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Bernanke & Co. Play A Confidence Game

On an August Sunday in 1971, President Richard M. Nixon ordered the world to trust the full faith and credit of the United States. The world, having no alternative, obliged.

Today’s disorderly credit markets, and the response by U.S. policy-makers who seem desperate to avoid a recession, may put the world’s trust in America and its currency to the greatest test yet. The worst economic turmoil since the 1970s could lie ahead if confidence fails. (For a look at what a dollar crisis might bring, please turn to Worst-Case Scenario Is Not Pretty on Page 6.)

To understand why the future looks increasingly risky, it helps to look back. Near the end of World War II, representatives of 45 nations gathered at Bretton Woods, N.H., to establish a financial system for the postwar era. That system required other countries to link their currencies to the dollar. With the United States holding 65 percent of global gold reserves when the fighting stopped, the dollar was in turn linked to gold, at a fixed rate of $35 per ounce.

Bretton Woods made the dollar the world’s reserve currency. Other countries needed dollars to pay for their imports. The primary means of earning dollars was to sell goods to Americans. But because America’s factories came through the war unscathed while others lay ruined, the United States ran an unbroken string of trade surpluses from the war’s end through the 1960s. Foreign aid, cross-border investments and U.S. spending on overseas military bases plugged the gap, facilitating the postwar recovery of Western Europe and Japan.

As other countries accumulated and sometimes redeemed dollars, the American gold hoard shrank. U.S. reserves were just 16 percent of the world total by 1970. That year, America ran its first postwar trade deficit. With American inflation climbing past 5 percent and its stock of gold shrinking, the administration began to fear a run on the dollar. Those fears were heightened when, a few days before President Nixon’s speech on Aug. 15, 1971, the British government asked to redeem $3 billion for gold.

The Nixon speech shocked the world. He froze all U.S. wages and prices for 90 days and asked corporations to freeze dividends as well. He set up a government panel to regulate wages and prices after the 90-day period ended. He imposed a 10 percent tax on all imports. And he declared that the United States would no longer back its dollars with gold.

Suddenly, dollars — and, by extension, all other currencies in the non-communist world — were supported by nothing but faith. This is not quite the same as being supported by nothing at all. As long as dollar-holders believe the greenback will retain meaningful purchasing power, like the ability to buy Boeing jetliners or South Beach condos, they have an incentive to retain our currency. In fact, we have seen many times since 1971 that in unusually stressful times global investors flock to the dollar, especially obligations of the U.S. government itself.

This global faith was neither cheaply nor easily earned. Foreign governments could not have been the least bit pleased when the United States slammed its gold window on their eager fingers. It probably did not help when President Nixon’s Treasury secretary, John Connally, declared that the administration’s goal was to “screw the Europeans before they screw us.”

The United States endured three recessions between 1974 and 1982. In that period, there were three interest rate cycles in which the Fed pushed short-term rates to growth-choking double-digit levels of up to 20 percent. As recently as 1989, the Fed responded to a whiff of inflation by ratcheting its target rate to 9.75 percent. Another recession soon followed.

A combination of high interest rates and strict limits on money supply growth halted the late-1970s inflation surge that followed the demise of Bretton Woods and the 1974-75 recession. The world came to trust that a dollar today would be worth a dollar tomorrow, more or less, even without the backing of gold reserves. American willingness to sacrifice jobs, profits and growth to preserve the dollar’s value was the show of good faith that foreigners needed. The United States has benefited enormously from this foreign confidence. When other countries run persistent budget and trade deficits, their currencies tend to crash after investors conclude that the local coin is insufficiently backed by foreign exchange, namely dollars.

The United States, in contrast, has been able to maintain a generally strong currency throughout the 1980s and 1990s and into the current decade, despite persistently large and growing deficits. Americans’ propensity to spend has been matched by foreigners’ propensity to lend. As China built an enormous surplus in trade with the United States, it accumulated vast reserves of U.S. Treasury obligations. Total Chinese dollar reserves now are estimated at more than $1 trillion. And this is just one country’s holdings.

(A brief digression: Whatever the economic drawbacks of having China as such a large creditor, this debt may be the best missile defense system yet imagined. Why would any country want to fight, let alone win, a war against a nation that owes it $1 trillion?)

In the closing weeks of 1996, two years into a stock market rally, then-Federal Reserve Chairman Alan Greenspan wondered aloud whether “irrational exuberance” might be driving asset values to unreasonable levels. Two years later, the stock market stalled when a hedge fund, Long-Term Capital Management, lost more than $4 billion and threatened to create panic in the banking system. The Fed responded by swiftly cutting interest rates and arranging a bailout for the hedge fund. The boom resumed and lasted to the end of the century.

That 1998 interest rate cut was a turning point. Though the financial markets had been tumultuous since the Asian currency crisis a year earlier, the U.S. economy had shown no signs of slowing down. An interest rate cut is usually meant to bolster a slowing economy. Cutting rates in 1998 risked fueling inflation, which did not appear, or creating a further escalation in stock prices, which certainly did. Today, we call that era the dot-com bubble.

The bubble finally burst in 2001 after the Fed applied the brakes by raising its target lending rate to 6.5 percent. The stock market crashed, the economy slid into recession, and the Sept. 11 attacks increased anxiety. Greenspan pushed rates down to 1.75 percent by the end of that year, then even lower to 1 percent from 2003 to 2004, long after economic growth had resumed. Amid this extraordinarily long period of easy money, the U.S. real estate market took off like a Roman candle. It flamed out when rates reached more normal levels by 2006. Today’s debt crisis was born in the rush to issue a mortgage to anyone who asked for one during that easy-money period.

Since last summer, various parts of the credit markets have intermittently seized up because nobody trusts anybody else. The recent tide of bad loans has contaminated so many securities in so many ways that neither the creators nor the current owners of those securities know what they are really worth. This environment threatens to bring the U.S. economy to a halt because some lenders lack the wherewithal to keep lending, while others lack the desire.

Congress and President Bush hope to fight the problem with the economic stimulus act passed earlier this election year. The government is giving free money to most votingage Americans. The money, of course, is borrowed from those foreign buyers of our Treasury obligations.

Federal Reserve Chairman Ben Bernanke and his colleagues, meanwhile, apparently have decided that recessions are no longer a necessary evil. They are simply evil. The round of interest rate cuts that commenced last fall and accelerated this winter is like using a wet noodle to push the economy forward. Low interest rates do not help much if lenders are unwilling to lend. One example cited by David Walters in his story on Page 3 is the abrupt suspension of hundreds of thousands of home equity credit lines earlier this year by Countrywide and other institutions that fear falling home values have made borrowers more likely to default. To have any impact, the Fed may have to force rates to extremely low levels once again.

I do not see that much good can come of the Fed’s latest round of rate cuts. Assuming we could magically go back to the freewheeling easy-money environment of 2004, would we want to?

Can we give our economy lasting strength by making more artificially cheap loans to borrowers who cannot afford the real cost of either the goods or the money they want? Even as they cut rates early this year, Fed officials cautioned that they may need to turn around and raise rates — perhaps abruptly and soon — to try to tamp down inflationary pressures. What, then, is the point of cutting rates in the first place?

Bernanke & Co. risk stoking inflation with more easy money, perhaps only to see the economy slow yet again when they are forced to bring interest rates back to more reasonable levels. In the meantime, what happens to that all-important worldwide confidence in the dollar? If foreigners become concerned that their dollar holdings are going to lose much of their value to inflation, they may abandon the dollar in favor of stronger currencies. This could trigger a dollar crash, which would make imported goods from oil to sweatshirts so expensive for American consumers that drastic anti-inflation measures might again be needed.

Even if foreigners hold on to most of their dollar reserves, the increasing flood of money in worldwide circulation is driving up the prices of commodities at rates unseen in many years. Most countries are feeling the pinch, but the dollar’s downward trend is making the pain more acute here.

Embers of inflation are always present in a growing economy. The Fed’s job is not to drown the ashes, but neither is it to pour gasoline on the hot coals. This Fed is playing with fire.