US Dollar Stupidity
Imagine that you are a famous multi-millionaire. At Christmas you go out with
your entourage to buy presents and pay for each purchase by cheque. The stores
are pleased to accept your cheques and consider them better than cash.
Consequently, they don’t cash the cheques but use them as currency among
themselves. After spending, say, $30 million on Christmas presents you are well
pleased. The cheques haven’t been cashed so effectively you got everything
free. Now roll on six months later and your fortune is starting to look a bit
doubtful. Word gets around that you may become insolvent and the stores decided
that they had better cash the cheques whilst they still can. So when you can
least afford it bills start rolling in from purchases made some time ago.
The US is in a similar position. According to this web site: http://www.ncpa.org/ea/eand95/eand95i.html
60 – 70% of US dollars are in circulation abroad. These are as a result of
goods that the US has purchased from abroad and effectively have never had to
pay for. This has always been seen as a source of pride in the US and a symbol
of the strength of their economy and is why the Fed has always supported a
strong dollar policy. If a crack appears in the strength of the dollar people
may well decide that they would be better off trading their dollars for Euros
thus exacerbating the decline. Well, cracks have started to appear and we can
see the dollar beginning to fall against the Euro whist gold is going up.
Whether this will gather in momentum depends on how much faith people have in
the (tried and tested) US economy and to a lessor extant whether they think the
(unpredictable) European economy will get stronger.
One lesson to be learnt from this is the extent that pride interferes with
rational policy. A sensible policy would have been to reign in US dollars
circulating abroad, which are effectively IOUs that can be redeemed on a whim.
The web site above actually proposes that counties use US dollars as a solution
to currency problems and gives as an example the good record set by Argentina!
Another lesson to be learnt is the folly of abandoning the gold standard.
It's long been fashionable to allow currencies to float, which allows a central
bank to have some measure of control over an economy. This control may be to
reduce unemployment or keep inflation under control and is usually manipulated
by changing the rate of interest that banks charge on loans. In order to
understand the reason this has the effect it does it is necessary to understand
fractional banking.
Fractional banking is the system used in most western economies whereby a
bank may loan more money than it has in assets and, consequently, to get
interest on these loans. Typically, a bank only requires to have 10% in assets
of money lent out. This is effectively a license granted by the government to
banks for them to create money. It is well known that if extra money is printed
then inflation results as more money in circulation means that the value goes
down and thus more money is required to purchase items. Wealth created as a
result of the fractional banking system has a similar effect, which is why
inflation is a characteristic of western economies and is actually essential for
the money system to operate.
If interest rates are high there is less borrowing and therefore less money
injected into the economy – the economy slows down and so does inflation.
Lowering of interest rates has the opposite effect. This is why most central
banks have a brief to control unemployment or inflation - they can’t control
both. In Japan interest rates have hit zero percent and the economy is still
sluggish, in fact there is deflation. Even at zero percent people won’t borrow
if they think they may be unable to pay the money back. What’s more, when
there is deflation it is better to hang on to money and put off spending it, as
prices will come down. Effectively holding on to cash means it gains interest.
The Japanese psyche is different to the American psyche as Japanese people are
more careful and will save if they are uncertain of the future. Americans have
always had a poor record of saving and tend to have a ‘spend now – pay
later’ approach which stimulates the economy in the short term.
If the US dollar drops against other currencies then exports from the US
become cheaper which stimulates manufacturing, as long as other countries are
prepared to buy the goods. The long-term effect is that the US becomes a
manufacturer supplying other countries, a status typically held by Asian
countries. It also means that the US loses its ability to control other
economies, which is far more a factor in the US being a ‘super power’ than
its arms.
Pegging the dollar to the gold standard means that market forces govern the
money supply and central banks no longer have control, which is why, in general,
governments don’t like it. However, forces that effect currency and stock
markets are similar to forces that effect earthquakes. Earthquakes are caused
when two tectonic plates are forced in different directions. The forces build up
until there is a movement that is felt as an earthquake. If the forces are
dissipated early then a series of minor tremors will result; otherwise the
pressure builds up until there is a major earthquake. Similarly if pressure
builds up on currency supply which is not allowed to adjust naturally it will
finally give way in a major crash. The stock market has recently gone through a
major ‘correction’, which is perceived as a natural way of dissipating the
pressures of the economy. However, given sufficient hype, people will continue
buying stocks even at prices where the price / earnings ratio would indicate
that such purchases are foolhardy. When this occurs natural market forces are
not operating and a huge ‘earthquake’ becomes probable.
A war in Iraq could put an added burden on the economy and put George Bush in
a similar position to his father – successful in Iraq but booted out because
of the economy.
Phil Braham © 2002
