Government Guarantees And the US Dollar Standard

``At some point, it will become necessary to guarantee failing pension plans, income, Medicare payments, mortgage payments, bank deposits, student loans, commercial paper, insurance policies, jobs, unemployment payments, old age payments, and much else, all at the same time. People will question the worth of shifting massive resources from one set of pockets to another set of pockets. They will see that the government guarantees nothing. It recycles resources it extracts from us back to us. This realization will mark the sunset of belief in federal guarantees.”-Professor Michael Rozeff, The Sunset of Federal Government Guarantees

One of the main objections to the risks of sovereign credit default is the purported faith on government guarantees.

Such belief is representative of unremitting and inexorable dependence in governments as drivers of the economic and financial prosperity. Yet bereft of the lessons of history and the basic principles of economics, never have these people realized that governments EVERYWHERE through the years and through their coercive police and military powers almost always change the rules in the middle of the game, or in accordance to leader’s whims or to fungible political priorities or imposed policies with short term noble sounding relief programs at the expense of negative long term costs or protected a few interest groups in the “name of the patriotism” or have robbed people of their property rights through unjust distributive inflationary policies.

In short, despite the repeated failures to achieve major societal goals, people have come to believe government guarantees mean something.

Yet believing in governments as solution to society’s upliftment could be fatal. What people haven’t realized is that guarantees require real capital or real resources for it to be dependable. Running huge deficits and paying them off with printing press money which can’t be backed by real capital means government guarantees “are not worth the paper they’re printed on” to quote Professor Michael Rozeff.

As we pointed out in It’s a Banking Meltdown More Than A Stock Market Collapse!, Iceland for instance, just last year used to be among the world’s wealthiest economies with a per capita income which was the 6^th highest. As the recent crisis unfolded, the Icelandic government guaranteed the deposits of its financial system and nationalized its overleveraged major banks in the hope to apply the magic wonders of the government wand. Unfortunately, due to the lack of real capital, the country of 320,000 went bankrupt.

Iceland’s banking system which operated like a national hedge fund during the heydays will be paying a pretty stiff price for its misadventures and policy blunders, according to Economist (bold emphasis mine), ``Gross government debt is forecast by the IMF to increase from 29% of GDP at the end of 2007 to 109% of GDP in 2009. Apart from the widening deficit, the increase in debt will result from three main causes: first, the recapitalisation of the failed commercial banks now under public ownership will cost around Ikr385bn, or 25% of GDP; second, the costs of recapitalising the Central Bank will be close to 10% of GDP; and third, meeting the extensive obligations of the failed banks (that is, compensating depositors and other creditors) will cost around 47% of GDP. A sizeable portion of this should, however, be recovered over the coming years as the banks' assets are sold. Nevertheless, there will a large debt-servicing burden on the central government that will have to be met by extensive cuts in government spending or through higher taxes.” Ouch.

The lesson here is that paper guarantees from any government may not even be worth anything unless they are backed by real resources or real capital. The same applies with the US dollar, the world’s preeminent currency backed by full faith and credit by the US government.

The belief that the US dollar is insuperable and is unlikely to seriously suffer from negative repercussions from its accrued reckless and imprudent past and present policies could signify as perilous complacency.

The fact that the recent crisis has its epicenter in the US and has rattled the foundations of the global banking system aside from disrupting the world trade financing have prompted some governments to explore alternative means of conducting trade outside the US dollar system such as:

1. The recent case of rice for oil barter between Thailand and Iran (see Signs of Transitioning Financial Order? The Emergence of Barter and Bilateral Based Currency Based Trading?),

2. Mounting talks about the resurrection of a modern form of Bretton Woods Standard (as previously discussed in Bretton Woods II: Asia Weighing In Too? and in Bretton Woods II: Bringing Back Gold To Our Financial Architecture?),

3. Utilization of a new payment system which uses local currency for trade as in Brazil and Argentina’s Local Currency Payment system. China and Russia has likewise been reportedly mulling to engage in a similar domestic currency based bilateral trade and

4. A pilot form of regional currency standard such as China’s recent proposal to expand the use of its currency as a medium of trade for China, Hong Kong Macau and ASEAN countries (BBC)

So aside from policy induced fundamental deterioration, all these exogenous events serve as ample evidence of the growing vulnerability of the US government guaranteed US dollar standard system.

Mike Hewitt of Dollardaze.org has made a splendid study on currencies where he observes that some 173 currencies are in circulation in the world today.

Yet not all of the existing currencies are widely used or circulated. Mr. Hewitt gives some examples as the “unofficial banknotes of the crown dependencies (Isle of Man and the Balliwicks of Jersey and Guernsey).”

Importantly Mr. Hewitt provides us some very important facts from today paper currency regime (all bold highlights mine):

-The median age for all existing currencies in circulation is only 39 years and at least one, the Zimbabwe dollar, is in the throes of hyperinflation.

-Excluding the early paper currencies of medieval China (and India, Japan and Persia) as well as the majority of paper currencies that existed in China until 1935, there are 612 currencies no longer in circulation. The median age for these currencies is only seventeen years.

Figure 3: DollarDaze.org: Fates of Currencies

-Both war and hyperinflation have each been responsible for the demise of 145 currencies. The Second World War saw at least 80 currencies vanish as nations were conquered and liberated.

-Second only to war, hyperinflation is the greatest calamity to strike a nation. This devastating process has destroyed currencies in the United States, France, Germany, and many others.

As one can observe, paper currencies tend to be generally short lived. Importantly, the fact that war and hyperinflation have been the main proximate factors which has caused most of the world’s currencies to disintegrate depicts that both are related.

To quote Ludwig von Mises in Nation State and Economy,

``One can say without exaggeration that inflation is an indispensable means of militarism. Without it, the repercussions of war on welfare become obvious much more quickly and penetratingly; war weariness would set in much earlier.”