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

Consider the evidence. Not including the debt absorbed by federal trust funds (particularly Social Security), the federal government's general operating deficit from 1980 through 2007 has averaged 4.2 percent of GDP. Federal investment in government-owned assets like office buildings and warships represented about 1.3 percent of GDP; this part of the deficit was almost exactly equaled by federal borrowing from non-bank private investors. Current federal consumption of goods and services, meanwhile, has accounted for the remaining 2.9 percent of GDP. About a third of this was funded by (mostly) foreign central banks, and two thirds by spending government trust-fund surpluses to fund the general operating budget — thus expanding the budget while masking the deficit.


Relying on currency-reserve financing to expand government spending for current consumption is bad enough in itself. What made it much worse this time around was that Treasury bonds were joined in the mix by mortgage-backed securities issued by Fannie Mae and Freddie Mac and implicitly backed by the government. This funneled inflation (and then deflation) into residential real estate at the very time when Congress was forcing Fannie and Freddie to lower the quality of their mortgage loans drastically to promote homeownership. In the fall of 2007 Rep. Barney Frank, chairman of the House Financial Services Committee, said: "I'm not worried about Fannie's and Freddie's health. I'm worried that they won't do enough to help out the economy. That's why I've supported them all these years — so that they can help at a time like this." The result: Fannie and Freddie became insolvent and were nationalized, while Frank continued (as he still continues) his role as financial "watchdog."

The housing deflation hasn't stopped yet, partly because foreign monetary authorities (and recently the Federal Reserve) have been selling Fannie and Freddie's securities (as an analysis of the recent Federal Reserve balance sheet shows). If these sales continue, it will trigger more deflation of real estate, stocks, and commodities, as happened in the U.S. after 1928 and Japan after 1989. The current crisis did not strike suddenly and unexpectedly; signs of its approach were abundantly clear for years before. Despite these signs and the historical precedents, the Federal Reserve had neither the understanding, nor the interest, nor the will to stop the massive, inflationary accumulation or the subsequent sale of dollar reserves abroad.

Similar facts explain why U.S. international trade has swung from a chronic surplus in the early 1960s to a chronic and growing deficit ever since. Increased American consumption and reduced saving have caused an increasing U.S. current-account deficit, and therefore an equal surplus in countries that acquire dollar reserves.

These international imbalances consist almost entirely of goods and services purchased from foreign producers, ultimately paid for by federal deficit spending and financed largely by U.S. official borrowing from foreign monetary institutions. But the private investment position — the money U.S. citizens owe to and are owed by foreigners — actually shows a net surplus, proving that the dollar's reserve-currency status and the related federal deficit spending, rather than American consumers' private profligacy, are the driving force behind U.S. international-payments deficits.


The dollar's reserve-currency status provides short-term political advantages to U.S. congressmen seeking reelection, but these are far outweighed by the perennial disruptions it has caused to the world and U.S. economy and to financial markets. There has also been a heavy political cost for presidents whose well-intentioned and sophisticated advisers have not, for two generations. grasped the perversities of the dollar-based world monetary system. This is why the Fed has been surprised repeatedly by large changes in U.S. prices, including housing-price deflation, stock-market selloffs, and commodity-price gyrations.


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

In Memoriam
Professor Jacques Rueff

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