Demise of the Dollar, Part 2

Note: What does the dollar have to do with The Mustard Seed? See, for starters, my 2 essays, Will the Economic Crisis Inflame the Culture Wars or End Them? and The Wiley E. Coyote Economy.


In today's Wall Street Journal, Professor Allan Meltzer, who authored the multi-volume A History of the Federal Reserve, pens a great column warning about the demise of the dollar.

The United States is headed toward a new financial crisis. History gives many examples of countries with high actual and expected money growth, unsustainable budget deficits, and a currency expected to depreciate. Unless these countries made massive policy changes, they ended in crisis. We will escape only if we act forcefully and soon.

As long ago as the 1960s, then French President Charles de Gaulle complained that the U.S. had the "exorbitant privilege" of financing its budget deficit by issuing more dollars. Massive purchases of dollar debt by foreigners can of course delay the crisis, but today most countries have their own deficits to finance. It is unwise to expect them, mainly China, to continue financing up to half of ours for the next 10 or more years. Our current and projected deficits are too large relative to current and prospective world saving to rely on that outcome.

Worse, banks' idle reserves that are available for lending reached $1 trillion last week. Federal Reserve Chairman Ben Bernanke said repeatedly in the past that excess reserves would run down when banks and other financial companies repaid their heavy short-term borrowing to the Fed. The borrowing has been repaid but idle reserves have increased. Once banks begin to expand loans or finance even more of the massive deficits, money growth will rise rapidly and the dollar will sink to new lows. Do we have to wait for a crisis before we replace promises with effective restraint?...

It is far better to begin containing the problem before we blow a hole in the dollar and start another downturn…

We do need a fully specified, multi-year program to restore fiscal probity by reducing spending, and a budget rule that limits the size and frequency of deficits. Except for a few years in the 1990s, both parties have been at fault for decades, and the Obama administration is one of the worst offenders. Its $780 billion stimulus bill, enacted earlier this year, has been wasteful and ineffective…

High inflation is unlikely in 2010. That's why a program beginning now should start to lower excess reserves gradually so that the Fed will not have to make its usual big shift from excessive ease to severe contraction that causes a major downturn in the economy.

**UPDATE, OCT. 23, 2009**


Gillian Tett had an insightful piece in yesterday's Financial Times: Rally Fueled by Cheap Money Brings a Sense of Foreboding...

“Was October 2008 just a dress rehearsal for the crash when this latest bubble bursts?...”

Six months ago, the financial system was in deep distress, reeling from a meltdown. Now despair and panic have been replaced not simply by relief – but, in some quarters, euphoria…

No doubt many brokers would like to attribute this to fundamentals. After all, last year’s crash in asset prices was so extreme that some rebound was almost inevitable…

Yet, if you talk at length to traders – or senior bankers – it seems that few truly believe that fundamentals alone explain this pattern. Instead, the real trigger is the amount of money that central bankers have poured into the system that is frantically seeking a home, because most banks simply do not want to use that cash to make loans. Hence, the fact that the prices of almost all risk assets are rallying – even as non-risky assets such as Treasuries bounce too.

Now, some western policymakers like to argue – or hope – that this striking rally could be beneficial, in a way, even if it is not initially based on fundamentals. After all, the argument goes, if markets rebound sharply, that should boost animal spirits in a way that could eventually seep through to the “real” economy.

On this interpretation, the current rally could turn out to be akin to the firelighter that one uses to start a blaze in a pile of damp wood…

After all, much of the current economic rebound seems to reflect stimulus packages (and flattering year-on-year comparisons) that will end next year. And while there are still plenty of firelighters around – in the form of monetary stimulus and ultra low market rates – there seems to be a good chance of a future interest rate shock as central banks implement their exit strategies…

In the meantime, it is crystal clear that the longer that money remains ultra cheap, the more traders will have an incentive to gamble (particularly if they privately suspect that today’s boom will be short-lived and want to score big over the next year). Somehow all this feels horribly familiar; I just hope that my sense of foreboding turns out to be wrong.