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The Dollar Crisis by Richard Duncan

Richard Duncan is my favorite economist. He has his own blog where he regularly gives his update on the economy, a video series called Macro Watch where he publishes about 2 videos a month about the economy, and he also has 2 great classes that he published on Udemy.

This book was written in 2000 but Richard was spot on about the dollar losing its value due to large deficits and lots of money printing. His book following this one called The New Depression was about the financial crisis in '08 and was very good as well.

This book, The Dollar Crisis, taught me a lot about the government's balance sheet and how it is structured with the current account (imports and exports) and the capital account (financial assets such as government bonds).

It also taught me a lot about how the gold standard used to work and how globalization has led to deflation in goods because the goods are produced in countries with low wages.

Some things he got wrong were he mentioned that the printing of money following a bubble being popped makes the situation worse. He currently supports money printing after a bubble burst though because that is the path we took in '08 and it's too late to go back now, in his opinion, because money printing is what is needed to prevent another Great Depression.


Intro The primary characteristic of the dollar standard is that it has allowed the U.S. to finance extraordinarily large current account deficits by selling debt instruments to its trading partners instead of paying for its imports with gold, as would have been required under the Bretton Woods system or the gold standard.

The trading partners of the U.S. have accumulated large reserves of U.S. dollar denominated assets with their trading surpluses, rather than converting those dollars into their own currencies, which would have caused their currencies to appreciate and their trade surplus and economic growth rates to slow. Consequently their acquisitions of U.S. dollar denominated stocks, corporate bonds, and U.S. agency debt have helped fuel the stock-market bubble, facilitated the extraordinary misallocation of corporate capital, and helped drive U.S. property prices higher.

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the current system involved.

The Bretton Woods system and the gold standard had automatic adjustment mechanisms that prevented persistent trade imbalances between countries. The primary flow of the dollar system is that it lacks any adjustment mechanism.

International reserve assets consist of external assets that a country may use to finance imbalances in its international trade and capital flows. In earlier centuries, gold or silver fulfilled that function, but today foreign exchange comprises the vast majority of the world’s reserves.

Pg 8-9 tutorial on how the gold standard operated

The balance of payments is comprised of 2 main groups of accounts, the current account and the capital and financial account. The current account pertains to transactions in goods and services, income, and current transfers between countries. The capital and financial account pertains to capital transfers and financial assets and liabilities. It measures net foreign investment or net lending/net borrowing vis-a-vis the rest of the world.

The reserve assets of a country rise when the overall balance of that country’s balance of payments is in surplus or expressed differently, when more money enters the country than leaves it. Such a situation can arise through a current account surplus, or because of a surplus on the capital and financial account. When more money enters a country than leaves it, that money (unless it is hidden in a mattress or destroyed) is almost always deposited into that country’s banking system. When exogenous money enters a banking system, it sparks off a process of credit creation unless the central bank takes action to sterilize the capital inflows. When the sums entering a country are very large, and when the monetary authorities fail to absorb that inflow by issuing a sufficient amount of bonds to soak up the additional liquidity, the outcome is a rapid expansion of the money supply and the emergence of an economic bubble.

The origin of almost every large scale economic boom is credit creation.

Under the gold standard, reserve assets were comprised of gold. Today, reserve assets are comprised of currency and deposits, and equity, bonds, and money market instruments.

The current international monetary system has 3 inherent flaws: overheating of excess reserves leading to boom and bust cycles (more severe; bubbles); dependent on a very, very indebted U.S., and the system generates deflation.

One of the themes of this book is that when national economics are flooded with foreign capital inflow, regardless of whether the capital enters the country as a result of trade surpluses or capital account surpluses, it causes economic overheating and asset price inflation.

When the U.S. has an unfavorable balance with another country (example=France) it settles up in dollars. The Frenchmen who receive these dollars sell them to the central bank, the Banque de France, taking their own national money, francs in exchange. The Banque de France, in effect, creates these francs against the dollars. But then it turns around and invests the dollars back in the U.S. Thus the very same dollars expand the credit system of France, while still underpinning the credit system in the U.S.

In 1980, total credit market assets in the U.S. amounted to 4.7 US dollars. By the third quarter of 2001, that figure had risen by more than 500% to U.S. $28.9 trillion. [It now exceeds $55 trillion as I’m reading this in May 2015.]

The collapse of the classical Gold standard in 1914 set off the same chain of events. Huge trade imbalances fueled the surge in credit creation responsible for the “Roaring Twenties…” and the Great Depression that inevitably followed.

The public has been led to believe that the government achieved a budget surplus from 1998-2001. That is not really the complete truth. The government has been counting a large part of the contributions paid into social security and some of the contributions paid into the pension plans of government employees as government revenues without counting the government’s obligations to pay benefits in the future as government liabilities.

Americans buy more from the rest of the world than the rest of the world buys from the United States because the rest of the world uses very low labor to make goods at a much lower cost than American manufacturers can. This could not be more obvious. That is why the current account surpluses of Mexico, China, Thailand, and the rest of the Asia crisis countries rose sharply following the devaluation of their currencies: their labor costs fell, making their products even more attractively priced to the U.S. consumer.

Every asset price bubble requires credit as fuel.

The United States lent Germany a great deal of money [following World War I], which Germany used to pay war damages to England and France. That money then returned to the United States as England and France repaid their war debts to the Americans. Those inflows back into the U.S. allowed the Americans to lend still more to Germany, enabling the Germans to pay subsequent installments of reparations to the victors, pay interest on their earlier loans from the U.S., and according to historians of the period, spend freely all across Germany on infrastructure and entertainment facilities such as concert halls and public swimming pools. Eventually, it all ended in hyperinflation and many of the largest German and Austrian banks went kaput. In The Economic Consequences of the Peace, John Meynard Keynes warned that forcing Germany to pay crippling war reparations would end in disaster. It did. The economic collapse in Germany contributed to Hitler’s rise to power. However, in the United States, once the war ended, the Roaring Twenties began. The country was rich. It had more than twice as much gold as before the war, at a time when gold mattered.

The destruction of so much wealth in the banking system - or expressed differently, the sharp drop in the money supply - was the main reason the Great Depression was so severe and protracted.

There are 2 reasons why the current trade arrangements are deflationary. 1. An increasing proportion of the manufactured goods in the world are made with very low cost labor; consequently, the price of those goods are falling because they cost less to make. 2. Trade imbalances generate reserve assets that fuel credit creation and over investment. Over investment causes excess capacity, and excess capacity causes deflation.

Although the minimum wage for most countries is not available, the minimum wage in Thailand is known. It is 165 baht (US$3.80) per day in Bangkok, and less in the provinces. Since Thailand’s per capita GDP is more than twice as high as that of the first five countries shown in Table 8.1, it is reasonable to assume that the minimum wage in those countries is lower than that paid in Thailand. The combined populations of those five countries amount to approximately 45% of the world’s total population. So, quite clearly, there is no shortage of workers in the world willing to work for US$4 per day. Moreover, considering that a very large percentage of the population of those countries is currently less than 20 years old, demographic trends are more likely to put downward pressure on wages as more young people enter the workforce. So long as wage rates are determined by the law of supply and demand, wages are more likely to fall than to increase, since the number of manufacturing jobs will not increase as rapidly as the global workforce.

China’s economic bubble has not yet popped… Between 1986 and 2000, China’s reserve assets rose from US$11.5 billion to US$168 billion, and domestic credit skyrocketed from 794 billion yuan to 11.9 trillion. Between 1980 and 2000, domestic credit in China expanded at an average rate of 22% per annum to an amount equivalent to 133% of the country’s GDP.

Increasing the money supply is no cure for the deflation that results when a credit bubble pops, because it is excessive money supply growth that causes economic bubbles in the first place. To think otherwise is like believing that consuming more alcohol is the cure for dunkness. The consumption of more and more alcohol will eventually lead to death, just as the unlimited expansion of the money supply will end in the death of the currency system involved.

The flaw in Kugman’s argument - and by extension, monetary theory - is that it incorrectly assumes that somehow the “extra money” would find its way into “people’s pockets”. That is because banks “awash in reserves” still have not become more willing to lend. In a post bubble economy, there are no profitable investment opportunities.

During the 20 years between 1949 and 1969, international reserves rose by 55%. Since 1969, when the Bretton Woods system began to break down, international reserve assets have increased by 1900%.

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