In the larger scheme of things, the nation’s descent into permanent fiscal profligacy during the late twentieth century should not have been surprising. The historical record prior to the T-bill standard quite clearly demonstrates that fiscal discipline had never really depended upon the fortitude of principled statesmen.
GREENSPAN’S BORROWED PROSPERITY
After the Greenspan Fed abruptly abandoned its 1994 effort to impose a mild semblance of monetary discipline, the world’s T-bill-based monetary system was off to the races. Frenetic money pumping by the Fed was reciprocated by even more aggressive currency pegging in East Asia, most especially in China, where the exchange rate was devalued by nearly 60 percent at the beginning of Mr. Deng’s export campaign in 1994.
Fueled by this reciprocating monetary engine of central bank printing presses, the world economy was soon booming and the US current account deficits swelled to massive proportions. Thus, the current account deficit of $114 billion in 1995 was already an alarming 1.6 percent of GDP, but that was just a warm-up for the coming binge of borrowed prosperity.
Thereafter, the US current account deficit with the rest of the world went parabolic, rising to $416 billion, or 4.2 percent, of GDP by the year 2000. Indeed, for the entire 1990s decade the nation’s cumulative deficit with the world was $2.0 trillion—a giant loan from abroad that bought a lot of designer jeans, personal computers, granite-top kitchen counters, gaschugging SUVs, and luxury cruises that American households had not actually earned.
Yet the borrowing binge fostered by the Greenspan Fed was just getting warmed-up. American overspending financed by exporter nation loans attained nearly riotous proportions after the turn of the century, reaching, a peak current account deficit of $800 billion, or 6.1 percent, of GDP in 2006.
For the decade ending in 2011, cumulative borrowings from the rest of the world tripled from $2 billion in the 1990s to $6 trillion. And so America’s garages, pantries, media rooms, and second homes filled up with even more stuff bought on the prodigious flow of credit generated by the world’s T-bill-based monetary system.
In the fullness of time, floating-rate money led to fiscal profligacy on a scale never before imagined. Spending without the inconvenience of taxing opened the door to state subventions, bailouts, and endless tax breaks throughout the length and breadth of the American economy.
But the plenary mobilization of the state and all its agencies and organs of intervention, including the prosperity management régime of the central banking branch, is what fueled the rise of crony capitalism. It is a longstanding truism of political science that focused, organized special interests will always trump the diffuse public interest. So once raiding the Treasury and leveraging Wall Street and the banking system were deemed to be the pathway to the greater good, K Street lobbies and political action committees (PACs) captured the instruments of policy and extracted the resources of the public purse like never before.
So the irony was abundant. Friedman the historian was dead wrong on the gold standard and the Fed’s responsibility for the Great Depression. Accordingly, the libertarian economist from the University of Chicago, more than any other single intellectual, fostered the Nixonian breakdown of monetary integrity and helped crush the last age of fiscal rectitude so painstakingly restored by Dwight D. Eisenhower.
Proffering what is by the hindsight of history a spurious rule of money supply growth, Friedman gave birth to the T-bill standard and a massively disordered and unbalanced international system in which mercantilist governments swap the labor of their people and natural resources of their lands for “money” which is merely dollar-denominated American debt.
Worse still, the later process became the foundation for the age of bubble finance, a great financial deformation that resulted in a Wall Street crescendo of speculation and rent seeking that had no historical parallel. Neither did Friedman’s folly.
PART IV
THE AGE OF BUBBLE FINANCE
CHAPTER 14
PORK BELLIES, FLOATING MONEY,
AND THE RISE OF
SPECULATIVE FINANCE
NIXON’S ESTIMABLE FREE MARKET ADVISORS WHO GATHERED AT the Camp David weekend were to an astonishing degree clueless as to the consequences of their recommendation to close the gold window and float the dollar. In their wildest imaginations they did not foresee that this would unhinge the monetary and financial nervous system of capitalism. They had no premonition at all that it would pave the way for a forty-year storm of financialization and a debt-besotted symbiosis between central bankers possessed by delusions of grandeur and private gamblers intoxicated with visions of delirious wealth.
In fact, when Nixon announced on August 15, 1971, that the dollar was no longer convertible to gold at $35 per ounce, his advisors had barely a scratch pad’s worth of ideas as to what should come next. The nationalists led by Treasury Secretary Connally wanted our trading partners to absorb a sharp devaluation of the dollar. Hence, the illegal 10 percent surtax on imports was to remain in place until they sued for peace.
Others led by Fed chairman Arthur Burns believed that the shocking announcements from Camp David would be merely a catalyst for international negotiations to “reset” the existing Bretton Woods system. The gold parity would be set at a more realistic (higher) level and this would be coupled with more favorable (lower) dollar exchange rates against the other major currencies. Once Bretton Woods was “reset,” the Burns traditionalists believed that the advantages of fixed exchange rates and global financial stability and discipline could be preserved.
And the free markets faction led by George Shultz didn’t think any follow-up plan was even necessary. Instead, following Nixon’s Sunday evening announcement that he was unplugging Bretton Woods, they apparently thought that the “market” would take over the very next morning. No sweat.
THE POST–CAMP DAVID BOLLIX
In fact, the aftermath was thoroughly bollixed. Lacking any semblance of a plausible game plan, the Nixon administration stumbled around for another twenty months seeking to modulate the chaos it had unleashed.
Its first attempted solution was a Burns-Connally hybrid known as the Smithsonian Agreement of December 1971. This originated shortly after Camp David when Secretary Connally pronounced that whatever ailed the American economy, fixing it would be no problem: to wit, the United States needed precisely a $13 billion favorable swing in its balance of trade. This was not to be achieved the honest way—by domestic belt tightening and thereby a reduction of swollen US imports that were being funded by borrowing from foreigners. Instead, America’s trading partners were to revalue their currencies upward by about 15 percent against the dollar.
The immediate effect of revaluation would have been a drastic loss on the billions of exchange reserves that major foreign central banks had previously not converted to gold in deference to Washington. This was September 1931 all over again.
Furthermore, along with taking this balance sheet hit, trading partners would also have to tighten their own belts by absorbing more American exports, which would now be cheaper and more competitive in their home markets. At the same time, they would be shipping fewer of their own goods to the American market, because their exports to the United States would now be more expensive and less competitive.
Connally’s blatant mercantilist offensive was cut short in late November 1971, however, when the initially jubilant stock market started heading rapidly south on fears that a global trade war was in the offing. Seeing his opening, Paul Volcker, who was undersecretary for monetary affairs, deftly jerked the rug out from under Connally and Nixon. At a finance ministers’ meeting in Rome he offered to increase the dollar price of gold by 10–15 percent.
In truth, this was an element of Burns’ scheme to reset Bretton Woods at a higher, more defensible gold price. At the moment, however, it was received by the European negotiators as a huge US concession, because until then Nixon and Connally stoutly insisted there would be no change in the gold pri
ce. Realignment would consist exclusively of trading partners making their currencies more expensive against the dollar.
As it turned out, a few weeks later Connally’s protectionist gauntlet ended in an amicable paint-by-the-numbers exercise in diplomatic pettifoggery. The United States agreed to drop the 10 percent import surtax and raise the price of gold by 9 percent to $38 per ounce. At the same time, the major foreign trading partners who had gathered at the Smithsonian agreed to revalue their currencies against the dollar by an average increase of 8 percent, including a 14 percent upward adjustment by Germany and 17 percent by Japan.
On the surface, these agreements appeared to comprise a comprehensive realignment of the fixed-rate international monetary order, thereby providing the framework for a putative “Bretton Woods II.” Indeed, at the closing dinner at the Smithsonian on December 18, Nixon appeared unannounced to herald the agreement as “the most significant monetary agreement in the history of the world.”
THE SMITHSONIAN AGREEMENT:
GOLD STANDARD WITHOUT GOLD
In fact, the Smithsonian Agreement was a Texas Special: all hat and no cattle. Quite simply, the United States had made no commitment whatsoever to redeem paper dollars for gold at the new $38 price or to defend the gold parity in any other manner. Yet without an anchor on the dollar, there was absolutely nothing to stop a worldwide process of competitive devaluation in response to excessive dollar creation, an outcome which would doom the newly aligned matrix of fixed exchange rates to chronic turmoil and instability.
In reality, the Smithsonian deal granted the United States a monetary hall pass, allowing the Fed to print dollars at will and the American economy to continue binging on inflationary credit expansion, soaring imports, and an expanding current account debt to the rest of the world. Ironically, the traditionalist Burns had wished the Fed to be actually re-tethered to gold at $38 per ounce; that is, that there be an honest “reset” of Bretton Woods, including a US obligation to redeem dollars for gold when presented by foreign central banks.
But since the new $38 per ounce gold value was only a meaningless reference price, the Smithsonian outcome put him at the end of an altogether different kind of tether; namely, that of heavy-handed demands from the Nixon White House for an election-year spree of easy money. Without the threat of a run on gold, Burns’ only defense was a stiff backbone, something he manifestly did not possess.
Paul Volcker had surveyed the scene at the time of Nixon’s preposterous pronouncement at the Smithsonian dinner and had delivered a more sober and accurate verdict. “I hope it lasts three months,” said the man who years later would be brought into the Fed to stop the monetary mayhem which ensued.
Volcker’s cynicism at the moment was absolutely warranted. At bottom, the Smithsonian Agreement attempted the futile task of perpetuating the Bretton Woods gold exchange standard without any role for gold. It bestowed the responsibility for leadership of this jerry-built arrangement on a White House which quickly went AWOL. Yet without a US commitment to defend the gold parity, the newly minted Smithsonian exchange rates were sitting ducks for speculative attack.
Accordingly, the British pound soon came under heavy fire. By the late spring of 1972 when the pound crisis came to a head, there was no chance that the United States would help defend the system it had foisted on the world just a few months earlier.
By now Shultz had moved to the treasury secretary post, and his automatic refrain on exchange rate issues was to lip-synch Milton Friedman on the virtues of floating. For reasons that were purely political rather than ideological, Nixon was moving his lips on the subject, too. When the British finally gave up on June 22 and allowed the pound to float, Chief of Staff H. R. Haldeman mentioned this development the next morning and offered a briefing. “I don’t care about it,” retorted Nixon.
When Haldeman persisted with the topic, the White House tape-recording system captured the essence of why chaos was about to descend on the international monetary system. Chairman Burns had informed the White House staff that the British float would encourage further attacks by speculators and that the Italian lira was likely the next currency in the line of fire. “Well,” the president of the United States observed, “I don’t give a shit about the lira.”
During the next eight months, further international negotiations attempted to rescue the Smithsonian Agreement with more baling wire and bubble gum. But the die was already cast and the monetary oxymoron which had prevailed in the interim, a gold standard system without monetary gold, was officially dropped in favor of pure floating currencies in March 1973.
Now, for the first time in modern history, all of the world’s major nations would operate their economies on the basis of what old-fashioned economists called “fiduciary money.” In practical terms, it amounted to a promise that currencies would retain as much, or as little, purchasing power as central bankers determined to be expedient.
WHEN A SPECULATOR’S PARADISE ARRIVED IN MONETARIST BLINDERS
In stumbling to this outcome, Nixon’s advisors were strikingly oblivious to the monetary disorder they were unleashing. Indeed, they were creating a speculators’ paradise, but their monetarist blinders did not permit them to see it coming.
In fact, there is no evidence of any awareness among Nixon administration policy makers of the financial pounding that industrial corporations and banking institutions alike would take when exchange rates and interest rates began to gyrate wildly—and over huge amplitudes that had never before been experienced in peacetime. Nor was there any attempt to explore with Wall Street, or other major financial institutions, the development of hedging and risk mitigation arrangements which might now be needed.
Alas, the reason for this glaring neglect was not a rigid White House commitment to laissez-faire. After all, at the time the gold dollar was being flushed, the Nixon White House was busy imposing wage and price controls across the length and breadth of the American economy. In fact, the passivity of the “religious floaters” club in the White House was owing to their reflexive adherence to the profoundly erroneous monetarist doctrines of Milton Friedman.
As detailed in chapter 13, Friedman was a committed anti-statist who had low regard for politicians and much disdain for their attempts at the economic betterment of society. And justifiably so. Yet in pushing the gold standard and fixed exchange rate system onto the scrap heap of history, the modern-day godfather of free markets helped foster the greatest project of statist intervention and subvention ever conceived—that is, monetary central planning of the national and, indeed, world economy by the Federal Reserve.
Milton Friedman never saw this lethal threat to free markets and sound money, however, owing to his blinding disdain for politics and the unaccountable presumption that—somehow—the inner sanctum of the Eccles Building would be populated by monetary eunuchs. Oblivious to short-term economic fluctuations, election cycles, unemployment rates, and sectoral and sectional economic dislocations, as well as the macroeconomic effects of pestilence, drought, and flood, they would operate far removed from the clamor for policy action on both ends of Pennsylvania Avenue.
A Friedmanite Fed would keep the money growth dial set strictly at 3 percent, year in and year out, ever steady as she goes. Like the fabled Maytag repairman of that era, central bankers in the Friedman mold would mostly sit around quietly in the library of the Eccles Building playing Scrabble and reading book reviews.
Not surprisingly, therefore, Friedman’s pre-1971 writings nowhere give an account of the massive hedging industry that would flourish under a régime of floating paper money. This omission occurred for good reason: Friedman didn’t think there would be much volatility to hedge if his Chicago-trained central bankers stuck to the monetarist rulebook.
Accordingly, Friedman never even entertained the possibility that once the central bank was freed from the stern discipline of protecting its gold reserves, it would fall into the hands of monetary activists and central planners. Most assuredly, he
did not realize that once politically driven theories of macroeconomic betterment gained policy dominance, the Fed as an institution would become a fount of rationalizations for incessant tinkering and intervention in financial markets.
And, most certainly, Friedman did not see that an unshackled central bank would eventually transform his beloved free markets into gambling halls and venues of uneconomic speculative finance. Yet that would be the unavoidable outcome of a central bank that contaminated private financial markets with cheap credit, while providing “put” protections for carry trades and accommodation to dirty floats and pegged currencies. All of these deformations tended to fuel violent swings in exchange rates, interest rates, and capital markets.
In fact, Friedman was so blind to the hedging monster that would inexorably arise from his model of fiat central banking that within weeks of the Camp David events the renowned Professor Friedman put a pitifully low price tag on his own ideas for commercial exploitation of floating currencies. The precise number was $7,500, and even in that day it didn’t amount to much.
As it happened, Friedman priced his own advice at rock bottom shortly after Nixon closed the gold window. He had been approached to consult on a potential currency-hedging market, but the inquiry did not come from the great currency-dealing international banks of New York, London, or even the big Loop banks in Friedman’s hometown of Chicago.
At the time, institutions such as Morgan Guaranty, Citibank, and Continental Illinois were deeply immersed in the financing of world trade and capital and money flows, facilitating billions in currency transactions every week. Yet none of these great financial institutions even anticipated that a new business opportunity of immense magnitude was unfolding with each new monetary stumble in Washington. Even after Camp David very few experienced financiers believed that a purely floating-rate currency régime was likely or workable.
The Great Deformation Page 39