U.S. Debt Culture and the Dollar's Fate

U.S. Debt Culture and the Dollar's Fate

Mini Teaser: If the United States cannot get its fiscal house in order, the dollar’s privileged position as the world’s reserve currency may be at risk—at a time when there seem to be few if any plausible alternatives.

by Author(s): Christopher Whalen

While a large part of the real economy suffered during the post–World War I period, speculation in real estate and on Wall Street grew through the 1920s. With it came financial fraud. The party ended, though, with the landmark 1925 Supreme Court decision written by Louis Brandeis in Benedict v. Ratner, which set a new standard for collateralized borrowing. The Brandeis decision, which ruled that the failure to specify the collateral was “fraud on its face,” arguably helped cause the great crash of 1929 because it effectively shut down the Wall Street sausage machine, cutting liquidity to the market.

The great Wall Street crash of 1929 completed the process of speculative boom and bust that made the market collapses and currency crises of the previous half century pale by comparison. John Kenneth Galbraith noted in The Great Crash of 1929 that Americans displayed “an inordinate desire to get rich quickly with a minimum of physical effort.” As a chronicler of the Great Depression, Galbraith describes the run-up to the Wall Street crash, including the real-estate mania in Florida in the mid-1920s. Few today recall that the precursor to the Great Depression was a real-estate bubble in the mid-1920s, an eerie parallel to the real-estate boom and bust of the 2000s. But in each case, it was the supply of credit in the form of debt that drove the boom and eventual bust in the economy.

IN THE wake of the financial and social catastrophe that followed the 1929 crash, the Franklin D. Roosevelt administration responded with government and more government. Whatever the laissez-faire excesses of the era of Republican rule in the 1920s, the New Deal Democrats lurched in the opposite direction. Historian Arthur M. Schlesinger Jr. noted that “whether revolution was a real possibility or not, faith in a free system was plainly waning.”

Roosevelt launched a campaign of vilification and intimidation against private business, a terrible but probably deliberate blunder that worsened the Depression and drove the formation of private debt capital in the United States to zero by the mid-1930s. Economist Irving Fisher notes in his celebrated 1933 essay, “The Debt-Deflation Theory of Great Depressions,” that FDR’s reflation efforts did help to avoid catastrophic price deflation, but he also blames Roosevelt for prolonging the Depression. The man Milton Friedman called America’s greatest economist wrote:

In fact, under President Hoover, recovery was apparently well started by the Federal Reserve open-market purchases, which revived prices and business from May to September 1932. The efforts were not kept up and recovery was stopped by various circumstances, including the political “campaign of fear.”

The Second World War and the new debt used to fund it ultimately rescued the United States from FDR’s economic mismanagement. The mobilization to meet the needs of the conflict quickly soaked up the excess workforce, either in terms of conscription or war industries, which were organized in a centralized fashion, as had been the case in World War I under production czar Herbert Hoover. The Fed played a secondary role in financing the New Deal and America’s military effort in World War II. By contrast, the Reconstruction Finance Corporation (RFC) under Jesse Jones took the lead as the government’s merchant bank and provided the financial muscle to fund government programs by issuing its own debt.

At the end of World War II, Britain was broke, and its leaders worried openly that the United States would take advantage of its parlous financial position in the postwar era. In geopolitical terms, the war was the handoff of imperial responsibility from London to Washington. During World War II, Britain liquidated $1 billion in overseas investments and took on another $3 billion in debt, much of which would be rescheduled and eventually forgiven. But when the British, Americans and other Allies met at Bretton Woods at the war’s end, the objective was to stimulate growth and thereby avoid another global war. The key decision taken at that meeting, which set the pattern for the post–World War II financial order, was equating the fiat paper dollar with gold.

When FDR confiscated public gold holdings in 1933 and devalued the dollar, the RFC and not the Fed was the instrument of government action. Jones took delight in having the Fed of New York execute open-market purchases of gold on behalf of the RFC. Together with giants like Leo Crowley—who organized the Federal Deposit Insurance Corporation (FDIC), ran the “lend-lease” operation in World War II and managed two reelection campaigns for FDR—Jones restructured the American economy and then financed the war’s industrial effort with massive amounts of debt.

Besides the RFC, many other parastatal entities were created before, during and after the Depression and war years that were modeled after the experiments of fascist European nations. These included the Federal Housing Administration, the Federal Home Loan Banks, Fannie Mae, the Export-Import Bank, the FDIC, the World Bank and the International Monetary Fund. All of these GSEs were designed to support economic growth via the issuance of debt atop a small foundation of capital—capital that was not in the form of gold but in the form of fiat greenback dollars and U.S. government debt.

Most industrial nations had backed away from gold convertibility by the 1950s, but the metal was still the symbolic unit of account in terms of national payments and private commercial transactions. By stating explicitly that the dollar was essentially interchangeable with gold, Bretton Woods vastly increased the global monetary base and created political possibilities for promoting economic growth that would not have been otherwise possible. Just as Lincoln used a vast expansion of the money supply and the issuance of debt to fund the Civil War, the cost of which approximated the U.S. gross national product of that era, the United States and Allied victors after World War II built the foundation of prosperity on old-fashioned money (gold) and debt (paper dollars). Civil War–era greenbacks originally bore interest to help make these “notes,” which were not backed by gold, more attractive to the public. But by 1945, the paper dollar had become de facto money for the entire world—one of many legacies of war.

Multilateral GSEs such as the World Bank and IMF fueled growth in the emerging world, while U.S. domestic growth in defense spending and later housing was driven by a growing number of domestic GSEs. “Created to rebuild Western Europe, the World Bank soon was eclipsed by the Marshall Plan and its appendages as West European capital markets recovered,” notes author and journalist Sol Sanders. “Looking for new fields to conquer, it turned to what then were unambiguously called undeveloped countries, entering its golden age under Eugene Black (1949–1963), a former Wall Street bond salesman.”

Carried by the demographic tsunami known as the baby boom, created when the “greatest generation” returned from the war, the U.S. economy fueled the rebuilding of European and Asian nations. The Marshall Plan supported growth in Europe while loans from the World Bank and IMF supported nations around the globe with everything from infrastructure loans to social-welfare schemes to explicit balance-of-payments financing—the latter something John Maynard Keynes would have condemned in a loud voice. Hardly a free trader, Keynes wrote in 1933:

I sympathize, therefore, with those who would minimize, rather than with those who would maximize, economic entanglement among nations. Ideas, knowledge, science, hospitality, travel—these are the things which should of their nature be international. But let goods be homespun whenever it is reasonably and conveniently possible, and, above all, let finance be primarily national.

Based on the dollar as the common currency of the free world, in the era known as the Cold War, the United States led a marathon of economic stamina against the Warsaw Pact nations. Loans to nations of all sizes and descriptions fueled global growth and also supported the geopolitical objective of blocking the military expansion of the Soviet Union. Developing nations such as Mexico, Brazil and India became clients of the World Bank and IMF through large loans, causing periodic political and economic crises and currency devaluations as the world reached the 1970s.

When the Berlin Wall fell in 1989, it was not from force of arms by the NATO alliance but the weight of spending and debt by the U.S. defense-industrial and multilateral-aid complex. As in World War II, the ability of America to outmatch the foe in terms of logistics and sheer weight of money—that is, credit—won the day over often-superior weapons and military forces. But while the United States won the Cold War in a geostrategic sense, the economic cost mounted enormously in terms of decades of debt issuance, accommodative monetary policy and extremely generous free-trade policies. Consumers felt the wasting effect of steady inflation, and the impact on American free-market values was corrosive in the extreme. Recalling the allegory in George Orwell’s Animal Farm, all the politicians in Washington, regardless of affiliation, became pigs. In the 1970s, when Washington tried to manage the economy via price controls, “this initiative was not the handiwork of left-wing liberals but of the administration of Richard Nixon,” wrote Daniel Yergin and Joseph Stanislaw, “a moderately conservative Republican who was a critic of government intervention in the economy.”

Image: Pullquote: The reason that the dollar is the currency of choice in the free world is because of the American political system, not just economic or foreign-policy considerations.Essay Types: Essay