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Currently, nothing seems to work. Chairman Bernanke and the Federal Reserve are working overtime to calm things down. Still, things seem to be getting worse and worse.

Maybe the reason nothing seems to be working is that these actions are not really attacking the main problem. Maybe these actions are just ‘quick-fixes’ that try to keep things together but do not really solve the underlying difficulty. It is like the ship has been build with a deficient plan and, as a consequence, has sprung holes. The holes certainly need to be plugged in order to keep the boat afloat, but the longer-term question relates to how sea worthy is the ship itself. If the ship has been constructed using a plan that cannot weather the current seas, then somehow the ship is going to have to be rebuilt according to different specifications so that it can continue to function. The problem is that we do not have the luxury to bring the ship into dry dock for the rebuilding to take place, the rebuilding must occur on the high seas.

The American financial system has achieved the position it has through the support and encouragement of the United States government. Not only has the government contributed an infrastructure to support the financial system along with rules and oversight, it has also contributed relatively sound monetary and fiscal policies that have helped the system grow and get through some difficult spots. The government and its agencies have not always performed perfectly, but they have performed well enough so that system became the envy of the world.

After the Second World War, the American financial system continued to surpass itself, in volume, in stability, and in terms of innovation. But, the system was constructed upon the foundation of the United States government being able to do pretty much what it wanted to with respect to its fiscal and monetary policy. For the most part, the government behaved pretty well. It ran into a little trouble in the late 1960s and 1970s as it attempted to provide a wider expanse of social programs to the country while, at the same time, it took on the responsibility of financing a war in Southeast Asia.

This lead to one of the worst bouts of inflation in United States history. Despite this fact, in most cases, the government could still act as it pleased because the American economy was robust enough, and the U.S. dollar was strong enough so that world markets and market participants maintained supreme confidence that the dollar and dollar denominated securities, like the government securities used to finance the Federal deficits, could be held without fear.

Other major countries in the world did not find this to be the case. The world financial system had been constructed to allow, as much as possible, sovereign nations to conduct their monetary and fiscal policies independent of the rest of the world. Building such a system was one of the major goals of many of the participants who were a part of the peace negotiations following the First World War. This carried into the 1920s, the economist John Maynard Keynes being one of the major intellectual forces behind the effort.

Why did Keynes and others want to build such a system? There was great concern at that time over the social unrest amongst the ‘working classes.’ The Russian Revolution was a real example of what could happen in a country if this discontent got out-of-hand and became inflamed by radical leaders. Nations that did not want this to happen could only combat the situation by creating economic policies aimed at attaining the highest amount of employment possible. But, all agreed that conducting such policies could tend to be inflationary and when inflation occurred, bankers sold the currency in foreign exchange markets and the value of the country’s currency declined.

The question Keynes and others posed was how could countries conduct policies to maintain high levels of employment if their currencies would come under attack because of such policies? They believed that such a system would require fixed foreign exchange rates so that some, at least, short run stability could be achieved in their foreign exchange rate while the government could focus on the construction of a fiscal and monetary policy built to achieve high levels of employment.

This system became an institutional reality with the Bretton Woods Conference held in the United States in July 1944. It was said that Keynes ‘dominated’ this conference. In the same spirit, the United States Congress, in 1946, passed an “Employment Act” that emphasized the government’s responsibility to seek and maintain ‘maximum employment’ within the country. Other major governments supported such efforts to maintain high levels of employment in their own countries. This allowed governments to conduct economic policies in a relatively independent manner, changing foreign exchange rates from time to time as market conditions warranted. The U. S. dollar, the strongest currency in the world, was also tied to the price of gold, at $35.00 per ounce, giving it further importance in world financial markets.

The breakdown in this system started to occur in the late 1960s and 1970s. In the early 1970s, the dollar’s tie to gold was severed and the value of the U. S. dollar was allowed to float freely in the world’s foreign exchange markets. Other currencies were also freed from time-to-time as economic and political conditions warranted. Still sovereign governments continued to act independently of the rest of the world as envisioned by the Bretton Woods agreements even through currencies were allowed to trade freely.

Then the system began to break down. Major government after major government found that devising their economic policies independent of the rest of the world would not be tolerated by ‘international bankers.’ Governmental policies that were inflationary in nature were met with these ‘bankers’ selling their currency so that it became impossible for the governments to act without a consideration of what would happen to the value of their currency once the path of their fiscal and monetary policies were determined.

The reaction of these ‘bankers’ became swifter and swifter the longer a government delayed changing its approach. As a consequence, budget deficits were reduced or eliminated and central banks were made independent of their national governments. “Inflation targets’ were introduced as guides to policy.

The United States government was able to maintain its independence relatively well through the 1980s and the deficits created by the Reagan administration. Perhaps one very strong reason for this was that Paul Volcker led Federal Reserve System at this time. As the story goes, Volcker was not the choice of President Jimmy Carter to become Chairman of the Board of Governors of the Federal Reserve System - he was too independent.

However, the Fed, under Volcker’s leadership put the United States through the necessary pain in order to constrain prices increases and bring inflation under control. Alan Greenspan seemed to be a worthy successor to Volcker as the 1990s began. The Clinton Administration then proceeded to bring the Federal budget under control leaving the budget in surplus as it left office, a fiscal stance that provided the best of all possible worlds for the conduct of monetary policy.

In these twenty years, however, the world changed:

  • Globalization really took hold along with the development of world financial markets.
  • Inadequate energy policies meant that the nations that produced oil could accumulate massive amounts of wealth to become an offset to American economic dominance in the world.
  • China and India became more important as world powers with sufficient economic clout.
  • The United States government put itself in a hole by creating substantial budget deficits, primarily caused by a massive tax cut and the need to finance a ‘bottomless’ series of wars.
  • This situation was exacerbated by a monetary policy that kept interest rates excessively low for around three years. The result: The last nation that conducted its economic policy independently of the rest of the world came under attack.

    The recent actions of the Federal Reserve System and the Federal government have only confirmed what the world financial markets have been betting on for the past six or seven years. The United States is now monetizing the debt that it had created through its ill-advised tax cuts and its very expensive wars.

    The old ship is no longer sea worthy, and plugging holes that have sprung leaks will not provide the blue print for the future. Yes, the holes need to be plugged in order that the world financial system can limp along. But, there must be a new plan for the ship that takes into account the new water it is sailing in.

    Source: Learning from Past Mistakes to Solve the Current Crises