Triffin Wasn’t Wrong, Just Early

Dear Reader,

Economist Robert Triffin believed the dollar could not survive as the world’s reserve currency without requiring the U.S. to run up ever-growing deficits. Was he right or wrong? Is Triffin’s Dilemma obsolete?

The answer to these questions may be the most important element in understanding the role of the dollar. Before we explore these questions, an introduction to the Triffin Dilemma is in order.

Robert Triffin was a Belgian-American economist most active in the 1950s and 1960s. This was the heyday of the original Bretton Woods system. Bretton Woods was agreed on in 1944, but it was not until the early 1950s that the needed institutions and staff (especially the International Monetary Fund) were in place to operate it as intended.

Bretton Woods as a regime of fixed exchange rates was over in 1971 when Richard Nixon ended the convertibility of U.S. dollars held by foreign trading partners into gold. The early 1960s were the mid-point between the formation and end of Bretton Woods. It was a kind of golden age for the international monetary system.

This golden age was ruled by King Dollar.

In the 1960s, Russia (then the Soviet Union) was practically excluded from the international monetary system. China barely had a functioning economy as it staggered from the humanitarian disaster of The Great Leap Forward (1958– 1962) into the social chaos of The Cultural Revolution (1966–1976).

For practical purposes, the international monetary system was comprised of the U.S., Canada, Australia, Western Europe and Japan. The so-called Third World was along for the ride. Of those members, only the U.S. had a strong enough currency and a sufficiently developed bond market to finance world trade and development. The dollar itself was pegged to gold. Other currencies were pegged to the dollar.

Triffin made two observations concerning this state of affairs, both of which were highly prescient. The first observation was that if there was only one reserve currency, the issuer of that currency had to supply it to the world. Otherwise the world would not have the money needed to invest, expand and finance trade.

The only ways to supply dollars to the world at the time were direct aid (such as the Marshall Plan), loans and trade deficits. Triffin’s second observation was more blunt. Any country that ran continual trade deficits would eventually go broke.

Triffin said this in 1959 at a time when the dollars held abroad already exceeded the value of gold held by the U.S. Treasury. Triffin was vindicated in 1971 when President Nixon broke the link between dollars and gold, an acknowledgment that the excess dollars abroad could not possibly be exchanged for gold.

Still, the dollars abroad could be exchanged for U.S. goods and services and invested in U.S. assets such as real estate, stocks and bonds. This was rapidly seized upon by Wall Street. In fact, the Dow Jones Industrial Average rallied the day after Nixon’s speech.

A new age of asset bubbles had begun.

Triffin’s Dilemma had not gone away; it had simply taken new shape. U.S. dollars were still piling up abroad. But they were recycled into financial assets instead of gold hoards. This dynamic was solidified by Henry Kissinger’s petrodollar deal with Saudi Arabia in 1974. The Saudis agreed to accept U.S. dollars for oil and to deposit those dollars in U.S. banks.

What was left unsaid was that the U.S. was considering invading Saudi Arabia if they did not agree. My first meeting in the White House in early 1974 was with Kissinger’s deputy, Helmut Sonnenfeldt, precisely to discuss invasion plans.

The petrodollar deal worked.

The Saudis put dollars in U.S. banks, and the banks lent the money to developing nations in Latin America and Africa which bought U.S. goods in return. The dollar pump was back in action except now it was powered with oil not gold. Still, Triffin’s question remained. When would the U.S. go broke?

It has been over sixty years since Triffin posed the problem. If he was right, why has the U.S. not gone broke?
In some ways, the U.S. did go broke in 1971. By breaking the link with gold, we also broke the dollar. Between 1971 and 1980, the dollar value of gold rose 2,200% from $35.00 per ounce to $800.00 per ounce.

If one thinks of gold as a constant measured by weight, this is equivalent to saying that the dollar was devalued by 96%. Between 1977 and 1981, U.S. inflation was 50% which means the dollar was devalued by 50% using 1977 as a baseline.

Either way, this U.S. dollar devaluation was a form of going broke and reneging on contracts. If you didn’t own gold or other hard assets in the 1970s, you suffered the losses Triffin predicted.

Still, the dollar system persists. The U.S. still runs budget deficits (and trade deficits) and the U.S. dollar still represents over 60% of global reserves. How does the dollar system prevail given U.S. fiscal profligacy?

As early as 1969, the IMF could see Triffin’s Dilemma playing out. Their solution was the invention of the special drawing right (SDR). This was a kind of world money printed by the IMF. It could be used to bolster reserve positions of IMF members.

The SDR was originally pegged to gold. In fact, the SDR was informally referred to as paper gold. The SDR gold peg was abandoned shortly after the dollar gold peg was abandoned.

The SDR is still around. In fact, the IMF had a large issuance a few months ago after a small issuance was made in 2009 as a response to the 2008 global financial crisis. (It had little impact and was perhaps no more than an effort to test the plumbing after a 30-year hiatus. The plumbing worked).

Yet, no liquid SDR bond market ever developed. SDR trading is by appointment at a secret trading facility inside the IMF headquarters in Washington, D.C. There’s no doubt that the IMF would like to expand SDR usage in the future, but as of now there is no depth in the market and no consensus among IMF members on how to proceed.

So, how does the dollar still prevail? The answer is that the dollar system itself has adapted in ways that Triffin did not foresee and central bankers still do not understand.

The answer is Eurodollars.

Most monetarists and Wall Street analysts still believe that dollars are created through Federal Reserve money printing. But Fed money printing is limited to one narrow definition of money called base money or M0.

This money is impotent. The Fed creates it by buying bonds from banks and paying with money from thin air. The banks then return the money to the Fed as deposits called excess reserves on which they receive interest. The money is never lent or spent; it doesn’t do anything.

More potent forms of money are created by banks themselves when they make loans. At closing, the loan proceeds are deposited in your checking account to be used as you see fit. That money also comes from thin air, but it’s controlled by banks.

This more high-powered form of money is called M1, M2 or M3 (each successive measure including more attenuated forms). Even this money does not power the economy today because the turnover of money (velocity) is crashing. Banks don’t want to lend and businesses don’t want to spend. So, this broadly defined money has little stimulative effect.

The key source of money creation (and the solution to Triffin’s Dilemma) consists of Eurodollars created by international banks outside the direct purview of any national regulator. No one knows exactly how many Eurodollars are in circulation. Still, Eurodollars are the lifeblood of the international monetary system.

Triffin assumed that dollars had to come from loans, grants or trade deficits originating in the U.S. to power world commerce. That was true in 1959, but it hasn’t been true since the early 1970s, about when Bretton Woods crashed and burned.

Even as gold was abandoned and the U.S. dollar was grossly devalued, Eurodollars stepped in to pick up the slack. The world would not run out of dollars, not because of Fed printing or U.S. fiscal prolificacy, but because of unlimited Eurodollar creation by essentially unregulated big banks.

Where are we now?

The Eurodollar system still reigns. But that system depends on leverage, and leverage depends on good collateral. The best collateral is a U.S. Treasury bill. Those are in short supply due to Fed buying and restrained Treasury issuance (partly due to the debt ceiling debate now ongoing in Washington).

Eurodollar banks are desperate to get Treasury bills and need dollars to buy them. That creates strong dollar demand, which explains today’s reign of King Dollar in foreign exchange markets.

This system is unsustainable. Either banks will get their collateral, in which case investors should expect raging inflation. Or banks won’t get their collateral, in which case a monetary contraction and possible financial crisis is in the cards.

Triffin was not wrong. He was just far ahead of his time. The incompatibility of a dollar reserve currency and unlimited dollar creation is coming to a head. The result will be a crash for the ages.

Regards,

Jim Rickards

Jim Rickards is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. He was the principal negotiator of the rescue of Long-Term Capital.
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