Remarks on Money: How the Destruction of the Dollar Threatens the Global Economy — and What We Can Do about It by Steve Forbes and Elizabeth Ames
These remarks were delivered at a Cato Book Forum, June 19, 2014, Washington, D.C.
My big takeaway from Money (McGraw Hill, 2014) is that Steve Forbes is no James Dean. Forbes is a rebel with a cause. Free-markets and sound money, please. In what follows, I will briefly mention 11 other takeaways from my reading of Money by Steve Forbes and Elizabeth Ames.
The dedication to Alexander Hamilton signaled right away that Moneywas going in the right direction. We all know that Hamilton was an extraordinary financial engineer. Among other things, he established a federal sinking fund to finance the Revolutionary War debt. Hamilton also engineered a large debt swap in which the debts of individual states were assumed by the newly created federal government. Hamilton’s ability to solve the debt problem established America’s financial credibility and gave the new nation a muchneeded positive confidence shock. We are also aware of the fact that Hamilton was a great contributor to the Federalist Papers — a superb document. Indeed, no less than Milton Friedman once wrote in Newsweek (June 4, 1973) that Federalist Paper 15 “contains a more cogent analysis of the European Common Market than any I have seen from the pen of a modern writer.”
What we do not all know, particularly many of those who espouse the sanctity of private property rights, is that Hamilton was a distinguished lawyer who took on some of the most famous property cases in U.S. legal history. After the Revolutionary War, the state of New York enacted harsh measures against Loyalist and British subjects. These included the Confiscation Act (1779), the Citation Act (1782), and the Trespass Act (1783). All involved the seizure of property and garnered wide public support. Hamilton saw the acts as an illustration of the inherent difference between democracy and law. Hamilton took his views to court and successfully defended, in the face of enormous public hostility, those who had their property taken under the three New York state statutes.
Speaking of the taking of property and money — right here in the USA, not the USSR — let us not forget the U.S. Congress’ abrogation of the Gold Clauses in June 1933; a confiscation of property that the Supreme Court upheld in 1935.
Before that abrogation, private and public bond covenants included gold clauses. Under this system, bond holders received interest and principle payments in dollars that contained as much gold as the dollar contained when the bonds were issued. Well, after April 1933, the U.S. government manipulated the price of gold upward until President Roosevelt redefined the dollar in gold terms under the Gold Reserve Act of January 1934. Overnight, the dollar became 41% lighter. This left gold-clause bond holders out to dry.
Because of the Congress’ abrogation of the gold clauses, bondholders could only receive the nominal dollar amounts of interest and principle, as stated on their bonds. They could not receive enough additional dollars to make their payments equal in value to the amount of gold originally stipulated. In short, bondholders were stuck with new “light” dollars, not the original “heavy” ones that had been specified in the original bond covenants.
Of course Bondholders sued over this theft. But, the Supreme Court held that the abrogation of the gold clauses for private bonds was constitutional in 1935. The Court’s decision rested on the fallacious argument that contracts that contained the gold clauses interfered with Congress’ authority to coin money and regulate its value (Article 1, Section 8 of the U.S. Constitution).
For bonds issued by the U.S. government, the situation was different because Congress did not have the authority to repudiate obligations of the U.S. government. But, because the legal briefs were defective in proving actual damages, the plaintiffs who had held U.S. government bonds “protected” by gold clauses could not collect damages from the U.S. government.
In anticipation of additional gold-clause cases, Congress simply passed a law amending the jurisdiction of federal courts, barring them from hearing any further gold-clause cases. Every time I reflect on this Congressional maneuver, Paul McCartney’s classic “Back in the USSR” rings in my ears. Yes, when it comes to money, the rule of law is rather elastic (particularly during National Emergencies), even in the U.S..
This elasticity in the rule of law with regard to money is not limited to the U.S., however. Even Germany has witnessed this elasticity: under the European Monetary System’s (EMS) exchange rate mechanism (ERM), which was established in December 1978, the Bundesbank was required by law to intervene with unlimited amounts of Deutschmark sales and foreign currency purchases, whenever another member country’s currency reached the ERM’s floor.
Well, the mighty Bundesbank could not bear the thought of such an external interference with its conduct of monetary policy. So, on November 16, 1978, prior to the final EMS agreement, Herr Emminger, President of the Bundesbank, sent a missive to the West German Chancellor Helmut Schmidt. The missive states that the Bundesbank wanted to be freed from its obligation to intervene during a currency crisis.
The Chancellor wanted an EMS agreement, which was ultimately agreed to by resolution of the European Council at a meeting in Breman on December 5, 1978. But, what to do about the Bundesbank? On November 30, 1978, the Chancellor complied with the Bundesbank’s wishes by initialing the Emminger letter, before he signed the EMS agreement. But, he also told the Bundesbank Council that the Emminger letter must remain secret and not be part of the EMS agreement — yes, a secret agreement.
The Chancellor further stated that all this agreement was allowable under the classical legal exemption clause: “Clausula rebus sic stantibus” (For those of you who aren’t Latin lovers: treaties may become inapplicable because of changes in circumstances).
Well, the Bundesbank trotted out the Emminger letter 14 years later. On Friday September 11, 1992, the Bundesbank indicated that, on Monday, it would stop supporting the hapless Italian lira. This forced a devaluation of the lira over the weekend and helped spark the run on the British pound on “Black Wednesday,” September 16th — the day both Italy and the U.K. were forced to leave the ERM. In case you have forgotten, this was the event that allowed George Soros to fill his pockets in a few minutes.
It is clear that Forbes and Ames have taken the water in Vienna, or perhaps in Baden bei Wien. Indeed, Moneycontains many Austrian themes:
- Forbes and Ames reject the closed economy model. Like Bob Mundell, who once said that the only closed economy is the world, Forbes and Ames embrace an open economy framework. This outlook is in sharp contrast to our last Fed Chairman Ben Bernanke. Bernanke did not even include the USD/EUR exchange rate (the most important price in the world) on his six-gauge dashboard.
- Forbes and Ames junk the idea of equilibrium and economic stability.
- Also, they embrace the central role of the entrepreneur in markets that are seen as a means to assemble dispersed knowledge and information.
- As Forbes and Ames say, “Information combined with trade and enterprise: that says everything one really needs to know about economics. Money — sound, trustworthy money — is the crucial facilitator that brings it all together.” Totally Austrian, indeed.
For those who do not like to get out in the theoretical weeds and want a more practical takeaway from Money, allow me to quote from Paul Volcker’s preface to Marjorie Deane and Robert Pringle’s 1995 book The Central Banks. Volcker’s edifying preface captures both the substance and spirit of Money:
“We sometimes forget that central banking, as we know it today, is, in fact, largely an invention of the past hundred years or so, even though a few central banks can trace their ancestry back to the early nineteenth century or before. It is a sobering fact that the prominence of central banks in this century has coincided with a general tendency towards more inflation, not less. By and large, if the overriding objective is price stability, we did better with the nineteenth-century gold standard and passive central banks, with currency boards, or even with “free banking.” The truly unique power of a central bank, after all, is the power to create money, and ultimately the power to create is the power to destroy.”
Like Volcker, and unlike most money and banking professionals, Forbes and Ames are straightforward and clear, but they are puzzled:
“Why then is so much writing on the subject of money so needlessly complicated, with dense, impenetrable language and equations that make sense to only a handful of academicians? And why do so many people insist that bad ideas about monetary policy, like ‘inflation is needed to increase employment,’ are as settled and unassailable as scientific principles?”
To answer that question, we need go no further than research by Larry White. He found that 74% of articles on monetary policy published in 2002 were in Fed sponsored publications and authored by people on the Fed’s staff or associated with the Fed. Fortunately, Forbes and Ames leapfrog that Fed hurdle.
Where does this near-monopoly of the professional publications lead us? Well, let’s look at the current crisis and the Great Recession that we are still in the midst of. Even after the financial crises of 2008-2009, we are still cursed by the central bankers’ mantra of inflation targeting and floating exchange rates. To refresh your memories, consider the following:
1. Former Fed Governor Ben Bernanke sounded an alarm in November 2002. He claimed that the major danger facing the U.S. economy was deflation. It was, of course, a false alarm. Never mind.
2. To fight the phantom deflation, the Fed pushed the federal funds rate all the way down to 1% by July 2003, when the natural rate was 3% - 4%.
3. With those artificially low interest rates, the Fed became the great enabler for the wild yield chasing, risk taking, accelerating carry trade, leveraging, and relative price distortions.
4. The behavior of the CPI inflation target and other important prices in the 2003-2008 period tell the tale: the CPI, excluding food and energy, only increased by 12.4% during that period. Indeed, that metric increased at a steady annual rate of 2.1% –right on target. Housing prices, however, went up 45% from 2003 until 2006 (Q1). Stock prices went up 66% from 2003 until 2007 (Q4). Commodities zoomed 92% from 2003 until 2008 (Q2).
5. As Prof. Gottfried Haberler put it in 1928, “The relative position and change of different groups of prices are not revealed, but are hidden and submerged in a general [price] index.” But, inflation targeters ignore Haberler’s observation. In consequence, they (read: the Fed) fly blind. Yes, going into the 2008-2009 storm, the Fed was flying blind. Recall that Bernanke’s dashboard, had no exchange-rate gauges!
6. This resulted in a disaster. Indeed, the error of 2008 was to engage in a very tight monetary policy. If Bernanke had an exchange-rate gauge, he would have seen the dollar soar against the euro by 33% from June 2008 to late October 2008. As the USD soared, oil prices plummeted, falling by about the same percentage as the USD appreciated against the euro. And oil prices plunged from $148/bbl to $35/bbl. Annual inflation measured by the CPI was 5.6% in July 2008. By February 2009, negative annual CPI numbers were being registered. So much for those alleged long and variable lags between changes in monetary policy and inflation.
7. But, we are left today with the Deputy Governor of Sweden’s Riksbank and inflation targeting guru Lars Svensson’s words: “My view is that the crisis was largely caused by factors that had very little to do with monetary policy.” What nonsense.
8. Never mind. With the central bankers’ grip on the professional press, we are left with inflation targeting too. Indeed, that nostrum is even more entrenched than it was before the crisis.
Foreign Exchange Comment I:
Now for some remarks about exchange rates that support the exchange-rate fixity espoused by Forbes and Ames. Many think current account surpluses and deficits are the product of misaligned exchange rates. Well, truths in economics often boil down to accounting principles that are as immutable as the laws of physics. Current account deficits are, for example, equal to the sum of two quantities: the excess of private investment over savings and the government deficit. Exchange rates have little to do with current account deficits.
Foreign Exchange Comment II:
Forget the D.C. chatter about currency manipulation. The U.S. Treasury (UST), as well as everyone else, cannot even define currency manipulation. That is why the UST has never formally branded China a currency manipulator. Fortunately, during the 1997-2004 period, the RMB/USD rate was marked by fixity. And, as the accompanying table shows, the RMB link to the USD was very good for inflation and growth in China. This link was also good for the global economy.
Foreign Exchange Comment III:
According to economic folklore, Milton Friedman only advocated floating exchange rate regimes because they are the only free market mechanisms for foreign exchange. False. In principle and in many real-world cases, Friedman backed currency unification and fixed exchange rates. A review of Friedman’s exchange-rate taxonomy explains why:
As for cases when Friedman endorsed currency boards, I will mention two. In 1992, I co-authored a book with Lars Jonung and Kurt Schuler, Monetary Reform for a Free Estonia. It carries the following dust jacket endorsement by Friedman: “A currency board such as that proposed by Hanke, Jonung, and Schuler is an excellent system for a country in Estonia’s position.” Friedman also embraced Hong Kong’s fixed exchange rate, writing in 1994, “The experience of Hong Kong clearly indicates that a particular country like Hong Kong does not need a central bank. Indeed, it has been very fortunate that it has not had one. The currency board system that was introduced in 1983 has worked very well for HK and I believe it is desirable that it be continued.”
A currency-board fixed exchange-rate regime is a free market system. Friedman understood this. With a currency board, the exchange rate between domestic money issued by the board and the board’s reserve, or anchor, currency is fixed, and the two currencies are fully convertible. So, the supply curve for domestic money is infinitely elastic. This means that the currency board will supply more domestic money as long as people wish to freely exchange anchor currency money for domestic money at the fixed exchange rate. In consequence, with currency board, the quantity of domestic money in the economy is determined by changes in the demand for domestic money. The quantity of domestic high powered money is, therefore, freely determined by changes in the demand for domestic money. Such a system operates automatically to determine the quantity of domestic base money in the system. Indeed, it does so without a monetary policy.
When it comes to exchange rates, more currency unification, please. The world’s two most important currencies — the dollar and the euro — should, via formal agreement, trade in a zone ($1.20 - $1.40 to the euro, for example). The European Central Bank would be obliged to maintain this zone of stability by defending a weak dollar via dollar purchases. Likewise, the Fed would be obliged to defend a weak euro by purchasing euros. The East Asian dollar bloc, which was torpedoed during the 2003 Dubai Summit, should be resurrected with the yuan and other Asian currencies tightly linked to the greenback. Many other countries (Brazil and Venezuela, for example), should adopt currency boards linked to either the dollar or euro. Or, they should simply “dollarize” by adopting a foreign currency (like the dollar, for example) as their own.
Yes. Why not dollarize? It works. Just look at Ecuador, El Salvador and Panama. They are all dollarized, and, based on my Misery Index, they are the three least miserable countries in Latin America. Dollarization, like currency boards, provides discipline. This discipline leads to prosperity and less misery.
Steve H. Hanke is Professor of Applied Economics at the Johns Hopkins University in Baltimore, MD. He is also a Senior Fellow and Director of the Troubled Currencies Project at the Cato Institute in Washington, D.C. You can follow him on Twitter: @Steve_Hanke