The dollar has been a linchpin of the global economic system since the end of World War II. It was a symbol of economic probity and reliability. As recently as in the 1990s, economists proclaimed the death of monetary gold and major central banks were selling off their gold reserves, replacing them with U.S. government bonds. Soviet — and then Russian — propagandists never tired of proclaiming the imminent collapse of the greenback, but their citizens, including Vladimir Putin’s kleptomaniac officials, continue to put their trust in the U.S. currency.
And yet, Washington has been abusing the reserve currency status of the dollar, literally papering over deep socioeconomic rifts that have developed in its economy and allowing its citizens to live above their means. The abuse has been getting worse with every new administration and may get out of control in the post-pandemic recovery. That will have major implications for every nation of the world.
The COVID-19 pandemic was one of those Black Swan events that couldn’t have been predicted. The pandemic created a new reality but, in many ways, it merely accelerated pre-existing trends that had been developing slowly — such as work from home, the use of streaming entertainment services or e-commerce, etc. While 2020 was a disaster year for retail and commercial real estate, it was the time compression of their losses that would have inevitably occurred over the next decade or so.
The same is true of the widening of the U.S. budget deficit and the unbridled growth of American public debt. America’s debt-to-gross domestic product ratio, which was well over 100% when the country emerged from World War II, was cut to around 30% by the time Ronald Reagan became president. In a classic bit of demagoguery, he railed against “tax and spend Democrats,” but it was his administration that started to slash taxes and expand the government deficit.
Thus began an unprecedented transfer of resources from the government—and future generations of Americans who will be deprived of public goods such as modern infrastructure, quality education, arts, etc., and saddled with an insurmountable debt burden. Pretty much every administration since Reagan’s — the Republicans more than the Democrats — followed the same pernicious course. The deficit and debt exploded in the pandemic, surpassing the size of GDP once more, but it merely compressed in time what would have happened anyway under normal conditions.
Hand in hand with fiscal profligacy came extremely loose monetary policy, pursued at the Federal Reserve by the Reagan appointee Alan Greenspan and his three successors. Ben Bernanke slashed interest rates to zero after the 2008 financial debacle and they have stayed there for more than a decade despite the longest U.S. economic boom in history. Or rather, the economic boom was artificially prolonged by zero-percent interest rates and deficit spending.
The reserve status of the U.S. dollar has been allowing Washington to use savings by foreigners around the world to fund its budget deficits. But with such a massive fiscal gap this is no longer enough. Inevitably, the Fed is starting to monetize U.S. government debt in order to keep U.S. rates low. Its balance sheet, already bloated by the rescue effort after the 2008 financial crisis, has now doubled again, to $27 trillion. Basically, the Fed has been printing money to allow Washington to finance spending. Put another way, the Fed is debasing the U.S. dollar.
The debasement of the currency has not been reflected in conventional measures of inflation such as the consumer price index. That is because they were developed in the early postwar decades, when labor, along with capital, participated in the division of the economic pie. Today, labor not only doesn’t benefit when the economy grows but its share of the pie is under constant pressure. The fact that those useless measures of inflation are still relied upon and no adequate measure of the debasement of currency has been developed is perhaps the most damning indication of the crisis in the economic profession.
The debasement of the dollar will have major implications for other currencies and for the dollar-based economic system. Huge amounts of dollars in circulation, which are being dumped abroad via the U.S. current account deficit, force other central banks to buy up excess dollars to prevent appreciation of their own currencies. But that in turn debases their currencies.
Other countries used to abuse their ability to print fiat money — i.e., paper currency that is not backed by any real asset. Those countries eventually got hyperinflation and all kinds of economic crises. But America’s relative discipline kept the global financial system at even keel. Now, massive abuse by Washington of its power to issue dollars will eventually undermine trust for paper currency. The latest rally in Bitcoin and other cryptocurrencies, as well as gold, is the direct result of this trend.
Another consequence of the debasement of paper currency is the relentless rally in the stock market in the face of a slumping global economy. However much U.S. stock indices have jumped, their gains should be measured against a 30% increase in the money supply. In other words, the bubble in the financial markets is no longer just in stocks, bonds, real estate, art, or other assets. The real bubble is now in paper currency.
The fact that oil prices have been so lackluster in this environment should worry oil producers such as Russia, Saudi Arabia, and the U.S. own oil patch. Oil is hovering around its post-2014 average, which means that its price is down some 30% in real terms.
There was a time in economic history when Spain was pumping gold out of its newly acquired New World Empire. It created inflation in Spain and helped the Dutch and the British develop advanced industrial economies by supplying goods to Spain paid for with that gold.
Now China has built a powerful industrial base and infrastructure using U.S. dollars. But the fact that paper money is now involved makes the situation fundamentally different.
From its inception, economists saw paper money as inherently dangerous and the government’s ability to print it at will open to abuse. Initially, it was backed by gold, but that was ended by the Nixon administration in the early 1970s. For a while after that, the Fed more or less followed the prescriptions of monetarists, which required money supply to increase in line with economic growth. But by now abuse has become rampant and it is likely to get worse and in nearby years, when the effects of the pandemic will have to be counteracted.
As a result, we may see an even more dramatic rally on Wall Street this year as well as in all other assets as investors rush to get rid of the plentiful and rapidly cheapening cash. But it is going to be little more than fool’s gold. Over a longer time period, however, the global financial system will start to look something like Argentina ca. 1989-90, when the annual rate of inflation measured 2,600%.
