Making the dollar accountable

Recovering from the crisis requires a new paradigm for exchanging currencies which restores checks and balances that operated under the gold standard.

An economics professor once commented to an undergraduate class in which I was enrolled that thanks to the modern world of credit, he had spent twice as much as he had ever earned. His only wish was to spend twice again as much in the future and die deeply in debt.

My brain spontaneously retrieved that mental snippet as I contemplated President Barack Obama's actions to get the American economy back on track. After eight years of the Bush administration, people the world over desperately want to believe in Obama. They want to believe that what he is doing will lead the United States and the world away from the brink of financial collapse.

Some of his actions are laudable. One example is increasing taxes over the next ten years that will total $900 billion (Dh3.3 billion) in additional revenues. Another is rationalising American health care and social security programmes which are spiralling upwards cost-wise.

However, other views are disheartening. For example, Obama blames the recession on a lack of demand and points the finger at the creation of high-risk securities which he characterises as a shell game to pass "risk to others for profit."

What seems to elude Obama when he says that the US economy is like a house built on sand is that the sand is the US dollar - more specifically the use of the dollar as the world's reserve currency.

Correcting this by creating a new foreign exchange system is the central task that must be accomplished to restore the health of the global financial system. Anything less is only a brief respite from a certain reckoning that would again throw the world's economies into turmoil.

However, why is the US dollar the problem? The simple answer is that the United States unilaterally abandoned the gold standard in 1973 at which point the dollar become the de facto standard. That enabled the United States as the world's dominant economy, now its reserve currency provider, to finance deficits with debt - not gold.

As long as investors were willing to loan money to the United States in the form of Treasury bonds and other securities and the United States could service its debt, it could continue consuming more than it produced. And, of course, it has for decades. No other nation can do that. Nor can the United States continue doing that forever.

The resulting imbalance in world trade created a chronic deficit nation - the United States - but necessarily chronic surplus nations like China, Mexico, Brazil and the Asian tigers. All deficits and surpluses must net to zero in the world economy.

The growing US debt also meant that credit markets have been inundated with liquidity resulting in overvalued assets. Surplus nations like Japan in the 1980s and Thailand in 1997 engorged with US dollar reserves experienced price bubbles that inevitably burst wrecking both their currencies and economies.

The same phenomenon has been at work in the United States but for different reasons. Surplus nations with large dollar reserves have sought dollar-denominated assets rather than convert dollars into their local currencies. All those dollars have driven down the US cost of capital and have produced an orgy of over-investment that accounts for such aberrations as the 'New Paradigm' and the recent US housing price bubble.

Matters may, however, get worse and this is where Obama's economic strategy is wanting. During Bush's White House years, the United States created $50 million in new debt every hour. Under Obama's budget, that will rise to $75 million per hour over the next ten years with deficits far in excess of those of the past - deficits that approach or exceed $1 trillion per year.

Where is the United States going to get the money to finance these deficits? The assumption, of course, is that other nations and Americans alike will pony up even greater sums - roughly twice as much each year as in the past - to the American government.

Will they do that? If not, then the United States will be faced with some extremely tough options. If the United States cannot find financing for its proposed deficits, then that could - some experts say will almost certainly - result in a loss of confidence in the dollar that could trigger a significant decline in its value. Spend twice again as much and die deeply in debt?

These are complex issues. The complexity of both the current crisis and proposed solutions has too often eluded government leaders, financial experts, economists and others. It has also been very difficult for the media to explain to the public just why in the midst so much global economic success that things went so terribly wrong.

Scapegoats are plentiful - the subprime mortgage crisis, the collapse of the derivatives market, the greed of Wall Street. They may be good sound bites but they are not the causes.

The starting point to rebuild the global financial system must begin with a new paradigm for exchanging currencies. It must restore the checks and balances that operated under the gold standard. Those checks and balances ensured that no nation could run deficits or surpluses forever. Over the long-run, all economies had to be in balance. All nations had to produce as much as they consumed.

Rod Monger is an independent journalist who writes on economic, business and political issues.