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Time will tell if deficit can be without tears
The first official departure came in 1922, when at the International Monetary Conference at Genoa a resolution was adopted to allow central banks to keep their reserves in dollars or sterling, which remained payable in gold. -- The elasticity provided by the “gold exchange standard”, as it was called, contributed to the glorious prosperity of the 1920s. The US was able to export capital to Europe in the 1920s without contracting its domestic credit base. Balance of payments deficits no longer had to be corrected in a prompt fashion. -- This house of cards collapsed in 1931, after the failure of Austria’s Credit-Anstalt bank stopped the flow of credit to Europe and European central banks demanded their dollar reserve balances be paid in gold.
Financial Times

Time will tell if deficit can be without tears

By Edward Chancellor

During the boom years, the rapid growth of central bank reserves was hailed as a wonderful thing. Bolstered by plentiful foreign exchange holdings, crises in emerging markets would become a thing of the past. Yet the expansion of central bank reserves played a key role in inflating the global credit bubble. Historically, periods of strong reserve expansion have been accompanied by great apparent prosperity. But they have always ended unhappily.

In Victorian times, a country had to pay for its imports or foreign investments with money gained from a surplus on trade. If more money was sent abroad than had been earned through exports, then gold would be packed onto ships to discharge foreign creditors. A declining stock of bullion would induce the central bank to raise interest rates in order to attract gold from abroad. Rising rates would produce a credit contraction, unemployment and general economic misery. The typical nineteenth-century economic crisis was severe, but short-lived.

The attraction of this system is that it prevented countries from running prolonged deficits in their balance of payments. In time, people tired of the merciless rule of the gold standard. They wanted more flexibility. The first official departure came in 1922, when at the International Monetary Conference at Genoa a resolution was adopted to allow central banks to keep their reserves in dollars or sterling, which remained payable in gold. This move was intended to economise on gold. But it also removed the automatic stabiliser.

The elasticity provided by the “gold exchange standard”, as it was called, contributed to the glorious prosperity of the 1920s. The US was able to export capital to Europe in the 1920s without contracting its domestic credit base.  Balance of payments deficits no longer had to be corrected in a prompt fashion. The pyramid of credit upon the gold base could be extended further than ever before. As the French economist Jacques Rueff famously remarked, the “international monetary system [had been] reduced to a mere child’s game in which one party had agreed to return the loser’s stake after each game of marbles”.

This house of cards collapsed in 1931, after the failure of Austria’s Credit-Anstalt bank stopped the flow of credit to Europe and European central banks demanded their dollar reserve balances be paid in gold. The lessons were not heeded, however. After the war, once the dollar became the linchpin of the Bretton Woods monetary system, there was nothing to prevent America flooding the world with its currency.

The US started to generate balance of payments deficits from around the mid-century. Foreign central banks dutifully mopped up these excess dollars in their reserves. In the 1950s and early 1960s, this accumulation of reserves was accompanied by strong economic growth around the world and rising stock markets. Everyone was happy, apart from Mr Rueff who denounced the “deficit without tears”. He compared the Bretton Woods system to an arrangement with his tailor in which the money he paid for a new suit is immediately returned to him so that he might order another.

Whereas the Gold Exchange Standard collapsed in the deflation of the early 1930s, the increasing torrent of dollars into the world monetary system brought about the Great Inflation. Pegged to the international reserve currency, central banks in countries with growing trade surpluses, such as Japan, were forced to buy up dollars with their own freshly printed currencies. International monetary reserves soared in the late 1960s and inflation followed. The collapse of Bretton Woods, which finally occurred in April 1971 had long been anticipated by Mr Rueff.

Mr Rueff, who died in 1978, would not have been impressed with our recent monetary arrangements. The informal Dollar Standard which succeeded Bretton Woods has allowed deficit countries, such as the US, to consume more than they produce and surplus countries, such as China, to produce more than they consume. Between January 2004 and the beginning of last year, worldwide international reserve assets more than doubled. They peaked last year at $7,000bn. Asian countries have boosted reserves by acquiring export dollars. These dollars then flowed back to the US, where they funded the excesses in the subprime mortgage, leveraged buy-out and structured credit markets. 

The liquidity provided by the Dollar Standard evaporated towards the end of last year as trade dried up and hot money flows retreated. As the global economy contracted, central bank reserves started to decline. In March, this decline was arrested. Foreign central bank holdings of Treasuries and agency bonds, which are held in custody at the Federal Reserve, now exceed $2,750bn, an increase of 10 per cent since the beginning of the year. The US trade deficit persists, while China’s surplus continues expanding. For the time being, at least, the deficit without tears lives on.

Edward Chancellor is a member of GMO’s asset allocation team

Time will tell if deficit can be without tears