The Future of the Dollar
JANUARY 01, 1974 by HENRY HAZLITT
Mr. Hazlitt is the well-known economist, columnist, editor, lecturer and author of numerous books, including What You Should Know About Inflation which is available in paperback from the Foundation for Economic Education.
Before we consider the future of the American dollar it may be wise to cast a glance at the glories of its past and examine the main causes that have brought it to its present humiliating state.
The logical starting point in this examination is Bretton Woods. When the representatives of some forty nations met there in 1944, heretical monetary notions were floating in the air. Lord Keynes, who was there, was their chief spokesman. The most definite of these notions was that the gold standard was a barbarous relic, and neither could nor should be restored. It put every national economy in a strait jacket. It prevented full employment; it strangled economic growth; it tied the hands of national monetary managers. And all for no good reason except an outworn mystique. Besides, there wasn’t enough gold in the world to sustain convertibility.
But because some American Congressmen and some parliaments were thought to have a lingering prejudice in favor of gold, it seemed prudent to compromise, and to set up something that looked almost like a gold standard — a thinly gold-plated standard. So, through an International Monetary Fund (IMF), a sort of world central bank, every other currency was to be pegged at a fixed rate to the Almighty Dollar. Each nation, after fixing an official parity for its currency unit, pledged itself to maintain that parity by buying or selling dollars. The dollar alone was to be convertible into gold, at the fixed rate of $35 an ounce. But unlike as in the past, not everybody who held dollars was to be allowed to convert them on demand into gold; that privilege was reserved to national central banks or other official institutions.
Thus, everything seemed to be neatly taken care of. When every other currency was tied to the dollar at a fixed rate, they were all necessarily tied to each other at fixed rates. Only one currency was tied to the dreadful discipline of gold, and even that in a very limited way. Gold was "economized" as never before. It was now the servant, no longer the master.
In addition, the Bretton Woods agreements provided that if any nation or central bank got into trouble, it was entitled to automatic credit from the Fund, no questions asked.
Thus, not only released from a strict gold standard, but tempted to imprudence, individual nations felt free to expand their paper money and credit supply to meet their own so-called domestic "needs." The politicians and the monetary managers in practically every country were infected with a Keynesian or inflationary ideology. They rationalized budget deficits and continuous monetary and credit expansion as necessary to maintain "full employment" and "economic growth." As a consequence, there were soon wholesale devaluations. The IMF has published hundreds of thousands of statistics; but the single figure of how many devaluations there were between the opening of the Fund and August 15, 1971, when the dollar itself became officially inconvertible into gold, the IMF has never published.
There were certainly hundreds of devaluations. To my knowledge, practically every currency in the Fund, with the exception of the dollar, was devalued at least once. The record of the British pound was much better than that, say, of the French franc, but the pound itself, which had already been devalued from $4.86 to $4.03 when it entered the IMF, was devalued again from $4.03 to $2.80 in September 1949 (an action that touched off 25 more devaluations of other currencies within a single week), and devalued still again from $2.80 to $2.40 in November, 1967.
Devaluation, let us remember, is an act of national bankruptcy. It is a partial repudiation, a government welching on part of its domestic and foreign obligations. Yet, by repetition by all the best countries, devaluation acquired a sort of respectability. It became not a swindle, but a "monetary technique." Until the dollar went off gold in August 1971 and was devalued in December, we heard incessantly how "successful" the Bretton Woods system had proved.
During the early part of this period, however, the world suffered from what everybody called a "shortage of dollars." The London Economist, among others, even solemnly argued that there was now a permanent "shortage of dollars." Americans thought so too. Our monetary managers seemed completely unaware of the tremendous responsibility we had assumed when we allowed the dollar to become the standard and the anchor for all the other currencies of the world. Our money managers never dreamed that it was possible to create an excess of dollars. They issued and poured out dollars and sent them abroad in foreign aid. Total disbursements to foreign nations, in the fiscal years 1946 through 1971, came to $138 billion. The total net interest paid on what the United States borrowed to give away these funds amounted in the same period to $74 billion, bringing the grand total through the 26-year period to $213 billion.
This amount was sufficient in itself to account for the total of our Federal deficits in the 1946-1972 period. The $213 billion foreign aid total exceeds by $73 billion even the $140 billion increase in our gross national debt during the same years. Foreign aid was also sufficient in itself to account for all our balance-of-payments deficits up to 1970.
We created a good deal of this money through internal inflation. From January 1946 to August 8, 1973, the money supply, as measured by currency in the hands of the public plus demand bank deposits, increased from $102 billion to $264 billion, an increase of $162 billion, or of 159 per cent. In the same period the money supply as measured by currency plus both demand and time deposits increased from $132 billion to $549 billion, an increase of $417 billion, or 316 per cent.
Because of what our monetary authorities believed was the necessity of keeping this enormous inflation going, they adopted one expedient after another. In 1963, blaming the deficit in our balance of payments on private American investment abroad, they put a penalty tax on purchases of foreign securities. In 1965 they removed the legal requirement to keep a gold reserve of 25 per cent against Federal Reserve notes. They resorted to a "two-tier" gold system. Next they invented Special Drawing Rights, or "paper gold." But all to no avail. On August 15, 1971, they officially abandoned gold convertibility. They devalued the dollar by about 8 per cent in December, 1971. They devalued it again, by 10 per cent more, on February 15, 1973.
Before we bring this dismal history any further down to date, let us pause to examine some of the chief fallacies prevailing among the world’s journalists, politicians, and monetary managers that have brought us to our present crisis.
Because we were sending so many of our dollars abroad, the real seriousness of our own inflation was hidden both from our officials and from the American public. We contended that foreign inflations were greater than our own, because their official price indexes were going up more than ours were. What we overlooked —what most Americans still overlook — is that we were exporting part of our inflation and that foreign countries were importing it.
This happened in two ways. One was through our foreign aid. We were shipping billions of dollars abroad. Part of these were being spent in the countries that received them, raising their price level but not ours. The other way in which we exported inflation was through the IMF system. Under that system, foreign central banks bought our dollars to use them as part of their reserves. But in addition, under the rules of the IMF system, central banks were obliged to buy dollars, whether they wanted them or not, to keep their own currencies from going above parity in the foreign exchange market. The result is that foreign central banks and official institutions today hold some 71 billion of our dollars.
These dollars will eventually come home to buy our goods or make investments here. When they do, their return will have an inflationary effect in the United States. Our domestic money supply will be increased even if our Federal Reserve authorities do nothing to increase it.
Balance of Payments
The meaning of the "deficit" in our balance of payments has been grossly misunderstood. It has not been in itself the real disease, but a symptom of that disease. The real question Americans should have asked themselves is not what consequences the deficits in the balance of payments caused, but what caused the deficits. I have just given part of the answer — our huge foreign aid over the last 27 years, and the obligation of foreign central banks under the Bretton Woods agreements to buy dollars. But the foreign central banks had to buy dollars because dollars had become overvalued at their official rate. They became overvalued because the U.S. was inflating faster than some other countries.
After the United States formally suspended gold payments, and after the dollar was twice devalued, foreign banks no longer felt an obligation to buy dollars. The dollar fell to its market rate, and as one consequence we again have a monthly excess of exports. The economists who had all along been demanding the restoration of free-market exchange rates were right. Now that the dollar is no longer even nominally convertible into gold there is no longer any excuse for governments to try to peg their paper currency units to each other at arbitrarily fixed rates. The IMF system ought to be abandoned. The International Monetary Fund itself ought to be liquidated. Paper currencies should be allowed to "float" — that is, people should be allowed to exchange them at their market rates.
But it is profoundly wrong to assume, as many economists and laymen unfortunately now do, that daily and hourly fluctuating market rates for currencies will be alone sufficient to solve the multitudinous problems of foreign commerce. On the contrary, these wildly fluctuating rates create a serious impediment to international trade, travel and investment. They force importers, exporters, travelers, bankers, and investors either to become unwilling speculators or to resort to bothersome and costly hedging operations. With 125 national currencies represented in the IMF, there are some 7,750 changing cross-rates to keep track of, and twice as many if you state each cross-rate both ways. With a gold standard gone, with the dollar standard gone, there is no longer a single accepted unit in which all of these rates can be stated.
Some Gain — Some Loss
It is a great gain when currencies can be exchanged at their true market rates. Since this has happened the American trade balance has improved. In the second quarter of 1973, for example, there was again a surplus of exports. In July, 1973, American exports in dollar terms were the highest for any single month on record. But it is one thing to allow trade to improve by abandoning arbitrary pegs on foreign-exchange rates; it is quite another thing for a country to seek to increase its exports at the expense of its neighbors by deliberate devaluation. Yet this is what the United States government has very foolishly done.
In early August, 1973, Frederick B. Dent, the U. S. Secretary of Commerce, assured the American public that the devaluations of the dollar had provided the nation with a "bright opportunity." "Without question," he added, "the most important factor in the improving trade trend is the combination of the two devaluations." In fact, the U. S. Department of Commerce placed an advertisement in the issue of Time of July 2, and in other magazines, declaring that to the U. S. exporter the devalued dollar means "vastly improved prospects," that it would help him to capture "a bigger share of over-sea markets," and that it was up to him to "start putting the devalued dollar to work."
The basic fallacy in this euphoric picture is that it looks only at the short run consequences of devaluation and even at these only as they affect a small segment of the population.
It is true that the first effect of a devaluation, if it is confined to a single country, is to stimulate that country’s exports. Foreigners can buy that country’s products cheaper in terms of their own money. Thus, as the Department of Commerce’s ad correctly pointed out: "For instance, an American product for which a West German importer paid 1000 deutsche mark only 18 months ago would now cost him as little as 770 marks. Or about 23 per cent less than before." So the American exporter stands to sell more goods abroad at the same price in dollars, or the same volume of goods in higher prices in dollars, or something in between, depending on whether his product is competitive or a quasi-monopoly.
So far, so good. But U. S. exports amount to only 4¹/2 per cent of the gross national product. Now let us enlarge our view. If the dollar is devalued, say, by a weighted average of 25 per cent in terms of other currencies, something else happens even on the first day after devaluation. The prices of all American imports go up by that percentage (or more precisely, by its converse). Every American consumer has to pay more, directly or indirectly, for meat, coffee, cocoa, sugar, metals, newsprint, petroleum, foreign cars, or whatever. Even the American exporter, as a consumer, has to pay more, and also more for his imported raw materials. So the immediate effect of a devaluation is to force the consumers of the devaluing nation to work harder to obtain a smaller consumption than otherwise of imported goods and services. Is it really a national gain for the American people to sell their own goods for less and buy foreign goods for more?
The belief that devaluation is a blessing, because it temporarily enables us to sell more and forces us to buy less, stems’ from the old mercantilist fallacy that looked at international trade only from the standpoint of sellers. It was one of the primary achievements of the classical economists to explode this fallacy. As John Stuart Mill said:
The only direct advantage of foreign commerce consists in the imports. A country obtains things which it either could not have produced at all, or which it must have produced at a greater expense of capital and labor than the cost of the thing which it exports to pay for them…
The vulgar theory disregards this benefit, and deems the advantage of commerce to reside in the exports: as if not what a country obtains, but what it parts with, by its foreign trade, was supposed to constitute the gain to it.
So far I have considered only the immediate effects of a devaluation. Now let us look at the longer effects. The devaluation or depreciation of a currency soon leads to a rise of the internal price level. The prices of imported goods, as I have just pointed out, have a corresponding rise immediately. The demand for exports rises, and therefore the prices of export goods rise. This rise of prices leads to increased borrowing by manufacturers and others to stock the same volume of raw materials and other inventories. This leads to an expansion of money and credit which soon makes other prices rise. (Often, of course, the causation is the other way round: an expansion of a country’s currency and a consequent rise of its internal price level will soon be reflected in a fall of its currency quotation in the foreign exchange market.) In brief, internal prices soon adjust to the foreign-exchange quotation of the currency, or vice versa.
We can see more clearly how this must take place if we look at a freely transportable international commodity like wheat, copper, or silver. Let us say, for example, that copper is 50 cents a pound in New York when the deutsche mark in the foreign exchange market is 25 cents. Then purchases, sales, and arbitrage transactions will have brought it about that the price of copper in Munich is four times as high in marks as in dollars plus costs of transportation.
Suppose the dollar is devalued or depreciated so that the mark now exchanges for 40 cents. Then, assuming that the price of copper in terms of marks does not change (and though I have been specifically mentioning marks, dollars, and copper I intend this as a hypothetical and not a realistic illustration), purchases, sales, and arbitrage transactions will now bring it about that the price of copper in New York will have to rise 60 per cent in terms of dollars. To bring this new adjustment about, more copper will flow from the U. S. to Germany. But after this temporary stimulus to American export, the new price adjustment will bring it about that, other things being equal, the relative amount of copper exported may be no different than before the devaluation.
A Brief Period of Transition
I have been speaking of international commodities, traded on the speculative exchanges, and easily and quickly transportable. In these commodities the international price adjustments will take place in a few days or weeks. The price adjustments of most other goods will, of course, take place more slowly. The main point to keep in mind is that there is a constant tendency for the internal purchasing power of a currency to adjust to its foreign-exchange value —and vice versa. In other words, there is a constant tendency for the internal prices in a country to adjust to the changing foreign-exchange value of its currency —and vice versa. Though our modern monetary managers and secretaries of commerce seem to know nothing about this, the purchasing power theory of the exchanges was first explained a century and a half ago by Ricardo.
In other words, the alleged foreign trade "advantages" of a devaluation last for merely a brief transitional period. Depending on specific conditions, that period may stretch over more than a year or less than twenty-four hours. It tends to become shorter and shorter for any given country as depreciation of its currency continues or devaluations are repeated. Internal currency depreciation usually lags behind external depreciation, but the lag tends to diminish.
Statistical studies have been made of the relationships of the internal and external purchasing power of a currency under extreme conditions — for instance, the German mark during the 1919-1923 inflation. (See The Economics of Inflation, by Constantino Bresciani-Turroni, 1937.) It would not be too hard for any competent statistician, with the help of a copy of International Financial Statistics, published monthly by the IMF, to put together revealing comparisons of foreign-exchange rates and internal prices for any country that publishes reasonably honest wholesale or consumers price indexes.
It is instructive to recall, incidentally, that at the height of the German hyperinflation, which eventually brought the mark to one-trillionth of its former value, monthly exports, measured in tonnages, fell to less than half of what they had previously been, while the tonnage of imports doubled or tripled.
In brief, the pursuit of a more "favorable" balance of payments, or a trade "advantage," through depreciation or devaluation of one’s own currency, is the pursuit of a will-o-the-wisp. Any gain of exports it brings to the devaluating nation is temporary and transient, and is paid for at an excessive cost — an internal price rise and all the economic distortions and social discontent and unrest this brings about.
The usual criticism of currency devaluation is that it will provoke reprisals; that other countries will try the same thing, and the world may be plunged into competitive devaluations and trade wars. This objection is, of course, both a valid and a major one. But what I have been trying to emphasize here is a point that few of our monetary managers have grasped — that even if there is no retaliation, devaluation as a deliberate policy pursued for the sake of a foreign trade gain is self-defeating and stupid. The two American devaluations, for example, were monumental blunders. If the world’s monetary managers can be brought to learn this one lesson, the economic and political gain will be immense.
What steps should be taken to halt the present world inflation and return the world to sound money? The immediate steps are simple and can be briefly stated.
The United States — and for that matter every country — should forthwith allow its citizens to buy, sell, and make contracts in gold. This would be immediately followed by free gold markets, which would daily measure the real depreciation in each paper currency. Gold would immediately become a de facto world currency, whether "monetized" or not. The metal itself would not necessarily change hands with each transaction, but gold would become the unit of account in which prices would be stated. Exporters would be insured against the depreciation of the currencies in which they were being paid.
The second (and preferably simultaneous) step can be stated more briefly still. Every nation should refrain from further increase in its paper money and bank credit supply.
For the United States a special measure would also be needed. A hundred billion dollars or more are held by foreign central banks and foreign citizens. Most of these are no longer wanted. They dangerously overhang the market, and constantly threaten to bring sudden and sharp declines in the dollar.
The U. S. government must do two things. It must follow monetary policies that will assure foreign dollar holders that they are not holding an asset that is likely to depreciate still further but, on the contrary, one that is likely to keep its value or even to appreciate a little. Secondly, the U. S. government should volunteer to fund the dollar overhang. It could do this by offering foreign central banks interest-bearing long-term obligations for their liquid dollar holdings — say, bonds that would be repayable and retirable, principal and interest, in equal installments over a period of twenty-five or thirty years. It should preferably negotiate with each country separately, and should guarantee its bonds by making principal and interest repayable, at the option of the central bank holding them, in either the face value of the dollars or in the currency of the country holding them, at the same ratio to the dollar as of the market rate on the day the agreement was reached. Thus, the Bank of Japan would be paid off, at its option on any payment date, either in dollars or in yen; the Bundesbank either in dollars or in marks; and so on.
Ricardo’s Recommendations of a Full Gold Standard
Of course, the world should eventually return to a full gold standard. A gold standard is needed now for the same reason that David Ricardo gave for it in 1817:
Though it (paper money) has no intrinsic value, yet, by limiting its quantity, its value in exchange is as great as an equal denomination of coin, or of bullion in that coin…. Experience, however, shows that neither a State nor a bank ever have had the unrestricted power of issuing paper money without abusing that power; in all States, therefore, the issue of paper money ought to be under some check and control; and none seems so proper for that purpose as that of subjecting the issuers of paper money to the obligation of paying their notes either in gold coin or bullion.
A return to gold will involve some difficult but not insuperable problems, which we shall not attempt to discuss in detail here. The main immediate requirement is that individual countries stop increasing their paper money supplies.
But my topic here is the future of the dollar — not what it ought to be, but what it is likely to be. And I am obliged to say that the outlook for the dollar — or, for that matter, of national currencies anywhere — is hardly bright. The world’s currencies will be what the world’s politicians and bureaucrats make them. And the world’s politcians and bureaucrats are still dominated everywhere by an inflationary ideology. Whatever they say publicly, whatever fair assurances they give, they still have a mania for inflation, domestic and international. They are convinced that inflation is necessary to maintain "full employment" and to continue "economic growth." They will probably continue to "fight" inflation only with false remedies, like "income policies" and price controls.
The International Monetary Fund is the central world factory of inflation. Nearly all the national bureaucrats in charge of it are determined to continue it. Having destroyed the remnants of the gold standard by printing too much paper money, they now propose to substitute Special Drawing Rights, or SDR’s, for gold — in other words, they propose to print more international paper money to serve as the "reserves" behind still more issues of national paper monies. The first international step toward sound money, to repeat, would be to abolish the IMF entirely.
In August, 1973, the present American Secretary of the Treasury, George P. Schultz, named fourteen men as members of a new advisory committee on reform of the international monetary system. These included three former Treasury secretaries, all of whom pursued the very monetary policies that brought the United States and the world to its present crisis. The whole list of men in this committee included only two professional economists. I don’t want to attack individuals, but to my knowledge not a single man appointed to the new panel believes in the gold standard, has ever advocated its restoration, or has ever spoken out in clear and unequivocal terms even against the chronic increase in paper money issues. But the climate of opinion is now such in the United States that I must confess I would find myself hard put to it to name as many as fourteen qualified Americans who could be counted on to recommend a sound international monetary reform.
The truth is that everybody is afraid of a return to sound money. Nobody in power wants to give up inflation altogether because he fears its abandonment would be followed by a recession. It’s true that if we stopped inflation forthwith we might have a recession, for much the same reasons as a heroin addict, deprived of his drug, might suffer agonizing withdrawal symptoms. But such a recession, even if it came, would be a very minor and transient evil compared with the catastrophe toward which the world is now plunging.
This article is from a paper delivered at a regional meeting of the Mont Pelerin Society in Guatemala, September 4, 1973.