Ever wonder why your dollar doesn’t seem to stretch as far as it used to? There is a simple explanation: It’s worth less. The reason? The nation’s money supply is constantly being expanded.
Between 1783 and 1913, the U.S. dollar was a real store of wealth. Except during wartime periods, inflation within the United States was essentially zero. If you saved one dollar in 1800, a hundred years later you could still purchase approximately the same amount of goods with your savings.
But in 1913 something changed, and the U.S. dollar started down a long, steady road of devaluations. Using the U.S. government’s own figures, to obtain the same amount of purchasing power of $100 in 1913, you would need over $2,000 today.
In 1970, at the age of 77, Herbert W. Armstrong wrote about how as a boy his mother had asked him to “[g]o to the meat shop and get a dime’s worth of round steak. And tell the butcher to put in plenty of suet.” A “dime’s worth” meant each person in his family received a modest-sized piece of meat, plus plenty of gravy for the potatoes.
In times past, the dollar certainly stretched further. Mr. Armstrong quoted the Labor Department’s figures for how much $5 would have purchased in 1913: 15 pounds of potatoes, 10 pounds of flour, 5 pounds of sugar, 5 pounds of chuck roast, 3 pounds of round steak, 3 pounds of rice, 2 pounds each of cheese and bacon, and a pound each of butter and coffee; that money would also get you two loaves of bread, 4 quarts of milk and a dozen eggs. “This would leave you with 2 cents for candy,” he wrote.
Wow. At most grocery stores today, with $5 you would be hard-pressed to buy a pound of round steak and a chocolate bar.
What changed in 1913? That was the year America adopted the Federal Reserve Banking (frb) system and the nation took its first steps toward abolishing the gold standard and replacing it with a banking system that allowed for unlimited paper money to be created.
Creation of the Fiat System
As described by Alan Greenspan in 1966, the new system consisted of “regional Federal Reserve banks nominally owned by private bankers, but in fact government sponsored, controlled and supported. Credit extended by these banks is in practice (though not legally) backed by the taxing power of the federal government. … But now, in addition to gold, credit extended by the Federal Reserve banks (‘paper reserves’) could serve as legal tender to pay depositors.”
In other words, the dollar would only be partially backed by gold, and banks could create money by lending out money secured by credit from the Federal Reserve banks (even though the reserve banks did not necessarily have gold on deposit themselves). Thus the seeds of America’s first fiat (currency not backed by gold) dollar system were sown.
At that time, however, there were still restraints upon money-supply growth because the dollar was still convertible to gold upon demand. Anyone cashing in paper dollars was still legally entitled to its value in gold, so the money supply did not balloon completely out of control.
Yet by 1934, the paper money supply had expanded faster than the nation’s gold supply, so in order to prevent the nation’s gold supply from being drained, the U.S. decided to devalue the dollar—by 41 percent. Prior to 1934, an ounce of gold could be redeemed for just us$20.67, however after the revision, the U.S. government would only part with an ounce of gold in exchange for $35. In gold terms, anyone who had a U.S. savings account lost 41 percent of its value—overnight.
Even though the 1934 U.S. currency devaluation rocked people’s confidence in the dollar, World War ii thrust the U.S. dollar into a new status: the world’s reserve currency. Toward the end of the war, representatives of most of the world’s leading nations met to create a new international monetary system, later known as the Bretton Woods agreement. At this meeting, the war-torn and virtually bankrupt nations of the world decided that since the U.S. economy had come to dominate the globe, and because it held 80 percent of the world’s gold due to the war, they would tie their currencies to the dollar, which, in turn, could be converted into gold at $35 per ounce.
Yet under the Bretton Woods system there were still limits on how much paper money a country could create. Each country had to police its own currency or be forced into embarrassing devaluations. The U.S. itself was constrained from overprinting money because the dollar remained fully convertible into gold.
However, by 1971, America had again printed vastly more paper money than was backed by precious metal. According to some estimates, so many paper dollars had been created that the nation’s gold supply only backed 22 percent of them. At the same time, French President Charles de Gaulle, recognizing that the dollar was losing value, had been exchanging his nation’s collection of U.S. dollars for American gold reserves. Seeing other nations following suit, U.S. President Richard Nixon closed the gold window in August 1971, no longer allowing foreigners to exchange their U.S. dollars for gold and thus ending the Bretton Woods agreement.
From that point on, America’s dollar became fiat, not backed by tangible assets. As the Federal Reserve bank of Minneapolis says, the U.S. dollar is fiat and is valuable only as long as “[p]eople are willing to accept fiat money in exchange for the goods and services they sell”—and only as long as “they are confident it will be honored when they buy goods and services.”
Since people were already in the habit of accepting paper backed by gold, Americans hardly noticed when the U.S. greenback became backed by nothing more than faith—until it started affecting their pocketbooks. Loss of the dollar’s gold backing resulted in a U.S. dollar sell-off in which foreign nations dumped dollars on the open market. This in turn caused roaring inflation and gold to spike up into the $800-per-ounce range. After the frb jacked interest rates into the high teens, both Americans and foreigners decided they would trust the government and continued using the U.S. dollar.
The U.S. now operates on what many refer to as the Bretton Woods 2 system. Although there is no formal central bank agreement (as was the case with Bretton Woods 1), many countries, especially those in Asia, have more or less informally pegged their currencies to the dollar.
This system is inherently more unstable than the previous precious-metal-based non-fiat system. Since the U.S. dollar is no longer convertible to gold, there is no theoretical limit to how much the U.S. money base can expand—and the U.S. has been taking full advantage of this situation to increase its money supply.
Nevertheless, as one well-known economics saying goes, there’s no such thing as a free lunch. America’s monetary expansion has been a primary driver behind the massive and continual erosion in the U.S. dollar’s purchasing power.
The Dollar’s Decline
During Alan Greenspan’s term at the frb alone, America’s monetary base tripled and more new money came into being than under all previous Fed chairmen combined. As the government has massively increased the money supply—doubling it in the last seven years alone—those dollars have become less valuable.
So many dollars have been created that only the dollar’s status as a reserve currency, along with the kindness of America’s trade partners, has prevented a complete dollar meltdown. Unfortunately, these dollar supports seem to be crumbling.
At one point, 86 percent of the globe’s transactions were denominated in dollars. Whether it was Russians and Saudis selling oil to the world, or Chinese purchasing wheat from Canada, the dollar was the primary means of payment. Thus, foreign nations needed to keep huge dollar reserves on hand. This was a gigantic plus for the dollar. Had foreign nations not needed to increase their holdings of dollars as world trade grew, there would have been a massive wave of homeless dollars roaming the world looking to be spent, and as the supply of dollars increased, the dollar’s value would have plummeted. Instead, over the years, America has been able to get away with creating the money needed to pay its bills and finance an otherwise unaffordable standard of living.
However, the dollar’s status as a reserve currency is now being challenged. In 2005, the percentage of dollar-denominated reserves held by foreign nations was 76 percent. Now, not two years later, it is down to 65 percent. “[T]here is a gentle and osmotic process underway,” says economic analyst Julian D.W. Phillips: “a lessening of the role of the U.S. dollar in the global reserves” (Financial Sense Online, Nov. 6, 2006).
Former Fed Chairman Alan Greenspan is also warning of possible protracted dollar dumping. “We’re beginning to see some move from the dollar to the euro, both from the private sector … but also from monetary authorities and central banks,” he said in October last year.
Although an all-out revolt against the dollar hasn’t yet occurred, clear signals are emerging that the dollar’s role as the world’s reserve currency of choice could be ending. Last year, Russia’s central bank, Sweden’s Riksbank, the Central Bank of the United Arab Emirates, Qatar Central Bank and the Central Bank of Syria all announced intentions to diversify their reserves away from the greenback.
Perhaps more worrisome is the fact that China and other Asian nations also have been hinting at diversifying out of their dollar reserve holdings. Australian Treasurer Peter Costello admonished central bankers in East Asia “to ‘telegraph’ their intentions to diversify out of American investments and ensure an orderly adjustment” (Sydney Morning Herald, Oct. 18, 2006). Over the past several years, central banks in China, Japan, Taiwan, South Korea and Hong Kong have spent hundreds of billions purchasing American government bonds. They have done so to support the dollar and help keep American consumers purchasing Asian-made products. If Mr. Costello is correct, however, “the strategy [has now] changed.” Recent trends suggest Asians are weaning themselves off American consumption. Consumer demand within China and Asia is growing, as is Asian trade with Europe. As the importance of Asian-American trade wanes, the incentive for Asians to support the dollar and to hold on to their massive dollar reserves is waning as well.
America’s Asian creditors are up to their necks in U.S. dollars and may now be reaching the point where they no longer feel it is safe to hold so great a proportion of their foreign currency reserves in the dollar.
“The exchange rate of the U.S. dollar, which is the major reserve currency, is going lower, increasing the depreciation risk for East Asian reserve assets,” warned the People’s Bank of China Deputy Governor Wu Xiaoling in November. The same month, the central bank’s governor, Zhou Xiaochuan, was quoted as saying that China has plans to diversify its assets into “many instruments,” presumably indicating a move away from the dollar (Forbes, Nov. 24, 2006).
This is big news, since China is the second-largest foreign holder of dollars in the world after Japan. China is estimated to hold approximately 70 percent of its $1 trillion of currency reserves in U.S. dollars. It certainly seems that Chinese central-bank officials are following Costello’s advice about being up front when they plan to sell their dollars. The question doesn’t seem to be whether the Asian banks will dump dollars—it is how orderly and significant the dollar devaluation will be.
America’s massive monetary expansion could be about to boomerang on itself, as it did in 1934 and 1971—only this time, the number of dollars involved absolutely dwarfs all previous currency crises. As the U.S. persistently destroys the value of the dollar by overprinting (or, more correctly, over-creating, since most money created is now digital), foreign nations are losing confidence in the dollar and its role as a reserve currency. Foreign central bank sales are the first waves of a coming dollar storm. The more that central banks dump dollars, the greater the loss of investor confidence in the dollar.
As Congressman Ron Paul wrote in Texas Straight Talk, May 15, 2006, “The consequences of a rapidly declining dollar are not yet fully understood by the American public. The long-term significance has not sunk in, but when it does there will be political hell to pay in Washington. Our relative wealth as a nation is measured in dollars, and the steady erosion of the value of those dollars means we will all be poorer in the future.”
As much as the dollar’s value has fallen in the past, Americans must face the reality of far more dramatic drops to come. ▪