The Triffin Dilemma and the Gold/Dollar Standard: Never made to last.

by Francis Lee for the Saker Blog

There was always going to be a fundamental incompatibility of the dollar between the attainment of 1. An anchor currency for international trade fixed against gold at $35 per ounce, and 2. A single and flexible national currency for the internal economy of the US – the $. From the outset this dual mandate for the US$ was problematic. As a global reserve currency, the US$ has to be the anchor of the world’s trading system; however, it must also serve as the domestic internal currency of the US. This meant that the dollar needed to have sufficient flexibility for internal economic policy, but at the same time must serve as an international and invariant gold-backed currency. Thus, at the heart of the dollar’s value was a structural incongruity for the dual and contradictory roles of this currency.

During the Bretton Woods ‘golden age’ which lasted from 1944 until 1971, the US$ was fixed against gold at $35 per oz. However, the cost of US wars of choice in Korea and Indochina, as well as ambitious social programmes like US President Lyndon Baines Johnson’s ‘Great Society’, bore witness to a global build-up of surplus dollars accumulating in dollar states around the world. These superfluous dollar countries in Europe and East Asia then began trading in their excess dollars for gold at the gold window at the Federal Reserve Board (the US Central Bank). This was a situation which the US could not tolerate as demand for gold meant the precious metal was flying out of the US to various overseas bank venues as foreign states were exchanging their inessential dollars for US gold.

These alarming developments had for a long time passed unnoticed until they became too obvious to ignore. From the American perspective this situation had to be stopped, and, as it was, that on August 15, 1971, that President Nixon in a TV statement suspended dollar/gold convertibility for a temporary period, which in fact morphed into a permanent arrangement – an arrangement which persists to this day. The gold standard was replaced with the US$ fiat standard. The dollar was to be regarded as being as good as gold, which was rather more like an act of faith than rational economic policy.

See Below the effect of the US$ devaluation in 1971. From being a surplus nation, the US is now a debtor nation. Whether the rest of the trading world will put up with this ‘exorbitant privilege’ forever is a moot point, however.

It was the maverick Belgian economist Robert Triffin who first drew attention to this anomaly during the 1960s in his seminal work Gold and the Dollar Crisis: The Future of Convertibility. He observed that having the US dollar performing the role of the world’s reserve currency created fundamental conflicts of interest between domestic and international economic objectives. Namely and on the one hand the international economy needed dollars for liquidity purposes and to satisfy demand for reserve assets. But this forced, or at least made it easy, for the US to run consistently large current account deficits. These deficits were brought about by a strong dollar policy which gave rise to an outflow of US dollars to surplus states in Europe and East Asia. The situation arose whereby dollars overseas were now poised to exceed gold holding undermining the whole post-WW2 structures.

Suffice it to say that this policy had unfortunate side effects for local investors which became manifest during the East Asian crisis episode in 1997. These investors, both local and global were committed to an investment policy based upon highly leveraged positions. But a local investor borrowing in his own currency was in a vulnerable position: woe betide him if US dollar interest rates increased which they did. He would have to find the additional cash to pay back his borrowed dollars or go broke.

Triffin had argued that a policy of running persistent deficits would eventually put pressure on the dollars convertibility and ultimately lead to the demise of the Bretton Woods system of international exchange which is exactly what happened in 1971.

This arrangement led to what in effect were tangible advantages for the US, at least in the current situation.

‘’A controversial benefit’’ (among others) ‘’of the dollars international currency status is the real resources that other countries provide the United States in order to obtain our dollars. It costs only a few cents at the Bureau of Engraving to produce a $100 bill, but other countries have to pony up $100 of real goods and services to obtain one. (The difference between what it costs the government to print the note and a foreigner to procure it is known as seignories after the right of the medieval lord, or seigneur, to coin money and keep for himself some of the precious metal from which it was made. At that time about $500 billion of US currency circulated around the world outside the United States, for which foreigners have had to provide $500 billion to the US for actual goods and services.’’ (Barry Eichengreen – Exorbitant Privilege – pp.3/4)

Nice work if you can get it. International trade as denominated in US$’s meant that the US$ acting as the world reserve currency could use its dollars to buy foreign assets and pay for them in dollars. These dollars were then held by foreigners who could no longer convert surplus dollars into gold but could only purchase more US Treasuries (Bonds) and other US dollar-denominated assets which were never going to be repaid. Surplus dollar countries would sell their hard-earned dollars to purchase US Treasuries which pushed up the value of the dollar and kept US interest rates low; and the US in turn would buy goods and services from these same surplus countries.

It worked rather like this: a foreign computer company – say ‘Japcom’ – sells you a computer by lending you the money (US$s) to buy it! This was the ultimate free lunch!

But of course, there’s always a catch! The effect of a strong dollar which raised domestic US industries costs, lead to the hollowing out of the US domestic economy which ultimately could not compete with more efficient overseas competition. The last thing that the US rust belt needed was/is a strong dollar which had the effect of making its export industries less competitive. This left the US in an economic quandary. Namely, that the United States must on the one hand simultaneously run a strong/dollar, policy and on the other a weak/dollar policy; or put another way must allow for an outflow of dollars to satisfy the global demand for the currency but must also engineer an inflow of dollars to make its domestic industries more competitive. As explained thus: when the Federal Reserve  cuts interest rates, investors sell dollar-denominated assets and buy foreign assets, which tends to weaken the dollar’s exchange rate.

Having it both ways! Which of course is hardly possible.

Moreover, it is a moot point as to whether the rest of the world will continue to support this ‘exorbitant privilege’ in perpetuity. So far, the Vichy-Quisling-Petainst regimes in Europe and East Asia have to touch their forelocks and prostrate themselves before their Lords and Masters, but it would be wrong to imagine that this can continue as a permanent arrangement. Ironically, however, the US hegemon treats its friends and allies considerably worse than its putative enemies. Such is the nature of geopolitics. I’ll leave the last word to Barry Eichengreen.

‘’ The dollar-system’s problems should not have come as a surprise. There was an obvious flaw in the system whose operation rested upon the commitment of the United States to provide 2 assets, gold and dollars, both at a fixed price, but where the supply of one was elastic (paper money FL) whilst the other (gold metal FL) was not.’’

Addendum

The causes of the East Asian Crisis during the 1990s were related to and described as being the nemesis of the actually existing and defunct gold-dollar system and its consequences. At that time and throughout East Asia there were massive and unregulated, speculative flows of footloose capital. A major cause is considered to be the collapse of the hot money bubble. During the late 1980s and early 1990s, many Southeast Asian countries, including Thailand, Singapore, Malaysia, Indonesia, and South Korea, achieved massive economic growth of an 8% to 12% increase in their gross domestic product (GDP). The achievement was known as the “Asian economic miracle.” But a significant risk was embedded in the achievement.

The economic developments in the countries mentioned above were mainly boosted by export growth and foreign investment. Therefore, high interest rates and fixed currency exchange rates (pegged to the U.S. dollar) were implemented to attract hot money. Also, the exchange rate was pegged at a rate favourable to exporters. However, both the capital market and corporates were left exposed to foreign exchange risk due to the fixed currency exchange rate policy.

In the mid-1990s, following the recovery of the U.S. from a recession, the Federal Reserve raised the interest rate against inflation. The higher interest rate attracted hot money to flow into the U.S. market, leading to an appreciation of the U.S. dollar. (my emphasis – FL)

Those currencies pegged to the U.S. dollar also appreciated, and thus hurt export growth. With a shock in both export and foreign investment, asset prices, which were leveraged by large amounts of credits, began to collapse. The panicked foreign investors began to withdraw.

These massive capital outflows caused a depreciation pressure on the currencies of the Asian countries. The Thai government first ran out of foreign currency to support its exchange rate, forcing it to float the baht. The value of the baht thus collapsed immediately afterward. The same also happened to the rest of the Asian countries soon after.

The countries that were most severely affected by the Asian Financial Crisis included Indonesia, Thailand, Malaysia, South Korea, and the Philippines. They saw their currency exchange rates, stock markets, and prices of other assets all plunge. The GDPs of the affected countries even fell by double digits.

The long hard road back to growth from 1998 which still persisted as late as 2007 should be an object lesson in how not to borrow at the margin and pump and leverage up in foreign currencies.