banks to honor their liquidity commitments. The path to the destruction of our nation through endless wars and welfare would end with the destruction of the Fed.

Delanda est in Susidium Foederatum Bank!

"Keep your own promises" and "Harming one's own citizens"

Two headlines from today's Open Europe news summary, along with my comments at the end:

Tsipras expected to request additional help at EU summit as Greek funding problems deepen

Speaking in the Greek parliament yesterday, Greek Prime Minister Alexis Tsipras struck a defiant tone and insisted that his party will not “go back on what [it has] promised” – adding that it is the rest of the Eurozone which must stop taking “unilateral actions” and stick to the extension agreement.

German court issues nationwide ban against Uber

A German regional court in Frankfurt yesterday imposed a nationwide ban on the online taxi firm Uber, preventing it from running services using unlicensed cab drivers. The court also set a €250,000 fine for any violations of local transport laws.

Comment number one:

Why should the rest of Europe be required to pay for promises made by the Greek government to its own people?

Comment number two:

Germany harms its own citizens when it denies them the right to purchase a good or service. This is an obvious case of protecting vested interests at the expense of the rest of society. (I doubt that this court ruling stops Uber, because people obviously value the service.)

My letter to the NY Times re: False love affair with inflation

Re: Asia Rushes to Lower Rates, But Maybe Not Fast Enough by Neil Gough

Dear Sirs:

In the first two short paragraphs of his article Mr. Gough reveals the premise upon which his title depends. Since his premise is faulty, the entire article is faulty. To wit:

"Central Banks across Asia are racing to cut interest rates, but they may not doing it fast enough to stave off economic malaise. The problem is weak inflation...If prices drop too long, companies invest less and people's pay shrinks."

What nonsense; let me count the ways:

1. Inflation (rising prices) destroys consumer purchasing power.

2. Deflation (falling prices) restores consumer purchasing power.

3. Spending is NOT a panacea for economic recovery--savings is.

4. Investment is funded out of savings not spending; therefore, decreased consumer spending and increased savings is the path to economic recovery and future prosperity.

5. Debasing one's own currency does not spur economic growth via increased exports. It merely transfers wealth from savers to exporters and foreign buyers, making the overall economy poorer.

My letter to the NY Times re: Currency debasement destroys capital

Re: Delight or Dread as Euro Falls

Dear Sirs,

Of all the economic fallacies perpetrated on the public by so-called "macro economists", recommending currency debasement as the path to economic recovery and permanent prosperity may well be the most destructive. Giving foreigners more units of one's own currency in order to spur export industries merely transfers wealth from current holders of one's own currency to exporters and foreigners. Exporters' price advantage, the purpose of money expansion, is quickly erased by the law of diminishing marginal utility. What is permanent, however, is the transfer of wealth. In effect, expansion of the money supply robs patient savers and impoverishes all of society.

A lesson from Greece in the difference between private and public finance

From today's Open Europe news summary (my emphasis):

Greece to start technical talks with creditors tomorrow amid criticism that too much time is being wasted

Eurozone finance ministers agreed yesterday that officials from the Greek government and the EU/IMF/ECB Troika will on Wednesday start technical discussions on the implementation of the first batch of reforms proposed by Athens. The talks will take place in Brussels, although Eurogroup Chairman Jeroen Dijsselbloem told the press, “In parallel, as needed, technical teams from the institutions [the Troika] will be welcomed in Athens, with a view to support this process.” Speaking after the meeting, Greek Finance Minister Yanis Varoufakis confirmed that officials from the three institutions would travel to Athens if needed, but said, “The idea of Troika visits comprising cabals of technocrats in lockstep walking to our ministries and trying to implement a programme which has failed…that is a thing of the past.” According to sources quoted by Bloomberg, ECB President Mario Draghi put pressure on Varoufakis to let Troika officials visit Athens in future.

This is an object lesson in the difference between private loans and public loans. Private lenders risk their own money and require remedies for nonpayment that are enforceable in a court of law with practical means of collecting. In other words, private lenders make sure that courts will aid them in attaching and liquidating assets in order to satisfy unpaid loans. But public lenders are not lending their own money; nor do they ensure that they have collateral that can be liquidated for nonpayment. In effect, lenders of public funds buy unsecured bonds using other people's money from judgement proof creditors.  Far from sovereign debt being credit of the highest quality, from a strictly financial standpoint, it is the worst when viewed from the ability of the creditor to collect. It appears that the new socialist Greek government has figured this out.

How not to win friends!

From today's Open Europe news summary:

Greek Defence Minister: We’ll flood Europe with refugees if Greece is ‘hit’ by Germany; 

Speaking at a meeting of Independent Greek MPs yesterday, party leader and Greek Defence Minister Panos Kammenos argued that “If they [Germany] hit out at Greece then they should know that the migrants will get [travel] papers and go to Berlin.” He also reportedly added that if there were any members of the self-proclaimed Islamic State among these migrants, then Europe would only have itself to blame due to its behavior towards Greece.

In other words, "We take no responsibility for our own finances. Just give us the money or we'll use the open borders policy of the EU to send all our undesirables, many of whom we admit may actually be criminals, to your country."

Now that's real statesmanship!

I think this is an object lesson in understanding the kind of people who rise to the top of politics under socialism. Not only are the members of the new Greek government socialists who wish to extend socialism within their own country, but they recognize that the very nature of the European Union has been transformed into a continent-wide socialist experiment. Therefore, statements such as the one above can be understood as simple demands that the EU execute its duty to bailout bankrupt members. Furthermore, they realize that the EU's implicit if not explicit promise to bailout bankrupt members confers no legally enforceable obligation on its members to reform the policies that led to national bankruptcy and adopt policies that will bring it out of bankruptcy.

The Threat to the Dollar as the World's Primary Reserve Currency

(Following is the text of my presentation today at Drake University in Des Moines, Iowa at the annual convention of the Iowa Association of Political Scientists.)

The Threat to the Dollar as the World's Premier Reserve Currency

...but does it really matter?

By Patrick Barron

My answer is that, "Yes", it really matters. And that is why we need to take action today to protect all of our interests. The source of the threat may surprise you.

We refer to the dollar as a "reserve currency" when referring to its use by other countries when settling their international trade accounts. For example, if Canada buys goods from China, China may prefer to be paid in US dollars rather than Canadian dollars. The US dollar is the more "marketable" money internationally, meaning that most countries will accept it in payment, so China can use its dollars to buy goods from other countries, not solely the US. Such might not be the case with the Canadian dollar, and China would have to hold its Canadian dollars until it found something to buy from Canada. Multiply this scenario by all the countries of the world who print their own money and one can see that without a currency accepted widely in the world, international trade would slow down and become more expensive. Its effect would be similar to that of erecting trade barriers, such as the infamous Smoot-Hawley Tariff of 1930 that contributed to the Great Depression. There are many who draw a link between the collapse of international trade and war. The great French economist Frederic Bastiat said that "when goods do not cross borders, soldiers will." No nation can achieve a decent standard of living with a completely autarkic economy, meaning completely self-sufficient in all things. If it cannot trade for the goods that it needs, it feels forced to invade its neighbors to steal them. Thus, a near universally accepted currency is as vital to world peace as it is to world prosperity.

However, the foundation from which the term "reserve currency" originated no longer exists. Originally the term "reserve" referred to the promise that the currency was backed by and could be redeemed for a commodity, usually gold, at a promised exchange ratio. The first truly global reserve currency was the British Pound Sterling.  Because the Pound was "good as gold", many countries found it more convenient to hold Pounds rather than gold itself during the age of the gold standard.  The world's great trading nations settled their trade in gold, but they might accept Pounds rather than gold, with the confidence that the Bank of England would hand over the gold at a fixed exchange rate upon presentment. Toward the end of World War II the US dollar was given this status by treaty following the Bretton Woods Agreement. The US accumulated the lion's share of the world's gold as the "arsenal of democracy" for the allies even before we entered the war. (The US still owns more gold than any other country by a wide margin, with 8,133.5 tonnes to number two Germany with 3,384.2 tonnes.) The International Monetary Fund (IMF) was formed with the express purpose of monitoring the Federal Reserve's commitment to Bretton Woods by ensuring that the Fed did not inflate the dollar and stood ready to exchange dollars for gold at $35 per ounce.  Thusly, countries had confidence that their dollars held for trading purposes were as "good as gold", as had been the British Pound at one time.

However, the Fed did not maintain its commitment to the Bretton Woods Agreement and the IMF did not attempt to force it to hold enough gold to honor all its outstanding currency in gold at $35 per ounce.  During the 1960's the US funded the War in Vietnam and President Lyndon Johnson's War on Poverty with printed money. The volume of outstanding dollars exceeded the US's store of gold at $35 per ounce. The Fed was called to account in the late 1960s first by the Bank of France and then by others. Central banks around the world, who had been content to hold dollars instead of gold, grew concerned that the US had sufficient gold reserves to honor its redemption promise. During the 1960's the run on the Fed, led by France, caused the US's gold stock to shrink dramatically from over 20,000 tons in 1958 to just over 8,000 tons in 1970. At the accelerating rate that these redemptions were occurring, the US had no choice but to revalue the dollar at some higher exchange rate or abrogate its responsibilities to honor dollars for gold entirely.  To its everlasting shame, the US chose the latter and "went off the gold standard" in September 1971. (I have calculated that in 1971 the US would have needed to devalue the dollar from $35 per ounce to $400 per ounce in order to have sufficient gold stock to redeem all its currency for gold.) Nevertheless, the dollar was still held by the great trading nations, because it still performed the useful function of settling international trading accounts. There was no other currency that could match the dollar, despite the fact that it was "delinked" from gold. 

There are two characteristics of a currency that make it useful in international trade: one, it is issued by a large trading nation itself, and, two, the currency holds its value over time.  These two factors create a demand for holding a currency in reserve.  Although the dollar was being inflated by the Fed, thusly losing its value vis a vis other commodities over time, there was no real competition.  The German Deutschemark held its value better, but the German economy and its trade was a fraction that of the US, meaning that holders of marks would find less to buy in Germany than holders of dollars would find in the US.  So demand for the mark was lower than demand for the dollar.  Of course, psychological factors entered the demand for dollars, too, since the US was the military protector of all the Western nations against the communist countries.

Today we are seeing the beginnings of a change.  The Fed has been inflating the dollar massively, reducing its purchasing power and creating an opportunity for the world's great trading nations to use other, better monies. This is important, because a loss of demand for holding the US dollar as a reserve currency would mean that trillions of dollars held overseas could flow back into the US, causing either inflation, recession, or both. For example, the US dollar global share of central bank holdings currently is sixty-two percent, mostly in the form of US Treasury debt. (Central banks hold interest bearing Treasury debt rather than the dollars themselves.) Foreign holdings of US debt currently total $6.154 trillion. Compare this to the US monetary base of $3.839 trillion.

Should foreign demand to hold US dollar denominated assets diminish, the Treasury could fund their redemption in only three ways. One, the US could increase taxes in order to redeem its foreign held debt. Two, it could raise interest rates to refinance its foreign held debt. Or, three, it could simply print money. Of course, it could use all three in varying amounts. If the US refused to raise taxes or increase the interest rate and relied upon money printing (the most likely scenario, barring a complete repudiation of Keynesian doctrine and an embrace of Austrian economics), the monetary base would rise by the amount of the redemptions. For example, should demand to hold US dollar denominated assets fall by fifty percent ($3.077 trillion) the US monetary base would increase by eighty percent, which undoubtedly would lead to very high price inflation and dramatically hurt us here at home. Our standard of living is at stake here.

So we see that it is in America's interest that the dollar remain in high demand around the world as a unit of trade settlement in order to prevent price inflation and to prevent American business from being saddled with increased costs that would derive from being forced to settle their import/export accounts in a currency other than the dollar.

The causes of this threat to the dollar as a reserve currency are the policies of the Fed itself. There is no conspiracy to "attack" the dollar by other countries, in my opinion. There is, however, a rising realization by the rest of the world that the US is weakening the dollar through its ZIRP and QE programs. Consequently, other countries are aware that they may need to seek a better means of settling world trade accounts than using the US dollar. One factor that has helped the dollar retain its reserve currency demand in the short run, despite the Fed's inflationist policies, is that the other currencies have been inflated, too.  For example, Japan has inflated the yen to a greater extent than the dollar in its foolish attempt to revive its stagnant economy by cheapening its currency. Now even the European Central Bank will proceed with a form of QE, apparently despite Germany's objections. All the world's central banks seem to subscribe to the fallacious belief that increasing the money supply will bring prosperity without the threat of inflation. This defies economic law and economic reality. They cannot print their way to recovery or prosperity. Increasing the money supply does not and cannot ever create prosperity for all. What is more, this mistaken belief compounds a second mistake; i.e., that savings is not the foundation of prosperity, but rather spending is the key. This mistake puts the cart before the horse.

A third mistake is believing  that driving their currencies' exchange rate lower vis a vis other currencies will lead to an export driven recovery or some mysteriously generated shot in the arm that will lead to a sustainable recovery. Such is not the case. Without delving too deeply into Austrian economic and capital theory, just let me point out that money printing disrupts the structure of production by fraudulently changing the "price discovery process" of capitalism. Capital is allocated to projects that will never be profitably completed. Bubbles get created and collapse and businesses are suddenly damaged en mass, thus, destroying scarce capital.

Because of this money-printing philosophy the dollar is very susceptible to losing its vaunted reserve currency position to the first major trading country that stops inflating its currency. There is evidence that China understands what is at stake; it has increased its gold holdings and has instituted controls to prevent gold from leaving China.  Should the world's second largest economy and one of the world's greatest trading nations tie its currency to gold, demand for the yuan would increase and demand for the dollar would decrease overnight.

Or, the long festering crisis in Europe may drive Germany to leave the eurozone and reinstate the Deutschmark. I have long advocated that Germany do just this, which undoubtedly would reveal the rot embodied in the Euro, the commonly held currency that has been plundered by half the nations of the continent to finance their unsustainable welfare states. The European continent outside the UK could become a mostly Deutschmark zone, and the mark might eventually supplant the dollar as the world's premier reserve currency.

The underlying problem, though, lies in the ability of all central banks to print fiat money; i.e., money that is backed by nothing other than the coercive power of the state via its legal tender laws. Central banks are really little more than legal counterfeiters of their own currencies. The pressure to print money comes from the political establishment that desires both warfare and welfare. Both are strictly capital consumption activities; they are not "investments" that can pay a return. In a sound money environment, where the money supply cannot be inflated, the true nature of warfare and welfare spending is revealed, providing a natural check on the amount of funds a society is willing to devote to each. But in a fiat money environment both war and welfare spending can expand unchecked in the short run, because their adverse consequences are felt later and the link between consumptive spending and its harm to the economy is poorly understood. Thus, both can be expanded beyond the recuperative and sustainable powers of the economy.

The best antidote is to abolish central banks altogether and allow private institutions to engage in money production subject only to normal commercial law. Sound money would be backed one hundred percent by commodities of intrinsic value--gold, silver, etc. Any money producer issuing money certificates or book entry accounts (checking accounts) in excess of their promised exchange ratio to the underlying commodity would be guilty of fraud and punished as such by both the commercial and criminal law, just as we currently punish counterfeiters. Legal tender laws, which prohibit the use of any currency other than the one endorsed by the state, would be abolished and competing currencies would be encouraged. The market would discover the better monies and drive out less marketable ones; i.e., better monies would drive out the bad or less-good monies.

We need to look at the concept of a reserve currency differently, because it is important. We need to look at it as a privilege and a responsibility and not as a weapon we can use against the rest of the world. I we abolish, or even lessen, legal tender laws and allow the process of price discovery to reveal the best sound money, if we allow our US dollar to become the best money it can--a truly sound money--then the chances of our personal and collective prosperity are greatly enhanced.

We all have the same interest. We all want to have the highest standard of living for ourselves and our families. A sound money reserve currency offers us the best chance of achieving our shared goal; therefore, we should rally around every effort to make it so.

My letter to the NY Times re: Japan's Solar Mandates Lack Free Market Coordinating Function

Re: Japan's Growth in Solar Power Falters as Utilities Balk

Dear Sirs:

One of the prime reasons for the failure of Japan's solar power initiatives is the government's ignorance of the coordinating function of the the free market. The article lays the proximate cause of its huge untapped solar power generation capacity in the paucity of the appropriate infrastructure to bring the power to its users. This is similar to the experience time after time in the Soviet Union. For example, bumper wheat crops rotted in the fields due to the lack of transport and storage facilities. Government bureaucracy is no substitute for the millions of subtle free market coordinating processes that bring the most mundane goods and services to our doorsteps at just the right time in just the right amounts and at affordable prices.

My letter to the NY Times re: Keynesian macro economists are confused

Re: Saving Big on Energy Bills, People Take It to the Bank, by Nelson D. Schwartz

Dear Sirs:

Keynesian school macro economists may be scratching their heads that the spending numbers that they hold so dear are not increasing, but we Austrian school economists have a deeper understanding of the issue. First of all, it is foolish to try to psychoanalyze market participants as if they were automatons responding in predictable ways to incentives. Mr. Schwartz does recognize that viewing consumers in this way results in many diverse explanations. He hits on the better answer at the end of his article when he recognizes that increased purchasing power has helped the higher-income workers. The same can apply to those at all levels of income. But increases in purchasing power do not come from arbitrary decisions to increase wages, as Mr. Schwartz's example of Walmart and TJX Companies suggest. Increases in purchasing power can come only from increases in worker productivity. That can come from capital investment, better management practices, and other improvements in business methods. Sound money is one key ingredient, too, perhaps the most important ingredient. Under a sound money regime, worker productivity and worker purchasing power can improve without a rise in wages, because prices will fall. And if workers save more, then all the better for our collective future, which depends upon increases in real capital accumulation from real savings and not just monetary pumping via ZIRP and QE from the Fed. Therefore, the fact that the savings rate is the highest in two years is a good sign that only confused Keynesians could rue.