We’ve said before that the US is in the same position as Thailand and Indonesia circa 1996, except we have the reserve currency and nukes. Some prominent commentators are making more polite observations along these lines.
An article, “A rising euro threatens US dominance” in the Financial Times, by Benn Steil, director of international economics at the Council on Foreign Relations, covers old and new ground in a discussion of the implications of a further decline in the dollar.
His well reasoned analysis contains some pointed observations, for instance, that the dollar’s standing heretofore permitted it to have loose monetary policy without paying the usual consequences of capital flight and inflation, but no longer. Like a developing economy (ahem, banana republic), the more the Fed eases, the higher long term rates go.
Steil enumerates the implications of what happens when the US falls into banana republic category, and they aren’t pretty. The “lender of the last resort” function breaks down in developing economies because investors withdraw funds from domestic accounts. Similarly, he raises the possibility that the US will have to issue foreign-currency-denominated debt. That is even more likely an outcome; the US briefly was forced to issue Deutchemark denominated bonds under Carter. Large scale non-dollar issuance would considerably constrain our formerly free-wheeling ways. He also notes a less widely noted cost: if the euro becomes more important, the US threat of sanctions as a tool of policy is neutered.
Note that these troubling scenarios are presented in an anodyne tone, and the author reminds us the US does not need to go down this path. But all indicators say that it will.
From the Financial Times:
As the dollar continues its relentless six-year slide against the euro and other main currencies, the question is being asked more and more: what would it mean if the dollar ceded its global dominance to the euro?
The question is a serious one because the US Federal Reserve is pumping new dollars into the global economy at an astounding pace. A broad measure of US money supply growth is increasing at a rate not seen since 1971 when President Richard Nixon imposed price controls and ended the dollar’s convertibility into gold, which recently roared above $1,000 an ounce. With consumer prices having climbed 4 per cent from a year ago, and wholesale prices having soared 6.9 per cent, presaging higher consumer price inflation around the corner, we are living witnesses to Milton Friedman’s famous dictum that “inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output”.
The Fed is acting with the best of intentions to head off a recession. But in a rapidly globalising financial marketplace it is in fact accelerating the demise of its own unique powers. Virtually all national economies show a positive link between currency depreciation and inflation and between depreciation and interest rates, meaning that their central banks cannot use loose monetary policy to stimulate their economies – it only fuels capital outflows and a rise in market interest rates to attract it back. Not so the US, whose currency has commanded a unique premium as the global store of value and the transaction vehicle for international trade. But this may be changing. The dollar is looking more and more like a typical developing country’s currency, with long-term market interest rates, crucial to determining borrowing and investment behaviour, climbing as the Fed pushes hard in the other direction.
If international use of the euro were to continue to rise, the Fed would lose other important powers. In a financial crisis, central banks are supposed to act as “lenders of last resort”, printing money to prop up banks and reassure their depositors. This does not work in developing countries. People withdraw money anyway, not because they fear the governments will let the banks collapse but because they fear the inflation and depreciation that printing money brings. So they exchange it for dollars, undermining the putative powers of their central banks. But what if Americans were to do the same, selling dollars for euros in a crisis? The Fed would become impotent. This is not science fiction. American investors have lately been pouring money into foreign bond funds at a record rate.
What about currency crises, the bane of developing countries? These happen when investors, local as well as foreign, fear that the country may face a shortage of foreign money, necessary to pay off its debts. If America were to become obliged to trade and borrow in euros, rather than dollars, it would face the very same risks.
What about America’s political power in the world? A continuing fall in the dollar means a fall in the global purchasing power of all its foreign assistance, whether for humanitarian, economic or military purposes.
But it means much more than that. The US has exploited the unique role of the dollar in international trade and investment to disrupt the financial flows of its adversaries, such as North Korea and Iran. If such transactions switched to euros and were funnelled through institutions not doing business in the US, this power would be neutered. The US would likewise lose influence over both friends and enemies facing financial problems, as they would be looking increasingly to Europe for euros, rather than to America for dollars.
None of this is inevitable. America is blessed to be the master of the dollar’s fate, in the sense that the world has no incentive to move to another monetary standard as long as the dollar’s long-term value appears secure. But it means that the US government needs to address the country’s economic problems deriving from the housing market collapse and the credit crunch “on-balance-sheet”, through direct, targeted, explicitly funded interventions, rather than “off-balance-sheet”, with the Fed undermining global confidence in the dollar by continuing to flood the market with new dollars. This can only lead to greater damage to America’s prosperity and global influence.