In this analysis, published Sunday in London's Financial Times, John Plender examines what history suggests about what the consequences of America's present financial irresponsibility will be. -- For as he points out, "We are in the middle of an unprecedented credit bubble." -- In the late 1960s and early 1970s, when the U.S. refused face up to the need to make tough fiscal choices, the consequence was the collapse of the Bretton Woods exchange rate system. -- Now, in 2005, "everyone knows that the U.S. balance of payments is unsustainable," Plender writes. -- "Alan Greenspan, chairman of the U.S. Federal Reserve, made an alarming admission to the French finance minister last week that the U.S. had lost control of fiscal policy. -- Yet the foreign central bankers, private investors, and financial institutions that now control the fate of the dollar remain completely unfazed. Net foreign purchases of U.S. assets are running at an incredible rate of about $100bn a month." -- Something has to give, though the timing remains uncertain. -- "Mr. Greenspan, chief author of the bubble, is warning revellers that 'history cautions that extended periods of low concern about credit risk have been invariably followed by reversal, with an attendant fall in the prices of risky assets.' Since he is tightening policy just as households and companies are struggling to cope with the energy shock, he may be helping ensure that history's lessons will become apparent sooner than many expect. And when credit spreads start to widen, rest assured that the speed of the feed-through into a falling dollar and falling equity market, as foreigners take fright, will catch out many of the party's late-stayers." ...
Comment & analysis
Columnists
A FOREIGN VIEW OF GUNS AND BUTTER
By John Plender
** What history tells us on currency and credit **
Financial Times (UK)
October 2, 2005
http://news.ft.com/cms/s/66b911a6-3373-11da-bd49-00000e2511c8.html (subscribers only)
After hurricanes Katrina and Rita, and the deteriorating situation in Iraq, the U.S. confronts a heightened "guns and butter" dilemma. The echoes here of the late 1960s grow louder by the day. Congress at that time refused to raise taxes to pay for the Vietnam war unless the Johnson administration cut its social programs. When the cuts were not forthcoming the stage was set for the collapse of the Bretton Woods exchange rate system.
The Bush administration is dealing with a less hostile Congress. But the historical parallel is still worth exploring. A fundamental difficulty with Bretton Woods, you may recall, was that U.S. balance of payments deficits could satisfy the global need for reserves only at the cost of undermining confidence in the dollar, as other countries' dollar holdings escalated in relation to the shrinking U.S. stock of gold.
The Europeans, most notably France and Germany, became increasingly reluctant to finance the deteriorating U.S. balance of payments. To soften them up for a negotiated devaluation the Nixon administration in 1971 suspended convertibility of the dollar into gold and imposed a 10 per cent tariff surcharge. By 1973 the dollar was abandoned to market forces as war in the Middle East sent oil sky high.
The contrast today with the Bretton Woods era is not just that the dollar floats freely. The current account deficit, at close to 6 per cent of gross domestic product, is vastly greater than in the early 1970s when the deficit rose from all of 0.1 per cent to 0.5 per cent between 1971 and 1972. We are in the middle of an unprecedented credit bubble. As in 1971 everyone knows that the U.S. balance of payments is unsustainable and Alan Greenspan, chairman of the U.S. Federal Reserve, made an alarming admission to the French finance minister last week that the U.S. had lost control of fiscal policy.
Yet the foreign central bankers, private investors, and financial institutions that now control the fate of the dollar remain completely unfazed. Net foreign purchases of U.S. assets are running at an incredible rate of about $100bn a month.
The Fed is removing the punchbowl at a very late stage in the credit binge party. Mr. Greenspan, chief author of the bubble, is warning revellers that "history cautions that extended periods of low concern about credit risk have been invariably followed by reversal, with an attendant fall in the prices of risky assets." Since he is tightening policy just as households and companies are struggling to cope with the energy shock, he may be helping ensure that history's lessons will become apparent sooner than many expect. And when credit spreads start to widen, rest assured that the speed of the feed-through into a falling dollar and falling equity market, as foreigners take fright, will catch out many of the party's late-stayers.