After the Crash: Helping the U.S. Economy Right Itself

James Grant. Foreign Affairs. Volume 87, Issue 6. November/December 2008.

Economic growth in the United States is almost, if not quite, irrepressible. Democratic administration or Republican, it hardly seems to matter to the long postwar trend. Indeed, based on the evidence of 232 years of federal tinkering, American enterprise is policyproof.

Not that the incoming administration can draw much solace from that historical observation. This year’s president-elect will be the heir to a burst financial bubble, just as George W. Bush was in 2000. Bush high-mindedly refused to blame the previous administration for the dot-corn mania, but the new incumbent would be better served by candor. The truth is that the current mess is a symptom of persistent financial derangement, in particular a sickness of the dollar. At all-too-frequent intervals over the past 20 or so years, supposedly sound institutions and ostensibly rational markets have gone off the deep end. To meet the crisis, the Federal Reserve has intervened with lower interest rates and a faster pace of printing money. But the emergency monetary stimulus has predictably ignited a new speculative upswing- and so it is over the cliff again.

What might an ambitious president do, besides no harm? He could plan for a return to a sound dollar, rein in Wall Street without incapacitating it, and resist the call to manipulate prices in a politically expedient direction. Do these things, and the very nearly irrepressible U.S. economy will right itself.

Skinning the Cat

However, before rushing off to improve what he cannot directly control, the newly installed CEO of the federal establishment should attend to the managerial mess in Washington. On the stump, Senator Barack Obama (D-IIl.) has talked about raising taxes on the rich. But there is no fatter cat to skin than that of the federal apparatus itself. In fiscal year 2007, the government took in $2.6 trillion, 7.6 percent more than it did in fiscal year 2006. Since 2003, federal cash collections have increased by an average of $200 billion a year. Are imposts of this staggering size truly necessary? Do they advance the national interest in a time of evident recession? In a new report, the Government Accountability Office charges that federal agencies last year mislaid, or misdirected, $55 billion. In 2006, $41 billion went missing. Last year, for the iith consecutive year, the GAO refused to opine on the government’s financial statements, but it did cite, among other deficiencies, accounting chaos at the Department of Defense. As a matter of simple equity, plugging the leaks in the sieve of state should precede any new tax increases.

Possibilities for sensible reform abound, from the minuscule (for example, reducing the $4.8 million budgeted for research into the utilization of plywood) to the midsize (eliminating the $1.2 billion earmarked for buying 20 copies of the possibly unnecessary F-22A fighter jet). The gargantua-that is, entitlements-is probably off-limits, but the government happens to own a gargantuan asset, namely, 28 percent of the U.S. landmass. Some of this land could be sold, although even the admittedly unimaginable sale of every last “stewardship” acre at $1,000 an acre would yield a mere $644 billion, barely enough to finance a single year’s Social security outlays.

Ultimately, however, the federal-revenue vein does not exist that is rich enough to solve the nations long-term entitlement problems. In the first seven years of the Bush administration, nominal GDP grew from $9.8 trillion to $13.8 trillion, but growth in federal financial commitments outpaced even that strong performance. Accordingly, whereas in 2000 the government was on the hook for $29 trillion of guarantees (implicit and explicit), insurance obligations, and projected future payments to Medicare and Social security recipients, now the grand total of such guarantees, obligations, and projected payments is more than $67 trillion. If current projections are anywhere close to the mark, vibrant economic growth will be more than ever a political necessity. Growth alone will not close the gap between the government’s promises and the resources necessary to meet them, but the absence of growth would pit the entitled elderly against the resentful young. And as a net debtor, the United States must somehow earn the money with which to pay its creditors.

A Declining Brand

The economy over which the next president is probably already losing sleep is a rarity in world history. In the long run, nations consume and produce in roughly equal measure; they have no choice. The United States is the rare exception. It is privileged to consume much more than it produces (a difference measured by the current account deficit) and to have done so virtually year in and year out for the past quarter century. This wonderful feat is possible because the dollar is the preeminent monetary brand-the world’s “reserve currency.” The United States’ creditors willingly accept it. And, accepting it, they turn around and invest it back into the obligations of the United States. There can be few items higher on the to-do list of the incoming administration than to freshen and strengthen the dollar brand.

The next president would do well to brush up on the history of the monetary arrangements created in the aftermath of World War II. Under the system known as Bretton Woods, the dollar could be exchanged for gold at the rate of $35 to the ounce. If another government’s monetary authority decided that the U.S. Federal Reserve was overcranking the press, that government could convert its greenbacks into bullion at the statutory rate. By the late 19605, however, there was not enough gold in U.S. hands to satisfy all the worried overseas dollar holders. The U.S. Treasury knew this as well as the creditors did. On August 15, 1971, the Nixon administration slammed shut the door to the national gold vault and decreed that the dollar was henceforth backed by the government’s good intentions alone. So it is today: the U.S. currency, like every other, is faith-based.

The golden anchor of Bretton Woods served two important purposes. It checked the tendency of the hegemonic power to live on the cuff (as the United States is grandly living today). And it fixed the dollar’s value against other leading currencies. At first, the post1971 dollar proved just as inflation-prone as the gold-standard conservatives had predicted it would. But the sky-high interest rates imposed by the Federal Reserve under Paul Volcker, in the 19805, mitigated the debasement disease. At length, the paper dollar came to seem as good as the gold-backed one.

Under the long tenure of Federal Reserve Chair Alan Greenspan, the world came to believe that the Fed could work miracles. By the artful manipulation of a single interest rate, the so-called federal funds rate (the rate that financial institutions pay to borrow federal funds on a short-term basis), it could-so it appeared-lead the world’s greatest economy around by the nose. The man whom the press took to calling “the Maestro” seemed to nip recessions, panics, and bear markets in the bud. And all the while, dollars piled up in the vaults of the central banks of the United States’ trusting creditors.

“The Great Moderation” is how admiring economists came to characterize the era from 1985 up to the current mortgage mess. Now comes a great tumult. In truth, Greenspan and the Fed dispensed no such magic as their fans imagined. By pushing the federal funds rate to the floor-just one percent-and holding it there for 12 months, until mid-2004, the Federal Reserve in fact facilitated the debt bubble. Millions of Americans have suffered in the aftermath, and so have the United States’ overseas lenders. Dozens of countries, mainly in Asia and the Middle East, link their currencies to the dollar in one form or another. And as the Fed has returned to cutting the funds rate to try to prop up the shaky U.S. financial system, the dollar-shadowing countries have had to reduce their central-bank interest rates, too, despite local rates of inflation that would seem to cry out for a tighter monetary policy.

Gold Is Back

It is the bad luck of the next president to be moving into the White House just as the monetary orthodoxy of the post-1971 era is coming in for a long-overdue reappraisal. But at the same time, it is his good fortune to have the opportunity to put the dollar on a sounder basis. Indeed, it is his duty.

The world’s reserve-currency franchise is a U.S. national treasure. To begin to understand its value, imagine how any other country would receive the news that it had been granted the right to discharge its international obligations, as the United States does, in its very own currency, which only it can lawfully print. There would be dancing in the streets.

Since the late nineteenth century, no international monetary system has lasted much longer than a generation. The post-i97i regime is, therefore, right on schedule, in its dotage. It shows its age in many ways: in the volatility of exchange rates, in the surge in worldwide inflation, and in the piling up of dollars on the balance sheets of the United States’ creditor central banks. The longer these excesses persist, the greater the danger of a worldwide monetary upheaval-a crisis not of the dollar alone but of paper currencies generally. “If it ain’t broke, don’t fix it” are wise words, and the monetary scheme in place is merely on the verge of breaking. But, for its own sake, the United States should be in the vanguard of planning for a better, more durable successor.

A committee of monetary visionaries, brainstorming the possibilities, might well fix on a system like Bretton Woods. The new regime, like its postwar predecessor, would be characterized by fixed exchange rates (not floating or governmentally manipulated ones) and by a reserve currency anchored by gold. Visionaries would see the advantages of it, but men and women of the world might-as yet-scoff. “Gold and fixed rates?” some would sputter. “Was it Dwight Eisenhower who won the 2008 presidential election?”

Pending a crisis scary enough to open closed minds, the next administration could strike a blow for the U.S. dollar franchise at little or no financial or political cost. Curiously, in the world of foreign exchange, words are sometimes as potent as deeds. By declaring his determination to protect and defend the external value of the dollar, the next president could do more than his immediate predecessor did in eight years of mumbling and inaction. Ben Bernanke’s current term as Federal Reserve chair will expire on January 31, 2010. It would lend weight to the president’s strong-dollar message if it came to be known that the next Fed chair-whoever it is-would stand up for the dollar abroad as well as at home.

Excelling At Failure

As FOR the current financial crisis, the job for the next administration will be to reform the banks and broker-dealers without overregulating them and thereby impairing their capacity to adapt and grow. As matters stand, Wall Street gorges itself in the up cycle. Taxpayers get few of the sweets of the boom but then bear much of the costs of the bust. The United States would be a fairer and better country if the officers, directors, and stockholders of a failing financial institution bore the cost of their own imprudence. In the old days, Wall Street firms were partnerships, and the general partners pledged their net worths to the solvency of their firms. The United States’ legal minds must devise a set of constraints on corporate officers that would mimic the sobering effects of the partnership form of organization.

No small source of strength in the U.S. economy is Americans’ capacity for failure. They excel at pratfalls. They file for bankruptcy and emerge without permanent social stigma. They recognize error and put it behind them. The next administration should thus turn a deaf ear to suggestions to manipulate energy prices, prop up housing prices, suppress short selling in the stock market, or otherwise try to prolong boom-time errors. Japan, refusing to let its own great bubble deflate, suffered a decade of economic stagnation. The United States, too, must take its bubble-related lumps, of which the current financial crisis is clearly one. But as the 44th president would be wise to remind his compatriots, the United States has no time for lost decades. Let markets clear and a new day dawn.