Money and inflation
It is sometimes said that war's legitimate child is revolution and war's bastard child is inflation. World War I was no exception. The US national debt multiplied 27 times to finance the nation's participation in that war, from $1 billion to $27 billion. Far from ruining the United States, the war catapulted the country into the front ranks of the world's leading economic and financial powers. The national debt turned out to be a blessing, for government securities are indispensable as anchors for a vibrant credit market.

Inflation was a different story. By the end of World War I, in 1919, US prices were rising at the rate of 15% annually, but the economy roared ahead. In response, the Federal Reserve Board raised the discount rate in quick succession, from 4% to 7%, and kept it there for 18 months to try to rein in inflation. The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility - the discount window. The result was that in 1921, 506 banks failed. Deflation descended on the economy like a perfect storm, with commodity prices falling 50% from their 1920 peak, throwing farmers into mass bankruptcies. Business activity fell by one-third; manufacturing output fell by 42%; unemployment rose fivefold to 11.9%, adding 4 million to the jobless count. The economy came to a screeching halt. From the Fed's perspective, declining prices were the goal, not the problem; unemployment was necessary to restore US industry to a sound footing, freeing it from wage-pushed inflation. Potent medicine always came with a bitter taste, the central bankers explained.

At this point, a technical process inadvertently gave the New York Federal Reserve Bank, which was closely allied with internationalist banking interest, pre-eminent influence over the Federal Reserve Board in Washington, the composition of which represented a more balanced national interest. The initial operation of the Fed did not use the open-market operation of purchasing or selling government securities to set interest-rate policy as a method of managing the money supply. The Fed could not simply print money to buy government securities to inject money into the money supply because the dollar was based on gold and the amount of gold held by the government was relatively fixed. Money in the banking system was created entirely through the discount window at the regional Federal Reserve banks. Instead of buying or selling government bonds, the regional Feds accepted "real bills" of trade, which when paid off would extinguish money in the banking system, making the money supply self-regulating in accordance with the "real bills" doctrine to maintain the gold standard. The regional Feds bought government securities not to adjust money supply, but to enhance their separate operating profit by parking idle funds in interest-bearing yet super-safe government securities, the way institutional money managers do today.

Bank economists at that time did not understand that when the regional Feds independently bought government securities, the aggregate effect would result in macroeconomic implications of injecting "high power" money into the banking system, with which commercial banks could create more money in multiple by lending recycles based on the partial reserve principle. When the government sold bonds, the reverse would happen. When the Fed made open-market transactions, interest rates would rise or fall accordingly in financial markets. And when the regional Feds did not act in unison, the credit market could become confused or disaggregated, as one regional Fed might buy while another might sell government securities in its open-market operations.

Benjamin Strong, first president of the New York Federal Reserve Bank, saw the problem and persuaded the other 11 regional Feds to let the New York Fed handle all their transactions in a coordinated manner. The regional Feds formed an Open Market Investment Committee, to be run by the New York Fed for the purpose of maximizing overall profit for the whole system. This committee became dominated by the New York Fed, which was closely linked to big-money central-bank interests, which in turn were closely tied to international financial markets. The Federal Reserve Board approved the arrangement without full understanding of its implication: that the Fed was falling under the undue influence of the New York internationalist bankers. For the United States, this was the beginning of financial globalization. This fatal flaw would reveal itself in the Fed's role in causing and its impotence in dealing with the 1929 stock market crash.

The deep 1920-21 depression eventually recovered by the lowering of the Fed discount rate into the Roaring Twenties, which, like the New Economy bubble of the 1990s, left some segments of the US economy and the population in them lingering in a depressed state. Farmers remained victimized by depressed commodity prices and factory workers shared in the prosperity only by working longer hours and assuming debt with the easy money that the banks provided. Unions lost 30% of their membership because of high unemployment in boom times. The prosperity was entirely fueled by the wealth effect of a speculative boom in the stock market that by the end of the decade would face the 1929 crash and land the nation and the world in the Great Depression. Historical data showed that when New York Fed president Strong leaned on the regional Feds to ease the discount rate on an already overheated economy in 1927, the Fed lost its last window of opportunity to prevent the 1929 crash. Some historians claimed that Strong did so to fulfill his internationalist vision at the risk of endangering the national interest. It is an issue of debate that continues in the US Congress today. Like Greenspan, Strong argued that it was preferable to deal with post-crash crisis management by adding liquidity than to pop a bubble prematurely with preventive measures of tight money. It is a strategy that requires letting a bubble pop only inside a bigger bubble.

The speculative boom of easy credit in the 1920s attracted many to buy stocks with borrowed money and used the rising price of stocks as new collateral for borrowing more to buy more stocks. Brokers' loans went from under $5 million in mid-1928 to $850 million in September of 1929. The market capitalization of the 846 listed companies of the New York Stock Exchange was $89.7 billion, at 1.24 times 1929 GDP. By current standards, a case could be built that stocks in 1929 were in fact technically undervalued. The 2,750 companies listed in the New York Stock Exchange had total global market capitalization exceeding $18 trillion in 2004, 1.53 times 2004 GDP of $11.75 trillion.

On January 14, 2001, the Dow Jones Industrial Average reached its all-time high to date at 11,723, not withstanding Greenspan's warning of "irrational exuberance" on December 6, 1996, when the DJIA was at 6,381. From its August 12, 1982, low of 777, the DJIA began its most spectacular bull market in history. It was interrupted briefly only by the abrupt and frightening crash on October 19, 1987, when the DJIA lost 22.6% on Black Monday, falling to 1,739. That represented a 1,021-point drop from its previous peak of 2,760 reached less than two months earlier on August 21. But Greenspan's easy-money policy lifted the DJIA to 11,723 in 13 years, a 674% increase. In 1929 the top came on September 4, with the DJIA at 386. A headline in the New York Times on October 22, 1929, reported highly respected economist Irving Fisher as saying, "Prices of stocks are low." Two days later, the stock market crashed, and by the end of November, the New York Stock Exchange shares index was down 30%. The index did not return to the September 3, 1929, level until November 1954. At its worst level, the index dropped to 40.56 in July 1932, a drop of 89%. Fisher had based his statement on strong earnings reports, few industrial disputes, and evidence of high investment in research and development (R&D) and in other intangible capital. Theory and supportive data not withstanding, the reality was that the stock-market boom was based on borrowed money and false optimism. In hindsight, many economists have since concluded that stock prices were overvalued by 30% in 1929. But when the crash came, the overshoot dropped the index by 89% in less than three years.

Money and gold
When money is not backed by gold, its exchange value must be managed by government, more specifically by the monetary policies of the central bank. No responsible government will voluntarily let the market set the exchange value of its currency, market fundamentalism notwithstanding. Yet central bankers tend to be attracted to the gold standard because it can relieve them of the unpleasant and thankless responsibility of unpopular monetary policies to sustain the value of money. Central bankers have been caricatured as party spoilers who take away the punch bowl just when the party gets going.

Yet even a gold standard is based on a fixed value of money to gold, set by someone to reflect the underlying economic conditions at the time of its setting. Therein lies the inescapable need for human judgment. Instead of focusing on the appropriateness of the level of money valuation under changing economic conditions, central banks often become fixated on merely maintaining a previously set exchange rate between money and gold, doing serious damage in the process to any economy temporarily out of sync with that fixed rate. It seldom occurs to central bankers that the fixed rate was the problem, not the dynamic economy. When the exchange value of a currency falls, central bankers often feel a personal sense of failure, while they merely shrug their shoulders to refer to natural laws of finance when the economy collapses from an overvalued currency.

The return to the gold standard in war-torn Europe in the 1920s was engineered by a coalition of internationalist central bankers on both sides of the Atlantic as a prerequisite for postwar economic reconstruction. Lenders wanted to make sure that their loans would be repaid in money equally valuable as the money they lent out, pretty much the way the IMF deals with the debt problem today. President Strong of the New York Fed and his former partners at the House of Morgan were closely associated with the Bank of England, the Banque de France, the Reichsbank, and the central banks of Austria, the Netherlands, Italy and Belgium, as well as with leading internationalist private bankers in those countries. Montagu Norman, governor of the Bank of England from 1920-44, enjoyed a long and close personal friendship with Strong as well as an ideological alliance. Their joint commitment to restore the gold standard in Europe and so to bring about a return to the "international financial normalcy" of the prewar years was well documented. Norman recognized that the impairment of British financial hegemony meant that, to accomplish postwar economic reconstruction that would preserve prewar British interests, Europe would "need the active cooperation of our friends in the United States".

Like other New York bankers, Strong perceived World War I as an opportunity to expand US participation in international finance, allowing New York to move toward coveted international-finance-center status to rival London's historical pre-eminence, through the development of a commercial paper market, or bankers' acceptances in British finance parlance, breaking London's long monopoly. The Federal Reserve Act of 1913 permitted the Federal Reserve Banks to buy, or rediscount, such paper. This allowed US banks in New York to play an increasingly central role in international finance in competition with the London market.

Herbert Hoover, after losing his second-term US presidential election to Franklin D Roosevelt as a result of the 1929 crash, criticized Strong as "a mental annex to Europe", and blamed Strong's internationalist commitment to facilitating Europe's postwar economic recovery for the US stock-market crash of 1929 and the subsequent Great Depression that robbed Hoover of a second term. Europe's return to the gold standard, with Britain's insistence on what Hoover termed a "fictitious rate" of US$4.86 to the pound sterling, required Strong to expand US credit by keeping the discount rate unrealistically low and to manipulate the Fed's open market operations to keep US interest rate low to ease market pressures on the overvalued pound sterling. Hoover, with justification, ascribed Strong's internationalist policies to what he viewed as the malign persuasions of Norman and other European central bankers, especially Hjalmar Schacht of the Reichsbank and Charles Rist of the Bank of France. From the mid-1920s onward, the United States experienced credit-pushed inflation, which fueled the stock-market bubble that finally collapsed in 1929.

Within the Federal Reserve System, Strong's low-rate policies of the mid-1920s also provoked substantial regional opposition, particularly from Midwestern and agricultural elements, who generally endorsed Hoover's subsequent critical analysis. Throughout the 1920s, two of the Federal Reserve Board's directors, Adolph C Miller, a professional economist, and Charles S Hamlin, perennially disapproved of the degree to which they believed Strong subordinated domestic to international considerations.

The fairness of Hoover's allegation is subject to debate, but the fact that there was a divergence of priority between the White House and the Fed is beyond dispute, as is the fact that what is good for the international financial system may not always be good for a national economy. This is evidenced today by the collapse of one economy after another under the current international finance architecture that all central banks support instinctively out of a sense of institutional solidarity. The same issue has surfaced in today's China where regional financial centers such as Hong Kong and Shanghai are vying for the role of world financial center. To do this, they must play by the rules of the international financial system which imposes a cost on the national economy. The nationalist vs internationalist conflict, as exemplified by the Hoover vs Strong conflict of the 1930s, is also threatening the further integration of the European Union. Behind the fundamental rationale of protectionism is the rejection of the claim that internationalist finance places national development as its priority. The Richardian theory of comparative advantage of free trade is not the issue.

The issue of government control over foreign loans also brought the Fed, dominated by Strong, into direct conflict with Hoover when the latter was secretary of commerce. Hoover believed that the US government should have right of approval on foreign loans based on national-interest considerations and that the proceeds of US loans should be spent on US goods and services. Strong opposed all such restrictions as undesirable government intervention in free trade and international finance and counterproductively protectionist. Businesses should be not only allowed but encouraged to buy when it is cheapest anywhere in the world, including shopping for funds to borrow, a refrain that is heard tirelessly from free traders also today. Of course, the expanding application of the law of one price to more and more commodities, including the price of money, ie interest rates adjusted by exchange rates, makes such dispute academic. The only commodity exempt from the law of one price is labor. This exemption makes the trade theory of comparative advantage a fantasy.

In July and August 1927, Strong, despite ominous data on mounting market speculation and inflation, pushed the Fed to lower the discount rate from 4% to 3% to relieve market pressures again on the overvalued British pound. In July 1927, the central bankers of Britain, the United States, France and Weimar Germany met on Long Island in the US to discuss means of increasing Britain's gold reserves and stabilizing the European currency situation. Strong's reduction of the discount rate and purchase of 12 million pounds sterling, for which he paid the Bank of England in gold, appeared to come directly from that meeting. One of the French bankers in attendance, Charles Rist, reported that Strong said that US authorities would reduce the discount rate as "un petit coup de whisky for the stock exchange". Strong pushed this reduction through the Fed despite strong opposition from Miller and fellow board member James McDougal of the Chicago Fed, who represented Midwestern bankers, who generally did not share New York's internationalist preoccupation.

Frank Altschul, partner in the New York branch of the transnational investment bank Lazard Freres, told Emile Moreau, the governor of the Bank of France, that "the reasons given by Mr Strong as justification for the reduction in the discount rate are being taken seriously by no one, and that everyone in the United States is convinced that Mr Strong wanted to aid Mr Norman by supporting the pound". Other correspondence in Strong's own files suggests that he was giving priority to international monetary conditions rather than to US export needs, contrary to his public arguments. Writing to Norman, who praised his handling of the affair as "masterly", Strong described the US discount rate reduction as "our year's contribution to reconstruction." The Fed's ease in 1927 forced money to flow not into the overheated real economy, which was unable to absorb further investment, but into the speculative financial market, which led to the crash of 1929. Strong died in October 1928, one year before the crash, and was spared the pain of having to see the devastating results of his internationalist policies.

Scholarly debate still continues as to whether Strong's effort to facilitate European economic reconstruction compromised the US domestic economy and, in particular, led him to subordinate US monetary policies to internationalist demands. In 1930, the US economy had yet to dominate the world economy as it does now. There is, however, little disagreement that the overall monetary strategy of European central banks had been misguided in its reliance on the restoration of the gold standard. Critics suggest that the ambitious but misguided commitment of Strong, Norman and other internationalist bankers to returning the pound, the mark and other major European currencies to the gold standard at overly high parities to gold, which they were then forced to maintain at all costs, including indifference to deflation, had the effect of undercutting Europe's postwar economic recovery. Not only did Strong and his fellow central bankers through their monetary policies contribute to the Great Depression, but their continuing fixation on gold also acted as a straitjacket that in effect precluded expansionist counter-cyclical measures.

The inflexibility of the gold standard and the central bankers' determination to defend their national currencies' convertibility into gold at almost any cost drastically limited the policy options available to them when responding to the global financial crisis. This picture fits the situation of the fixed-exchange-rates regime based on the fiat dollar that produced recurring financial crises in the 1990s and that has yet to run its full course by 2005. In 1927, Strong's unconditional support of the gold standard, with the objective of bringing about the rising financial predominance of the US, which had the largest holdings of gold in the world, exacerbated nascent international financial problems.

In similar ways, dollar hegemony does the same damage to the global economy today. Just as the international gold standard itself was one of the major factors underlying and exacerbating the Great Depression that followed the 1929 crash, since the conditions that had sustained it before the war no longer existed, the breakdown of the fixed-exchange-rates system based on a gold-backed dollar set up by the Bretton Woods regime after World War II, without the removal of the fiat dollar as a key reserve currency for trade and finance, will cause a total collapse of the current international financial architecture with equally tragic outcomes. Stripped of its gold backing, the fiat dollar has to rely on geopolitical factors for its value, which push US foreign policy toward increasing militaristic and belligerent unilateralism. With dollar hegemony today, as it was with the gold standard of 1930, the trade war is fought through currency valuations on top of traditional tariffs.

The nature of and constraints on US internationalism after World War I had parallels in US internationalism after World War II and in US-led globalization after the Cold War. Hoover bitterly charged Strong with reckless placement of the interests of the international financial system ahead of US national interest and domestic development needs. Strong sincerely believed that his support for European currency stabilization also promoted the best interests of the United States, as post-Cold War neo-liberals sincerely believe their promotion of market fundamentalism enhances the US national interest. Unfortunately, sincerity is not a vaccine against falsehood.

Strong argued relentlessly that exchange-rate volatility, especially when the dollar was at a premium against other currencies, made it difficult for US exporters to price their goods competitively. As he had done during World War I, on numerous later occasions Strong also stressed the need to prevent an influx of gold into the US and the consequent domestic inflation, by the US making loans to Europe, pursuing lenient debt policies, and accepting European imports on generous terms. Strong never questioned the gold parities set for the German mark and the pound sterling. He merely accepted that returning the pound to gold at prewar exchange rates required British deflation and US efforts to use lower dollar interest rates to alleviate market pressures on sterling. Like Fed chairman Paul Volcker in the 1980s, but unlike treasury secretary Robert Rubin in the 1990s, Strong mistook a cheap dollar as serving the national interest, while Rubin understood correctly that a strong dollar was in the national interest by sustaining dollar hegemony. In either case, the price for either an overvalued or undervalued dollar is the same: global depression. Dollar hegemony in the 1990s pushed Japan and Germany into prolonged depression.

The US position in 2005 is that a strong dollar is still in the US national interest, but a strong dollar requires an even stronger Chinese yuan in the 21st century. Just as Strong saw the need for a strong British pound paid for by deflation in Britain in exchange for the carrot of continuing British/European imports to the United States, Bush and Greenspan now want a stronger yuan, paid for with deflation in China in exchange for curbing US protectionism against Chinese imports. The 1985 Plaza Accord to force the appreciation of the Japanese yen marked the downward spiral of the Japanese economy via currency-induced deflation. Another virtual Plaza Accord forced the rise of the euro that left Europe with a stagnant economy. A new virtual Plaza Accord against China will also condemn the Chinese economy into a protracted period of deflation. Deflation in China at this time will cause the collapse of the Chinese banking system, which is weighed down by the BIS regulatory regime that turned national banking subsidies to state-owned enterprises into massive non-performing loans. A collapse of the Chinese banking system would have dire consequences for the global financial system since the robust Chinese economy is the only engine of growth in the world economy at this time.

When Norman sent Strong a copy of John Maynard Keynes' Tract on Monetary Reform (1923), Strong commented "that some of his [Keynes'] conclusions are thoroughly unwarranted and show a great lack of knowledge of American affairs and of the Federal Reserve System". Within a decade, Keynes, with his advocacy of demand management via deficit financing, became the most influential economist in post-World War I history.

The major flaw in the European effort for postwar economic reconstruction was its attempt to reconstruct the past through its attachment to the gold standard, with little vision of a new future. The democratic governments of the moneyed class that inherited power from the fall of monarchies did not fully comprehend the implication of the disappearance of the monarch as a ruler, whose financial architecture they tried to continue for the benefit of their bourgeois class. The broadening of the political franchise in most European countries after the war had made it far more difficult for governments and central bankers to resist electoral pressures for increased social spending and the demand for ample liquidity with low interest rates, as well as high tolerance for moderate inflation to combat unemployment, regardless of the impact of national policies on the international financial architecture. The Fed, despite its claim of independence from politics, has never been free of US presidential-election politics since its founding. Shortly before his untimely death, Strong took comfort in his belief that the reconstruction of Europe was virtually completed and his internationalist policies had been successful in preserving world peace. Within a decade of his death, the whole world was aflame with World War II.

But in 1929, the dollar was still gold-backed. The government fixed the dollar at 23.22 grains of gold, at $20.67 per troy ounce. When stock prices rose faster than real economic growth, the dollar in effect depreciated. It took more dollars to buy the same shares as prices rose. But the price of gold remained fixed at $20.67 per ounce. Thus gold was cheap and the dollar was overvalued and the trading public rushed to buy gold, injecting cash into the economy, which fueled more stock buying on margin. The price of gold-mining shares rose by 600%. But with a gold standard, the Fed could not print money beyond its holding of gold without revaluing the dollar against gold. The Quantity Theory of Money caught up with the financial bubble as prices for equity rose but the quantity of money remained constant, and it came into play with a vengeance. Because of the gold standard, there was reached a time when there was no more money available to buy without someone first selling. When the selling began, the debt bubble burst, and panic took over. When the stock market collapsed, panic selling quickly wiped out most investors who bought shares instead of gold. As the gold price was fixed, it could not fall with the general deflation, and owners of gold did exceptionally well by comparison to share owners.

What Strong did not figure was that when the Fed lowered the discount rate to relieve market pressure on the overvalued British pound sterling after its gold convertibility had been restored in 1925, the world economy could not expand because money tied to gold was inelastic, leaving the US economy with a financial bubble that was not supported by any rise in earnings. The British-controlled gold standard proved to be a straitjacket for world economic growth, not unlike the deflationary Maastricht "convergence criteria" based on the strong German mark of the late 1990s. The speculation of the Coolidge-Hoover era was encouraged by Norman and Strong to fight gold-induced deflation.

The accommodative monetary policy of the US Federal Reserve led to a bubble economy in the US, similar to Greenspan's bubble economy since 1987. There were two differences: the dollar was gold-backed in 1930, while in 1987 it was a fiat currency; and in 1930, the world monetary system was based on sterling hegemony while today it is based on dollar hegemony. When the Wall Street bubble was approaching unsustainable proportions in the autumn of 1929, giving the false impression that the US economy was booming, Norman sharply cut the British bank rate to try to stimulate the British economy in unison. When short-term rates fell, it created serious problems for British transnational banks, which were stuck with funds borrowed long-term at high interest rates that now could only be lent out short-term at low rates. They had to repatriate British hot money from New York to cover this ruinous interest-rate gap, leaving New York speculators up the creek without an interest-rate paddle. This was the first case of hot-money contagion, albeit what hit the Asian banks in 1997 was the opposite: they borrowed short-term at low interest rates to lend out long-term at high rates. And when interest rates rose because of falling exchange rates of local currencies, borrowers defaulted and the credit system collapsed.

The contagion in the 1997 Asian financial crisis devastated all Asian economies. The financial collapse in Thailand and Indonesia in July 1997 caused the strong markets of high liquidity such as Hong Kong and Singapore to collapse when investors sold in these liquid markets to raise funds to rescue their positions in illiquid markets that were wrongly diagnosed by the IMF as mere passing storms that could be weathered with a temporary shift of liquidity. Following badly flawed IMF advice, investors threw good money after bad and brought down the whole regional economy while failing to contain the problem within Thailand.

The financial crises that began in Thailand in July 1997 caused sell-downs in other robust and liquid markets in the region such as Hong Kong and Singapore that impacted even Wall Street that October. But prices fell in Thailand not because domestic potential buyers had no money. The fact was that equity prices in Thailand were holding in local-currency terms but falling fast in foreign-exchange terms when the peg of the baht to the dollar began to break. Then as the baht devalued in a free fall, stocks of Thai companies with local-currency revenue, including healthy export firms that contracted local-currency payments, logically collapsed while those with hard-currency revenue actually appreciated in local-currency terms. The margin calls were met as a result of investors trying not to sell, rather than trying to liquidate at a loss. The incentive for holding on with additional margin payments was based on IMF pronouncements that the crisis was only temporary and imminent help was on the way and that the problem would stabilize within months. But the promised help never came. What came was an IMF program of imposed "conditionalities" that pushed the troubled Asian economies off the cliff, designed only to save the foreign creditors. The "temporary" financial crisis was pushed into a multi-year economic crisis.

Geopolitics played a large role. US treasury secretary Robert Rubin decided very early that the Thai crisis was a minor Asian problem and told the IMF to solve it with an Asian solution but not to let Japan take the lead. Hong Kong contributed US$1 billion and China contributed US$1 billion on blind faith on Rubin's assurance that the problem would be contained within Thai borders (after all, Thailand was a faithful US ally in the Cold War). Then South Korea was hit in December 1997. Rubin again thought it was another temporary Asian problem. The Korean Central Bank was bleeding dollar reserves trying to support an overvalued won pegged to the dollar, and by late December had only several days left before its dollar reserves would run dry. Rubin held on to his moral-hazard posture until his aides in the Department of Treasury told him one Sunday morning that the Brazilians were holding a lot of Korean bonds. If South Korea were to default, Brazil would collapse and land the US banks in big trouble. Only then did Rubin get Citibank to work out a restructuring the following Tuesday in Korea by getting the Fed to allow the US banks to roll over the short-term Korean debts into non-interest-paying long-term debts without having to register them as non-performing, thus exempting the US banks from the adverse impacts of the required capital injection that would drag down their profits.

The Great Depression that started in 1929 was made more severe and protracted by the British default on gold payment in September 1931 and subsequent British competitive devaluations as a national strategy for a new international trade war. British policy involved a deliberate use of pound-sterling hegemony, the only world monetary regime at that time, as a national monetary weapon in an international trade war, causing an irreversible collapse of world trade. In response to British monetary moves, alternative currency blocs emerged in rising economies such as the German Third Reich and Imperial Japan. It did not take these governments long to realize that they had to go to war to obtain the oil and other natural resources needed to sustain their growing economies that collapsed world trade could no longer deliver in peace.

For Britain and the United States, a quick war was exactly what was needed to bring their own economies out of depression. No one anticipated that World War II would be so destructive. The German invasion of Poland on September 1, 1939, caused Britain and France to declare war on Germany on September 3, but the British and French stayed behind the Maginot Line all winter, content with a blockade of Germany by sea. The inactive period of the "phony war" lasted seven months until April 9, 1940, when Germany invaded Denmark and Norway. On May 10, German forces overran Luxembourg and invaded the Netherlands and Belgium. On March 13, they outflanked the Maginot Line and German panzer divisions raced toward the British Channel, cut off Flanders and trapped the entire British Expeditionary Force of 220,000 and 120,000 French troops at Dunkirk. The trapped Allied forces had to be evacuated by civilian small craft from May 26 to June 4. On June 22, France capitulated. If Britain had failed to evacuate its troops from Dunkirk, it would have had to sue for peace, as many had expected, and the war would have been over with German control of Europe. Unable to use Britain as a base, US forces would never have been able to land in Europe. Without a two-front war, Germany might have been able to prevail over the USSR. Germany might have then emerged as the hegemon.

Franklin D Roosevelt was inaugurated as president of the United States on March 4, 1933. In his first fireside-chat radio address, Roosevelt told a panicky public that "the confidence of the people themselves" was "more important than gold". On March 9, the Senate quickly passed the Emergency Banking Act giving the secretary of the Treasury the power to compel every person and business in the country to relinquish their gold and accept paper currency in exchange. The next day, Friday, March 10, Roosevelt issued Executive Order No 6073, forbidding the public from sending gold overseas and forbidding banks from paying out gold for dollar. On April 5, Roosevelt issued Executive Order No 6102 to confiscate the public's gold, by commanding all to deliver their gold and gold certificates to a Federal Reserve Bank, where they would be paid in paper money. Citizens could keep up to $100 in gold, but anything above that was illegal. Gold had become a controlled substance by law in the United States. Possession was punishable by a fine of up to $10,000 and imprisonment for up to 10 years. On January 31, 1934, Roosevelt issued another Executive Order to devalue the dollar by 59.06% of its former gold quantum of 23.22 grains, pushing the dollar down to be worth only 13.71 grains of gold, at $35 per ounce, which lasted until 1971.

1929 revisited and more
Shortsighted government monetary policies were the main factors that led to the market collapse, but the subsequent Great Depression was caused by the collapse of world trade.

US policymakers in the 1920s believed that business was the purpose of society, just as policymakers today believe that free trade is the purpose of civilization. Thus the government took no action against unconstructive speculation, believing that the market knew best and would be self-correcting. People who took risks should bear the consequences of their own actions. The flaw in this view was that the consequences of speculation were largely borne not by professional speculators but by the unsophisticated public, who were unqualified to understand how they were being manipulated to buy high and sell low. The economy had been based on speculation, but the risks were unevenly carried mostly by the innocent.

National wealth from speculation was not spread evenly. Instead, most money was in the hands of a rich few who quickly passed on the risk and kept the profit. They saved or invested rather than spent their money on goods and services. Thus supply soon became greater than demand. Some people profited, but the majority did not. Prices went up faster than income and the public could afford things only by going into debt while their disposable income went into mindless speculation in hope of magically bailing borrowers out from such debts. Farmers and factory/office workers did not profit at all. Unevenness of prosperity made recovery difficult because income was concentrated on those who did not have to spend it. The situation today is very similar. After the 1929 crash, Congress tried to solve the high unemployment problem by passing high tariffs that protected US industries but hurt US farmers. International trade came to a standstill both because of protectionism and the freezing up of trade finance.

This time, world trade may also collapse, and high tariffs will again be the effect rather than the cause. The pending collapse of world trade will again come as a result of protracted US exploitation of the advantages of dollar hegemony, as the British did in 1930 regarding sterling hegemony. The US dollar is undeservedly the main trade currency without either the backing of gold or US fiscal and monetary discipline. Most of the things people want to buy are no longer made in the United States, so the dollar has become an unnatural trade currency. The system will collapse because despite huge US trade deficits, there is no global recycling of money outside of the dollar economy. All money circulates only within the dollar money supply, overheating the US economy, financing its domestic joyrides and globalization tentacles, not to mention military adventurism, milking the rest of the global economy dry and depriving the non-dollar economies of needed purchasing power independent of the US trade deficit. World trade will collapse this time not because of trade-restricting tariffs, which are merely temporary distractions, but because of a global maldistribution of purchasing power created by dollar hegemony.

Central banking was adopted in the United States in 1913 to provide elasticity to the money supply to accommodate the ebb and flow of the business cycle. Yet the mortal enemy of elasticity is structural fatigue, which is what makes the rubber band snap. Today, dollar hegemony cuts off monetary re-circulation to all non-dollar economies, forcing all exporting nations with mounting trade surpluses into the position of Samuel Taylor Coleridge's Ancient Mariner: "Water, water, everywhere, nor any drop to drink."

Next: Trade in the age of overcapacity

Henry C K Liu is chairman of the New York-based Liu Investment Group.