In Whom We Trust

25^th October 2009

The Malta Independent - Friday Wisdom
Alfred Mifsud

IN GOD WE TRUST is the bold declaration on each US dollar currency note. I always found this motto, which is also the national motto of the United States, somewhat out of place on Caesar’s money and goes against the advice given by the Lord Himself to give Caesar what is Caesar’s and to God what is God’s.

But even beyond this undesirable mix of religion with Mammona’s basic stuff, declaring trust in God on dollar bills implies that we do not trust anyone else. This goes against the very basic concept of such money bills which are nothing else than IOU’s issued under a fiat monetary system which obviously can only work if holders of such bills trust their issuer, the central bank of US.

Fiat money means that the central bank can issue and print as much money as it considers necessary for the execution of its policies without any need to keep any specific reserve or tangible backing for the money its creates. Hence why the system is termed ‘fiat’, as money is created as if by magic without the need to provide any specific backing.

The basic question is whether we should trust the US dollar in spite of the implied warning they carry that we should only trust God.

In my article in this series published at the bottom of the financial crisis on 13 March 2009, I had remarked as follows on this subject:

This will not be without consequences on the US side. Without the Chinese readily financing their deficits, the US will have to finance their own by promoting less consumption and more saving. So US economic recovery can no longer depend on consumer demand and has to switch to export demand which is the other side of the coin of the shift in China from export-led growth to domestic-led growth. For this purpose we have to see a sharp reversal of the strength of the US dollar seen since the financial turmoil began.

If you want a marker of whether there is progress being registered in resolving this crisis, the value of the US dollar is a good marker. If the US dollar keeps strengthening it means that things are getting more serious. If things stop getting more serious we will see the US dollar weakening, eroding the strength it has artificially accumulated these last six months, giving a chance for the US economic engine to shift from consumption mode to productive mode.

At the time this was written, US$ 1.25 were needed to buy e1. Six months later and with the world confident that the financial system has been stabilised and that the economic recession has hit bottom it takes US$1.47 to buy e1. That means a fall of some 17.5% in six months despite various assertions during this time from the Treasury Secretary that the US administration still believes in a strong dollar policy. What the Treasury Secretary probably means but cannot expressly state is that the administration believes in a stable dollar policy but only after the dollar undergoes an orderly re-adjustment of its external value by falling substantially against major currencies to make the US economy export competitive. This will help to address the macro economic imbalances that led to the financial crisis by excessive consumption in the US and excessive savings in China and Japan.

Incidentally crude oil prices at the time was around US$40 and have since increased by 75% to US$70. However because of the fall in the value of the dollar, the increase in Euro terms was ‘only’ 49%!

Coming back to the trust issue, I cannot help noting that a very unorthodox situation is developing in the world of finance which is forcing the unobtrusive development of the fourth branch of government in most large economies. The executive branch, with the explicit or implicit approval of the legislative branch, has used fiscal policy to the hilt in order to stabilise economies from the negative impact of the financial crisis. Space for further fiscal injections is now very limited given that as a result of the huge emergency stimulus injections that had to be made, the public deficits and accumulating debts have reached very worrying levels.

If anything, governments have to worry about how to restore sanity to their finances on a medium term basis.

This leaves the main burden to engineer a recovery on monetary authorities, particularly the central banks of the major trading blocks i.e. the US, the EU, Japan and China.

Central banks are managed by unelected officials who have much more room for manoeuvrability than governments. The president of the United States can respond instantly to a missile attack with America’s military might but he cannot respond to a financial crisis with real money unless Congress acts. The Federal Reserve Bank, America’s central banking system, with no direct accountability to the nation’s voters, did not need anybody’s approval to flood the financial system with fiat money to address the illiquidity created by the banking crisis.

The same applies to the European Central Bank, the Bank of England, the Bank of Japan and the central bank of China. These institutions treasure their independence from the executive branch and proclaim that their freedom of direct accountability to the electorate gives them the facility to do what’s right not what’s popular.

In some ways these central banks have contributed to the financial crisis by focussing their inflation control mandate strictly on retail inflation and disregarded the asset price inflation in equities and real estate that brought two financial bubbles in this first decade of the new millennium. This has to change. In future central banks have to account for asset price inflation in their objectives.

But for the immediate future should we accept to have this unelected fourth branch of government, who did not protect us from the bubbles which have caused so much pain, to be responsible for leading us back to stable non-inflationary growth backed by a well regulated financial system which does not lead us from one bubble to another?

This question is somewhat rhetoric. In truth we have no choice. The central bankers have to make the judgements when to roll back the monetary easing to avoid an inflation explosion but without suffocating the fragile economic recovery. This is not unlike expecting them to perform complicated surgery with a carving knife and a spade. They need not just our trust but also our prayers.