Deflationists seem to believe, in accordance with Irving Fisher’s debt-deflation theory, that debt in a credit crisis will be liquidated, creating demand for currency. This simplistic approach ignores the fact that during an inflation, which perforce leads to far higher nominal interest rates, debt liquidation is an ever-present factor as well. Fisher’s description of how businesses and banks fail in an economic downturn is selective and has been used to justify monetary intervention to prevent borrowers and banks from paying for their mistakes. It changes the private sector from the survival of the fittest to survival of the influential, robbing savers for the benefit of the profligate. There is no economic justification for this one-sided view of debt-deflation, but we have to live with it. We can be sure that in the event of a general credit crisis the Fed will issue enough currency to stabilise the domestic economy. That is official policy and the reason the Fed was created and exists. The difficulties for foreign dollar-denominated obligations are a separate and secondary consideration. However, we can assume that the major central banks will extend inflationary swap agreements between themselves to allow them to support their individual financial systems, wherever foreign currency exposure is a risk factor.
But that still leaves us with imbalances that are likely to disrupt exchange rates.
There is a general assumption that the liquidation of cross-border positions will lead to net demand for the dollar, driving it up against other currencies. According to this logic, the superiority of the dollar as the reserve currency will ensure that sales of foreign currency arising from a credit crisis will result in the purchase of dollars.
After all, these dollar bulls tell us, this is corroborated by the Triffin dilemma. According to Professor Triffin, dollars required for international trade liquidity are supplied by US trade deficits. And if the US goes into recession, the economic contraction will restrict the supply of dollars, forcing the exchange rate higher. We need to unpick this flaky argument to challenge its validity.
Professor Triffin forecast the end of the Bretton Woods system in his book, Gold and the Dollar Crisis: The Future of Convertibility, published in 1960. In it, he argued that the flood of dollars that went abroad following the Second World War (Marshall plan, Korea, etc.) would lead to the dollar being driven off the gold standard. This actually happened in a series of events, starting with difficulties in the London gold market in the late 1960s, exacerbated by further overseas spending on the Vietnam War, and culminated with the suspension of the Bretton Woods agreement by President Nixon in 1971.
Triffin argued in his book that the dollar could only stay on the gold standard by running trade surpluses to reverse the tide and absorb loose dollars, which would otherwise be exchanged for gold. This, to an interventionist, was impractical, and exposed the dilemma: an international reserve currency required the issuer to run domestic deficits to provide the liquidity needed for it to act as a reserve currency. Yet, such a policy contained within it the seeds of its own destruction.
The relationship between trade deficits and reserve currency liquidity led Triffin to advocate a paper gold alternative to the dollar as the reserve currency, which could be expanded or contracted to offset deflationary or inflationary tendencies. This was essentially Keynes’s position in recommending the creation of the bancor, rather than using the dollar as the reserve currency in the Bretton Woods system.
The relevance today is found in the fact, as Triffin pointed out, that destructive domestic economic and monetary policies to support international liquidity would eventually undermine the reserve currency itself. This is conveniently forgotten by those who claim Triffin’s dilemma ensures demand for the dollar will continue, and that the US can always run trade deficits without undermining the dollar....