From Connolly to Baker to Paulson

October 2, 2006 – Connolly to Baker to Paulson. It could be the names of three infielders in an around-the-horn triple play, but it’s not. These guys are pitchers, and they throw bean-balls at anyone who holds dollars.

The history of John Connolly and James Baker is already written, as they served as Treasury Secretary to presidents Nixon and Reagan respectively. I expect present Treasury Secretary Hank Paulson to follow in the footsteps of these predecessors, and if history is any guide, you do not want to hold dollars as a result.

John Connolly got the ball rolling – decidedly downhill I might add – by an infamous 1971 remark. Speaking to a delegation of Europeans worried about the tenuous link then prevailing between gold and the dollar at the existing $35 rate of exchange, he opined: “The US dollar may be our currency, but it’s your problem.” Those few words have neatly summed up the US government’s dollar-policy toward the rest of the world ever since Connolly first uttered them.

Connolly is also reported to have said: “Foreigners are out to screw us, and it is our job to screw them first.” Even though there was no truth to his assertion about foreigners’ aims, screw them he did when the US government in August 1971 defaulted on its commitment to redeem one ounce of gold for each thirty-five dollars presented to it. Connolly seemed oblivious to the fact that the US dollar has a special responsibility. It is the world’s reserve currency and that role comes with an indisputable obligation to manage the currency wisely, as is clear when the British pound filled that role.

According to British historian Niall Ferguson, the classical gold standard was in effect a British pound standard. It was not just the British navy that created that country’s empire; sound money also played an important role. From the time Sir Isaac Newton invented the classical gold standard circa 1704 until 1914, the British pound had essentially the same purchasing power. Having confidence in what a currency will buy over time is a characteristic that is fundamental to sound money, and sound money is the essential ingredient of any successful reserve currency.

Throughout World War I and immediately thereafter, the dollar was sound money. Consequently, it assumed from the British pound the mantle to become the world’s de facto reserve currency, which was a reality eventually recognized by the Bretton Woods Agreement in 1944. The dollar back then became the world’s reserve currency because it was “as good as gold”, which was the standard description of it at the time.

So the dollar started out on the right path in its reserve currency role, but it has come up far short indeed compared to the British pound’s 200-year run. In fact, the inflation of the 1950’s, particularly during the Korean War, meant that the dollar’s “as good as gold” comparison lasted for less than ten years after Bretton Woods.

The path toward the inflationary debasement of the dollar was sown by William Martin, who was appointed chairman of the Federal Reserve in 1951. He left behind a mess when he retired from that position nearly two decades later in 1970. It was a mess that John Connolly had to deal with because the dollar’s international position is a responsibility of the Treasury Secretary. The inflation engineered by Martin made the link of only thirty-five dollars to gold indefensible, which in turn made the dollar’s international position untenable. So Connolly set out to screw the world, and I do mean the whole world because his policies also ended up screwing Americans as well.

Rather than devaluing the dollar like FDR did and keeping at least some semblance of discipline on money creation through the remnants of the gold standard then prevailing, Nixon under Connolly’s stewardship broke the dollar’s link to gold altogether, creating the fiat dollar. We’ve been suffering the terrible consequences ever since.

We know about the subsequent inflation of the 1970’s. We also know that some appearance of order was only restored by the early 1980’s with the high interest rates ushered in by then Fed chairman Paul Volcker.

By the mid-1980s it was James Baker that set the dollar on another downward path. In a government agreement in 1985 known as the Plaza Accord, Baker aimed to devalue the dollar against other currencies. It did that, and it also devalued the dollar against gold, which climbed as the dollar slid. But Baker wasn’t content in just sending the dollar lower. It is generally accepted that his squabbling with West Germany throughout most of 1987 caused the stock market to crash in October of that year.

The third person in the line-up is the present Treasury Secretary. I expect Paulson to follow the lead of Connolly and Baker. He will engineer another devaluation of the dollar, but probably not until after the November 7^th election.

Paulson though has a more difficult task than his predecessors. The problems with the dollar today are much greater, as are the structural imbalances underlying today’s international monetary system. What’s worse, the whole financial superstructure is tottering precariously because of too much debt and too many derivatives, both of which are land-mines on the road to devaluation.

In summary, for decades the US has lived beyond its means. It has barreled down a road that doesn’t impose any discipline on the process of money creation. The country has turned to debt and financial gimmickry, rather than hard work, in an attempt to maintain its standard of living. But that road is coming to an end, and the way to prepare for that end is to avoid holding dollar-denominated assets. Hold gold instead.