Why the Next Successful President Will End the ‘Reserve Currency Curse’

Atlas Foundation Conference on

“Consequences of Progressive Policy on Money and Investment”

Dallas, TX, 1 April 2011

I’m grateful for Alex Chafuen’s invitation—I’ve long admired his work—to take part at the Atlas Foundation conference on the consequences of progressive policy on money and investment, on this panel on the principles of sound money. I’d like to draw on a chapter in my recent book, Redeeming Economics, to explain why both American and world history show that only proper monetary reform—specifically, restoring the international gold standard without official-reserve currencies—will end three longstanding problems which have undermined the United States: first, endlessly expanding federal deficit spending; second, chronic episodes of inflation (or deflation) leading to recession; and third, declining U.S. international competitiveness. I’ll close by explaining why the reform that eluded President Ronald Reagan is now finally doable.


To put these problems in perspective, we must recall that the stability of the U.S. dollar has varied widely in history. This variation is explained by two factors: first (as Mark Wynne of the Federal Reserve Bank of Dallas correctly noted), how policymakers in this country set the monetary standard for the dollar; but also (which he did not mention), whether policymakers in other countries use securities payable in dollars as their own monetary standard—that is, use the dollar as their official “reserve currency.”

U.S. Consumer Prices and Monetary Standards

The United States has alternated between two kinds of standard money: inconvertible paper money, on the one hand, or a fixed weight of some precious metal, on the other (first silver, then gold). The dollar was an inconvertible paper money during and after the Revolutionary War (1776–92), the War of 1812 (1812–17), the Civil War (1862–79), and again from 1971 to the present. The dollar was effectively defined as a weight of silver in 1792–1812 and 1817–34, and as a weight of gold in 1834–61 and 1879–1971. The dollar was not used by foreign monetary authorities as a monetary reserve asset before 1913. But it has been an official “reserve currency” for many since 1913, and for most since 1944.

U.S. Consumer Price Index: Long-term stability & short-term volatility, 1800-2010

Applying both criteria divides the monetary history of the United States into several distinct phases. We can compare the stability of these monetary regimes by examining the variation in the Consumer Price Index (as reconstructed back to 1800) by two simple measures: long-term CPI stability and short-term CPI volatility. Long-term CPI stability is measured by the annual average change from beginning to end of each monetary standard. Short term volatility is measured by the standard deviation of annual CPI changes (up or down) during the period. Weighting these criteria equally, we see that the regime defined by the classical gold standard from 1879–1914 was unparalleled as the most stable of all U.S. monetary regimes, with not only the most stable price level over time, but also the lowest variability—and this despite the fact that the CPI was mostly food at the time.

Let’s consider the three problems that followed the gold standard’s abandonment.

Parkinson’s Debt Corollary

First, Loss of Federal Budget Discipline. The current monetary system is the main cause of the loss of federal budget discipline because it is based on monetizing U.S. public debt.

Under President Ronald Reagan, Congress reformed the income tax code and balanced pay-as-you-go Social Security despite deep partisan divisions. Yet by Reagan’s self-assessment, the Reagan Revolution was incomplete when he left office. “When a conservative says it is bad for the government to spend more than it takes in, he is simply showing the same common sense that tells him to come in out if the rain,” Ronald Reagan had remarked in a February 1977 address.  He was restating in common language the first principle of successful economic policy that went back to Washington and Hamilton. Yet after leaving office, Reagan assessed the result this way: “With the tax cuts of 1981 and Tax Reform Act of 1986, I’d accomplished a lot of what I’d come to Washington to do. But on the other side of the ledger, cutting Federal spending and balancing the budget, I was less successful than I wanted to be. This was one of my biggest disappointments as president. I just didn’t deliver as much to the people as I’d promised.”

President Reagan’s disappointment can be traced to the unintended consequences of applying Milton Friedman’s “allowance theory” of federal budgeting under the paper dollar standard. “I have long favored cutting taxes at any time, in any manner, by as much as possible as the only way of bringing effective pressure on Congress to cut spending,” Friedman explained. “Like every teenager, Congress will spend whatever revenue it receives plus as much more as it collectively believes it can get away with. Reducing spending requires cutting its allowance.”  President Reagan borrowed Friedman’s analogy in a 1980 presidential campaign debate and a 1982 budget speech, when he said, “increasing taxes only encourages government to continue its irresponsible spending habits. We can lecture it about extravagance till we’re blue in the face, or we can discipline it by cutting its allowance.”

Now, C. Northcote Parkinson famously theorized that “work expands so as to fill the time available for its completion.” Though often misinterpreted as advice on time management, Parkinson’s Law was actually the history professor’s attempt to explain the inexorable growth of bureaucracy along the lines of the neoclassical libertarian theory of public choice.  Friedman’s allowance analogy amounts to Parkinson’s fiscal corollary: public spending expands to absorb all available tax revenues. But the strategy failed in practice by overlooking Parkinson’s debt corollary: public borrowing expands to absorb all available means of finance. If tax revenues are Congress’ “allowance,” then purchases of Treasury securities by government trust funds and the banking system are its “credit cards.” The congressional teenager’s spending won’t be fazed by a cut in allowance, unless the indulgent parents also cut up the credit cards. Those “credit cards” consist, first, of the government trust funds accumulated ostensibly as “reserves” for Social Security and other supposedly self-financing programs, and second, purchases of U.S. public debt by the banking system, especially central banks that use such debt as official monetary “reserves.” Thus, while U.S. public debt jumped by more than 20 percentage points of GDP between 2007 and 2009, debt to the non-bank public debt stayed below 19 percent—because most of the increased debt was financed by central banks and trust funds. And the Congressional Budget Office (CBO) predicts that U.S. public debt will roughly double again to more than twice the size of our economy.

The World Dollar Base & U.S. Consumer Price Inflation, 1830-2010

Given the monetary system, the loss of budget discipline causes price instability. Milton Friedman was correct to say that “money matters,” but mistaken in ignoring the fact that foreign official dollar reserves have the same ultimate impact on the price level in dollars as the high-powered dollars created by the Federal Reserve. What I call the World Dollar Base is the sum of U.S. currency and commercial bank reserves plus foreign official dollar reserves. I’ve been able to reconstruct it back to 1830, and its variation relative to the real growth of U.S. productive capacity has preceded each major episode of consumer price inflation or deflation.

The World Dollar Base and Oil Supply vs. CPI Nondurables

Of course, the relation is a bit more complicated than that. As the next chart shows, the commodity-led inflations that triggered the recessions of 1974–75, 1979–80, 1990–91, and the Great Recession of 2007–09 were each proceeded by commensurate massive monetization (or less often, demonetization) of U.S. public debt through the monetary system. The chart compares the annual rate of inflation of CPI nondurable goods—mostly food and energy prices—with a ratio of the main factors affecting demand for them: the lagged “World Dollar Base,” divided by a proxy for the current demand for high-powered dollars (U.S. currency and commercial-bank reserves times current world oil production). In each case, voters blamed the president: Richard Nixon, Gerald Ford, Jimmy Carter, George H. W. Bush, George W. Bush, or Barack Obama.

Net U.S. Monetary Reserves vs. U.S. International Investment Position

The next chart depicts the third problem: The dollar’s official-reserve currency role has eroded U.S. international competitiveness. In 1980, U.S. residents owned net investments in the rest of the world equal to about 10 percent, but by 2009 had become net debtors equal to about 20 per cent, of U.S. GDP. Meanwhile U.S. net official monetary assets—official monetary assets minus foreign liabilities—declined by almost exactly the same amount, while the books of the rest of American residents remained in balance or showed a slight surplus. This comparison proves that the entire decline in the U.S. net investment position has been due to federal borrowing from foreign monetary authorities; and ending the dollar’s role as chief official reserve currency is necessary to end chronic U.S. payments deficits and restore U.S. international competitiveness.

Reagan’s Unfinished Monetary Reform. As Congressman Jack Kemp’s staff economist, I can attest that in 1980, then-Governor Ronald Reagan’s advisers agreed that it was necessary to limit the power of the Federal Reserve governors who make monetary policy. But nothing was done because they disagreed about the policy rule. “Domestic monetarists,” following Milton Friedman, proposed that the Federal Reserve regulate the quantity of bank reserves and the money supply. Many “supply-siders” advising Jack Kemp proposed to make the value of a paper dollar equal by law and convertible into a weight of gold, as it was for most of the two-hundred-plus years of U.S. history. But “global monetarists,” following Robert Mundell, advocated at least a temporary return to the 1944 Bretton Woods gold-exchange system, while others of us heeded Jacques Rueff’s warning that only restoring a multilateral gold standard without foreign-exchange reserves would be effective. On June 29, 1984, Congressman Jack Kemp introduced the Gold Standard Act of 1984, which would have defined the dollar as a fixed weight of gold, restored gold convertibility of Federal Reserve notes and deposits, and provided for gold coinage. Both Kemp’s explanatory statement and Lewis E. Lehrman’s op-ed of that day, which Kemp inserted into the Congressional Record, remain valid.

Why is it possible now to achieve what Reagan could not? Though they often disagreed, Friedman and Mundell exhibited colossal integrity in acknowledging that changing circumstances had made their earlier proposals infeasible. As Friedman summarized in a Financial Times interview, “The use of quantity of money as a target has not been a success. I’m not sure that I would as of today push it as hard as I once did.”  According to a recent Wall Street Journal interview with Judy Shelton, Mundell believes that “it would not be possible today to forge a monetary system with the dollar as the key reserve currency, as President Franklin Roosevelt and Treasury Secretary Henry Morganthau did in the 1940s. ‘To be fair, America’s position is not nearly as strong now,’ he concedes.’”

Thus, it is now finally possible to restore the first principle of successful presidential economic policy. As Rueff showed, the essential requirement is that the major countries agree to replace all official foreign-exchange reserves with an independent monetary asset that is not ultimately some particular nation’s liability: gold.

There are two conditions for the success of such a reform. First, the gold values of all national currencies must be properly chosen to preclude the deflation of wages and prices that occurred in the 1920s and 1930s in those countries (notably Britain and the United States) which tried to keep parities that did not allow for past wage and price inflation by substituting foreign exchange for gold reserves. Other countries, notably France in 1926 and 1959, restored gold convertibility successfully with strong economic growth but without inflation, deflation, or unemployment.

Second, existing official foreign exchange reserves must be removed from the balance sheets of monetary authorities by consolidating them into long-term government-to-government debts that would be repaid over several decades—much as the Washington-Hamilton administration funded the domestic and foreign Revolutionary War debt.

Gasoline Price vs. Presidential Voter Approval

My final chart shows the reason why the next successful president will end the reserve currency curse and restore the gold standard: both inflation and deflation are deeply unpopular, and American voters hold the U.S. president directly responsible. As with unemployment, whenever the consumer price of gasoline rises, the sitting president’s popularity drops. This is why any presidential candidate who does not wish to become a byword will have to end the dollar’s “reserve currency curse.”

As President Reagan asked, If not us, who? If not now, when? And if not in Washington, DC, where?

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