By Agnico-Eagle (Agnico-Eagle Mines Limited) [CC0], via Wikimedia Commons
By Agnico-Eagle (Agnico-Eagle Mines Limited) [CC0], via Wikimedia Commons

Pierre Siklos has written, here, about the return of fiscal dominance. Traditionally, this term has been applied to a situation in which monetary policy objectives are subordinated to the need to finance large fiscal overhangs. The concern Pierre identifies is that the Federal Reserve Board's quantitative easing will be maintained longer than is desirable because of inappropriately restrictive fiscal policy. One possible effect of this is an erosion of confidence in the role of the U.S. as the key global unit of account, medium of exchange, and store of value — the three canonical roles of money.

Such considerations reflect the swing of history's pendulum back to the negotiations leading to the Bretton Woods agreement and the creation of the post-war international monetary and financial architecture. That architecture, which contributed to the remarkable period of reconstruction and global economic growth, was based on a simple proposition: the U.S. dollar would be the anchor currency against which other currencies would be fixed, with the dollar fixed in terms of the price of gold.

In hindsight, there was probably no feasible alternative to this modified dollar-gold standard. The U.S. had the bulk of the world's gold reserves, its economy had grown enormously during the War, and, frankly, it alone had the capacity to provide the global leadership needed to provide the public good of international financial stability. By agreeing to fix their currencies to the dollar, signatories to the Bretton woods agreement were both conferring and recognizing an exceptional role for the U.S.

But the stability of the system rested on the understanding that U.S. policies would be consistent with the strictures of the gold standard. In other words, the quid pro quo for acceptance of exceptionalism was the commitment to "sound" policies that would support the fixed peg of the dollar vis-a-vis gold. Under the gold standard, policies that were excessively expansionary would generate current account deficits, leading to a loss of gold which would, in turn, drain liquidity from the banking system and reduce inflationary pressures.

Under the Bretton Woods system U.S. monetary policy was freed from the strict bonds of the gold standard in order to pursue full employment. But that freedom was contingent on other countries having confidence in the dollar's peg to gold. This confidence would not be sustained in the face of fiscal dominance — if, for example, monetary policy was subordinated to the need to finance reckless fiscal policy. In the negotiations leading to the Bretton Woods agreement, therefore, there was a suggestion to include "surveillance" —Fund speak for oversight —of U.S. fiscal policy. The proposal, initially entertained by the U.S. officials, was quickly dropped as the cost of Congressional acceptance of the Bretton Woods agreement. Congress would not accept "foreign entanglements" on its perogatives to tax and spend.

Regardless, in the early years of the Bretton Woods period, the U.S. provided the necessary discipline, as a large war-induced debt-to-GDP ratio was brought down through a combination of taxes, financial repression and restraint. By the mid-1960s, however, the U.S. was fighting a cold war against the Soviet Union, a hot war in Vietnam, and a war on poverty at home. As fiscal deficits increased, the cost of sustaining these three fronts gradually undermined the dollar's role as anchor currency, and by the late 1960s there were growing concerns about the sustainability of the dollar's peg to the price of gold.

These concerns came to a head in the Triffen paradox: as the value of U.S. Treasury securities outstanding (all theoretically backed by gold) grew, while U.S. holdings of gold at Fort Knox drained away, confidence in the U.S. dollar peg waned. Foreign central banks grew increasingly wary of holding U.S. Treasuries — central banks began demanding gold in exchange for Treasuries. As U.S. fiscal deficits continued, confidence eroded further, and ad hoc efforts to sustain the status quo through arrangements such as the gold pool (which attempted to control central banks demands for convertibility — the exchange of paper assets for gold bullion) became less effective. The paradox was that, given the dollar based nature of the Bretton Woods system, the only way to generate the liquidity needed to support growth in the global economy and the even greater increase in international trade was through U.S. current account deficits. But those deficits also increased the nominal value of assets backed implicitly by gold convertibility!

Of course, if the stock claims on U.S. gold holdings (represented by the stock of U.S. Treasuries outstanding held by foreign central banks) exceeded the stock of gold, not all creditors would be able to convert their holdings at the official dollar exchange rate. The situation was analogous to a potential bank run, in which the value of the bank's demand deposits exceeds cash on hand and liquid assets that can be converted to satisfy. The run starts when some depositors, seeking to withdraw their funds, for whatever reason, ignite a panic among those who fear that they will be left short. Of course, everyone thinking the same results in the panicked equilibrium in which all suffer and the bank is forced into illiquidity and insolvency, as it is forced to sell illiquid assets at firesale prices.

By 1971, then, the equivalent of a run on the dollar was in progress — albeit in slow motion — as countries feared that the U.S. would unilaterally change the price at which the dollar was fixed to gold. Unwilling to import the inflationary consequences of maintaining their own currency pegs to the dollar, major industrial countries adopted flexible/floating exchange. The Bretton Woods dollar-gold system officially ended in August, when President Nixon yielded to the inevitable and broke the dollar's link with gold.

For the avoidance of doubt: We are not at this point. That said, the next post will discuss the potential implications of concerns of renewed fiscal dominance on the international role of the dollar in the 21st century.

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