[R-G] The Buck Stopped Then

[Anthony Fenton]

September 24, 2008
Op-Ed Contributor
The Buck Stopped Then
By JAMES GRANT
http://www.nytimes.com/2008/09/24/opinion/24grant.html?_r=1&adxnnl=1&oref=slogin&ref=opinion&pagewanted=print&adxnnlx=1222276115-f4yx30B61/RWX0cFXkHY+A

CRITICS of the administration’s Wall Street bailout condemn the waste  
of taxpayer dollars. But the taxpayers aren’t the weightiest American  
financial constituency, even in this election year. The dollar is the  
world’s currency. And it is on the world’s opinion of the dollar that  
the Treasury’s plan ultimately hangs.

It hangs by a thread, if Monday’s steep drop of the greenback against  
the euro is any indication. We Americans, constitutionally inattentive  
to developments in the foreign exchange markets, should be grateful  
for what we have. That a piece of paper of no intrinsic value should  
pass for good money the world over is nothing less than a secular  
miracle. We pay our bills with it. And our creditors not only accept  
it, they also obligingly invest it in American securities, including  
our slightly shop-soiled mortgage-backed securities. Every year but  
one since 1982, this country has consumed much more than it has  
produced, and it has managed to discharge its debts with the money  
that it alone can lawfully print.

No other nation ever had it quite so good. Before the dollar, the  
pound sterling was the pre-eminent monetary brand. But when Britannia  
ruled the waves, the pound was backed by gold. You could exchange  
pound notes for gold coin, and vice versa, at the fixed statutory rate.

Today’s dollar, in contrast, is faith-based. Since 1971, nothing has  
stood behind it except the world’s good opinion of the United States.  
And now, watching the largest American financial institutions quake,  
and the administration fly from one emergency stopgap to the next, the  
world is changing its mind.

“Not since the Great Depression,” news reports keep repeating, has  
America’s banking machinery been quite so jammed up. The comparison is  
hardly flattering to this generation of financiers. From 1929 to 1933,  
the American economy shrank by 46 percent. The wonder is that any  
bank, any corporate borrower, any mortgagor could have remained  
solvent, not that so many defaulted. There is not the faintest shadow  
of that kind of hardship today. Even on the question of whether the  
nation has entered a recession, the cyclical jury is still out. Yet  
Wall Street shudders.

The remote cause of its troubles is the paper dollar itself — the  
dollar and the growth in the immense piles of debt it has facilitated.  
The age of paper money brought with it an increasingly uninhibited  
style of doing business.

The dollar emerged at the center of the monetary system that took its  
name from the 1944 convention in Bretton Woods, N.H. The American  
currency alone was made exchangeable into gold. The other currencies,  
when they got their peacetime legs back under them, were made  
exchangeable into the dollar.

All was well for a time — indeed, for one of the most prosperous times  
in modern history. Under the system of fixed exchange rates and a gold- 
anchored dollar, world trade boomed (albeit from a low, war-ravaged  
base). Employment was strong and inflation dormant. The early 1960s  
were a kind of macroeconomic heaven on earth.

However, by the middle of that decade it had come to the attention of  
America’s creditors that this country, fighting the war in Vietnam,  
was emitting a worryingly high volume of dollars into the world’s  
payment channels. Foreign central banks, nervously eyeing the ratio of  
dollars outstanding to gold in the Treasury’s vaults, began prudently  
exchanging greenbacks for bullion at the posted rate of $35 per ounce.  
In 1965, William McChesney Martin, chairman of the Federal Reserve,  
sought to reassure the quavering dollar holders. He lectured the House  
Banking Committee on the importance of maintaining the dollar’s  
credibility “down to the last bar of gold, if that be necessary.”

Necessary, it might have been, but expedient, it was not, and the  
Nixon administration, on Aug. 15, 1971, decreed that the dollar would  
henceforth be convertible into nothing except small change. The age of  
the pure paper dollar was fairly launched.

In the absence of a golden anchor, the United States produced as many  
dollars as the world cared to absorb. And the world’s appetite was  
prodigious. “Balance of payments” crises were now, for this country,  
things of the past. “Liquidity,” that bubbly speculative elixir,  
gurgled from the founts of the world’s central banks.

It was the very lack of gold-standard inhibition that permitted the  
buildup of titanic dollar balances overseas. At the end of 2007, no  
less than $9.4 trillion in dollar-denominated securities were sitting  
in the vaults of foreign investors. Not a few of these trillions were  
the property of Asian central banks. So, although the United States  
has run heavy and persistent current account deficits — $6.7 trillion  
in total since 1982 — they have been “deficits without tears,” to  
quote the French economist Jacques Rueff. The dollars American debtors  
sent abroad America’s creditors sent right back in the shape of  
investments in American stocks, bonds and factories.

Under the Bretton Woods system, worried foreign creditors would long  
ago have cleaned out Fort Knox. But, conveniently, the dollar is  
uncollateralized and unconvertible. America’s overseas creditors hold  
it for many reasons. Some — notably Asian central banks — acquire  
dollars simply to help make their exports grow. But even the  
governments that scoop up dollars for no better reason than to  
manipulate their own currency’s value presumably put some store in the  
integrity of American finance.

As never before, that trust is being put to the test. In the best of  
times, the Treasury and the Federal Reserve pretended as if the dollar  
were America’s currency alone. Now, in some of the worst of times,  
Washington is treating its vital overseas dollar constituency as if it  
weren’t even there.

Which failing financial institution will the administration pluck from  
the flames of crisis? Which will it let roast? Which market, or  
investment technique, will the regulators bless? Which — in a  
capricious change of the rules — will it condemn or outlaw? Just how  
shall the Treasury secretary spend the $700 billion he’s begging for?  
Viewed from Wall Street, the administration’s recent actions appear  
erratic enough. Seen from the perch of a foreign investor, they must  
look very much like “political risk,” a phrase we Americans usually  
associate with so-called emerging markets, not with our own very  
developed one.

Where all this might end, nobody can say. But it is unlikely that  
either the dollar, or the post-Bretton Woods system of which it is the  
beating heart, will emerge whole. It behooves Barack Obama and John  
McCain to do a little monetary planning. In the absence of faith, what  
stands behind a faith-based currency?

James Grant, the editor of Grant’s Interest Rate Observer, is the  
author of the forthcoming “Mr. Market Miscalculates: The Bubble Years  
and Beyond.”