Ever since the Bretton Woods agreement after the second world war, the US dollar has been the international reserve currency. The world agreed to it because in that era America constituted nearly 50% of the world economy, owned the bulk of world gold reserves and was the sole military superpower with nuclear weapons. There was a morbid fear that the stimulus of the war which was turned off, would throw the country and the world back into the pre-war depression and thus America embarked on the Marshall plan and persisted in massive military spending for fear that the capitalist economy would self-destruct. The spreading influence of Soviet Communism and its acquisition of nuclear weapons was an added reason. America confused rising nationalism in former colonies, as a monolithic communist threat after the Chinese communist victory and went on a spree of foolish misadventures in Korea, Congo, Indonesia and Vietnam.
The rising dissatisfaction at home and the civil rights movements led to simultaneous profligate spending for the Great Society and distant wars. The guns and butter policy led to deficit spending, economic weakening and a sinking dollar under Gaullist attack and Nixon's abandonment of the gold standard and floating currencies. This ended the era of rising living standards in America and much of the world except for the prot'g' Shikhandi economies of Japan, Western Europe and the Asian tigers.
The US Federal Reserve has two important functions.
To contain inflation to prevent it from eroding the wealth of the privileged minority for whose preservation the Republic was founded. It also keeps the purchasing power of the have-not majority from diminishing to the point of creating general labor unrest.
To keep the economy growing, again to prevent general discontent and mayhem. Due to the nature of a feedback control mechanism to overshoot and because the first priority trumps the second, we get periodic recessions and the business cycle, a natural result of a capitalist economy. Thus as a witty former head of the Reserve said,"The Fed's job is to take away the punch bowl as soon as the party gets really going". The collateral damage of this modus operandi is spelt out in William Greider's classic tome "The Secrets of The Temple" which analyzes the Volcker era. It also led to Milton Friedman's classic prescription of the Federal Reserve increasing the money supply by a fixed percentage every year instead of constant tinkering. The irresponsible fiscal policies of the executive and legislative branches and the lack of independent integrity by prior Chairmen like Arthur Burns makes this impossible.
The long reign of the current Chairman Greenspan is litany of fraudulent waffling documented in Ravi Batra's book Greenspan's Fraud and led to the Senate Democratic Leader Harry Reid's calling him a political hack. He has connived at irresponsible tax cuts by Republican administrations, omitted taking any concrete steps to stem what he called irrational exuberance and opened the money spigots to save friendly entities like Long Term Capital Management and money center banks, and blow a housing bubble to extricate himself and the economy from the catastrophe of his previous creation, a stock market bubble.
The total abandonment of fiscal responsibility by this Republican administration compounding the Reagan era supply side insanity, the rising national debt, the disasters of hurricanes Katrina and Rita and the foolish Iraq war expense and debacle have brought us to the brink of the precipice. The ballistic rise of energy prices are the last push or straw. Unlike Japan nearly two and a half trillion of the US national debt of four and a half trillion dollar is held by Japan, China, Taiwan, South Korea and other countries. That requires nearly 150 billion dollars of annual interest payments to be made to foreigners. The trade and current account deficits require borrowing 800 billion dollars more every year. Unfunded US government liabilities including Social Security and Medicare are nearly 50 trillion dollars.
So far the deflationary effects of cheap Chinese imports had kept inflation and interest rates low. It has also destroyed the bargaining power of American labor and thus reduced wage demands. The savings obsessed rest of the world and the shock of the Asian crisis of the late nineties have led to policies making less developed countries creditors with large dollar reserves. The insecurity of the Japanese and EU citizens have made them poor spenders. Their economies have become export dependent. Germany replaced America as the world's number one exporter of manufactured goods. Their high unemployment is the cause of near zero and 2% interest rates in Japan and the EU respectively. These countries are reluctant to raise interest rates for fear of depressing their economies and increasing unemployment. The victory of Merkel in Germany is a direct result of the failure of Schroeder's policies.
The precariously erected house of cards while tottering, was still managing to stay erect. The gradual raising of interest rates by the US Fed allowed the economy to continue growing at over 3% without inflation. The foreigners willing to finance the US deficit and the low interest rates kept the national interest rate burden manageable. The necessary huge fiscal spending to counter the hurricane damage and more importantly the sinking Bush presidency required more deficit spending. The damage to US oil and gas production and the stratospheric energy prices will crimp consumer spending and has stoked inflationary fires. Thus the Fed has taken a publicly hawkish stand roiling the stock markets. The Fed has to push interest rates up to curb inflation and make lending us and investing in dollars more attractive. While the dollar value is nominally the responsibility and prerogative of the US Treasury, the Fed is a front-line defender as well. The problem for the Fed is that the higher interest rates increase current and future interest payments and may push the economy into a recession, particularly if they burst the housing bubble that gives the consumer a false sense of wealth.
The investment banks, brokerage and other financial institutions make their money mainly by trading and underwriting, making much of the economy a casino without any output of goods that can be exported to citizens of the world. These institutions are parties to derivative trading (swaps, currencies, interest rates and commodities) whose value exceeds their capitalization and net worth by hundreds of times. Thus a single major default fear like with Refco can lead to a meltdown of the capital markets. The sinking of the Indian stock market due to the offshore trading of Mauritius based entities after the BJP loss in the national elections is a harbinger of what can happen. This is the reason for forcibly opening up banking, insurance etc. in China, India and other countries under the aegis of the WTO to increase these institutions' trading profits. The lack of due diligence by underwriters, NYSE and even the SEC in the recent IPO of Refco stock and the subsequent collapse and halt in trading are clear examples of negligence or fraud. Prior debacles of Enron, Tyco, Worldcom, Adelphia and the numerous huge fines paid by financial institutions without admitting guilt after investigations by the New York Attorney General Eliot Spitzer reveal the crookery, manipulation and fraud prevalent in the US markets. The malfeasance of several hedge and mutual funds compounds the perils for the average investor.
The rising inflation, energy prices and interest rates will burst the housing bubble and consumer discretionary spending. This will eventually send the economy and or the dollar into a tailspin. This is why the gold prices are rising in spite of a recently rising dollar. America needs to borrow a trillion dollars a year from the rest of the world. Such a situation can have only one of two outcomes. Either the lenders will stop lending or demand pounds of flesh and the disaster is not a matter of if, but when.