The True Gold Standard (Second Edition)
Previous article: Rupturing the Link
The other major case of a “rupture of the link between the money supply and the cash requirements of the people” is the international counterpart to the monetized budget deficit: the monetized balance-of-payments deficit of a “reserve currency” country.
In discussing Walras’ Law, we saw that wealth can be divided into three broad categories – money, claims and goods. The same classification applies to international payments – only then they are called, respectively, “the official settlements account,” “the private capital account,” and “the current account.” The sum of all three must equal zero, just as the excess supply of money must equal the excess demand for claims and goods – because the supply of one kind of wealth is always the demand for another.
An overall balance of payments deficit does not refer to a “trade deficit” (which is part of the “current account”); it refers to the “money” or “official settlements” account. A balance-of-payments deficit means that, after all other payments and receipts have been offset, a nation still owes some money because it has purchased more goods and claims abroad than it sold. Under a gold standard, this deficit was settled by a loss of gold reserves. This directly removed the excess money from the deficit country and added it to the surplus country, which had an excess demand for money. Since domestic money was redeemable in gold, a significant gold loss set in motion a tightening of credit that removed the original source of the balance-of-payments deficit. This is how not only domestic but global price stability was preserved by the mechanism of the international gold standard.
But this is not the case with a "reserve currency" system. A reserve currency is used as money not only by that country's residents, but also by foreign central banks. The foreign central banks hold the IOUs of the reserve currency country instead of an international money like gold. An increase in such reserves involves a balance-of-payments deficit for the reserve currency country. But in this case, the non-reserve countries acquire international purchasing power without the reserve country losing it. A foreign central bank typically acquires dollar reserves in the foreign exchange market – and then immediately redeposit the money in the New York-centered money market. Since the foreign central bank treats these deposits as a substitute for an asset like gold, the international deficits of the reserve currency country can become “monetized.”
The practical effect is to prevent a removal of excess money from the reserve currency country that would normally occur. Some would argue that the excess money is caused by the Federal Reserve being too easy, and others that the problem is caused by foreign central bank intervention. But in either case the result is the same: excess money stays in the dollar market. The system tends to be inflationary for the reserve currency country and for all currencies tied to it.
It’s important to understand that the inflationary effect for the United States does not depend on whether foreign central banks “sterilize” the effect of the increases in dollar reserves on their domestic money supply. That is, there will be about the same effect on dollar price inflation whether or not the Bundesbank manages to keep the German money supply unchanged by selling Deutschmark assets when it purchases dollar assets. (The choice can make a difference as to whether Germany joins in the U.S. inflation, however: under fixed exchange rates, Germany has limited ability to control its money supply or avoid the inflation; but by appreciating its currency against the dollar, Germany can have a lower inflation rate.) The inflationary excess of money in the dollar market does not depend on an increase in the German money supply – but rather on an increase in official dollar reserves, which occurs in the dollar market.
Hence any attempt to predict U.S. inflation requires us to take into account changes in foreign official dollar reserves.
As we saw, most of the U.S. monetary base is created by purchasing U.S. Treasury securities. But the majority of foreign official dollar reserves also consists of U.S. Treasury securities. That is, most foreign official dollar reserves have been used to finance operating deficits of the U.S. Treasury. In both cases, the Treasury securities cannot be sold by the central banks at their purchase price as long as the U.S. Treasury is in deficit. Hence the inflation they have caused is, for all practical purposes, irreversible.
I said that a budget deficit, by itself, does not necessarily upset the balance between the supply and demand for money, or for non-monetary wealth. However, there is a kind of Parkinson’s Law at work: deficits expand to fill the means available to finance them. Well over half a trillion dollars worth of U.S. budget deficits have been directly monetized by central banks – not to mention the indirect finance by private banks that this enabled – through the monetary system we have just described. Rueff argued that “An efficient monetary policy is the only means to avoid the [monetized] deficit – by making its financing impossible” (The Age of Inflation,p. 28).
All the theories we have considered so far concern a closed economic system. So if the supply of money (M) and the demand for money (L) refer to domestic money and the demand for such money to finance domestic transactions, then something is missing from each theory’s explanation of inflation.
As a historical curiosity, Irving Fisher’s original Equation of Exchange included a term for the excess demand for foreign exchange. But Fisher dropped it because, “For a large country like the United States, the outside trade is so small, compared with the internal trade, as to be negligible” (The Purchasing Power of Money, Appendix VI). But this is not true of a small, open economy – or for a reserve currency country like the United States today.
Next Installment: The Way the World Dollar Base Works
The Rueffian Synthesis