Go Forward to Gold - How to Lift the Reserve Currency Curse

We all hold our wealth in one of three forms: money, goods (including services), or securities (which are in effect claims on future goods). It is therefore a fundamental truth of accounting that the net international payments for official reserves (money), current account (trade in goods and services), and private-capital account (securities) must equal zero: That is. a surplus or deficit in one account requires an offsetting surplus or deficit in the other two combined. Simply put, if you trade $100 in currency for $50 in goods and $50 in securities, somebody else has traded $50 in goods and $50 in securities for $100 in currency. Payments have to balance out. When foreign countries increase their dollar reserves, it means that U.S. residents buy that much more foreign wealth than they have sold. The result is a net outflow of capital known as "hot money" because it is highly mobile, speculative, and very sensitive to fluctuations in interest and exchange rates.


The overall U.S. balance-of-payments deficit has persisted almost continuously since 1960, and within the last few years has reached its highest levels ever. This growth in U.S. demand for goods and securities, stoked by central-bank financing, has taken place without a matching growth in supply of goods and services to soak it up. The result is inflation: more money chasing the same amount of goods. And it works both ways: When official reserves are sold, the process is thrown into reverse and deflation can result, as in the Depression.

It now typically takes about two and a half years for these effects to work their way through the economy, as one sector responds to another and the hierarchy of prices adjusts to (positive or negative) excess monetary demand. As happened in 1973-74, 1979-80, and 1990-91, the massive 2002-08 commodity-price surge was set in motion by the previous massive expansion of what we defined in the 1980s as the "world dollar base": the sum of U.S. currency, commercial-bank dollar reserves, and foreign official dollar reserves. These reserves are sometimes called "high powered" dollars because they permit private banks to expand their lending by a multiple of their reserves. When reserves disappear, lending has to contract by a similar multiple.

By observing the growth of the world dollar base and tracking its impact on the markets, our firm was able to predict correctly in 2005 that crude oil would hit $100 a barrel by the end of 2007 and then, as rising production costs squeezed profit margins, to warn investors to shift from equities to Treasury bills. Retail gasoline prices ultimately more than quadrupled — not because energy supplies fell, but because the world supply of "high-powered dollars" (money available to be multiplied through bank lending) had expanded much faster than world energy supplies.



Congress has become increasingly addicted to reserve-currency finance by a kind of fiscal version of Parkinson's Law: Public spending expands to absorb all available tax revenues. Working in tandem with this is Parkinson's Debt Corollary: Public borrowing expands to absorb all available means of finance. In other words, the government will borrow as much as it can from whoever will lend to it. If tax revenues are Congress's "allowance" (as Milton Friedman, envisioning Congress as a spendthrift teenager, once put it), then purchases of Treasury securities (by U.S. government trust funds and by the domestic and foreign banking systems) are its "credit cards." But the congressional teenager's spending won't be constrained by a cut in allowance unless the indulgent parents also cut up the credit cards.


Kathleen M. Packard, Publisher
Ralph J. Benko, Editor

In Memoriam
Professor Jacques Rueff

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