Still No Crash: Were Austrian Economists Wrong about the Dollar? – Robert Murphy

Robert murphy Economist

By Robert Murphy –

Critics of the U.S. government often warn of the dangers of “fiat money.” Indeed, ever since the Richard Nixon severed the dollar’s gold backing (in 1971), many proponents of “hard money” have warned about a dollar crash. This has led critics of these “gold bugs” to laugh at their seemingly erroneous predictions and crankish views. In the present post I’ll walk through some of the main issues in this area. As we’ll see, the “gold bugs” may have the last laugh.

Under the classical gold standard, the U.S. dollar was convertible into gold at the rate of $20.67 per ounce. When FDR came into office in 1933, he took the dollar off this strict peg and confiscated the nation’s gold. (The famous gold depository at Fort Knox was actually constructed in order to store the gold stolen from Americans.) Eventually the dollar was locked into a stable convertibility ratio of $35 per ounce, which lasted throughout the Bretton Woods era following World War II. Under this arrangement, regular citizens had no right to turn in their paper dollars for gold, but other central banks could do so. The rest of the world was encouraged to use dollars—not gold—as their reserve, because (they were told) the dollar itself was as good as gold.

The huge government expenditures of the late 1960s—including the Vietnam War and LBJ’s “War on Poverty”—caused the Federal Reserve to issue new dollars in order to purchase the federal government’s bond issues. In other words, it was the time-honored method of government turning to the printing press (indirectly in this case) to cover its budget deficits during wartime. Other governments began to get nervous, notably France, and began sending their dollars back to the U.S. for redemption in gold. This eventually put the U.S. government in a position of either slowing its monetary inflation (and hence cutting its spending), or abandoning its commitment to redeem dollars in gold. Nixon opted for the latter in 1971.

At the time, some Keynesian economists predicted that the price of gold would fall as measured in dollar terms. They thought that the yellow metal had been propped up by its convertibility into the precious money issued by the mighty U.S. government. Of course, the opposite happened. With its hands untied, the Fed ramped up its monetary inflation (i.e. creation of new dollars), and this led to a surge in consumer prices as well as a large spike in gold prices throughout the 1970s.

Now had U.S. officials followed the fateful paths of some other regimes, the chronic price inflation of the late 1970s would have spiraled into outright hyperinflation. But Paul Volcker, the newly installed Fed chair appointed by Carter in 1979, gave the nation some bitter medicine by applying the brakes to the printing press. This led to sharp spikes in interest rates, which crashed the economy and led to the awful recessions in the early 1980s. However, the shock therapy worked in the sense that the dollar’s fall in purchasing power was greatly slowed, breaking the inflationary death spiral into which other governments have plunged their countries.

Because of the obvious commitment to protect (relatively speaking) the dollar’s exchange value, as well as the sharp reduction in top marginal income tax rates under the Reagan Administration, the 1980s saw a large increase in the international demand for dollar-denominated assets. Now if the rest of the world wants to acquire (net) ownership in U.S. financial assets (such as stocks, bonds, or even real estate), the international trade accounts must show a deficit in the current account (which is a broader concept than the more intuitive “trade balance”). Indeed, the U.S. began running enormous current account deficits in the mid-1980s.

The U.S. government since 1971 has enjoyed being the producer of the world’s reserve currency. Dumbing it down somewhat, here’s what’s going on: With no constraints on its monetary inflation, the government can print new dollars and send them abroad, where foreigners add them to their holdings along with their own domestic assets denominated in their own currencies. The way these foreigners pay for their dollars is by exporting real goods and services to the United States. It’s a nice racket while it lasts: Uncle Sam types “$100” on a green piece of paper, for which somebody in China sends over a television set. The only thing keeping the system afloat is that foreigners are willing to absorb greater and greater amounts of dollar-denominated assets, because they trust that U.S. officials won’t debase the dollar too quickly.

This system has lasted much longer than many of the gold bugs predicted, it’s true. In more recent times, I personally have been wrong in at least one of my predictions (made among economist friends) of how fast consumer prices would rise in response to the various monetary injections since 2008. And yet, since the early 1970s the dollar is down about 25% against major currencies, and it’s down about 97% against gold. (A dollar bought 1/35 of an ounce of gold in 1971, while it gets you only 1/1300 of an ounce today.) Meanwhile, there are currently some $2.6 trillion in “excess reserves” in the U.S. commercial banking system, which loosely speaking means that the banks have the legal ability to create an additional $26 trillion in new deposits in the hands of the public, if and when they feel comfortable lending again.

In short, I believe that the U.S. dollar, U.S. Treasuries, and the U.S. stock market are all overvalued—in a “bubble,” as they say. The difficulty in proclaiming a bubble is that you might be right, but still look foolish for a few years while the bubble keeps inflating. (Remember how people literally laughed in Peter Schiff’s face when he called the housing bubble.)

If and when the U.S. dollar bubble bursts, we will see prices rise not just because of what Bernanke (and now Yellen) have pumped in since 2008, but because of the rush of dollars flowing back to the U.S. that have accumulated from years of trade deficits. At that point, the Fed will have to decide: Does it wreck the U.S. financial sector and broader economy in order to save the dollar (comparable to what Volcker did in the late 1970s, only on a much grander scale)? Or will it go the way of several other central banks in history, and run the printing press until the game ends? Either way, it’s going to be ugly.


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