It is not yet generally understood, however, the extent to which the 2008–2009 financial crisis and global economic policy responses to it have already fatally undermined the fiat-dollar standard equilibrium. This is due primarily to a misconception within the economics profession that for most, if not all, of the key players involved, the costs of moving away from the fiat-dollar standard still far exceed the benefits.
This view has been the conventional wisdom for some years. In late 2003, three prominent economists, David Folkerts-Landau, Michael Dooley, and Peter Garber, published a paper making the case that the so-called Bretton Woods II arrangement of fixed or generally managed emerging market exchange rates vis-à-vis the dollar—a system that had been more or less in place following the various Asian currency crises of 1997–1998—was a stable equilibrium for a variety of reasons. The most important reason given was that the emerging markets were undergoing a long-term structural investment boom that could be properly financed only through export-led growth, much as had been the case under the original Bretton Woods arrangements in the 1950s and 1960s, when Western Europe and Japan exported their way to renewed postwar prosperity. As such, notwithstanding a declining share of global economic output and rising fiscal and current account deficits, the fiat dollar was likely to remain the world’s preeminent reserve currency for the foreseeable future, indeed, for decades to come.
Here is the abstract to the paper on the NBER website, which originally appeared in the International Journal of Finance and Economics:
The economic emergence of a fixed exchange rate periphery in Asia has reestablished the United States as the center country in the Bretton Woods international monetary system. We argue that the normal evolution of the international monetary system involves the emergence of a periphery for which the development strategy is export-led growth supported by undervalued exchange rates, capital controls and official capital outflows in the form of accumulation of reserve asset claims on the center country. The success of this strategy in fostering economic growth allows the periphery to graduate to the center. Financial liberalization, in turn, requires floating exchange rates among the center countries. But there is a line of countries waiting to follow the Europe of the 1950s/60s and Asia today sufficient to keep the system intact for the foreseeable future.
I was not alone at the time in being somewhat skeptical that this was indeed a stable equilibrium. As a result of maintaining fixed or managed exchange rates with the United States, not only were the emerging markets growing much faster than the United States but also accumulating vast dollar reserves that were then reinvested in US assets, thereby pushing down dollar interest rates and pushing up asset valuations, including, of course, house prices, to levels inconsistent with US household income growth . But with consumer price inflation low as a result of cheap manufactured goods from abroad and low rents at home—the flip side of the increasing rate of home ownership, courtesy of low interest rates—the US Federal Reserve saw no need to raise interest rates in response to the domestic credit, housing, and consumption boom, which ultimately originated from the Bretton-Woods II regime.
It is now generally accepted by the economic mainstream that the Fed’s decision to hold interest rates low for a sustained period in 2003–2005 was the key contributing cause of the growth of the US housing bubble that burst in 2007, thereby triggering the subsequent global financial crisis. As the bubble was inflating, Fed officials repeatedly claimed that not only was the rise in house prices not a bubble but also that low interest rates had little if anything to do with it. In 2005, Ben Bernanke, who had only recently assumed the Fed chairmanship, claimed that low US borrowing costs were the result of a “global savings glut,” in particular in rapidly growing Asian countries, rather than a function of Fed monetary policy. But the global savings glut and Fed policy should never have been separated in this way. The latter directly enabled the former.
By focusing on consumer price inflation only, rather than money and credit growth generally, the Fed completely missed the connection between US interest rates, global savings, investment, and asset prices. It therefore failed to see that its policies were the ultimate cause of the housing bubble and that the global savings glut was just one link in a long money-and-credit chain that had become unanchored. The late great Austrian economist Kurt Richebächer recognized clearly that this was the case. As he wrote in April 2005:
In earlier studies published by the International Monetary Fund about asset bubbles in general, and Japan’s bubble economy in particular, the authors repeatedly asked why policymakers failed to recognize the rising prices in the asset markets as asset inflation. Their general answer was that the absence of conventional inflation in consumer and producer prices confused most people, traditionally accustomed to taking rises in the CPI as the decisive token for inflation.
It seems to us that today this very same confusion is blinding policymakers and citizens in the United States and other bubble economies, like England and Australia, to the unmistakable circumstance of existing rampant housing bubbles in their countries.
Thinking about inflation, it is necessary to separate its cause and its effects or symptoms. There is always one and the same cause, and that is credit creation in excess of current saving leading to demand growth in excess of output. But this common cause may produce an extremely different pattern of effects in the economy and its financial system. This pattern of effects is entirely contingent upon the use of the credit excess— whether it primarily finances consumption, investment, imports or asset purchases.
A credit expansion in the United States of close to $10 trillion—in relation to nominal GDP growth of barely $2 trillion over the last four years since 2000— definitely represents more than the usual dose of inflationary credit excess. This is really hyperinflation in terms of credit creation. In other words, there is tremendous inflationary pressure at work, but it has impacted the economy and the price system very unevenly. The credit deluge has three obvious main outlets: imports, housing and the carry trade in bonds. On the other hand, the absence of strong consumer price inflation is taken as evidence that inflationary pressures are generally absent. Everybody feels comfortable with this (mis)judgment.3
The mistake made by Folkerts-Landau, Dooley, and Garber was that they failed to see back in 2003 that the Fed’s easy money policy was fueling rampant money and credit growth that, in time, would lead to a colossal global credit crisis. To be fair, the entire economic mainstream missed it too. But this just begs the question of why. The best explanation is that the modern economics profession focuses primarily on consumer price inflation as a potential source of economic instability, rather than money and credit growth generally. Austrian School economists, such as Richebächer, know better. He was hardly the only Austrian economist to predict the crisis.
- Source, John Butler via James Turk's Gold Money
