The UN Got it Right

I hate to admit it, but it's true. I read an article today titled "World economy on thin ice - U.N." with the accompanying subtitle "The United Nations blames dire situation on the decline of the U.S. housing and financial sectors." What is the significance of this, and how accurate is the assertion?

To answer these questions, one must go back at least as far as to the 1944 Bretton Woods conference, at which the US was granted the status of holding the world's reserve currency. As mentioned in a previous posting on this blog, the reserve currency status essentially translated into the fact that foreign currencies would be linked, or "pegged," to the US dollar; commodities such as oil and gold would be priced in dollars; and these dollars would be redeemable in gold if a country so chose to make the conversion. An advantage of this system for the US has been the fact that we are allowed to maintain a "current account deficit" -- mainly, carry a trade imbalance by importing far more goods than we export. (In even more simplified terms, consuming much more than producing.)

In the 1960's, the US underwent a significant increase in federal spending, as Presidents Kennedy, Johnson, and Nixon indulged in "guns and butter" programs that ratcheted up the federal budget deficit. These expenditures included the Vietnam War, Medicare and Medicaid, various other Great Society initiatives under LBJ, and so on and so forth. With all this spending, and not enough economic output to match it, the US went to the tried and true method of simply printing the needed currency.

This decision did not sit well with foreign countries that, by way of the Bretton Woods system, were forced to accept US dollars as their reserves. You see, with all of the money-printing occurring in the '60's, the dollar was steadily being devalued, thus decreasing the value of foreign countries' monetary reserves. It was then that many of these countries approached the US government and demanded redemption of their US dollars in gold. The problem was, there wasn't enough gold in our possession to redeem all of our creditors.

So how did we solve this dilemma? Simple: President Nixon simply decoupled the dollar from the gold standard in 1971. This action amounted to the US government telling members of the world economy "trust us" when it comes to our currency; in other words, trust us that our word is good when we say the currency is viable, and can be accepted as a legitimate form of payment with the backing of the full faith and credit of the US and its Treasury.

Fast forwarding about 35 years, and here we are with foreign countries stockpiling US dollars in their reserves, with little choice but to trust the US that our economy and our currency are healthy and able to withstand the recent perturbations in our financial system. As the article pointed out, these perturbations include the overall credit and housing crises that have wracked our economy. Both of these crises can be traced back to the monetary policy of the US Treasury and the Fed, due to the expansion of credit and the money supply, and the resulting debasement of the currency as inflation naturally follows.

Or is the only choice to trust us? The dollar as reserve currency is not carved in stone, and already, entities like the economic Group of 7 (G-7) have hinted that extreme weakness in the dollar could lead to significant changes in the global economic system. Change such as de-emphasizing the dollar as reserve currency, and possibly switching to another, stronger alternative. If this becomes the case, the consequences for our economy will be dire in comparison to what we are experiencing today. The reason being, once other countries are no longer obligated to accept the dollar in their economic transactions, there will be little reason to accept it at all, as it will be worth so little these countries will have lost any incentive to deal economically with the US. And why should they? We hardly produce anything anymore, and our massive appetite for consumption could gradually be replaced by other emerging economies with more robust currencies and trading potential. It will be at that point that the standard of living for Americans will plummet, and our economy will resemble those of third world nations. Then we will understand what the term "Great Depression" really means.