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Author: Cees Bruggemans*|

30 December 2012 17:12

The US debt ceiling in context

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It is much larger than mere petty politics attributed to extremely foolish politicians.

Perhaps it may be useful to see the now seemingly regular US debt ceiling clash in a historic context much larger than mere petty politics attributed to extremely foolish politicians.

There might be more method than madness that meets the eye here, at least at times.

Towards the end of the book “Volcker” by William Silber (Bloomsbury Press 2012), in a chapter entitled “Trust”, a few major historic thoughts are expressed.

These put mostly indirectly, even casually, into context how the current fiscal cliff saga may go much deeper than what may appear on face value to be the case.

It may be useful to bear this in mind in the years and decades ahead.

What follows is some of the context thinking in bullet-point format.

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In 1933, President Franklin Roosevelt took the US off the gold standard domestically, making it illegal for US citizens to hold gold other than as jewellery and impossible to redeem paper dollars for gold.

The US retained the gold standard vis-à-vis foreign central banks following the 1944 Bretton Woods agreement, in terms of which foreign central banks could continue to redeem accumulated dollars for US gold.

Gold lost its central monetary importance in global monetary affairs in 1971 when President Nixon ended this right of foreign central banks to convert dollars into gold.

Since then the world has been on a pure dollar standard, a fiat currency backed only by the full faith and credit of the United States.

Dollars serve as legal tender for all debts, public and private, without a fixed link to any commodity.

Milton Friedman supported the overthrow of gold. He testified in Congress (1968) that the gold reserve requirement (backing paper money, even only fractionally) is an anachronistic survival from an earlier age.

In this he echoed Keynes’s denunciation of gold as a “barbarous relic”.

But Friedman worried, writing that the worldwide experiment in fiat currency has no historical precedent, citing the warning by Irving Fisher 100 years ago.

According to Fisher (1911), irredeemable paper money has almost invariably proved a curse to the country employing it, worrying as he did about hyperinflation.

Friedman was less pessimistic, but not by much, suggesting “it is not possible to say whether Fisher’s 1911 generalisation will hold true in coming decades”.

According to Friedman, it will depend on whether we find a substitute for convertibility (into gold) that will serve the same function: maintaining pressure on the (US) government to refrain from inflation as a source of tax revenue.

The proposed Friedman monetary rule (steady, modest money supply expansion) intended to be such a systemic stability feature.

It is perhaps mainly in this context that modern debt ceiling politics should be seen, with irresponsible fiscal behaviour seen as main inflation instigator.

The 1970s nearly confirmed Fisher’s worst fears as US inflation (especially inflation expectations) took off.

Debate over the cause of the 1970s Great Inflation in the US continues, but cannot dismiss as coincidence the removal of gold as the monetary anchor.

Congress might have prevented irresponsible monetary policy by refusing to adjust the gold reserve requirement, had it still been the law (which was no longer the case).

The same way Congress occasionally refuses to raise the debt ceiling to extract fiscal concessions (which was the comment making me pause).

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Paul Volcker, then US Undersecretary for International Monetary Affairs, was centrally involved in suspending central bank gold convertibility in 1971 (the world fully going on to a dollar paper standard).

During 1979-1982 Fed Chairman Volcker rescued the experiment in fiat currency from eventual failure by nearly singlehandedly, through sheer personality, using the independence of the Fed, ensuring a strict US monetary policy, eventually forcing fiscal adjustments and breaking inflation expectations.

Volcker as Fed chairman strongly experimented with monetary policy (in whose tradition Fed Chairman Ben Bernanke continues today, if in different ways in the aftermath of massive disinflationary financial crisis disturbances).

When he threw the policy switch in 1979, Volcker initially conducted a typical monetarist policy, trying to control the money supply. It then materialised that money supply was endogenous to the economy and couldn’t be controlled independently.

Experiments with control over high-powered money (bank reserves) gave similar results.

From these “live” experiments followed the modern insight that money supply can best be influenced through using the cost of credit as a policy instrument.

Today, inflation-targeting functions as anchor for a stable monetary policy in which instrument discretion (setting interest rate levels) represents the discretionary aspect of monetary policy.

Central to such active, determined experimentation, seeking a viable answer to the increasingly dangerous inflationary drift of the 1970s was Volcker’s belief that price stability belongs in the social contract and that inflation undermines trust in government. It was this strongly held conviction that drove policies to restore monetary discipline during the 1980s.

Volcker showed that a determined central banker can behave like a surrogate for gold. But even Volcker needed help. His refusal to monetise federal deficits eventually forced Congress to implement a plan for fiscal responsibility, reinforcing the Fed’s credibility.

After much trial and error it was this combination that brought decades of price stability to America and preserved trust in the dollar both at home and abroad.

The crisis that began in 2007 threatens that trust anew.

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As to the regular US debt ceiling standoff (about US government borrowing powers, within Congress and between it and the president), one can make various observations.

The ceiling can be a pawn in the hands of the politically powerful to leverage some advantage regarding the tax and/or public spending regime.

The ceiling offers leverage to the politically powerful to enforce greater fiscal discipline, if so desired.

The ceiling can be a lever in the struggle between ideological opposites, in particular those in favour of greater emphasis on property rights and less government (the Austrian School) as opposed to those wishing to achieve greater social ends through government taxing and borrowing powers.

Perhaps nothing new here, except the realisation that in the absence of built-in limitations (such as gold backing of the money supply), society has to create other mechanisms that can function as breaks on undesirable policies when needed.

It need not be only an ideological faceoff doing the running in debt ceiling debates.

That society may need such checks at all should make one pause. Maintaining discipline is not as simple as it sounds, as Volcker had first-hand opportunity to observe in the 1960s, 1970s and 1980s, and then all over again under entirely new management in the 1990s and 2000s, with dire warnings as to what still lies ahead if there aren’t more systemic checks (in banking but also in fiscal and monetary affairs, as the post-second world war US history shows so graphically).

Acknowledgement: Prof PDF Strydom. Any remaining misconceptions are my own.

*Cees Bruggemans is a consulting economist to FNB

Topics: Paul Volcker, FNB, fiscal cliff, gold, debt ceiling, Ben Bernanke



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