Dollar Bulls Meet Prof. Robert Triffin

August 26, 2008

I believe that it is time for us all to become (re)acquainted with Robert Triffin. Triffin was an economics professor at Yale University in 1960, when he exposed a gaping flaw in the Bretton-Woods monetary system:

If the United States stopped running balance of payments deficits, the international community would lose its largest source of additions to reserves. The resulting shortage of liquidity could pull the world economy into a contractionary spiral, leading to instability.

If the U.S. deficits continued, a steady stream of dollars would continue to fuel world economic growth. However, excessive U.S. deficits (dollar glut) would erode confidence in the value of the U.S. dollar, it would no longer be accepted as the world’s reserve currency. The fixed exchange rate system could break down, leading to instability.

Robert Triffin

1960

Triffin was referring to the dilemma (later referred to as the Triffin Dilemma) that the U.S., as the issuer of the world’s reserve currency, was always going to be required to run a current account deficit to ward off a global contractionary spiral, but constantly running such a deficit would lead to an undermining of the dollar itself, also setting off global economic instability. In short, there was no way for the Bretton-Woods system to find any way to sustain itself in the long-run.

As most know, Bretton-Woods was a fixed rate monetary system where countries held dollars as the reserve currency and the U.S. promised to exchange those foreign held dollars at the fixed rate of one ounce of gold per $35. As the U.S. ran current account deficits, dollars began to pile up in the vaults of foreign central banks. By 1960, when Triffin recognized the dilemma, foreign central banks held nearly $19 billion in short-term dollar based assets. The U.S. gold stock at the time, valued at $35 per ounce, was worth just under $18 billion. Speculators quickly recognized the problem and gold began trading at a premium to this $35 per ounce price. By 1971, the charade of $35 gold could no longer be maintained by the U.S., and Bretton-Woods died, replaced by the fiat dollar standard. Currencies would be allowed to float in value, while the fiat U.S. dollar would be adopted as the world’s reserve currency.

This adoption of the fiat U.S. dollar as the reserve currency was a grave error. The one lesson that should have been learned from the failure of Bretton-Woods is that any monetary system that adopts the currency of a single country (or region) as the reserve currency is doomed to fail. Adoption as the reserve means that demand to hold that currency is very high outside the country or region of issue. This strong demand pushes the value of that currency higher relative to the currency of other countries, making businesses in the issuing country uncompetitive on the global stage. Unless the reserve issuing country is willing to live with the attendant economic weakness and unemployment engendered by the high valuation of its currency (and the U.S. never is), the issuing country will be tempted to meet the high demand for its currency by issuing large amounts of debt denominated in its currency for goods until demand is satisfied, the value of the currency falls and economic weakness is arrested. This will lead to trade and current account deficits.

Differences between the Fiat Dollar Standard and Bretton-Woods

What made Bretton-Woods unique was that dollars were worth more to foreigners than they were to Americans. Foreigners could exchange their dollars for goods and services that were denominated in dollars or they could acquire gold from the Federal Reserve at $35 per ounce. The latter option was not open to Americans. The option to acquire gold at $35 per ounce made it simple calculate whether the dollar was over or undervalued in the market since it was easy to see how many dollar based assets foreigners were carrying compared with the value of the gold stock held by the U.S.

Today, no such simple calculation can help us with the dollar’s value in the marketplace. Instead, we first need to understand what all of these dollar based assets really are. Certainly the majority of dollar based asset holders retain their paper because they expect to be able to exchange it for as many, or more, goods and services in the future as they could exchange it for today. The question then becomes, is this expectation a valid one?

Without question, holding dollar based assets is a “sucker’s bet.” If we look at the Fed’s Z.1 report, which is a summation of debt outstanding and its rate of growth, we can see that non-financial debt in the U.S. has been growing at more than $2 trillion per year since 2005, and for 2007 and through the first quarter of 2008 that figure has been closer to $2.3 trillion per year. All of this debt represents a claim on output in the U.S. If we were to balance that figure against normalized output growth (real GDP growth) plus savings we might come up with about $600-700 billion dollars (we include savings here because saved output that is lent out is not inflationary as the debt created by this lending process is backed up by the saved output itself). That is, claims against output and savings are growing more than 3X faster than output and savings itself. Why investors are willing to accept low coupon U.S. dollar based debt in exchange for their own output and savings is beyond me, but this is clearly a situation that cannot go on forever. Dollar based debt issuance of this magnitude constitutes a glut and will erode confidence in the dollar per Triffin.

Unfortunately, slowing down the rate of credit growth isn’t much of an option either. Clearly, new credit growth of more than the recent run rate of credit growth is required in order to keep the system solvent. Debts of the magnitude of those racked up in the U.S. over the years clearly cannot be serviced out of GDP and require fresh credit growth to service the old debt (in short, a Ponzi scheme). Slowing credit growth in the U.S. now will lead to a massive recession and the wiping out of most of the equity in the global financial system. For instance, if credit growth were to slow to the rate of GDP growth plus savings so that those accepting dollars could feel confident in not losing purchasing power, we would see credit growth collapse some $1.6 trillion per year. At an interest rate of 6.5%, this would require wiping out about $25 trillion in net worth somewhere. Given that the banking system itself has only slightly more than $1 trillion of equity I think that we could safely assume that there would be precious few survivors. Again, Triffin’s insight into our present dilemma was rather prescient.

Conclusion

Just as Triffin correctly identified the end of the Bretton-Woods system long before its collapse, I think that it is now fairly obvious that the dollar is going to fail as the reserve currency of the world. Any reserve currency issued by a single country or region is doomed to fail. Protecting the currency requires economic pain of a magnitude that is not tolerable in the issuing country while meeting demand for the reserve currency undermines the currency itself as issuance will dwarf the issuers output of goods and services. Today, we are clearly staring at the dilemma that Triffin warned about nearly fifty years ago while many remain “bullish” on the dollar. This is folly.

The first use of gold as money occurred around 700 B.C., when Lydian merchants (western Turkey) produced the first coins