On June 25th, the Fed made no changes in its key interest rates and issued a statement that underscored how narrow their room for maneuver had become. Caught between the opposing forces of economic contraction and inflation, the Fed revealed that it was locked in neutral. Given that the Fed must use opposite remedies to satisfy the demands of its dual mandate (higher rates to curb inflation and lower rates to stimulate growth), the Fed is stuck firmly in neutral. There appears to be nothing left to do except to talk and hope for the best.
This inaction did not inspire confidence. The market sell-off in the days since the meeting has accelerated the swoon that has seen American stocks down by some 20 percent in the first six months of 2008. It is now official: the 'bear' market has begun.
Although leading policy makers do not dare to utter the name, the conditions currently confronting the Fed are known as "stagflation". However, America is not the only major economy facing this grizzly beast. The European Union is also coming to grips with the problem. The difference in the manner that the America and Europe deal with the issue could make a huge impact on the world economy for years to come.
Unlike the American Fed, the European Central Bank (ECB) has only a single mandate; to curb inflation. Further, the ECB is based in Germany and is infused with a distinctly Germanic ethos. Although the bank president is in fact a Frenchman, Monsieur Jean-Claude Trichet, his policy moves firmly root him in the Teutonic financial tradition.
It is widely known that, since its terrible experiences with hyper-inflation after World War I, the Germans have developed an ingrained intolerance of inflation. As a result, the ECB has shown a backbone that is completely lacking among the invertebrates at the Federal Reserve. The resulting confidence has led many holders of U.S. dollars, including central banks, to diversify major parts of their vast holdings of U.S. dollar trade surpluses into the Euro.
In just eight short years, this vast transfer of money has made the relatively young Euro the second most important currency in the world. There are now more Euros in physical circulation than there are U.S. dollars. Also, the Euro has risen in price by some 64 percent since its launch in 2000, to $1.64. This is all the more extraordinary, when one considers that Europe does not have either a single economy or even a single government. As yet, it is still only an association of governments!
Of course, much of the credit for the astounding rise of the Euro must go to the massive debasement of the U.S. dollar, a debasement that has robbed every single man, woman and child who holds or invests in dollars.
The debasement of the U.S. dollar started way back in the 1970s, with the choice of inflation, over taxation and debt, as the means of financing the unpopular Vietnam War. It was enhanced by President Nixon's breaking of the U.S. dollar/gold 'exchange window' in 1971. Since then, the American economy has tragically become transformed from that of a 'producer' base to one of a 'consumer' base.
Some may wonder why the holders of vast U.S. dollar reserves, such as central banks around the world, could tolerate this continued dilution of their dollar wealth. The answer, of course, was that there was no alternative. The American economy dominated the world and its dollar was 'King' largely because it was the undisputed 'reserve' currency. As a result, almost all internationally traded commodities were priced in U.S. dollars.
In addition, many nations, including OPEC countries and China, have decided to peg their currencies to the dollar. Finally, all international oil producers demanded payment in U.S. dollars. This meant that a Swiss buyer of oil had first to purchase U.S. dollars in order to buy oil.
The result was that the 'reserve' status provided a massive underpinning for the U.S. dollar and has long delayed its decline.
Today however, things have changed, dramatically. Many oil producers now demand Euros in payment for oil. Important nations have abandoned the dollar as a peg for their currencies. Worst of all, the debasement of the U.S. dollar is fast eroding faith in paper money. There is now rising, but so far hidden, pressure for a more reliable international 'reserve' currency.
The most obvious choice would be the Euro, especially after the expected European unification treaty of Lisbon is finally ratified in 2009. If it is, one can expect increasing pressure to have the Euro adopted as a replacement or as an alternative international reserve currency.
If the U.S. dollar loses or even has to share its 'reserve' status, it will become increasingly vulnerable to a panic run. The July 3rd meeting of the ECB is likely to prove crucial. If the Germanic view wins out and the ECB raises its rates, it risks both a run on the dollar and the possible loss of the dollar's 'reserve' status.
If such a move were adopted, it would involve a further international risk; the pushing of a looming recession into a depression, just as it did in 1930, when the same anti-inflation sentiment prevailed.
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