The Free Market 16, no. 5 (May 1998)
Winter’s economic crisis in Asia was blamed on “go-go capitalism” and “crony capitalism,” but those explanations don’t get to the root cause. The Asian meltdown stems from structural defects deep within the world monetary system itself. These are defects that no amount of bailouts, exchange controls, IMF power, or even U.S. monetary discipline can repair.
Crushing price inflation in Indonesia most dramatically illustrates the monetary dimension. From the summer 1997 to early 1998, the rupiah lost 75 percent of its purchasing power against the dollar and domestic prices for basic necessities skyrocketed. Rice was up 36 percent, cooking oil 40 percent, milk 50 percent, and electricity 200 percent. This sparked runs on stores, a drought of investment, growing exodus of businesses, a collapse of the banking system, massive layoffs, violence and riots, soaring interest rates, and sinking stock and real estate markets.
The Suharto regime froze prices for basic foodstuffs, mandated wage increases, allowed a few bank mergers, sent troops into the streets to quell unrest, and suggested a debt moratorium. The IMF pressed Indonesia to raise taxes to balance its budget, adopt American-style bankruptcy laws, and bail out bad debt to the tune of $43 billion. But this Suharto-IMF onslaught only aggravated a desperate situation by short-circuiting market forces.
If it hasn’t helped Indonesia, what is the point of the IMF plan? It is designed to enforce the international dollar-reserve system deemed essential to U.S. interests. U.S. banks and companies will be relieved of some of their losses by the massive bailout. But more importantly, the IMF is part of the attempt to maintain American monetary and economic hegemony by ensuring that the ravages of price inflation stay far from America’s shores.
This is no mean feat considering the massive monetary and credit expansion engineered by the Federal Reserve in the 1990s “global” boom. From the end of 1990 to the end of 1996, the Fed used its open market operations to increase the monetary base (MB), which is currency plus bank reserves, by 55 percent. Currency itself increased 60 percent.
Only a corresponding increase in money demand can forestall price inflation once monetary inflation of this magnitude has been set in motion. But growth rates of the American economy—not high by historical standards—have been insufficient to absorb this monetary inflation and bring about the current low, and even falling, rates of price inflation. The greater money demand has come overseas as the U.S. has asserted the dollar’s status as the world’s reserve currency.
The dollar-reserve system of the “global economy” of the 1990s is the resurrection of the Bretton Woods system without gold. Under the “gold-reserve” system of Bretton Woods, each country’s currency had a fixed exchange rate against the dollar and foreign governments could redeem the dollar at the U.S. Treasury for gold at the fixed rate of $35 an ounce.
The arrangement forced a coordinated monetary and credit inflation among the member countries at a rate determined by the Federal Reserve. Any rogue nation intent on excessive monetary inflation would be punished by devaluation and domestic price inflation, and the attendant problems now being suffered by the Indonesians. Just the threat of such a catastrophe was normally sufficient to induce the profligate nation to curtail its liberal monetary inflation.
The linchpin of the Bretton Woods agreement was the fixed rate of redemption between the dollar and gold. The Fed broke this link by accelerating monetary inflation in the 1960s to help finance expenditures for the Great Society and Vietnam war.
From the beginning of 1960 to the end of 1964, the Fed increased the money base 3 percent per year, but from the beginning of 1965 to the end of 1970, the Fed more than doubled the rate of increase to 6.3 percent. The average annual rate of price inflation went from 1.3 percent in the earlier period to 4.2 percent in the latter one.
Recognizing that the monetary inflation was reducing the purchasing power of the dollar sufficiently to make the fixed rate between the dollar and gold untenable, foreign governments began to cash in dollars at the U.S. Treasury for gold.
When Nixon reneged on the U.S. promise to exchange dollars for gold to foreign governments at $35 an ounce in 1971, foreigners dumped dollars in anticipation of an official devaluation to bring the dollar’s official exchange rate in line with its, much lower, market-determined purchasing power.
The sudden reduction in money demand brought devaluation and, as the dollars were repatriated, domestic price inflation. By 1973, the dollar had devalued 18 percent and annual price inflation rates averaged 6.8 percent from 1971 to 1974. As the dollar lost its purchasing power, interest rates rose to compensate lenders for the reduced value of dollars they would receive in the future. The 3-month Treasury bill rate went from 4.1 percent in 1971 to 7.9 percent in 1974; the 10-year Treasury bond rate jumped from 6.1 percent in 1971 to 8 percent in 1975.
Higher interest rates caused capital values to collapse and the ensuing losses led to bankruptcies and rising unemployment. From late 1972 to late 1974, the Dow fell 45 percent; unemployment rose from 3.5 percent in 1970 to 8.5 percent by late 1975. The Nixon administration responded to the crisis with price controls, changes in bank regulations and bankruptcy laws, and more Fed inflation.
After increasing the monetary base 8.7 percent per year from 1971-1974, the Fed accelerated the rate to 10.4 percent from 1975 to 1981.But after the debacle of the first half of the 1970s, it was difficult to convince foreigners to hold more dollars as reserve. Accelerating monetary and credit inflation by the Fed led immediately to severe domestic price inflation (average annual rates of 11.2 percent), soaring interest rates (peaking in 1981 at a 14 percent 3-month), collapsing capital values (from 1976 to 1982, the Dow lost 22 percent and stood at 774 in 1982), and higher unemployment (peaking at 9.7 percent in 1982, a rate not seen since 1941).
This entire scenario is precisely the reverse of the American economy in the 1990s. From 1982 through 1990, the dollar began to regain its status as the world’s reserve currency. The Fed expanded the monetary base 11 percent per year in the 1980s, but the demand to hold dollars overseas helped soak up the monetary inflation and the American economy experienced economic growth with low levels of price inflation. The annual rate of price inflation was only 5.9 percent. But the improved performance of the economy in the 1980s was only a foretaste of the renaissance of dollar dominance in the world.
American supremacy in the wake of the collapse of communism allowed the Fed to fully exploit the international dollar reserve system. The new system opened up a vast new vista for overseas dollar holdings. From Russia and Eastern Europe to China and East Asia, the governments of former communist countries began to soak up dollars to hold as official reserves as they became part of the American, “global” system. From the beginning of 1991 to the end of 1996, the Fed increased the MB 9.1 percent per year, while price inflation ran only 3.6 percent annually.
The new regime differs from Bretton Woods in the absence of a link between the dollar and gold. Without the fetter of gold reserves and redemption commitments of dollars for gold binding it, the Fed has no objective constraint in determining the rate of dollar inflation.
But like Bretton Woods, the new regime depends on foreigners’ willingness to hold dollars and use them as the basis for their own domestic monetary inflation and credit expansion. Only with harmonized monetary policies can the system survive.
Any country trying to take advantage of the fixed exchange rate of its currency against the dollar by excessive domestic monetary inflation and credit expansion will be punished, as under Bretton Woods, with devaluation and domestic price inflation.
But therein lies the great danger of the system to the American economy. A rogue nation will be tempted to defend its currency, and stave off devaluation, by spending its dollar reserves. Any significant disgorging of dollars would threaten to ignite price inflation in America if the dollars were repatriated. Significant domestic price inflation would, at best, bring a repeat of the 1970s, and, at worst, a hyperinflation.
This danger explains the U.S. interest in promoting IMF austerity policies and bailouts. The bailouts are intended to soften the blow of devaluation and price inflation. In exchange for taxpayers subsidizing banks and large corporations, and other key beneficiaries of the system, the IMF can use the bailout money as leverage to impose conditions favorable for the future of the dollar-reserve system.
One condition the IMF has imposed across Asia is for the recipient country to establish an “independent” central bank, i.e., one independent of local political control, and therefore at liberty to harmonize monetary policy with the Federal Reserve. Other conditions concern fiscal policy consistent with much lower rates of domestic monetary inflation, ones that allow stable exchange rates between domestic currencies and the dollar: raising taxes, restricting spending, balancing budgets. The remaining conditions address the hemorrhaging bankruptcies and collapsing financial systems across Asia.
In the last three years, the system has faced a $50 billion bailout of Mexico, a $57 billion bailout of South Korea, $43 billion for Indonesia, $18 billion for Thailand, for a total of $118 billion in Asia (some estimate that it will eventually rise to $160 billion) to fend off its own destruction. But by delaying the day of reckoning with bailouts, the international mountain of dollars and debt grows, making the inevitable collapse all the more devastating.
Will the system be able to prevent disgorging of dollar reserves to fend off Asian-style financial debacles in China, South America, Russia, and a repeat performance in Mexico? If the euro becomes the common currency of the EU, what will happen if its members replace their dollar reserves with euros? And if Japan recovers, what will happen if the yen becomes the reserve currency across Asia?
The Fed has overseen the best of times for the American economy in the 1990s, a period of rapid monetary inflation and credit expansion with current benefits of low interest rates, high earnings, soaring capital values, low unemployment, and steady economic growth. It has come courtesy of foreigners who have absorbed enormous quantities of dollars and, in so doing, kept U.S. price inflation at bay.
If Fed and Treasury officials seem tired and hypersensitive about their every remark these days, maybe they realize the worst of times must be the future cost to be paid when U.S. dollar hegemony wanes.
Jeffrey Herbener teaches economics at Grove City College.
