Keeping the genie in the bottle

Baltimore, Maryland — The fiat currency system is elegant and innovative. It has served us well, and might continue to do so if we could as a society change our culture so drastically that we might reign in credit growth — both public and private — responsibly.

This would be the fairy-tale solution, one where the paper and electronic money supply behaves as if it were backed by gold, but actually isn’t. But that restrictive system would institutionalize mild deflation as the deterrent against runaway credit.

Instead, central bankers everywhere aspire to target inflation at a minimal nominal percentage, say 1 to 2 percent. Even so, saying and doing are two very different things.

For starters, central bankers cannot address fiscal issues, and their pegging the cost of money at friendly levels encourages the government to pursue policies of cutting taxes and increasing spending simultaneously, which has been the practice since the Reagan era.

Central bankers are also trusting the fox to guard the henhouse, for they accept that inflation is low despite considerable tinkering of methodology maintained by the U.S. Commerce Department that may understate it by 3 to 4 percent.

However, the built-in bias towards inflation of asset values, such as real estate and stock prices, is not reflected in tame inflation yardsticks. A fiat money supply will forever encourage the amassing of debt by the private sector and the government alike.

That, in turn, makes it only a matter of years before another financial calamity destroys the hopes of another generation. We may no longer operate fiat currencies as clumsily as did Massachusetts of 1690 or the French Assembly. Instead, we may be more like the Roman Empire, charted upon a course of slow decline, run by arrogant but physically fit potentates with exceptional or miserable oratorical skills, as you like.

In an act of intellectual finesse, in November 2005 the Fed stopped publishing its estimate of M3, the broadest measure of money, at a time when its running three-month growth rate had probed solidly into double-digit territory.

It gave up targeting money supply in the mid-1980s, this turning out to be a brief attempt to synthetically replicate a hard currency. Abandoning it succeeded then because (as in the 1920s) overinvestment in commodity production had paved the way for disinflation for years in the 1980s and 1990s.

Fed actions also easily kept inflation at bay initially because the systemic growth of credit of today had not yet reached the extreme level where it is now (though some seers at that time thought that it had).

In the last decade or so, the additions of tens of millions of low-wage workers from around the globe have lowered manufacturing costs.

The bogey of merely restraining inflation was achieved easily. It enabled the banking system to print enormous sums of money, trillions of dollars, seemingly without consequence. But there is never a consequence felt while the bubble is inflating, because interest and principal can be financed by new debt.

When debt reaches an untenable height relative to income or equity, the system becomes susceptible to the most minor cyclical downturn, with years of accumulated excess to be purged.

What new developments might cause the supposedly $1 trillion to $2 trillion of popularly expected losses from the credit crisis to break the quarantine the Federal Reserve and the Treasury wishes to maintain to such an extent that they would overwhelm the economy?

For starters, the savings-rich trading partners of the United States or other investors generally might demand our adoption of a hard currency of some sort. This they could accomplish by rapidly converting their holdings to gold (and not other currencies).

It could be that another country, such as Switzerland, might seize the opportunity to operate a new high-level reserve currency. Or, countries such as Japan or the United States might suffer extreme economic contraction from the sharp appreciation of their currencies in the floating foreign exchange markets that, like the gold standard in the 1930s, they would reject the fiat-floating model of trade.

Similar to the heresy of going off gold then, today these governments might likewise conclude that floating exchange rates are inexplicably hurting their terms of trade, forcing dramatically lower industrial production and employment relative to currencies that have depreciated greatly.

If this were judged to be the root of the problem, governments would jump ship, something they could only do by reverting to gold. Even with a tarnished financial reputation, it is difficult to imagine that the United States would not still be able to capitalize upon its position as the strongest country in the world, even if it lost control of the world’s reserve currency.

If a consensus between the Fed and the Treasury could be reached, federally chartered banks might back the dollar with gold again, or the issuance of private currency could be authorized.

It would be smartest for the Treasury to quietly buy in massive quantities of gold before such a strategy became known. Then like Roosevelt did, it could anchor the dollar at a higher level, perhaps $2,000 or $5,000 per ounce. But as the lessons of the interwar era taught us, this carries a substantial risk and as shown in calculations to follow these prices would excessively trigger gold reserve redemption.

Now as then, the correct peg level is unknowable, and the success of such a measure is dependent upon the price central banks of foreign nations would establish (even if they opted for a gold exchange standard). The temptation would be for each country to lock in a trade advantage, which would force deflation and higher interest rates upon the United States, an unwanted outcome. A critical problem to be addressed before such a change could happen would be how to treat the national debt, and for that matter the even greater debt held by the U.S. citizenry.

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