In the early 1790s, after passage of the Constitution, the newly organized government of the United States of America turned its attention to monetary issues. Alexander Hamilton, secretary of the Treasury, recommended the term “dollar” and it was adopted by Congress. They knew the importance of having precious metals backing a currency, so each U.S. dollar was backed by gold (1.6 grams) and silver (24.06 grams). In 1834, the first dollar devaluation occurred (6%) by increasing the ratio of silver to gold in the dollar coin. In 1853, the weight of the coins was reduced in another devaluation.
In the second half of the 19th century, the discovery of large silver deposits in the western United States caused the price of silver to decline and by 1900, the 100% gold standard was formally adopted.
In 1933, during the Great Deflationary Depression, the ownership of gold was outlawed. The Roosevelt administration abandoned the gold standard for international transactions. That allowed the government to use unlimited amounts of paper money.
In 1971, the United States under President Richard M. Nixon removed the official link between the U.S. dollar and gold. In other words, the U.S. dollar was no longer backed by gold or any other precious metal. This event was a major contributor to the explosion of oil prices in the early 1970s and subsequent high inflation.
Today we measure inflation through the Consumer Price Index. The government has a stake in keeping inflation low, which is probably why the Federal Reserve Bank has taken to using that index sans food and energy. While it may make sense to exclude food and energy on a monthly basis given their volatility, when looking over a year’s time the prices of these elements are the most relevant because people must use them. Investopedia defines inflation as, “The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. As inflation rises, every dollar will buy a smaller percentage of a good.”
If this is the case, then as the dollar itself falls — particularly in our global economy — inflation must rise. Comparing today’s economy to that of the 1970s shows that the decreasing dollar may be a more accurate measure of inflation. Sharply rising gold and oil prices and the manic infusion of money into the banking system are highly inflationary and usually go hand in hand with a falling dollar. The Fed stopped reporting the M3 money supply and the government has found a way to “cook the books” on inflation in a combined effort to report stable inflation in the United States. This is done to minimize payments for social security, salary increases for government workers and a myriad of other elements tied to the inflation index.
Inflating the Great Credit Bubble
Congress authorized the formation of the Fed in 1913 to limit the wild cyclical inflationary and deflationary swings in the economy that occurred in the 1800s. The main “knobs” that the Fed turns are “money supply” and “credit supply.”
The Fed creates money for the banking system, which uses the new money as “reserves” against which the banks can make new loans. New money is synonymous with new credit. Banks are allowed to lend 90% of their deposits (10% of deposits are kept as reserves to cover withdrawals). The borrowed money could be deposited in other banks, which could continue the lending sequence, ad infinitum. This system can expand the supply of credit to the sky. It has the potential of becoming a runaway train.
In the early 1990s, the Federal Reserve Board, under Chairman Alan Greenspan, removed the reserve requirements almost entirely. It is difficult to imagine what the reasons were for such an irresponsible action. By the year 2000, in an effort to increase profits, banks lent out virtually all of their deposits. Banks had devised ingenious ways to create their own new money for lending purposes. By 2002, banks had extended at least 25% more total credit than they had in total deposits. It was and is a runaway train!
In a “sure thing” to become wealthy, people borrowed money to buy houses with nothing down and made interest-only payments on their loan. No payment of principal was required. This allowed normally unqualified buyers to play in the housing casino. Between 2000 and 2006, home prices doubled, averaging an increase in value of 10.5% per year, and everyone was happy.
In 2008, the slowing U.S. economy is expected to go into recession. Many of the weak debtors are defaulting on their home mortgages. Some just walk away from their homes. This subprime group is just the tip of the iceberg. In 2007, subprime-mortgaged homes declined in price by 15% because mortgagees were making a desperate effort to sell and recoup some value. Meanwhile, the Fed is attempting to keep banks liquid by massive infusions of computer-generated money. It is clear that the Fed fears deflation and economic depression. If the housing and complex derivative related defaults occur simultaneously, it is likely that the Fed will become overwhelmed and impotent.
Deflating the Great Credit Bubble
In the early 1970s, OPEC made an agreement with the United States to price oil in U.S. dollars exclusively for all worldwide transactions in return for a U.S. promise to protect the various oil-rich kingdoms in the Persian Gulf against threats of an invasion or a domestic coup. This “protection racket” contributed to a radical Islamic movement to protest the U.S. influence in the region. This arrangement allowed tremendous economic benefits for the United States by allowing it to use paper to buy oil, while at the same time prohibiting the redemption of the paper U.S. dollars for gold.
Because of the prolonged and projected weakness in the dollar, OPEC members did not want to accept it. In 2000, Saddam Hussein demanded euros for his oil instead of dollars. Though not listed as one of the numerous justifications for the invasion of Iraq, this most likely was a factor because of the importance of obtaining Iraqi oil reserves and protecting the dollar charade. In 2001, there was talk of Venezuela switching to the euro for their oil sales. That was followed by a failed coup attempt against Venezuelan President Hugo Chavez. The U.S. dollar dominance was maintained. In 2006, Iran announced plans to initiate an oil bourse with their oil priced in euros. Iran was promptly vilified by the United States.
What does all this mean for inflation/deflation in the next few years and beyond (by 2012)? Gold can be expected to reach $2,000 per ounce and WTI crude oil to reach $180 per barrel. This inflationary period should drop the U.S. Dollar Index to about 50, about a 60% decline from 120 in 2002 (see “Where are we going?”).
Beyond 2012, high quality long-term interest rates are signaling a prolonged period (decades) of deflation that includes all asset classes with the likelihood of a lengthy economic depression associated with the deflation (unwinding) of the great credit bubble (see “Inflationary/deflationary cycles”).
Stanford Field began his career in the oil industry in 1951. In 1993, he retired from Stanford Research Institute, where he was director of energy programs.