Hans F. Sennholz, “On the Horns of a Dilemma” — Summary

This short September 2002 monetary-policy essay analyzes the Federal Reserve’s predicament after repeated rate cuts and rapid credit expansion failed to dispel recessionary pressures. Sennholz’s thesis is that the Fed faces a genuine dilemma of its own making: further monetary ease may undermine the dollar and estrange foreign creditors, while recession, debt liquidation, and heightened cash demand may make monetary stimulus ineffective.

The Federal Reserve System may have run out of room to maneuver.

The essay moves from immediate policy diagnosis to a broader critique of managed credit. Sennholz argues that years of intervention have left the credit system distorted, overleveraged, and resistant to further manipulation. The “horns” are therefore not simply technical policy choices but consequences of prior inflationary policy.

The Fed’s dilemma springs from an abused and maladjusted credit market which, after many years of Fed intervention and manipulation, is turning unmanageable.

A central conceptual move is his distinction between the Fed’s unique global privilege and the limits that still bind it. Because the dollar functions internationally, the Fed can expand credit far more than smaller central banks without immediately provoking visible collapse. Yet this privilege also depends on foreign confidence and continued demand for dollar assets.

The Federal Reserve System is subject to the same inexorable principles of economics but, in contrast to all other central banks, the demand for its currency is world-wide. It is the world central bank managing the world dollar standard.

Sennholz then examines current-account deficits and rejects the reassuring view that they simply prove America’s attractiveness to foreign capital. His concern is qualitative: foreign funds increasingly finance government debt and consumption rather than productive enterprise. If foreign investors tire of holding Treasury securities and other dollar claims, the dollar will weaken, imports will fall, exports will rise, and domestic prices will climb.

The essay’s treatment of deflation is especially important. Sennholz does not deny monetary inflation; he argues that recession can temporarily mask it. Distress sales, liquidation, and a rising demand for cash can push goods prices downward even as the central bank expands the money stock.

In popular jargon, a recession may usher in "deflation," no matter how frantically the Fed may inflate its stock of money.

Japan serves as his cautionary example: near-zero rates and heavy deficit spending have not restored prosperity, but have deepened public indebtedness and prolonged stagnation. From this, Sennholz draws a broader lesson about credit quality. Once firms are insolvent or their debts trade at distressed yields, another cut in short-term rates cannot restore solvency.

In short, the Fed may become rather impotent when the economy sinks into recession.

The final section widens the analysis to the looming Iraq crisis. War, oil shocks, weakened alliances, and withdrawals by foreign holders of dollar assets could intensify pressure on the currency. Yet war spending accommodated by the Fed might also revive inflationary symptoms and temporarily interrupt the recessionary correction.

New distortions and maladjustments would be heaped on the old. In short, the needed correction would be postponed until, a few years from now, it would begin anew with a shrunken dollar.

The essay’s relevance lies in its early formulation of problems that later became central to debates over zero interest rates, reserve-currency privilege, balance-sheet recessions, and the limits of central-bank activism. Sennholz presents the Fed not as a stabilizer standing above the market, but as an institution whose interventions create the very maladjustments it later tries to cure.