The final chapter from The Dollar Crisis

Richard Duncan published his revised edition of The Dollar Crisis in 2005. It is a remarkably prescient analysis of the the problems now facing the global economy. I reproduce the short and somewhat chilling final chapter from the book below.

Chapter 20: Bernankeism

Anticipating the Policy Response to Global Deflation

“Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”

Fed Governor Ben Bernanke, 2002

The Fed would already be faced with its worst nightmare, deflation in the United States, had the price of oil not risen above US$50 a barrel following the U.S. invasion of Iraq. Globalization is exerting tremendous downward pressure on the U.S. cost structure that can only intensify in the years ahead as service sector jobs follow manufacturing jobs offshore. A correction in the U.S. current account deficit will cause the floor to drop out from under global prices and threaten the world with a 1930s-style deflationary depression. The following paragraphs will consider how policymakers in the United States are likely to respond to that event.

America’s free trade policy, which it has pursued for decades, is obviously flawed. Free trade between countries with enormous wage rate differentials, and within an international monetary system entirely lacking in any mechanism to prevent large-scale, persistent trade imbalances, is untenable. However, U.S. policymakers are afflicted by the collective hypnosis of conventional wisdom which has taught them that free trade is good and must always be good under any and all circumstances. It is anyone’s guess as to how much longer those in charge of economic policy in the U.S. will cling on to this strange idea.

Meanwhile, it is almost certain that they will respond to the approaching crisis by applying the two great economic policy tools of the last century: Keynesianism and monetarism. The abuse of those tools will prolong and exacerbate the death throes of the dollar standard.

The first recourse will be to employ more fiscal stimuli. With prices falling and in light of the extraordinary amount of paper that has been created in recent years, interest rates will be very low and there will be little difficulty in paying interest on a much larger amount of government debt. It would not be surprising to see the U.S. budget deficit surpass US$1 trillion by 2007 or 2008 if the U.S. current account has come down significantly by that time.

[Note: the U.S current account deficit has started to fall significantly in the last few months and the budget deficit is likely to exceed US$1 trillion in 2009]

If, at that point, the U.S. current account deficit has been reduced, foreign central banks would not have a sufficient inflow of dollars to finance such a large deterioration in the U.S. budget deficit, even assuming that Fannie Mae and Freddie Mac have ceased issuing any new, competing, debt of their own.

The Fed, however, as Governor Bernanke explained, has already put considerable thought into how to deal with such a contingency and stands ready, in Bernanke’s opinion, to support “a broad-based tax cut” through “a program of open-market purchases to alleviate any tendency for interest rates to rise.”

How long could such “cooperation between the monetary and fiscal authorities” underpin the global economy? For quite a number of years, most probably. Economic cycles play themselves out over very long periods of time. Moreover, U.S. policymakers will use every last tool at their disposal to prevent, or at least delay, a global depression. An economic system underpinned by large-scale fiscal stimulus financed by central bank monetization of government debt could hardly be described as capitalism (perhaps the term “Bernankeism” would be appropriate) but, with any luck, it could stave off disaster for a considerable length of time.

Nevertheless, despite the best efforts of policymakers to keep the dollar standard alive and to stave off the depression that would most probably follow its collapse, ultimately, one of the following scenarios is likely to overwhelm even Bernankeism:

1. A protectionist backlash against free trade, resulting in a trade war similar to that which occurred during the Great Depression.

2. A U.S. asset price bubble (as interest rates fall toward zero) that drives property prices so high they can’t be financed even at very low interest rates. This is similar to what occurred in Japan at the end of the 1980s.

3. A meltdown of the under-regulated US$200 trillion derivatives market. (Two hundred trillion U.S. dollars is roughly six times global GDP.)

4. A loss of nerve on the part of policymakers that deters them from undertaking ever more unorthodox economic policies, resulting in a “deer in the headlights” kind of policy freeze.

5. A decline in interest rates to 0%, or very near 0%, as in Japan at present.

Any one of the first four scenarios could undermine the dollar standard, but the final scenario, where interest rates fall very near 0%, would certainly deal it a fatal blow. From that point, the only option left to stimulate aggregate demand would be to drop paper money from helicopters. That too would fail, however, for who would accept paper dropped from helicopters in exchange for real goods and services? Hyperinflation would quickly set in. Economic transactions would then be conducted through barter rather than via the medium of a debased script. Eventually, a gold standard would re-emerge.

Exactly how these events will unfold is impossible to forecast; nevertheless, the eventual outcome is within sight. The dollar standard is inherently flawed and increasingly unstable. Its demise is imminent. The only question is, will it be death by fire — hyperinflation — or death by ice — deflation? Fortunes will be made and lost, depending on the answer to that question.